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Session 1 - FD

This document provides an overview of financial derivatives, including what they are, how they are used, and how they are traded. It defines derivatives as instruments whose value is based on an underlying asset such as stocks, currencies, or commodities. Examples given include futures, forwards, swaps, and options. The document discusses how derivatives allow for risks to be transferred and managed, and how they can be traded on exchanges or over-the-counter. Specific types of derivatives like forwards, futures, and options are also defined and explained.

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Daksh Khullar
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107 views24 pages

Session 1 - FD

This document provides an overview of financial derivatives, including what they are, how they are used, and how they are traded. It defines derivatives as instruments whose value is based on an underlying asset such as stocks, currencies, or commodities. Examples given include futures, forwards, swaps, and options. The document discusses how derivatives allow for risks to be transferred and managed, and how they can be traded on exchanges or over-the-counter. Specific types of derivatives like forwards, futures, and options are also defined and explained.

Uploaded by

Daksh Khullar
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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Financial

Derivatives:
Introduction
What Is a Derivative?
• A derivative is an instrument whose value depends on or is derived
from, the value of another asset
• Examples: futures, forwards, swaps, and options etc.
Why Derivatives Are Important
• Derivatives play a key role in transferring risks in the economy.
• The underlying assets include stocks, currencies, interest rates,
commodities, debt instruments etc.
• Many financial transactions have embedded derivatives.
• Businesses can benefit from the knowledge of derivatives
How Derivatives Are Traded
• On exchanges such as the Chicago Board Options Exchange (CBOE),BSE,
NSE, NCDEX, MCX etc.
• In the over-the-counter (OTC) market where traders working for banks,
fund managers, and corporate treasurers contact each other directly
through Central Counter Party (CCP).
How Derivatives Are Used
• To hedge risks
• To speculate (take a view on the future direction of the market)
• To lock in an arbitrage profit
• To change the nature of a liability (Liability Swap)
• To change the nature of an investment without incurring the costs of
selling one portfolio and buying another (Can you protect your
portfolio?)
Foreign Exchange Quotes for GBP, May 21, 2020
Blank

Bid Ask

Spot 1.2217 1.2220

1-month forward 1.2218 1.2222

3-month forward 1.2220 1.2225

6-month forward 1.2224 1.2230


Forward Price
• The forward price for a contract is the delivery price that would be
applicable to the contract if it were negotiated today (i.e., it is the
delivery price that would make the contract worth exactly zero).
• The forward price may be different for contracts of different maturities
(as shown by the table above).
Terminology
• The party that has agreed to buy has what is termed a long position.
• The party that has agreed to sell has what is termed a short position.
Example
• On May 21, 2020, the treasurer of a corporation enters
into a long forward contract to buy million in six
months at an exchange rate of 1.2230.

• This obligates the corporation to pay $1,223,000 for

million on November 21, 2020.

• What are the possible outcomes?


Profit From a Long Forward Position (K = Delivery Price =
Forward Price at the time when the contract is entered into)
Profit From a Short Forward Position (K = Delivery Price =
Forward Price at Time Contract Is Entered Into)
Futures Contracts
• Agreement to buy or sell an asset for a certain price at a certain time
• Similar to forward contract
• Whereas a forward contract is traded OTC, a futures contract is traded
on an exchange
Exchanges Trading Futures
• CME Group (formed when Chicago Mercantile Exchange and Chicago
Board of Trade merged)
• BSE and NSE
• NCDEX and MCX
• Intercontinental Exchange
• B3 (Brazil)
• Tokyo Financial Exchange (Tokyo)
Examples of Futures Contracts

• Agreement to:
– Buy 100 oz of gold @ in December

– Sell @ 1.2500 in March

– Sell 1,000 bbl of oil @


1. An Arbitrage Opportunity?
Suppose that:
The price of a non-dividend-paying stock is $60.
The 1-year forward price of the stock is $65.
The 1-year US$ interest rate future is fixed at 5% per annum.
Is there an arbitrage opportunity?
2. Another Arbitrage Opportunity?
Suppose that:
The price of a non-dividend-paying stock is $60.
The 1-year forward price of the stock is $60.
The 1-year US$ interest rate future is fixed at 5% per annum.
Is there an arbitrage opportunity?
The Forward Price of a Non-Dividend-Paying Stock

If the spot price is S and the forward price for a contract


deliverable in T years is F, then

where r is the 1-year (domestic currency) risk-free rate


of interest.
In our examples, S = 60, T = 1, and r = 0.05 so that
1. Oil: An Arbitrage Opportunity?
• Suppose that:
• The spot price of oil is US$50.
• The quoted 1-year futures price of oil is US$60.
• The 1-year US$ interest rate future is fixed at 5% per annum.
• The storage cost of oil is 2% per annum.

Is there an arbitrage opportunity?


Options
• A call option is an option to buy a certain asset by a certain date for a
certain price (the strike price).
• A put option is an option to sell a certain asset by a certain date for a
certain price (the strike price).
Types of Traders
• Hedgers
• Speculators
• Arbitrageurs
Hedging Examples

• A US company will pay million for imports from


Britain in 3 months and decides to hedge using a long
position in a forward contract.
Value of Shares With and Without Hedging
Dangers
• Traders can switch from being hedgers to speculators or from being
arbitrageurs to speculators.
• It is important to set up controls to ensure that traders are using
derivatives for their intended purpose.
Thank you
for your patience

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