FINANCIAL DERIVATIVES

What is Risk?
Three important players: Hedger, speculator, Arbitrageur.
Functions performed by derivative markets. (a) Price Discovery (b) Risk transfer
(C) Market completion
What are derivatives ?

Forward contract
Futures
Hedging using futures Contract
Valuation of Futures
Option : Call option & Put option, Different terminologies
Examples of Call option
Examples of Put option
Hedging with option
Factors affecting option price
Valuation of option
Black and scholes model
SWAP
 What are derivatives?
A derivative instrument, broadly, is a financial contract whose pay off structure is
determined by the value of an underlying commodity, security, interests rate, share
price index, exchange rate, oil price etc.
A derivative instrument derives its value from some underlying variables.
Financial Derivatives

Forward Future Option Swap

1. Forward Contract
A forward contract is a simple derivative that involves an
agreement to buy/sell an asset on a certain date at an
agreed price. This is a contract between two parties:
Buyers and sellers

Money
Buyer Seller
Seller
Buyer
Security
Who takes a Who takes a
long position short position
 Problems of Forwards

Counter - party risk:

A party to the contract may not fulfil the obligation.
Thus each party faces the risk of default.

Low degree of liquidity:

Both the parties have to wait till maturity. No one can
come out from the contract.
 Future Contracts
A future contract is a standardized forward contract between
two parties where one of the parties commits to sell and the
other to buy a stipulated quantity of a security or an index at an
agreed price on or before a given date in the future.
Seller Buyer
A Clearing
Clearing House
House B
(Buyer) (Seller)
 Futures v/s Forwards
• Exchange traded & transparent v/s Private
contracts
• Standardised v/s Customised
• Settlement through Clearing House v/s Settlement
between Buyers and Sellers
• Require margin payment v/s no margins
• Mark - to - Market margins v/s no margins
• Counter - party risk is absent in Futures
(settlement of trades is guaranteed)
• Most settled by offset and very few by delivery v/s
most settled by actual delivery.
 Futures

Individual Index futures

stock future

Underlying asset is the Underlying asset is the stock

individual stock index

BSE Sensex Future S & P Nifty

BSE SENSEX? 30 shares Future
S & P Nifty? 50 shares One lot = 50 indices
one lot= 200
indices
 4700
Future Price=
Future 4600 Spot price
Price
4590

4568
4570
4535

Spot
4500
price

Op. CL. CL.2 CL.3 CL.4 CL.27 Jan.

1
-1650 + 2750 - 1000 + 1500
Future Price of January Index Future (maturing on 27th Jan. last Thursday)
 Margin Money
Margin Money @ 5%= Rs. 4568x50x 5/100= Rs.228400 x 5/100=Rs.11420

Marking to Market
1st day when price decreases from Rs. 4568 to Rs.4535 loss per index = Rs. 33
(4568 - 4535) Total loss= Rs. 50 X 33= 1650
2nd day Gain (4590 - 4535) X 50 = 55 X 50 = 2750
3rd day Loss (4590 - 4570) X 50 = 20 X 50 = 1000
4th day Gain (4600 - 4570) X 50 = 30 X 50 = 1500

Margin (at the beginning)= Rs. 11420 Total gain upto 4th day
1st day Less: Loss - 1650 (4600 - 4568) x 50 = 32 x 50 = 1600
2nd day Add: Gain + 2750 i.e. 13020 - 11420 = 1600
3rd day Loss : Loss - 1000
4th day Add : Gain + 1500= 13020
 How to protect your portfolio
from market crash
• What can go wrong in times of volatility
- panic selling
• What can be done
- Hedge long position on the portfolio, with short
position on Nifty futures
- Beta of the portfolio = weighted average of betas
of individual stocks
 How ?
25th January 2007
• Raju has a portfolio of 5 securities worth Rs. 1,87,085
- The beta of the portfolio is 0.95
• Hence he needs to sell index futures worth 0.95*187085
= Rs. 1,77,731 i.e. 1 market lot
• The expiry date of Nifty Jan. futures is 27th March 2007
• Sell Nifty futures at 1141
• 10 March 2007 Nifty July futures trading at 970.60
• Portfolio value reduces to Rs. 1,54,095
• Raju unwound the position making a profit of Rs. 1090.
i.e. portfolio dropped by Rs. 32990 and his sell position
on Nifty gained by Rs.34080
 ADJUSTING THE BETA OF A PORTFOLIO
USING STOCK INDEX FTURES

A manager has a portfolio consisting of three

secuirities of Rs20 lakh, with a beta value of
1.17. We may now see as to how to use stock
index futures to, say,
(a) Decrease the portfolio beta to 0.9, and
(b) Increase the portfolio beta to 1.5
• (a) To decrease the portfolio beta from 1.17 to 0.9, the portfolio
manager may sell off a portion of equities and use the proceeds to buy
riskfree securities.
• If we designate the existing portfolio as asset 1 and the riskfree
security as asset 2, we have,
• βp =w1β1 + w2β2= w1β1 + (1-w1) β2
• (since the new portfolio consists of only two assets)
• We have βp = 0.9, β1 = 1.17, and β2 = 0(this being a risk free asset).
• Substituting the known values, we get
• 0.9 = w1 x1.17 + (1- w1)0
• Or, w1 = 0.76923
• This implies that a portfolio consisting of
Rs 15.3846 lakh, (0.76923 x Rs20 lakh),
invested in three securities and Rs 4.6154
lakh (Rs20 lakh –Rs15.3846 lakh) in
riskfree securities would have a beta of 0.9.
• Alternatively, the manager can sell stock
index futures contracts.
• Rupee value of the spot position to be
hedged = Rs4.6154 lakh
• The amount of future contract to be sold
• = 1.17 x Rs4.6154 lakh =Rs 5.4 lakh
• If they apprehend that price may reduce, it
is better to have low portfolio beta.
• Their portfolio value = Rs20 lakh
• They want to reduce their portfolio beta
from 1.17 to 0.9. Thus if price reduces by
10%, their portfolio value will reduce by
9%, i.e., by Rs 20,00,000x(9/100)
=Rs1,80,000
• They have sold future for Rs5.4 lakh
• If future price reduce by 10% because of general decline of
market of 10%, they will earn from future selling = Rs
5,40,000x.1 = Rs 54,000.
• Now, since they are holding the same portfolio having β=1.17,
portfolio value will reduce by 11.7% for a 10% decline of
market price.
• Thus portfolio reduces by Rs20 lakh x(.117)=Rs2,34,000.
• Less: Earning from future selling = 54,000
• Total loss = Rs1,80,000 (the same loss)
• (b) To increase the portfolio beta from 1.17 to 1.50, we
proceed as follows:
• We have, βp = w1β1 + (1-w1) β2
• Or 1.5 = w1x1.17 + (1-w1) 0
• Or w1 =1.28205
• This implies shorting the risk free TB with a market value
of Rs 20x0.28205 lakh = Rs 5.641 lakh, so that the total
investment in the portfolio of three securities be Rs 25.641
lakh and Rs 5.641 lakh is borrowed.
• The aim of increasing the beta to 1.5 can be
achieved alternatively by buying stock
index futures contract equivalent to Rs 1.17
x Rs5.641 lakh= Rs 6.6 lakh.
• Anticipating bullish condition of the market
the manager wanted to increase the
portfolio β from 1.17 to 1.5 so that if market
price increase by 10%, portfolio value will
increase by 15%, i.e., by Rs20, lakh x (.15)
= Rs 3 lakh.
• Now since he has bought future contract
amounting to Rs 6.6 lakh,
• Profit from future buying
• =Rs6.6 lakh x (.1) = Rs 66,000
• Profit from portfolio
• =Rs 20 lakh x (.117)=Rs 2.34,000
• Total Profit = Rs 3,00,000.
 Valuation of Futures Prices
Price = Spot Price + Carry Costs - Carry Return
Case 1 : Securities Providing No Income
F = Soe rt.
Where F = Future price

S = Spot Price

r = the risk free rate of interest p.a. with continuous compounding

Example:
t = the time to murturity

Considere =aexponential
forwardvalue
contract on a non-dividend paying share which is available
= 2.7183
at Rs. 70, to mature in 3 - months’ time
r = .08 (Compounded continuously).

F = So e rt = Rs. 70 e(.08) (.25)

= Rs. 70 e .02 = Rs. 70 (1.0202)= Rs. 71.41
 Case 2 : Securities Providing a known cash Income
F = (S - I) e rt.
I = PV of Income D received after t time.
I = De-rt
Example :
Let us consider a 6- month future contract on 100 shares with a
price of Rs. 38 each. The risk free rate of interest (continuously
compounded) is 10% p.a. The share in question is expected to
yield a dividend of Rs. 1.50 in 4 months from now. What is F ?
Div. Receivable after 4 months = 100 X 1.50 = 150
P.V. of the div; I = 150 e-(0.1)(4/12) = 150 x 0.9672 = Rs. 145.08
F = (3800 - 145.08) e (0.1) (0.5) = 3654.92 X 1.05127 = Rs. 3842.31
Case 3 : Securities Providing a Known Yield
F = S e (r - y) t
y = Yield rate (continuously compounded)
Example :
Assume that the stocks underlying an index provide a dividend
yield of 4% p.a., the current value of the index is Rs. 520 and that
the continuously compounded risk free rate of interest is 10% p.a.
Here S = 520, r = 0.10, y = 0.04, t= 3/12 = 0.25
Thus :
F = 520 e (0.1 - 0.04) (0.25)
= 520 e (0.06) (0.25)
= 520 x 1.0151 = Rs. 527.85
 OPTION
An option is a contract which gives the right, but not the obligation,
to buy or sell the underlying at a stated date and at a stated price.
Underlying assets

Individual Stock Indices

(Introduced on 2.7.2001
S & P CNX Nifty (introduced
on 4.6.2001 in NSE)
 Option

Call option Put option

Option Type Buyer of option Seller of option

(option holder) (option writer)
(a) Call Right to buy obligation to sell
(b) Put Right to sell obligation to buy
Exercise Price : the price at which the contract is settled (strike price)

Expiration date : the date on which the option expires.

Style of option

American option European option

Exercised at any time Exercised on the

prior to expiration expiration date

Option Premium : The price that the holder of an option pays

and the writer of an option received for the
rights conveyed by the option.
 Option on individual stock
Call Option :
X = option writer (Seller)
Y = option buyer (holder)
Size of the contract = 100 R.I. Shares
Spot price on 25.02.2006 = Rs. 40 per share
Exercise price = Rs. 42 per share
Date of maturity = 24.04.2006
Option price = Re 1 per share for call option
Profit/ Loss Profile for seller & buyer
Possible spot price at call maturity X (Rs.) Y (Rs.)
40 100 (100 X 1) - 100
41 100 (100 X 1) - 100
42 100 (100 X 1) - 100
BEP 43 0 0
44 - 100 (100 X 1) 100
45 - 200 (100 X 2) 200
46 - 300 (100 X 3) 300
 Profit

300
200
100
0 Share Price
40 41 42 43 44 45 46
-100
-200
-300 (a) For Call option writer X
 Profit

300
200
100
0 Share Price
40 41 42 43 44 45 46
100
200
(b) For Call option buyer
300
 Example of Put option :
X = Option writer => obligation to buy
Y = Option buyer => right to sell
Exercise price = Rs. 100 per ACC share; size of the contract =
100 ACC shares, spot price today = Rs. 105 per share ;option
premium = Rs. 10 per share
Profit/ Loss Profile for X and Y
Possible sport price (Rs.) X Y
60 -3000 (100 X 30) 3000
70 -2000 (100 X 20) 2000
80 -1000 (100 X 10) 1000
BEP --> 90 0 0
100 1000 -1000
110 1000 -1000
120 1000 -1000
 Profit

3000
2000
1000
Share Price
60 70 80 90 100 110
-1000 120
-2000
-3000 (a) Option writer (X)
 Profit

3000
2000
1000
Share Price
60 70 80 90 100 110
-1000 120
-2000
-3000 (b) Option buyer (Y)
 Have a view on the market ?
A. Assumption : Bullish on the market over the short term:
Action : Buy Nifty Calls
Example : Current Nifty is Rs. 1400
Buy one Nifty. The strike price 1430
Option premium = Rs. 20
Total premium = Rs. (20 X 200) = Rs. 4000
If at expiration Nifty advances by 5% i.e. 1470
Option Value : = Rs. 40 (1470 - 1430)
Less : option Premium = 20

Profit per Nifty: 20

Profit on the contract = 20 X 200 = 4000

B. Assumption : Bearish on the market over the short term.

Possible Action : Buy Nifty Put

Example : Nifty in cash market is Rs. 1400. Buy one contract of

Nifty puts for Rs. 23 each. The strike price is 1370 if
at expiration Nifty declines by 5% i.e. Rs. 1330.

Option Value = 40 (1370 - 1330)

Option Premium = 23
Profit per Nifty = 17
Profit on the contract = Rs. 3400 (17 X 200)
 Use Put as a portfolio hedge ?
To protect your portfolio from possible market crash.
Possible Action : Buy Nifty Puts
You held a portfolio valued at Rs. 10 lakhs
Portfolio Beta = 1.13
Current Nifty = 1440
Strike price = 1420
Premium = Rs. 26
To hedge, you bought 4 puts
[800 Nifty, equivalent to Rs. (10 X 1.13) lakhs or 11,30,000]
If at expiration Nifty declines to 1329 and your portfolio falls to Rs. 948276, then

Option Value = 91 (1420 - 1329)

Option premium = 26
Profit per Nifty = 65
Profit on the contract = Rs. 52000 (65 X 800)
Loss on Portfolios = Rs. 51724
Net Profit = Rs. 276
 SPREADS
A spread trading strategy involves taking a position in two or more
options of the same type.
Bull Spreads
A bull spread reflects the bullish sentiment of a trader. It can be
created by taking the following position:
Expiry Exer. Price Option Premium
1. Buy a Call option Same E1 E1 <E2 P1 P1 >P2
2. Sell a Call option Same E2 P2
Since, Premium Paid (P1)> Premium Received (P2)
Cash outflow for option premium = P1 - P2
If P1 = Rs. 8, P2 = Rs. 2.
Cash outflow = Rs. (8 - 2) = Rs. 6 i.e. initial cost of the spread
Let E1 = 30, E2 = 50.
 Possible spot
Price on Expiry If S1= 20 If S1=40 If S1= 60
(1) (2) (3)
Rs. 10 Rs. 10 Rs. 10 Rs. 10
20 20 (S1) 20 20
30 30 (E1) 30 (E1) 30 (E1)
40 40 40 (S1) 40
50 50 (E2) 50 (E2) 50 (E2)
60 60 60 60 (S1)
70 70 70 70
Pay offs from a Bull spread (Using Call)
Price of Share Pay off from Pay off from Total
Long Call Short Call Pay off
(1) S1<E1 0 0 0
(2) E1<S1<E2 S1 - E1 0 S1 - E1
(40-30=10) (40-30=10)
(3) S1>E2 S1 - E1 E2 - S1 E2 - E1
(60-30) (50-60) (50-30=20)
 Bear Spread

In Contrast to the bull spreads, bear spreads are used as a strategy

when one is bearish of the market, believing that it is more likely to
go down than up. It can be created by taking the following
position: Expiry Exer. Price O. Premium
1. Buy a Call Same E1 P1
E1>E2 P1<P2
2. Sell a Call Same E2 P2
Since premium paid (P1) < premium received (P2), a bear spread
involves an initial cash inflow of Rs. (P2 - P1)
If P1 = 2, P2 = 8
Initial cash inflow = Rs. (8 - 2) = Rs. 6
Let E1 = 50. E2 = 30
 Possible spot
Price on Expiry If S1= 20 If S1=40 If S1= 60
(1) (2) (3)
Rs. 10 Rs. 10 Rs. 10 Rs. 10
20 20 (S1) 20 20
30 (E2) 30 (E2) 30 (E2) 30 (E2)
40 40 40 (S1) 40
50 (E1) 50 (E1) 50 (E1) 50 (E1)
60 60 60 60 (S1)
70 70 70 70
E2<E1 S1<E2<E1 E2<S1<E1 E2<E1<S1
Pay offs from a Bear spread (Using Call)
Price of Share Pay off from Pay off from Total
Long Call Short Call Pay off
(1) S1<E2 0 0 0
(2) E2<S1<E1 0 E2 - S1 E2 - S1
(30-40= - 10) (-10)
(3) E1>S1 S1 - E1 E2 - S1 E2 - E1
(60-50) (30-60) (30-50= -20)
Butterfly Spreads.
The strategy is obviously meant for an investor who feels that
large price changes are unlikely
1. Buy a Call E1
E1<E2<E3
2. Buy another call E3
E2 = E1 + E3
3. Sell 2 Calls E2
2
E2 is usually close to current share price
1. Buy 1st call (right to buy for E1)
2. Buy 2nd call (right to buy for E3)
3. Sell 2 calls (obligation to sell 2 shares at E2)
Possible spot (1) (2) (3) (4)
Price on Expiry If S1= 20 If S1=35 If S1= 45 If S1=60
Rs. 10 Rs. 10 Rs. 10 Rs. 10 Rs. 10
20 20 (S1) 20 20 20
30 (E1) 30 (E1) 30 (E1) 30 (E1) 30(E1)
35 35 35(S1) 35 35
40 (E2) 40 (E2) 40 (E2) 40 (E2) 40(E2)
45 45 45 45(S1) 45
50 (E3) 50 (E3) 50 (E3) 50 (E3) 50(E3)
60 60 60 60 60(S1)
70 70 70 70 70
E1<E2<E3 S1<E1<E2<E3 E1<S1<E2 < E3 E1<E2<S1<E4 E1<E2<E3<S1

No call is excised All calls are

exercised
 Pay offs from a Butterfly spread
Price Stock Pay off from Pay off from Pay off from Total
Ist long call (E1) 2nd long call(E3) short calls(E3) Pay off

(1) S1<E1 0 0 0 0

(2) E1<S1<E2 S 1 - E1 0 0 S1 - E1
(35 – 30 = 5)
(3) E2<S1>E3 S 1 - E1 0 2( E2 - S1) E3 - S 1
(50-45=5)

(4) E3<S1 S1 - E 1 S1 – E 3 2(E2 - S1) 0

Since, 2 (E2 - S1) + S1- E1 = 2E2-2S1 + S1 - E1 = E1 + E3 - S1-E1 = E3- S1

 Factors Affecting Call option
Premium
(i)Level of existing spot price relative to
strike price (exchange price) S>E, the
higher will be the option premium.
(ii) Length of time before the expiration date.
(iii) Potential variability of stock Price
The greater the Variability, the higher the
P (S>E).
 Call Option. (right to buy)
* Level of Existing Spot Price (s) relative to Exercise Price (E).

The higher the spot rate (S) relative to exercise price (E), the higher the option price.
If S>E, higher option price, higher probability of exercise of option.
If S = 40, E = 42 33
34
35
36
37
38
39
40 If S = 40, E = 37 i.e. S>E
If E = 42 option is 41 lower E compared to S, higher is the
exercised when S is 42 probability to exercise the option
greater than or equal 43 => higher option price.
to 43
44
45
46
 Put Option (right to Sell)
The lower the spot rate (s) relative to exercise price (E), the higher the option
price. Relating S>E, the higher probability to exercise the option
33
If S= 40 34 S> E

E2 = 45 35 If E1 = 39, S = 40
36
S<E Option will be exercised when price
37 is les than or equal to 39
S is relatively low, the 38
higher the probability
39
to exercise the option.
40
High option premium 41
42
43
44
45
46
47
 The Black and Scholes Model (1973)
C = S0 N (d1) - E e -rt. N (d2)
Where d1 = log (S0 / E) + (r + 0.5σ 2) t
σ ( t ) 1/2
d2 = log (S0 / E) + (r - 0.5 σ 2) t
σ ( t ) 1/2
C = Current value of the option
r = Continuously compounded riskless rate of returns
S0 = Current price of stock
E = Exercise Price
t = time remaining before the expiration date (expressed as a fraction of a year)
σ = S.D. of continuously compounded annual rate of return
Log= Natural logarithm
N(d) = value of the commulative normal distribution evaluated at d
Example : Consider the following information with regard to call
option on the stock of X Ltd.,
S0 = Rs. 120
E = Rs. 115
Time period = 3 months; thus t = 0.25 year
σ = 0.6
r = 0.10
d1 = log (120/115) + (0.10 + 0.5 X 0.6 2).25
= 0.37 0.6 V 0.25
d2 = log (120/115) + (0.10 - 0.5 X 0.6 2 ) X .25
=0.07
0.6 V 0.25
.1443
N (d1) = 0.6443
N (d2) = 0.5279 d1 =0.37

.0279

d2 = 0.07
The value of the Call is
C = S0 N (d1) - E e -rt. N (d2)
= 120 X (0.6443) - 115 e -0.10 (.25) X (0.5279) = 18.11

Using the put- call parity, we can determine the put option
value on the share as follows:
P = C + E e -rt. -S0
= 18.11 + 115 X e - 0.10 (0.25) - 120
= Rs. 10.27
 Relationship between European Call and put options:

Portfolio P1:One European call option & cash for an amount of E e -rt..
Portfolio P2:One European put option & one share of stock worth S0
Determination of TERMINAL Values of Portfolios
Portfolio Cash Flow at t = 0 S1> E S1≤ E
P1 C S1 - E 0
E e -rt. E E
Total S1 E
P2 P 0 E - S1
S0 S1 S1
Total S1 E
Since both the portfolios have identical values on expiration, they must have equal
values at present as well. Accordingly we have
C + E e - rt.. = P + S0
or P = C + E e - rt.. - S0
 SWAP
A SWAP transaction is one where two or more parties exchange
(SWAP) one set of predetermined payments for another.

Interest Rate SWAP.

Company Fixed (%) Floating (%)

A 7.5 M IBOR + 0.5%
B 9 M IBOR + 3.5%
A borrows Rs. 10,000 from a bank at Floating rate
B borrows Rs. 10,000 from a bank at Fixed rate
As a separate transaction A and B agree as follows:
(i) A will pay B a fixed rate of 7%
(ii) B will pay A a floating rate of MIBOR + 0.5%
 SWAP
A
(7%) (MIBOR + 0.5%)

B
To understand the benefits from the swap consider the net cash flows of A and B
Party Swap Swap Swap outflows on Total
Outflow (%) Inflow(%) loan from bank (%)
A -7 (MIBOR + 0.5%) -(MIBOR + 0.5%) -7
B - (MIBOR + 0.5%) + 7% - 9% - (MIBOR+2.5)
It may be seen that the net result is
(a) For A, a fixed rate obligation at 7% (this is better than the 7.5% which A
would have paid if it had directly taken a fixed rate loan).
(A gains 0.5%)
(b) For B, a floating rate obligation at MIBOR + 2.5% (this is better then
MIBOR + 3.5%)
(B gains 1%)
 Presence of a Broker C
As a separate transaction A,B, and C agree as follows:
(i) A will pay C a fixed rate of 7%
(ii) A will receive from C a floating rate of MIBOR + 0.5%.
(iii) B will pay C a floating rate of MIBOR + 0.5%
(iv) B will receive from C a fixed rate of 6.5%
SWAP
MIBOR + 0.5 MIBOR + 0.5%

A C B

7% 6.5%

C gains (7% - 6.5%) = 0.5%

 To understand the benefits from the Swap consider the net cash
flows of A, B, and C
Party Swap Swap Outflows Total
Outflow (%) inflows (%) on loan
A - 7.0 + (M + 0.5) - (M + o.5) - 7.0
B - (M+0.5) + 6.5 -9 - (M + 3)
M + 0.5 M + 0.5
C - + 6.5 + +7 Nil + 0.5
It may be seen that the net result is
(a) for A, fixed rate obligation at 7% (this is better than the 7.5%
[A gains 0.5% (7.5 - 7)]
(b) for B, a floating rate obligation at (MIBOR+ 3%) which is better
than (MIBOR + 3.5%). [B gains 0.5%]
(c) for C, a profit of 0.5% for earning the transaction.