DERIVATIVES MASTER CLASS (CISI UK)

TRADING, HEDGING AND INVESTMENT STRATEGIES

Enita Pascal Odogun

ACSI CBAP PRINCE2

September 17,2020 1
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 Learning Objectives
Understand the categories of users of derivatives and their use cases;

Know the types of futures spreads and their applicable scenarios;

Understand hedge ratio calculation for futures with different types of underlyings;

Understand basis, basis risk, and the practical issues caused by changes in basis;

Understand the application and effects of delta hedging and be able to establish an investor’s net long/short position;

Understand the characteristics and effects of long and short straddles and strangles and use in differing market conditions;

Understand and be able to create basic synthetic options and futures;

Understand the advantages and disadvantages of using exchange-traded versus OTC products in hedge management; and

Analyse the relative attractiveness of derivative positions or investments to specific clientele

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 Content
Introduction

Futures Spreads

Hedging using Futures

Hedging using Options

Options Spreads

Options Combinations

Synthetics

Exchange-Traded Versus OTC Derivatives Hedges

Application
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 Introduction

Hedgers Arbitrageurs Speculators

Aim to reduce risk of Capitalize on asset mispricing View on the direction of
underlying price movement underlying price movement

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 Futures Spreads (1/2)
Futures spreads simply involve simultaneously buying and selling a futures contract.
There are two types:
• Intramarket Spread
• Intermarket Spread

Changes in basis
1
Spreads are used as the primary vehicle for
Intramarket Spread: This is the simultaneous capitalizing on anticipated changes in basis.
purchase and sale of futures on the same
underlying asset with different expiry dates 2 Reducing risk
The size and value of the market exposure arising
from spread trade is lower than an outright
position

3 Arbitrage
To capitalize on changes in price relationships
between similar products

4 Hedge rollover
To extend a hedge, you sell the current expiry
and buy the next expiry simultaneously 5
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 Futures Spreads (2/2)
Intermarket Spread: This is the simultaneous purchase Price relationship between two related assets has broken
and sale of futures on different (but often correlated) down and normalization is imminent e.g. steepening or
underlying assets with the same expiry dates. flattening of the yield curve

Asset allocation and portfolio rebalancing

Example
An international equity fund manager holds the view that UK shares will outperform US shares over the next few months.
How can she take advantage of this view?

She will sell the S&P 500 futures contracts and, at the same time, buy the FTSE 100 futures for the same maturity and for the
same amount.

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 Hedging using Futures (1/2)
Hedgers offset price risk in the underlying by taking an opposite position in the futures market. Hedges are not perfect due to
changes in basis (basis risk).

How do I know how many contracts to hedge with?

Hedge Ratio Cross Hedges

The hedge ratio compares the value of 1 2 Hedging with a product that has a
a position protected through the use of different (but correlated underlying).
a hedge with the size of the entire
position itself.

Static/Dynamic Hedge Optimal Hedge Ratio

Extent to which contracts are added or 3 4 Tells us the % of our exposure that we
removed as prices fluctuate over the should hedge to ensure minimum
life of the hedge. variance.

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 Hedging using Futures (2/2)
Computing hedge ratio with different underlyings:

Equities Commodities Bond Futures

Price factor * nominal value of CTD bond portfolio

Portfolio value Portfolio beta Commodity value nominal value of contract
Contract value * Contract value

The CTD (cheapest to deliver) bond is the deliverable bond with the highest implied repo rate. The
futures contract price is closely correlated to the CTD bond and the number of contracts used to
hedge is calculated on the basis of holding all CTD bonds in the portfolio, not any other bonds.
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 Hedging using Futures – Example (1/3)
A ₦5 million portfolio has a beta of 0.8 relative to the NSE30. The fund manager wants to hedge this portfolio using
NSE30 futures.

Assume:

• NSE30 futures contract size is ₦1,000 times the Index; and

• The NSE30 index is currently trading at 1100.

How many contracts are required to hedge this portfolio? Should the fund manager buy or sell the NSE 30 Futures
contract?

(5,000,000/(1000 *1100)) * 0.8

= 3.64 ~ 4

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 Hedging using Futures – Example (2/3)
An E&P Company wants to hedge $50 million in expected oil revenues using Brent crude oil futures.

Assume:

• Brent crude oil futures contract size is 1,000 barrels; and

• Brent crude oil futures is currently trading at $39.

How many contracts are required to hedge this portfolio? Should the treasurer buy or sell the Brent crude oil futures
contract?

(50,000,000/(1000 *39))

= 1282

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 Hedging using Futures – Example (3/3)
A hedge fund manager short on a CTD bond portfolio with nominal value of ₦5 million and market value of ₦5.5 million.
The price factor is 1.1143425. The contract size of the bond future is ₦100,000, nominal.

How many bond futures contracts are required to hedge this portfolio? Should the fund manager buy or sell the bond
futures?

1.1143425 * (5,000,000/100,000)

= 56

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 Basis and Basis Risk
A fund manager has a portfolio of bellwether Nigerian equities (beta of 0.8 relative to the NSE30), currently valued at
₦150,000,000. He hedges the portfolio by selling 105 NSE30 index futures at 1140. The NSE30 currently stands at
1105. A day later the NSE30 falls by 40 index points and the future falls by 34 points to 1106. The outcome for the fund
manager is as follows:

1. Unhedged equity portfolio value loss: ₦150,000,000 * (40/1105) * 0.8 = - ₦4,343,891

Day 1 Day 2
₦150,000,000 ₦144,570,136
2. Futures profit: 105 * (1140 – 1106) * ₦1000 = ₦3,570,000
3. Hedged portfolio value loss: - ₦ 4,343,891 + ₦3,570,000 = - ₦773,891 Occurred due to change in basis

Day 1 Day 2
₦150,000,000 ₦149,226,102

Basis is the difference between the cash and futures prices. Basis
risk is the risk that the change in futures prices will be different
from changes in the cash price.
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 Hedging using Options
The efficiency of hedging using options is dependent upon the delta of the option's position mirroring the delta of the
underlying position. Essentially, you want to create an overall delta neutral portfolio.

Generally:
Position Delta • What are the possible ways of hedging a long
Long underlying +1
underlying position?
Short underlying -1
Long future +1  Short future
Short future -1  Short call (deep ITM or 2 ATM)
Long call (deep ITM) +1
Long call (ATM) +0.5  Long put (deep ITM or 2 ATM)
Short call (deep ITM) -1 • What are the possible ways of hedging a short
Short call (ATM) -0.5
underlying position?
Long put (deep ITM) -1
Long put (ATM) -0.5  Long future
Short put (deep ITM) +1  Long call (deep ITM or 2 ATM)
Short put (ATM) +0.5
 Short put(deep ITM or 2 ATM)

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 Hedging a Long Underlying Position
An investor owns a portfolio of NSE30 shares currently valued at ₦3,000,000. The NSE30 index stands at 1050 points.
Assume:
Contract size = ₦1000 per point
How can she hedge?

Buy a put Sell a call

At a strike price of 1025: At a strike price of 1025:
One put hedges ₦1,025,000 (1025 * ₦1000) One call hedges ₦1,025,000 (1025 * ₦1000)
Buy 3 (₦3,000,000/₦1,025,000) put option contracts Sell 3 (₦3,000,000/₦1,025,000) call option contracts

Sub-optimal strategy
• Hedge inflow solely from premium
• Best used to hedge long positions to be
sold at a given point in time ( e.g.
Recall that unlike futures, there is a cost
implication – the premium – in buying commodity producers)
options.
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 Hedging a Short Underlying Position
An investor is short 500,000 units of Plc shares; ABC Plc is currently trading at ₦25.
Assume:
Contract size = 1000 shares
How should the investor hedge?

Buy a call Sell a put

• 500 calls precisely; • Receive premium on 500 puts;
• If the call goes ITM, the investor can sell the call – • If the put expires ITM, investor buys the stock at the
using that revenue to recoup the premium and the strike when the long party exercises; and
higher market price of the share; or she can • If the put expires OTM, the premium revenue offsets a
exercise at the lower strike price; and portion of the higher purchase price of the shares
• If the call expires OTM, the investor loses the incurred to close the short share position.
premium paid (if the fall in share price doesn’t
cover this cost)

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 Covered Options Positions
These are short options positions combined with opposite underlying or futures positions. They are used to enhance returns in
stagnant markets and (partially) hedge underlying positions.
Covered call: Also known as buy/write strategy. Constructed by combining long underlying position with a short call.

Example

An investor is long 10,000 XYZ Plc shares. Current share price is ₦110. She sells a XYZ Plc 120 call for a premium of ₦3.

What happens on expiry?

ATM Far OTM (Below share price at option writing)

• If the share price rises (to say 120), profit = share price • If the share price drops, the premium cushions the extent of
rise + premium: 10 + 3 = ₦13. This is the point of the loss on the long stock position.
maximum profit.
• If the fall is less than the premium, the investor is still net
• The ROI is 10 (120 – 110)/107 * 100 = 9.35% over the positive.
period; since the premium of ₦3 received for the call
• If the fall is greater than the premium, the investor loses
reduces the initial investment to 107.
the excess above the premium. 16
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 Covered Options Positions
Covered put: Constructed by selling a put but, at the same time, holding sufficient funds to buy the asset if necessary or
already having a short position
Example
XYZ Plc share price is ₦110. An investor leaves the funds (₦110,000) for one option on deposit and sells the 105 put for
₦5.5 per share.
What happens on expiry?

ATM/OTM ITM

• If the share price stays unchanged or falls and stays above • If the share price falls below 105, the option will be
105, the option is unexercised and the investor keeps the exercised.
premium. • The investor will have to buy the stock from the long put
• 105 is the point of maximum profit - ₦5.5 from the holder at ₦105 per share.
premium + interest on the funds + opportunity to buy the • The effective cost price to the investor is ₦99.5 (105 – 5.5).
stock at 105 instead of 110.

• If the price rises, the investor faces the opportunity cost of

lost returns from not buying the stock at ₦110. 17
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 Options Spreads

An options spread is a strategy involving the simultaneous purchase and sale of options in the same class, i.e. calls or puts on the
same underlying asset.

Vertical spread Horizontal (calendar) spread Diagonal (diagonal calendar) spread

• Buying and selling calls (or puts) with • Buying and selling options with the • Buying and selling options with different
different strikes, but the same expiry same strike, but different expiry months strikes and different expiry months.
• E.g. buy April 200 call and sell April • E.g., buy April 200 call and sell May
220 call or buy September 500 put 200 call or sell September 500 put and
and sell September 550 put. buy December 500 put.
• Two types – bull spread and bear
spread.

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 Vertical Spreads (1/3)
• In a bull spread, the investor buys the lower strike and sells Example
The current price of DEF Plc is 550 and the options
the higher strike.
available with the premium (PM) at a range of exercise
• For example, buying the 500 call and selling the 600 call (a prices are as follows:
bull call spread); Call PM Strike Put PM
70 500 18
• Or, alternatively, buying the 500 put and selling the 600 put 49 525 23
(a bull put spread). 37 550 35
25 575 47
19 600 67

Suppose an investor is bullish on DEF shares. She could buy the If the price rises to between 550 and 600, she will exercise
550 call and pay a premium of 37. She also thinks the shares the 550 call and collect the IV (the 600 call will be
will not rise beyond 590 by expiry. So she sells the 600 call at abandoned). To make a net profit on the trade, the intrinsic
the same time, receiving a premium of 19, making her net value of the 550 call needs to be greater than 18, her initial
outlay to 18. This is a bull call spread. net outlay.
If the price remains at 550 or below, both options will expire The break-even point is 568.
OTM and be abandoned. The loss will be limited to the net
outlay of 18. 19
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 Vertical Spreads (2/3)
Bull Call Summary
If the price rises beyond 600, both calls are ITM and will be
Motivation Moderately bullish.
exercised. In effect, the investor will exercise the 550 call and Buy at lower strike price, sell at higher
will be obliged to deliver the ABC shares at 600. The profit Construction strike price
Net premium Paid out.
will be capped at 32 ((600 – 550) – 18).
Maximum risk Net premium paid
Looked at another way, once the shares are above 600, all Difference in strike prices less the net
Maximum reward premium paid
the extra profit made from the 550 call is taken away by the
short 600 call. Break-even point Lower strike price + net premium paid.
Bear Call Summary
Motivation Moderately bearish.
• In a bear spread, the investor sells the lower strike and Sell at lower strike price, buy at
buys the higher strike; Construction higher strike price
Net premium Received.
• For example: selling the 500 call and buying the 600 call (a
Difference in strike prices less the net
bear call spread); Maximum risk premium received.
• Or, alternatively, selling the 500 put and buying the 600 Maximum reward Net premium received
Lower strike price + net premium
put (a bear put spread). Break-even point received.
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 Vertical Spreads (3/3)
Bull Put Summary Bear Put Summary
Motivation Moderately bullish. Motivation Moderately bearish.
Buy at lower strike price, sell at higher Sell at lower strike price, buy at higher
Construction strike price Construction strike price
Net premium Received. Net premium Paid out.
Difference in strike prices less the net Maximum risk Net premium paid
Maximum risk premium received. Difference in strike prices less the net
Maximum reward Net premium received Maximum reward premium paid
Higher strike price less net premium
Break-even point received. Break-even point Higher strike price + net premium paid.

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 Vertical Spreads - Example
Mr Z buys a 500 put in ABC plc shares for 18 and sells a What is the outcome of this trade at expiry if the price of
ABC plc shares is:
550 put at 35.
a. 490
What is the break-even point and what is the maximum b. 530
profit on this trade? c. 575

This is a bull put spread. a.The 550 put will be exercised, so he will buy the shares at
550 each and he will be able to sell them for 500 under
• The break-even will be when the share price reaches the terms of the put option he holds.
533. The loss will be 50, but he received a net premium of 17
• At this price the holder of the 550 put will exercise, so (35 – 18), so the net loss is 33 (50 – 17).
Mr Z will lose 17 (buying shares for 550 that are only b.The 550 put will be exercised, so Mr Z will buy the ABC
worth 533). shares at 550 each and he will be able to sell them for
• However, there is also the net premium receipt of 17 to 530 on the market.
consider (35 – 18), so overall Mr Z will break-even. The loss will be 20, but he has received a net premium of
• The maximum profit will occur at 550 or above. 17 (35 – 18), so in overall terms he has lost 3 (20 – 17).
• At 550, Mr Z will keep the premium of 35, having spent c. Neither option will be exercised, he will keep the net
a premium of 18 on the bought put with the lower premium of 17 (35 – 18).
exercise – a net profit of 17.

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 Horizontal Spreads (1/2)
Horizontal spreads are also known as calendar spreads. They are motivated by expected moves in volatility. There are two
basic types of horizontal spreads.

The first is based on the view that volatility will fall. It involves selling a shorter maturity and buying a longer maturity option
on the same asset with the same strike price. This is to take advantage of the fact that short-dated options will lose their time
value faster, and therefore react more quickly to a fall in volatility, than the longer-dated option.

Example • Trading view: Currency rates will remain steady over the
The GBP/USD spot rate is currently quoted at 1.4950/55, near term and that the slight premiums the sterling short-
the following options, with ATM strike prices, are currently term puts have will decrease.
quoted in the market: • An investor will sell the one-month 1.4925 put and buy
Expiration Call PM Strike Price Put PM the six-month 1.4950 put, for a net cost of 245. This is
1 month 45 1.4925 50
3 months 130 1.495 145 known as a horizontal spread.
6 months 280 1.495 295
12 months 575 1.49 585 23
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 Horizontal Spreads (2/2)

• If the GBP/USD FX rate settles into a trading range, the • The second type of horizontal or calendar spread is
implied volatility combined with the larger time decay based on the view that (volatility, particularly short-
will cause the premium on the shorter-term GBP put to term volatility, will rise).
fall faster than that of the longer maturity. • It involves buying a shorter maturing option and selling a
longer maturity option on the same underlying asset with
• After two weeks, when the premiums of these same
the same strike price.
options have fallen to, say, 20 for the two-week and
• This strategy is used most often ahead of key
275 for the five-and-a-half month GBP put, the investor
announcements, such as companies’ earnings reports or
will receive a net premium of 10, since he is able to
central bank meetings, to take advantage of any
unwind the spread and receive a net payment of 255,
dramatic short-term moves that may occur from the
compared to the initial cost of 245.
news.

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 Diagonal Spreads
Diagonal spreads are directional depending on market view.

• They are a cross between horizontal spreads from the calendar perspective and vertical spreads (from the directional
perspective);

• They will be constructed with call options if the investor’s view is bullish;

• They will be constructed with put options if bearish; and

• They are constructed by selling shorter-dated options closer to the money (or ITM) and buying longer-dated further OTM
options.

Horizontal spread and diagonal spread strategies both take advantage of the different rates of time decay for options with
different expiries. Essentially, the trades are designed to take advantage of changes in volatility inherent in options at
different points in their lifecycle.
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 Options Combinations
A combination strategy involves the simultaneous The current price of NSC Plc shares is 550 and the
purchase/sale of calls and puts.
following options are available:
• The two major strategies are straddles and strangles.
• They attempt to profit from a change in the volatility of the Call PM 70 49 37 25 19
underlying asset. Strike 500 525 550 575 600
• Long positions anticipate an increase in volatility and short Put PM 18 23 35 47 67
positions anticipate a decrease.

Long Straddle • If the share price rises to 660 by expiry, the investor will

An investor unsure about the direction of movement in NSC exercise the call (110 IV) and abandon the put.

share price. • She has paid 72 for the strategy, yielding 38 in net +ve.
• The strategy’s upside breakeven is 622 (550 + 72).
• By buying a 550 call for 37, she will profit if the price rises
• If the share price falls to 500, the investor will exercise
• By buying a put for 35 she will profit if the share price falls
the put (50 IV) and abandon the call.
• By doing both, a long straddle position is created for a net • The price needs to reach 478 (550 – 72) for the strategy
premium outlay of 72 (37 + 35) to yield a net profit (downside breakeven). 26
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 Straddles
Long Straddle Summary

Profit

+478
Motivation Expectation of increase in volatility
Buy a call and a put with the same
550 Construction strike and expiry
Price of asset
at expiry Maximum risk Total sum of premiums paid
478 622 Maximum reward Unlimited
Upside: strike price + total premium
-72
Downside: strike price - total
Break-even point premium

Loss

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 Straddles
Short Straddle
An investor unsure about the direction of movement in DEF • If the share price rises, the call is exercised and the IV
shares, but is convinced price will not move far away from lost. As long as rise is < 72, the ROI is net +ve.
the current price. Movement above 622 yields net loss.
• By selling the 550 call for 37, he will profit if the price • If the share price falls, the put is exercised and the IV
falls lost. As long as fall is < 72, the ROI is net +ve.
• By selling the put for 35 he will profit if the share price Movement below 478 yields net loss.
rises • The point of maximum profit is 550. Here, both
• By selling both, a short straddle position is created for options will be abandoned and the seller of the
net premium revenue of 72 (37 + 35) straddle will keep the total premium.
Profit Summary
Short Straddle
Motivation Expectation of decrease in volatility
Sell a call and a put with the same
Price of asset Construction strike and expiry
at expiry Maximum risk Unlimited
478 550 622 Maximum reward Total sum of premiums paid
-478 Upside: exercise price - premiums
Call PM 70 49 37 25 19 Break-even point Downside: exercise price - premiums
Loss Strike 500 525 550 575 600
Put PM 18 23 35 47 67 28
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 Strangles
A variation of a straddle undertaken in expectation of changes in volatility. A long strangle and a long straddle differ in the
following ways:
• A strangle involves buying a call and a put with the same expiry but different strike prices (normally constructed with the put
strike lower than the call strike).
• The premium outlay on a strangle will usually be lower than on a straddle.
• The strategy needs more volatility to succeed.
• The maximum loss on a long position will be crystallised over a range (between the two strike prices) where neither option
will be worth exercising. Long Strangle Summary
Motivation Expectation of large increase in volatility
Profit
Buy a call and a put with the same expiry but
Long Strangle Construction different strikes.
463 Total premiums paid. (Call strike > the put)
(If call strike < put, this’ll be limited to
500 600 Maximum risk premium less difference between strike prices.)
Price of asset
at expiry Maximum reward Unlimited
463 637 Downside: lower strike price less premiums.
-37
Upside: higher strike price plus premiums.
(Call strike price higher than the put.)
Loss 29
Break-even point (If call strike < put, these will be reversed.)
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 Strangles
A short strangle is the other side of a long strangle. The • The strategy can withstand more volatility before losses
differences between short strangle and short straddle are: are incurred.
• A short strangle involves the sale of a call and a put with • The maximum profit on a short position will be crystallised
the same expiry but different strikes (normally constructed over a range (between the two strikes) where neither
with the put strike lower than the call strike). option will be worth exercising against the seller.
• The total premium received on a strangle will usually be • For example, it will be created by selling a 500 put for
lower than on a straddle. 18 and selling a 600 call for 19.
Short Strangle Summary
Motivation Expectation of large decrease in volatility
Profit
Short Strangle Sell a call and a put with the same expiry but
Construction different strikes.
37 Maximum risk Unlimited
463 637
Price of asset Total premiums received. (Premium received
at expiry less difference between the strikes if call strike
500 600
Maximum reward < put strike.)
-463 Downside: lower strike price less premiums.
Upside: higher strike price plus premiums.
(Put strike price < the call.)
Loss 30
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Break-even point (If call strike < put, these will be reversed.)
 Synthetic positions
Synthetics exist to enable investors realize arbitrage opportunities. They are also used when a specific instrument is not
available in the market. There are six basic synthetics to for discussion:

Synthetic long future Synthetic short future

Buy a call and sell a put with the same Sell a call and buy a put with the same
strike and expiry strike and expiry

Synthetic long call Synthetic short call

Buy a future and buy a put. (Same as Sell a future and sell a put. (Effectively a
having a hedged long position.) short call position.)

Synthetic long put Synthetic short put

Buy a call and sell a future. (Same as a Sell a call and buy a future. (Effectively
hedged short position.) a short put position.)

Recall the put/call parity formula (C – P = S – K). When call

and put prices are out of line with another, synthetic positions
can be created to lock in a riskless profit.
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 Synthetic positions - Examples
The long bond future is currently trading at 114.14. The The long bond future is currently trading at 114.14. The
premium of the 114.00 call is 0.45 and the premium of the premium of the 114.00 call is 0.51 and the premium of the
114.00 put is 0.39. 114.00 put is 0.31.

What should you do? What should you do?

• Buy the call and sell the put for a net premium outlay of • Sell the call and buy the put for a net premium receipt
0.06. This gives you a long futures position (synthetically) of 0.20. This gives you a short futures position
at 114.06. (synthetically) at 114.20.

• But the actual future is trading at 114.14, so sell the • But the actual future is trading at 114.14, so buy the
future to lock in the difference of 0.08. future to lock in the difference of 0.06.

• The whole trade is known as a reversal. • The whole trade is known as a conversion.
Recall the put/call parity formula (C – P = S – K). When call is
cheaper - buy the call, sell the put, and buy the future. If the put
is cheaper, do the opposite.
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 ETD vs OTC Derivatives Hedges

Advantages Disadvantages
- More liquidity - Margin payments required
- Full price transparency - Standardised contracts
Exchange Traded
- Counterparty credit risk limited to the
exchange’s clearing house
- Flexible contracts to fit any exposure - Counterparty credit risk
Over-the-counter - No margin required, collateral - Limited price transparency
depends on counterparty - Higher transaction costs

Since 2009, the line between ETD and OTC has continues to get
increasingly blurry, especially with respect to standardization.
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 Application

RETAIL INVESTORS FUNDS CORPORATE TREASURIES HEDGE FUNDS

Vehicle Application Application Application Every strategy possible
Discretionary Speculative Currency risk
Accounts Hedging Guaranteed Commodity price risk
Moderate Synthetics Interest rate risk
CISs speculation

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 Contact

You can contact us using the following channels:

X-Academy Team
Website: www.nse.com.ng
Email: [email protected]
Phone call:
+234(0) 803 429 7737
(0) 807 726 8889
(0) 706 670 2693

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 Thank You!
Questions & Answers

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