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As the word implies, a derivative instrument is derived from “something” backing it. This
something may be – A loan, an asset, an interest rate, a currency flow, a stock trade, a commodity
transaction etc.
Derivates enable a company to hedge a company to hedge “this some thing” without
changing the flow associated with the business operations.
FORWARDS
Forwards are the oldest of all derivatives. A forward contract refers to an agreement
between two parties to exchange an agreed quality of an asset for cash at a certain date in future
at a predetermined price specified in the agreement.
FUTURES
A future contract is very similar to a forward contract in all respects excepting the fact
that it is completely a standardized one. Hence, it is rightly said that a futures contract is nothing
but a standardized forward contract. It is legally enforceable and it is always traded on an
organized exchange.
Clark has defined future trading “as a special type of futures contracts bought and sold
under the rules of organized exchanges.”
A future contract is one where there is an agreement between tow parties to exchange any
asset or currency or commodity for cash at a certain future date, at an agreed price. Both the
parties to the contract must have mutual trust in each other. It takes place only in organized
future markets and according to well established standards.
Short Position: This commits the seller to deliver an item at the contracted price on
maturity.
Long Position: This commits the buyer to purchase.
Key features of Futures contracts:
• Standardization.
• Intermediation by the Exchange.
• Price Limits.
• Margin requirements.
• Marking to market.
Price Limits:
Marking to market: while the forward contracts are settled down the maturity date futures
contracts are ‘marked to market’ on a periodic basis. This means that profits and losses on future
contracts are settled on a periodic basis.
Financial Futures: Financial futures refer to a futures contract in foreign exchange or financial
instruments like Treasury bill, commercial paper, stock market index or interest rate.
Some of the well established financial futures exchanges are the following;
1. International Monetary Market (IMM) to deal in US treasury bills, Euro dollar deposits
etc.
2. London International Financial futures exchange (LIFFE) to deal in Euro dollar deposits.
3. New York Futures Exchange (NYFE) to deal in Euro dollar deposits etc.
[Refer Prasanna Chandra (SAPM), Page number – 469 & 470 (old). 541& 542 (new)]
Index Futures:
• Index is the underlying security
• Derive their value from the underlying index
• Date of commencement of trading at NSE is 2/6/2000.
Stock futures:
• Stock is the underlying security.
• Derive their value from underlying stock.
• Date of commencement of trading is 9/11/2001
VALUATION OF FUTURES
So = Spot Price,
rf = Risk Free
t = time period.
OPTIONS
An option gives its owner the right to buy or sell an underlying asset on or before a given
date at a fixed price.
Call Option: Right to Buy a specified underlying at a set price on/or before an expiration date.
Put Option: Right to Sell a specified underlying at a set price on/or before on expiration date.
Option Holder: The buyer of the option.
Option Writer: The seller of the option.
Exercise price or Striking price: The fixed price at which the option holder can buy and/or sell
the underlying asset.
Formally, - C = S1 – E if S1 > E
C = 0 if S1 ≤ E
Pay off of a
Call option
P/L
E
Put Option – Pay off of a Put option:
The payoff of a put just before expiration depends on the relationship between the
exercise price (E) and the price of underlying security (So1).
If So1>E, the put option has a value of E-So1 and is said to be “in the money”
OPTION STRATEGIES: You can achieve an innumerable variety of pay off patterns by
combining puts and calls with various exercise prices. Some of the more popular strategies are
discussed below.
1. Protective Put: Suppose you are interested in investing in a stock because its upside
potential attracts you. How ever, you are concerned about fall in its price. To protect
yourself against potential losses beyond some given level, you can invest in the stock and
simultaneously purchase a put option on it. Such strategy is called Protective Put strategy.
2. Covered Call: A covered call strategy involves writing call option an asset along with
buying the asset. It is called a “covered position because the potential obligation to
deliver the stock is covered by the underlying stock in the portfolio.
3. Straddle: A long straddle involves buying a call as well as a put on a stock at the same
exercise price.
4. Spread: A spread involves combining two or more call options (or two or more Put
options) on the same stocks with differing exercise prices or times of maturity. Some
options are bought and some options are sold. A vertical or money spread involves
purchase and sale of options at different exercise prices. A horizontal or time spread
involves purchase and sale of options with differing expiration dates.
Where,
Co = Equilibrium value of call option.
So = Price of the stock now
E = Exercise Price
e = Base of natural logarithm
r = Annualized continuously compounded risk – free interest rate.
t = Length of time in years to the expiration date.
N(d) = Value of cumulative normal density function.
d2 = d1 - σ√t
Where,
ln = Natural logarithm
σ = Standard deviation of the annualized continuously compounded of return on the stock.
ASSUMPTIONS
The assumptions underlying Black & Scholes model are as follows;
• The Call Option is a European Option.
• The Stock price continuous and is distributed log normally.
• There are no transaction costs and taxes.
• These are no restrictions and penalties for short selling
• The Stock pays no dividend
• The risk – free interest rate is known and constant.
[Refer Prasanna Chandra (SAPM), pages – 454 & 455 (old), 523 – 525 (new)]