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 DERIVATIVES- THEORY AND NUMERICAL

DERIVATIVES

A derivative is a financial instrument, which derives its value from an underlying asset.
The value of a derivative is nothing without value of its underlying asset
Derivatives do not have physical existence but emerge out of contract between
two parties.

For example, a derivative/ security is issued, whose value is defined based on price
of rice in the market. As price of rice increases or decreases, the value of derivative
also goes up and down. If the asset (rice) underlying this derivative is removed, the
value of derivative will become zero because this security has no value on its own.

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Underlying Assets in Derivatives- The underlying asset can be a commodity, currency,

interest rate et cetera

Similarity of Derivatives with Insurance- Derivatives are very similar to insurance. Insurance
protects against specific risks such as accidents, fire, floods, droughts etc.
Similarly, Derivatives take care of market risks emanating from volatility in interest rates,
currency rates, share prices etc.
Derivatives help in redistribution of risk from one party to the other.

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Economic Benefits of Derivatives-

Derivatives reduce risk and therefore increase the willingness of

investor to invest his money in the financial or commodity market
but still remain “risk averse”

Derivatives increase the liquidity of underlying asset or financial

market

The cost of trading a real or financial asset like shares, bonds,

commodities etc is larger than the cost of trading in derivatives.
By trading in derivatives, the total cost of transaction for an
investor goes down.

Derivatives provide an opportunity to create an optimum

portfolio by adjusting “risk and return characteristic” of the
portfolio.
They help in shifting the risk from those who have it but don’t
want it to those who have the appetite and are willing to take
it.
3 types of risks which can be adjusted through derivatives are-
Market Risk, Interest Rate Risk and Exchange Rate Risk.

Market Risk- Market risk, also called as systematic risk, market risk is the risk of
the whole market going down or moving up. Market risk cannot be diversified
because it affects the entire market. It can only be shifted from one person to the
other.

Interest rate Risk- This risk is related to fixed income securities like Bonds and
debentures. This risk arises when interest rate on such securities goes up or down,
affecting the market value of such securities.

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Exchange rate risk- wherever foreign currency is involved, it gives rise to exchange
rate risk in terms of fluctuation in exchange rate of currencies.

Traders in a Derivative Market-

Hedger
• A hedger is a person who faces certain risk associated with price movement of an
asset and uses a derivative to reduce that risk. This is done by taking a position
opposite to movement of the underlying asset.
• For example, if A feels that his asset X is going to lose value in the near future, he
can hedge by buying a derivative whose value moves opposite to movement of the
underlying asset. So, if value of X goes down, value of derivative will go up by the
same or more proportion, hedging the risk for A.

Speculator
• Speculators are people interested in taking risk and making money out of higher
risk transactions. They are not risk averse investors. Speculators are the people
interested in taking risks that hedgers wish to transfer.

Arbitrageur
• Whenever there is a discrepancy in price of the same asset in different markets,
arbitrageurs simultaneously enter into transactions in 2 or more markets and take
advantage of the discrepancy by buying and selling the same asset simultaneously
in different markets.

Kinds of Derivatives-

Kinds of
Derivatives

Forwards Futures Options Swaps

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Forwards and Futures:

• Example- Person A wants to have carrots every month. But he expects prices of
carrots to rise in the future. He will ask person B to supply him “x” carrots at the
price of Rs “y” every month. B expects prices of carrots to fall. He will agree to
Supply “x” carrots for Rs “y” every month. This agreement is a Forward/ Future.
• Thus, a forward is a customized contract between two entities where settlement
takes place on a specified date in the future at today’s pre-agreed price.
• A forward is an OTC product where the counterparty is always a bank.
• Future is structurally similar to a forward contract. The only difference is that
forward contracts are dealt in Over the Counter (OTC) market whereas Futures are
standardized contracts dealt over stock exchange.

Forwards Futures

• Over the counter • Exchange traded

• Customized • Standardized

• Less liquidity • More liquidity

• Credit default risk in • Credit guarantee as they

high because one of are traded on the stock
the parties may exchange
default if the contract
turns unfavorable

• Paid at settlement • Marked to market- this

date- the derivative is means that value of
not tradable. derivative changes
Settlement between everyday according to
parties takes place at value of underlying asset.
the end of the An investor can trade the
commitment period. derivative on the stock
exchange.

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A Future is a standardized contract with:

▪ Standard underlying asset,

▪ Standard quantity and quality of the underlying asset that can be delivered, and
▪ Standard timing of such settlement (date and month of delivery)
▪ The units of price quotation and minimum price change
▪ Location of settlement

A futures contract may be offset prior to maturity by entering into an equal and opposite
transaction. In future contracts, the losses as well as profits for the buyer and the seller are
unlimited.

Terminologies in Futures Contract-

• Long- a party is said to be long on an instrument when he or she

purchases that particular instrument. By instrument is meant the
derivative (future) being talked about.
• Short- opposite of long, a party is said to be short when he or she sells
a contract, which he does not currently own. Short position indicates
an over-sold position.
• Spot price- the price at which an asset trades in the spot market is called
spot price. Also called as cash price or current price.
• Futures price- the price at which the future contract trades in the futures
market.
• Expiry date- the last day on which the contract will be traded, at the end
of which it will cease to exist.
• Margin- the amount of money deposited by both buyers and sellers of
futures contracts to ensure performance of terms of the contract is
called margin money. Margin reduces the risk of default by either
counter party.
• Basis- the difference between spot price and futures price of an asset is
called as basis. As a contract approaches maturity, the basis reduces and
becomes zero on the date of maturity because the future price and spot
price become the same on date of maturity.
• Spread- A spread is the difference between 2 futures prices. The futures

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involved may be intra commodity or inter commodity. Intra commodity

futures happen when the same underlying good with different expiration
dates has different futures prices.

Pricing of futures contract depends on the following variables:

Pricing of futures contract depends
on the following variables

Price of underlying asset

in the market

Rate of return expected

from investment in the
asset

Risk Free Rate of Interest

Question:

Q. 1 The current value of a share in robotronics is Rs 12.50 (So). One year riskless
rate is 6% (r). What is the price of a 2 year forward contract on robotronics stock.

Q. 1A. a 2 year forward contract is being sold for Rs 16 in the market. Outline an
Investment strategy that can take advantage of the opportunity this presents.

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Answer:
So = Rs 12.50; r = 6%; k = 2; we have to find F k
The formula for no arbitrage forward pricing is So – Fk (1 +r) –k = 0 or Fk = So(1 +r) k
Thus, Rs 12.5 – Fk (1 + 0.06) -2 = 0
12.5 (1 + 0.06) 2 = Fk ;
Fk = 14.045

If Fk = Rs 16 in the market, the investor can short (agreement to sell) forward

contract to sell @ Rs 16 one year from now. At the same time, she can borrow Rs
12.50 @ 6% from the market to purchase one robotronics stock. 2 years from
now, she can sell forward contract at Rs 16 and pay back the lender by using Rs
14.045, making a profit of Rs 16 – Rs 14.045 = Rs 1.955. this will continue till S o (1
+ r)k = Fk

Question: Current NIFTY is 1800 and minimum lot is 100. Risk free rate is 8%
and futures period is 3 months. What is the fair value of 3 months NIFTY futures?

Answer: Fk = So(1 +r) k

So = 1800 (spot price)

r = 8%
k = 3 months or 3/12 years

Fk = 1800(1+ 0.08)3/12 (to solve this using normal calculator, instead of using time k in
decimals, we divide r to make it equal to rate of interest for a quarter. Here, the rate of
interest for a quarter would be 2%. Therefore, the formula becomes 1800(1+ 0.02) 1 .
solving this, we get 1836 as the value of future contract)

Fk = 1836.36 (fair value of 3 month future. Since minimum lot of NIFTY stock is
100, the fair value comes to 1836.36*100 = 183636)

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Currency Future:

Example-
Mr X purchases $ 1000 at Rs 62 / $ in 3 months futures market. Now, as per terms of the
contract, irrespective of actual relationship between rupee and dollar, Mr X would get Rs
62/ $. If the actual price of a dollar on due date is Rs 65, Mr X would make a gain of Rs
3000. However, if the actual price remains Rs 60 / $, Mr X would be losing Rs 2000.

• When the actual price of dollar is Rupees 65/ dollar, Mr X will be able to buy $1000 by
paying 62000 rupees but he can sell his 1000 USD in the market at 65000 rupees, thus
making a profit of 3000
• Similarly, in case of actual price being 60/ dollar, he will be in a loss.

Options:
• An Option is a contract, which offers the buyer of the contract (long position) the right, but
not the obligation, to buy (call) or sell (put) a security or other financial asset at an agreed-
upon price (strike price) during a certain period of time or on a specific date (exercise date).
The seller of the Option gets premium for selling his right to take decision. There is no
premium involved in forwards and futures but Option contracts have premium paid to the
seller of Option contract. Futures contract have symmetric risk profile for both buyer and
seller of the contract whereas options have an asymmetric risk profile.

• Writer of an option is the person who creates an option and floats it in the market for people
to buy the option. Writer is the person who gets premium for selling his right to decide on
the future date about buying/ selling of the option. Writer of a call option is bearish and
writer of a put option is bullish.
• Popular models to determine value of an option- Black Scholes Option pricing model;
Binomial Model.
• Stock based option trading was allowed by SEBI in 2002.

3 things to be understood:

1. Buyer of contract versus seller of contract. The buyer of contract is in long

position while the seller is in short position.
2. Right to buy the asset or security (Call option)- belongs to the buyer of the
contract
3. Right to sell the underlying asset or security (Put option)- belongs to the buyer
of the contract

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Call Option Payoff-

A call option is a right to buy the underlying asset at a future date at a predetermined price.
As the holder of option contract has a right to buy the asset at a future date, he will exercise
this right only in case of profits from the exercise. Therefore, his losses are limited to
premium paid to the seller of contract.

Put Option Payoff-

A put option is the right to sell the underlying asset at a future date at a
predetermined price. As the holder of option contract has a right to sell the asset
at a future date, he will exercise this right only in case of profits from the exercise.
Profit in case of a put contract is maximum in a situation when the price of the
underlying asset is “0” as in that case, the option holder can buy the asset for “0”
from the market and sell it to the other party under contract at pre-determined
selling price.

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European vs. American Option:

• American-style Options can be exercised at any time up to and including the expiry date
• European-style contracts can only be exercised on the expiry date

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Important Terms in Option Contracts:

1. Option Premium- In options, the buyer of the option has to buy the right from the seller by
paying an option premium. The premium is a one-time non-refundable amount for availing
the right.
2. Expiration date- the last date when the option can be exercised is called expiration date. In
case of American options, the right can be exercised even before the last date.
3. Strike Price- the specified price at which the option can be exercised is known as the strike
price. The actual price of the underlying asset may be different from the strike price of the
option contract.

Relationship Call Option (right to buy) Put option (right to sell)

Actual Price > strike price In the money (exercise) Out of money (do not
exercise)
AP = SP At the money At the money
AP < SP Out of the money In the money

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Currency Options:

A Pound option call contract has a strike price of $ 1.820 / Pound, and a premium
of $ 0.08. Spot price on maturity is $ 1.920. Find gain or loss to option buyer/
option seller.

Answer- Option buyer will exercise the option.

Gain to option buyer = $1.920 - $ 1.820 - $ 0.08 = 0.02

Loss to Option seller = $1.920 - $ 1.820 - $ 0.08 = 0.02

Strike price is the price at which option contract can be exercised at a future date.
Option buyer will gain because he can buy Pound at a call price of $1.820 from the
other party and sell the same in the market at $1.920, making a profit

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Example of Call and Put options:

Call:
• An investor buys a call option to buy 100 force motors shares at a price of Rs 300 on october
1, 2016. The current price is Rs 250 per share and premium charged by writer/seller of the
contract is Rs 25 per share. Thus, the total premium to be paid by the buyer to writer is Rs
2500. If the market price of force motors goes up to Rs 400, the investor will exercise his
right by paying Rs 300 *100 (30,000) and selling the shares in the market at price of Rs 400.
The net gain to the investor in this case would be (40,000 – 30,000 – 2500) = 7500.
• The buyer of option contract will not exercise the contract if price of shares at the date of
expiration is less than Rs 300.

Put:

• An investor buys a put option to sell 100 force motors shares at a price of Rs 300 on
october 1, 2016. The current price is Rs 350 per share and premium charged by
writer/seller of the contract is Rs 25 per share. Thus, the total premium to be paid
by the buyer of contract to writer is Rs 2500. If the market price of force motors
goes down to Rs 200, the investor will exercise his right by buying the shares from
the market for Rs 200 *100 (20,000) and selling the shares to the writer of option
contract at price of Rs 300. The net gain to the investor in this case would be (30,000
– 20,000 – 2500) = 7500

Option Spreads:

The risk profile of option buyer and seller is different. While Option buyer is
exposed to limited losses but unlimited profits, option seller is exposed to limited
profits but unlimited losses. To limit this profit and loss profile for both buyer and
seller, a spread is created. An option spread involves taking a position in 2 or
more options of the same type.

For example, buying a call and selling another call with different strike price or
different expiration dates is termed as spread.

There are 3 types of spreads- Vertical spread, horizontal spread and diagonal
spread.

Vertical spread- In a vertical spread, the investor involves in simultaneous

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buying and selling of options of the same instrument but with different exercise
price/ Strike price. Vertical spreads are also called price spreads.

Horizontal spread- in a horizontal spread, the instruments purchased and sold

have the same strike price but different expiry dates.

Diagonal spread- combines features of both vertical and horizontal spread. Both
the expiration date and strike price are different in a diagonal spread.

SWAPS:

• A swap is an agreement between two parties in which they agree to exchange

their respective cash flows. The parties to a swap contract are called as
counter parties. In a swap, one party agrees to exchange his set of pre-
determined cash flows with pre-determined set of cash flows of the other
party.

• In a currency swap, 2 currencies are exchanged in the beginning and again at

maturity the currencies are re-exchanged.

Currency Swap:

Currency Swap involves exchanging principal and fixed interest payments on a

loan in one currency for principal and fixed interest payments on a similar loan
in another currency. Parties to a swap exchange principal amount at the
beginning as well as end of the swap.

For example, Company A, a US firm and company B, a European firm enter into a 5
year $50 million swap agreement. The exchange rate at the time of agreement is
$1.25 per Euro (0.80 euros per dollar). First, the firms will exchange principals. So,
company A pays $50 million to B and company B pays 40 million euros (1$ = 0.80
euros) to A. This satisfies each company’s need for funds.

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The parties will exchange interest at regular intervals. Because company A has
exchanged dollars for Euros, it would pay interest in Euros based on Euro interest
rate. Similarly, company B will pay interest in dollars.

Dollar denominated interest rate is 8.25% and Euro denominated interest.

rate is 3.5%. Therefore, company A pays 3.5% interest on 40 million euros
i.e. 1.4 million euros.

Company B pays 8.25% interest on 50 million Dollars i.e. 4.125 million USD.

If the exchange rate at the end of the year is $1.4 per euro, Company A’s
payment would be (1.4 million *1.4) 1.96 million USD and Company B’s
payment would be 4.125 million USD. Netting the amount, company B will
pay 2.165 million USD to A

At the end of 5 years, both companies would swap their principals. Principal
amount is unaffected by the exchange rate at the end of the period.

Interest rate swaps (IRS):

An interest rate swap is an exchange of interest flows on an underlying asset or

liability. In an interest rate swap, there is a shift of basis of interest rate
calculation, from fixed rate to floating rate or vice versa. The cash flows
representing the interest payments during the swap period are exchanged
accordingly.

Example:
Fixed rate Floating rate
Company A 10% LIBOR + 0.80
Company B 8.85% LIBOR + 0.30

Company B enjoys lower borrowing cost in both markets but Company A

has relatively lower cost in floating rate market.
In this case, Company A will borrow at floating rate from the market and

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lend to B at LIBOR. This will provide an advantage of 0.30 % to B and a loss

of 0.80% to A. Company B will borrow at a fixed rate interest of 8.85% and
lend to A at 9%. This way, company A will save 1% on its borrowing
through B and company B will gain 0.15%. Total gain to both parties due to
the agreement of swap:
A- 1% -0.80% = 0.20%
B- 0.3% + 0.15% = 0.45%

Questions:

1. The price of equity shares of Onida limited in rupees 30. The risk free rate is 12%
p.a. an investor wants to enter into a
a. 1 year and
b. 6 months forward contract.
Find out the forward price in both cases.

2. The debentures of ABC ltd. are currently selling at Rupees 930 per debenture.
The 4 months future contract on this debenture is available at Rupees 945. Should
the investor buy this future if the risk free rate of interest is 6%?

3. The share of ABC ltd is currently traded at rupees 47. An investor buys a call option
for a strike price of 50 and premium of 5. Under what circumstances does the
investor make profit?
4. Deeksha has bought a 3-month call option on SBI limited’s share with an exercise
price of Rs 50, at a premium of Rs 4. She has also bought a put option on the same
share at an exercise price of Rs 40, at a premium of Rs 1.50. SBI’s share is currently
selling for Rs 45. What will be deeksha’s position after 3 months, if the share price
turns out to be Rs 50 or Rs 30?

Answer:
Total premium paid = Rs 5.50

When share price is Rs 50-

She will not exercise call option because there will be no profit no loss for exercising the
option. Thus loss on call option = Rs 4 (premium)
She will also not exercise put option because actual price>strike price/ exercise price

Total loss = 5.50

When share price is Rs 30-

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She will not exercise call option

Profit on put option = Rs (40-30) = Rs 10 Total profit = Rs 10 – Rs 5.50 = Rs 4.50

5. Person A buys a call option of IBM with an exercise price of Rs 195 selling for a
premium of Rs 3.65. At the time of expiration of the option, the actual price of the
share is Rs 197. Find out the profit or loss for person A for exercising the option
contract?

Answer:
Value at expiration = stock price – exercise price = 197 – 195 = Rs 2 Loss on account of
premium paid = Rs 3.65
Total loss to A in the call option = Rs 3.65 – Rs 2 = Rs 1.65

6. Person A buys a put option of IBM with an exercise price of Rs 195 selling for
a premium of Rs 5. At the time of expiration of the option, the actual price of
the share is Rs 188. Find out the profit or loss for person A for exercising the
option contract?

Answer:
Value at expiration = exercise price – stock price = 195 – 188 = Rs 7

Profit to A = Rs 7 - Rs 5 = Rs 2 per share

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