CHAPTER EIGHT
8. DERIVATIVE INSTRUMENT
Derivative: A derivative is an instrument whose value depends on, or is derived from, the
value of another asset.
-Payoff structure (future payoff)
-where it’s based on an underlying asset (uncertain)
-Value of the underlying needs to be measureable.
oCan be based on elections
oWeather, through temperature
Has to be secure
Specify a certain location
Valuations: How do we value a position?
-No-arbitrage, assuming perfect markets
-If you have no-arbitrage: 2 portfolios with exactly the same payoffs under all future
circumstances, should have the same value.
Value Derivative = Replicating portfolio. (both have exactly the same payoffs).
Long forward: St-K
-Buy asset now, and borrow money to repay K.
-So = Ke^-rT
-Long Forward contract = So –Ke^-rT
-No-arbitrage, assuming perfect markets
oFrictionless trading (no transaction cost)
oPure competition
oRational investors (investors want’s more over less)
A derivative is a financial instrument whose value is derived from the value of an underlying
asset, index, or rate. Common underlying assets include stocks, bonds, commodities, currencies,
interest rates, and market indexes.
Types of Derivatives
1. Futures Contracts:
o Agreements to buy or sell an asset at a future date at a price agreed upon today.
o Traded on exchanges.
o Standardized terms.
2. Forward Contracts:
o Similar to futures but are private agreements between two parties.
o Not standardized.
o Traded over-the-counter (OTC).
3. Options:
o Contracts that give the holder the right, but not the obligation, to buy (call option)
or sell (put option) an asset at a specified price within a specified period.
o Can be traded on exchanges or OTC.
4. Swaps:
o Agreements to exchange cash flows or other financial instruments.
o Common types include interest rate swaps, currency swaps, and commodity
swaps.
o Traded OTC.
Characteristics of Derivatives
1. Leverage:
o Derivatives often require only a small initial investment (margin), providing
leverage.
o Can lead to significant gains or losses.
2. Risk Management:
o Used to hedge against price movements in the underlying asset.
o Helps in managing various types of financial risk.
3. Speculation:
o Traders can speculate on the future direction of market prices using derivatives.
o Can lead to high returns, but also high risks.
4. Price Discovery:
o Derivatives markets help in determining the future price expectations of assets.
o Reflects information and market sentiment.
5. Arbitrage:
o Derivatives provide opportunities for arbitrage, exploiting price differences in
different markets or instruments to make risk-free profits.
Uses of Derivatives
1. Hedging:
o Protects against adverse price movements.
o For example, a farmer can hedge against a decline in crop prices using futures
contracts.
2. Speculation:
o Traders aim to profit from price changes in the underlying asset.
o For example, buying call options on a stock expecting its price to rise.
3. Arbitrage:
o Taking advantage of price discrepancies between markets.
o For example, simultaneously buying and selling an asset in different markets to
exploit price differences.
4. Access to Assets or Markets:
o Allows investors to gain exposure to assets or markets that may be otherwise
inaccessible.
o For example, using currency swaps to access foreign exchange markets.
Risks Associated with Derivatives
1. Market Risk:
o Risk of losses due to changes in market prices.
2. Credit Risk:
o Risk that one party may default on the contract.
3. Liquidity Risk:
o Risk that it may be difficult to buy or sell a derivative quickly without affecting
its price.
4. Operational Risk:
o Risk of losses due to failures in internal processes, systems, or controls.
5. Leverage Risk:
o High leverage can amplify losses as well as gains.
On the downside, derivatives are difficult to value because they are based on theprice of another
asset. The risks for OTC derivatives include counter-party risks that are difficult to predict or
value as well. Most derivatives are also sensitive to changes in the amount of time to expiration,
the cost of holding the underlying asset, and interest rates. These variables make it difficult to
perfectly match the value of a derivative with the underlying asset.
ProsLock in pricesHedge against riskCan be leveragedDiversify portfolio
ConsHard to valueSubject to counterparty default (if OTC)Complex to
understandSensitive to supply and demand factors
Options are financial derivatives that provide the buyer with the right, but not the obligation, to
buy or sell an underlying asset at a specified price (strike price) on or before a specified date
(expiration date).
Options and futures are two types of derivatives contracts that derive their value from
market movements for the underlying index, security or commodity.
An option gives the buyer the right, but not the obligation, to buy (or sell) an asset at a
specific price at any time during the life of the contract.
A futures contract obligates the buyer to purchase a specific asset, and the seller to sell
and deliver that asset, at a specific future date.
Futures and options positions may be traded and closed ahead of expiration, but the
parties to the futures contracts for commodities are typically obligated to make and
accept deliveries on the settlement date.
Types of Options
1. Call Option: Gives the holder the right to buy the underlying asset.
2. Put Option: Gives the holder the right to sell the underlying asset.
Payoff of Options
Call Option Payoff:
Holder's Payoff:
o If the market price of the underlying asset (STS_TST) is above the strike price
(KKK) at expiration, the call option is exercised.
o Payoff Formula: Payoff=max(ST−K,0)\text{Payoff} = \max(S_T - K,
0)Payoff=max(ST−K,0)
o Graphically, the payoff increases linearly as the underlying asset price rises above
the strike price.
Writer's Payoff:
o The writer (seller) of the call option has the opposite payoff.
o Payoff Formula: Payoff=−max(ST−K,0)\text{Payoff} = -\max(S_T - K,
0)Payoff=−max(ST−K,0)
Put Option Payoff:
Holder's Payoff:
o If the market price of the underlying asset (STS_TST) is below the strike price
(KKK) at expiration, the put option is exercised.
o Payoff Formula: Payoff=max(K−ST,0)\text{Payoff} = \max(K - S_T,
0)Payoff=max(K−ST,0)
o Graphically, the payoff increases as the underlying asset price falls below the
strike price.
Writer's Payoff:
o The writer (seller) of the put option has the opposite payoff.
o Payoff Formula: Payoff=−max(K−ST,0)\text{Payoff} = -\max(K - S_T,
0)Payoff=−max(K−ST,0)
Example: Call and Put Option Payoffs
Call Option Example:
o Strike price (KKK) = $50
o Market price at expiration (STS_TST) = $60
o Payoff = \max(60 - 50, 0) = $10
Put Option Example:
o Strike price (KKK) = $50
o Market price at expiration (STS_TST) = $40
o Payoff = \max(50 - 40, 0) = $10
Futures
Futures are standardized contracts to buy or sell an underlying asset at a specified price on a
specified future date. Unlike options, futures contracts obligate both parties to fulfill the contract
terms.
Payoff of Futures
Long Position:
The buyer of a futures contract profits if the price of the underlying asset increases.
Payoff Formula: Payoff=ST−F0\text{Payoff} = S_T - F_0Payoff=ST−F0 Where
STS_TST is the spot price at maturity and F0F_0F0 is the futures price at the time of
entering the contract.
Short Position:
The seller of a futures contract profits if the price of the underlying asset decreases.
Payoff Formula: Payoff=F0−ST\text{Payoff} = F_0 - S_TPayoff=F0−ST
Example: Futures Payoff
Long Position Example:
o Futures price (F0F_0F0) = $100
o Spot price at maturity (STS_TST) = $120
o Payoff = 120 - 100 = $20
Short Position Example:
o Futures price (F0F_0F0) = $100
o Spot price at maturity (STS_TST) = $80
o Payoff = 100 - 80 = $20
Key Differences between Options and Futures Payoffs
1. Obligation:
o Futures contracts obligate both parties to execute the contract terms, while options
provide the right but not the obligation to buy or sell the underlying asset.
2. Symmetry:
o Futures payoffs are symmetrical, with gains and losses being equal and opposite
for the long and short positions.
o Options payoffs are asymmetrical, with limited loss potential and unlimited profit
potential for the holder.
3. Risk and Reward:
o Futures contracts involve higher risk since both parties are obligated to fulfill the
contract, leading to potentially unlimited losses.
o Options involve limited risk for the holder (premium paid) but can lead to
significant gains if the underlying asset moves favorably.
would have profited $17,780 [($80 - $62.22) X 1,000 = $17,780]. The trader with the short
position—the seller—in the contract would have a loss of $17,[Link] all futures contracts are
settled at expiration by delivering the underlying asset. Many derivatives are cash-settled, which
means that the gain or loss in thetrade is simply an accounting cash flow to the trader's brokerage
account. Futures contracts that are cash settled include many interest rate futures, stock index
futures, and more unusual instruments like volatility futures or weather [Link]
contracts—known simply as forwards—are similar to futures, but do not trade on an exchange,
only over-the-counter. When a forward contract is created,the buyer and seller may have
customized the terms, size and settlement process for the derivative. As OTC products, forward
contracts carry a greater degree of counterparty risk for both buyers and [Link]
risks are a kind of credit risk in that the buyer or seller may not be able to live up to the
obligations outlined in the contract. If one party of the contract becomes insolvent, the other
party may have no recourse and could lose the value of its position. Once created, the parties in a
forward contract can offset their position with other counterparties, which can increase the
potential forcounterparty risks as more traders become involved in the same
[Link] are another common type of derivative, often used to exchange one kind of
cash flow with another. For example, a trader might use an interest rate swap to switch from a
variable interest rate loan to a fixed interest rate loan, or vice [Link] that Company XYZ
has borrowed $1,000,000 and pays a variable rate ofinterest on the loan that is currently 6%.
XYZ may be concerned about rising interest rates that will increase the costs of this loan or
encounter a lender that is reluctant to extend more credit while the company has this variable rate
[Link] that XYZ creates a swap with Company QRS, which is willing to exchange the
payments owed on the variable rate loan for the payments owed on a fixed rate loan of 7%. That
means that XYZ will pay 7% to QRS on its $1,000,000 principal, and QRS will pay XYZ 6%
interest on the same principal. Atthe beginning of the swap, XYZ will just pay QRS the 1%
difference between the two swap rates.
If interest rates fall so that the variable rate on the original loan is now 5%, Company XYZ will
have to pay Company QRS the 2% difference on the loan. If interest rates rise to 8%, then QRS
would have to pay XYZ the 1% difference between the two swap rates. Regardless of how
interest rates change, the swap has achieved XYZ's original objective of turning a variable rate
loan into a fixed rate [Link] can also be constructed to exchange currency exchange rate risk
or the risk of default on a loan or cash flows from other business activities. Swaps related to the
cash flows and potential defaults of mortgage bonds are an extremely popular kind of derivative
—a bit too popular. In the past. It was the counterparty risk of swaps like this that eventually
spiraled into the credit crisis of [Link] options contract is similar to a futures contract
in that it is an agreement between two parties to buy or sell an asset at a predetermined future
date for a specific price. The key difference between options and futures is that, with an option,
the buyer is not obliged to exercise their agreement to buy or sell. It is an opportunity only, not
an obligation—futures are obligations. As with futures, options may be used to hedge or
speculate on the price of the underlying [Link] an investor owns 100 shares of a stock
worth $50 per share they believethe stock's value will rise in the future. However, this investor is
concerned about potential risks and decides to hedge their position with an option. The investor
could buy a put option that gives them the right to sell 100 shares of the underlying stock for $50
per share—known as the strike price—until a specific day in the future—known as the expiration
[Link] that the stock falls in value to $40 per share by expiration and the put option buyer
decides to exercise their option and sell the stock for the original strike price of $50 per share. If
the put option cost the investor $200 to purchase, then they have only lost the cost of the option
because the strike price was equal to the price of the stock when they originally bought the put.
A strategy like this is called a protective put because it hedges the stock's downside
[Link], assume an investor does not own the stock that is currently worth $50 per
share. However, they believe that the stock will rise in value over the next month. This investor
could buy a call option that gives them the right to buy the stock for $50 before or at expiration.
Assume that this call option cost $200 and the stock rose to $60 before expiration. The call buyer
can now exercise their option and buy a stock worth $60 per share for the $50 strike price, which
is an initial profit of $10 per share. A call option represents 100 shares, so the real profit is
$1,000 less the cost of the option—the premium—and any brokerage commission [Link] both
examples, the put and call option sellers are obligated to fulfill their side of the contract if the
call or put option buyer chooses to exercise the contract. However, if a stock's price is above the
strike price at expiration, the put will be worthless and the seller—the option writer—gets to
keep the premium as the option expires. If the stock's price is below the strike price at expiration,
the call will be worthless and the call seller will keep the premium. Some options can be
exercised before expiration. These are known as American-style options, but their use and early
exercise are rare.
8.4. Derivative as risk mag’t (hedging)
Derivatives are powerful tools used by investors and companies to manage and mitigate risks
associated with fluctuations in asset prices, interest rates, exchange rates, and other financial
variables. Hedging with derivatives involves taking a position in a derivative contract that offsets
the risk in an underlying asset or exposure.
Types of Derivatives Used for Hedging
1. Futures Contracts:
o Standardized contracts to buy or sell an asset at a future date at a predetermined
price.
o Commonly used to hedge commodity prices, interest rates, and currency exchange
rates.
2. Forward Contracts:
o Similar to futures but are customized and traded over-the-counter (OTC).
o Used for hedging specific risks such as foreign exchange exposures or customized
commodity contracts.
3. Options:
o Contracts that give the holder the right, but not the obligation, to buy (call option)
or sell (put option) an asset at a specified price before a specified date.
o Used to hedge potential adverse movements in stock prices, interest rates, or
exchange rates while retaining the potential for favorable movements.
4. Swaps:
o Contracts to exchange cash flows or financial instruments.
o Common types include interest rate swaps and currency swaps, used to manage
exposure to interest rate fluctuations or currency exchange rate movements.
Hedging Strategies Using Derivatives
1. Hedging Commodity Price Risk:
o Futures Contracts: A farmer expecting to harvest wheat in six months can hedge
against a potential decline in wheat prices by selling wheat futures contracts. This
locks in a price today for future delivery, reducing the risk of price fluctuations.
o Options Contracts: An airline concerned about rising fuel prices can buy call
options on fuel. If fuel prices increase, the airline can exercise the options and buy
fuel at the predetermined price, mitigating the impact of rising prices.
2. Hedging Interest Rate Risk:
o Interest Rate Swaps: A company with variable-rate debt can enter into an
interest rate swap to exchange variable-rate payments for fixed-rate payments.
This converts their variable-rate debt into fixed-rate debt, protecting against rising
interest rates.
o Forward Rate Agreements (FRAs): A financial institution expecting to borrow
funds in the future can enter into an FRA to lock in the borrowing rate today,
reducing the uncertainty of future interest rates.
3. Hedging Currency Risk:
o Forward Contracts: An exporter expecting to receive foreign currency payments
in the future can enter into a forward contract to sell the foreign currency at a
predetermined rate. This locks in the exchange rate, mitigating the risk of adverse
currency movements.
o Currency Options: A multinational corporation with foreign operations can buy
currency options to hedge against unfavorable exchange rate movements while
retaining the potential to benefit from favorable movements.
4. Hedging Equity Price Risk:
o Put Options: An investor holding a portfolio of stocks can buy put options on the
stocks or an index. If the market declines, the value of the put options increases,
offsetting losses in the portfolio.
o Futures Contracts: An investor can sell stock index futures to hedge against a
potential decline in the overall market. If the market falls, the gains in the futures
position offset the losses in the stock portfolio.
Benefits of Hedging with Derivatives
1. Risk Reduction: Derivatives provide a way to manage and mitigate various financial
risks, reducing uncertainty and stabilizing cash flows and earnings.
2. Cost Efficiency: Hedging with derivatives can be more cost-effective than other risk
management strategies, such as diversifying or adjusting the underlying asset positions.
3. Flexibility: Derivatives offer a wide range of instruments and strategies, allowing for
tailored risk management solutions that meet specific needs.
4. Leverage: Derivatives require a smaller initial investment (margin) compared to the
underlying assets, providing a cost-effective way to hedge large positions.
Risks and Considerations
1. Counterparty Risk: In OTC derivatives, there is a risk that the counterparty may default
on the contract. This risk is mitigated in exchange-traded derivatives through the
clearinghouse.
2. Complexity: Derivatives can be complex instruments requiring a thorough understanding
of their mechanics and the underlying risks.
3. Market Risk: While derivatives can hedge specific risks, they introduce market risk
related to the derivative instrument itself.
4. Liquidity Risk: Some derivatives may have limited liquidity, making it difficult to enter
or exit positions without affecting prices significantly.
Importance of derivatives in risk management
Derivatives play a crucial role in risk management by allowing investors to hedge against
potential losses in the underlying assets. Hedging is the process of offsetting potential losses
from an investment by taking an offsetting position in another market. Derivatives can be used to
hedge against various types of risks, including interest rate risk, currency risk, and commodity
price risk.
Interest rate risk hedge
One of the most common uses of derivatives in risk management is to hedge against interest rate
risk. This can be done by using interest rate swaps, which allow investors to exchange a fixed
rate of interest for a floating rate of interest. This can be useful for investors who have a portfolio
of fixed-rate assets and want to protect against rising interest rates.
Currency risk hedge
Another common use of derivatives in risk management is to hedge against currency risk.
Currency derivatives, such as currency forwards and options, can be used to protect against
potential losses caused by currency fluctuations. This can be especially important for
multinational companies that have operations in multiple countries and are exposed to currency
risk.
Hedging against commodity price risk
Derivatives can also be used to hedge against commodity price risk. This can be done by using
commodity futures and options. For example, a farmer may use commodity futures to lock in a
price for their crops before they are harvested, in order to protect against a potential fall in prices.
Future price movements
Derivatives can also be used to speculate on the future price movements of underlying assets.
This can be done by taking a position in a derivative that will increase in value if the price of the
underlying asset increases and decrease in value if the price of the underlying asset decreases.
This can be a high-risk strategy but can also result in large profits.
Increase leverage
Derivatives can be used to increase leverage, meaning that an investor can invest a smaller
amount of money to control a larger amount of the underlying asset. This can amplify potential
gains, but also increases the risk of losses.