Introduction to
Derivatives
What are derivatives?
Derivatives are financial instruments
whose
h prices
i depend on, or are
derived from, the prices of other
assets
What are the assets on which
their prices depend?
Underlying is financial in nature
Stock prices
Credit rating
Interest rates
Exchange rates
Also..
Electricity
The weather
Insurance
Cattle prices
In sum, if you can price the underlying asset, there can
always be a derivative on it.
Why are derivatives useful?
Hedging
Speculation
Arbitrage profit-making
The various kinds of derivatives
There are three principal classes of
derivative securities:
Futures and Forwards
Options
Swaps
In addition, it is possible to have options
on futures, futures on options,
swaptions Infinite complexity.
Forward Contracts
A agreement to buy or sell llan asset
at a certain time in the future for a
certain price
On expiry, one party buys the
asset for the agreed price from the
other party.
The contract is an over-the-counter
(OTC) agreement between 2
institutions.
Profit from Forward Positions
Futures Contracts
An agreement to buy or sell an
asset at a certain time in the future
at a certain price.
They are exchange-traded, and
hence standardized
Important futures exchanges:
CBOT, CME, NYMEX etc.
In India: BSE, NSE, MCX.
Examples of Futures Contracts
Agreement to:
Buy 1000 shares of Reliance at
Rs. 2500 in May (BSE)
Sell $1 million at 1.5000 US$/£
in april (CME)
Non-arbitrage futures price
If the spot price is S and futures price is F for a
contract deliverable in T years, then
F = S (1+r )T
If F > S (1+r )T, go short on futures and long
on spot and vice versa.
What is the value of the futures
contract?
Daily settlement and margins
Margin is cash or marketable securities
securities deposited by an investor
with the broker
Marking to market: Balance in the
margin account is adjusted to reflect
daily settlement
Margins guard against default
Options
An option is a security that gives the holder the
right but not the obligation to buy or sell a
security for a specified price at a specified
date.
Basic classification of options:
Call options/Put options
American options/European options
How are options different from
futures/forwards?
Long Call
Short Call
Intrinsic and Time Value
Option premium = Intrinsic Value + Time Value
What are in-the-money, out-of-the-money and
at the money options?
Effect of Variables on Option
Pricing
Variable C P
S0 + –
X – +
T
σ
+ +
+ +
r + –
D – +
• What is the relation between price of an American
option and a European option?
Valuation using Black
Scholes equation
c = S0 N (d1 ) − X e − rT N (d2 )
p = X e − rT N ( −d 2 ) − S0 N ( −d1 )
ln( S0 / X ) + (r + σ 2 /2)T
where d1 =
σ T
d2 = d1 − σ T
Put-Call Parity; No Dividends
Consider the following 2 portfolios:
Portfolio A: European call on a stock + PV of
the strike price in cash
Portfolio C: European put on the stock + the
stock
Both are worth Max (ST , X) at the maturity of the
options
Theyy must therefore be worth the same todayy
This means that
c + Xe -rT = p + S0
Trading Strategies
Covered position
Covered Call Protective Put
Naked position
Spread Trades Combinations
Bull Spread Straddle
Bear Spread Strip/Strap
Box Spread Strangle
Butterfly Spread
The Greeks: Delta
Delta (Δ) is the rate of change of the
option price with respect to the underlying
Delta
Delta = sensitivity of an option's theoretical
value to a change in the price of the underlying
contract.
delta = change in the option price
change in the stock price
What is the range
g of deltas for calls and
puts?
Gamma
Gamma (Γ) is the rate of change of
delta (Δ) with respect to the price of
the underlying asset
If gamma is large, delta is highly
sensitive to the price
i of the underlying
asset.
Theta
Theta (Θ) of a derivative (or portfolio of
derivatives) is the rate of change of the
value with respect to the passage of time
Vega
Vega (ν) is the rate of change of
the value of a derivatives portfolio
with respect to volatility
Rho
Rho is the rate of change of
the value of a derivative with
1: D ERIVATIVES
respect to the interest rate
Exotic Options
Bermudan option - non-standard American option in which
early exercise is limited to certain dates during the life of
the option. Also referred to as "hybrid-style" exercise.
Forward start option is an option that is paid for now, but
does not begin until some later date.
Compound option is an option on an option. Compound
options have two strike prices and two expiration dates. For
example, a call on a call is purchased. At some specified
date in the future, a person will have the right but not the
obligation of purchasing a call option.
Exotic Options
Chooser option also called an "as you like it" option allows
the holder to choose after a specified period of time
whether the option is a call or a put.
Barrier option is an option in which the payoff depends on
whether the underlying asset's price reaches a certain level
during the life of the option.
Up and out
reaches a specified boundary price.
Up-and-in option requires the underlying asset price to reach the
boundary price before the option can be activated.
Asian option (average price option) - payoff depends on the
average price of the asset (not the stock price itself) over a
specified amount of time during the life of the option.
Basket option - payoff depends upon a portfolio of assets.
1: D ERIVATIVES
