Derivatives

forward ,futures & options

 Derivatives came into being primarily to eliminate
price risk
 A derivate instrument ,broadly ,is a financial
contract whose payoff structure is determined by
the value of an underlying commodity like security,
interest rate, share price index, exchange rate, oil
price etc
 A derivative instrument derives its value from some
underlying variable
 A derivative instrument by itself does not constitute
ownership
 It is a promise to convey ownership
 Derivatives are specialised contracts which are
employed for a variety of purposes including
reduction of funding costs, enhancing yield on
assets ,however the most important use of
derivative is in transferring market risk ,called
hedging ,which is a protection against losses
resulting from unforeseen price or volatility changes
 Derivatives are very important tools for risk
management
 Kinds of derivatives include futures,options,interest
rate swaps,mortgage derivatives etc
History of derivative products
 In 1840 Chicago Board of Trade was formed to
trade in grains
 CBOT is well known for futures contract in grains
 CBOT introduced trade in options on 1973
 Black and Scholes published a formula to value
options in 1973
 In 1972 Chicago mercantile exchange started the
futures contract on foreign currencies
 In 1975 they introduced interest rate futures and in
1982 started the stock index futures
Spot market
 The spot market is also called the cash
market where the sale and purchase of
commodity takes place for immediate
delivery
 The price at which the exchange takes place
is called the cash price or spot price
 The spot market involves both the transfer
of ownership and the delivery of the
commodity or the instrument on the spot or
immediately
Forward contract
 A forward contract is an agreement made today between a
buyer and seller to exchange the commodity or instrument for
cash at a predetermined future date at a price agreed upon
today
 The agreed upon price is called the forward price,with a
forward market the transfer of ownership occurs on the spot,
but delivery of the commodity or instrument does not occur
until some future date
 No money changes at the time the deal is signed,but
sometimes one or both the parties may like to ask for some
initial ,good faith deposit to ensure that the contract is honored
by the other party
 Eg
 A wheat farmer may wish to contract to
sell his harvest at a future date to
eliminate risk of a change in prices by
that date
 The price at which the underlying
commodity or asset will be trade, is decided
at the time of entering the contract
 One is assured of the price at which one can
buy or sell assets or goods
 At the maturity of the contract if the market
price of the commodity is greater than the
price agreed,then the buyer stands to gain
while the seller is in the losing position
 The opposite holds when the market price
happens to be lower than the agreed price
 Problems of forward contracting
 It entails a element of risk that a party to the
contract may not honor its part of the obligation
 Each party faces the risk of default
 Once a position of buy or sell is taken in a forward
contract,a investor cannot retreat except through
mutual consent or by entering into an identical
contract and taking a position that is reverse of the
earlier position
 With forward contracts entered on a one to one
basis and with no standardisation ,they virtually
have no liquidity
 These problems of credit risk and no
liquidity have led to the emergence of
the futures contacts
 The futures contract are refined
forward contracts
Futures contract
 It represents an improvement over the
forward contract in terms of
 Standardisation
 Performance guarantee
 liquidity
 A futures contract is a standardised contract
between two parties where vone party
commits to sell,and the other to buy,a
stipulated quantity of a
commodity,currency,security,index at an
agreed price on a given date in the future
 The agreed upon price is called the future
price
 Futures are exchange traded contracts to
sell or buy financial instruments or
commodities for future delivery at an agreed
price
 When an investor buys a futures contract ,to
take a long position,he assumes the right
and obligation of taking delivery of the
specified underlying item on a specified date
 When an investor sells a futures
contract ,to take a short position,one
assumes the right and obligation to
make the delivery of the underlying
asset
Differences between forward
and futures
 Standardisation
 A forward contract is a tailor made contract
where the terms are settled in mutual
agreement between the parties,a futures
contract is standardised in regard to
quantity,quality,price, place of delivery
 Liquidity
 There is no secondary market for forward
contracts,while futures are traded on
organised exchanges
 Conclusion of contract
 A forward contract is generally concluded
with the delivery of the asset,whereas in a
futures contract conclusion is with the
delivery of the asset with payment pf price
differences, one who is long a contract can
always eliminate his obligation by
subsequently selling a contract for the same
asset, often called as offsetting a trade
 Margins
 A forward contract has zero value for
both the parties involved so that no
collateral is required for entering into
such a contract, but in a futures
contract a third party called clearing
corporation is involved with which
margin is required to be kept
 Profit/loss settlement
 The settlement of a forward contract takes
place on the date of maturity so that the
profit/loss is booked on maturity only,on the
other hand ,the futures contract are marked
to market daily so that profits or losses are
settled daily
Options
 Option represent another derivative instrument and
provide a mechanism by which one can acquire a
certain commodity or other asset,or take
positions,in order to make profits or to cover risk for
a price
 options are similar to futures but they represent a
right
 An option is the right ,but not the obligation,to buy
or sell a specified amount of a
commodity,currency,index or financial instrument,at
a specified price on or before a given date in the
future
 The price involved is called the exercise
price or the strike price and the date
involved is known as expiration
 The buyer of the contract pays the writer ( or
seller)for the right,but not the obligation ,to
purchase from, or sell to the writer at the
price fixed by the contract
 The right to choose ,is sold by the seller
(writer) of the option to the purchaser
(holder) in return for a premium
European and American
options
 In European option the holder of the option
can only exercises his right(if he so
desires)on the expiration date
 In an American option he can exercise this
right any time between purchase date and
the expiration date
 Most of the options traded in the world
,including those in Europe are American
style option
 Options are of two types
 Call options
 Put options
 Call option
 A call option gives an owner the right
to buy
 Put option
 A put option gives its owner the right to
sell
 In options the clearing corporation
takes the other side in every contract
so that the party with the long position
has a claim against the clearing
corporation and the party with the
short position is obliged to it
 While buying or selling futures does not
require any price to be paid,the options are
bought and sold on the exchange for a price
called the premium.
 This price is determined on the exchange
,like the prices of the share,by the forces of
demand and supply
 Both parties to a future contract are
required to keep deposit margin with
the exchange,only the party with the
short position is called upon to pay
margin money in case of options
trading .The party with the long
position does not pay anything beyond
the premium
 When an option contract is bought, it is upto the
holder to exercise it or not,and the writer has no say
 Eg
 If mr x decides to buy y co 600 shares with an
exercise price of 210/- ,if it is a call option the
investor obtains a right to buy 600 shares at the
rate of 210/- per share on the expiration date,if on
that date the price of the share in the market is
quoted at higher than 210/- ,the investor would like
to exercise the option,by buying shares at 210/- and
selling them at the prevailing higher price,the
investor can make profit.
 If the option is a put option ,it would give the
investor a right to sell the shares at rs 210/-
per share if called upon . The investor would
naturally be inclined to exercise the option if
the share price on the stipulated date
happens to be lower than 210/-.by buying
the shares at a rate lower than 210/- and
selling them at 210/- ,the investor would
stand to gain