Introduction to Derivatives

Lecture 1

Learning Objectives

What is Risk? Categories of Risk How to handle risks? What is Risk Management? What are Derivatives? Types of Derivatives Uses of Derivatives What is Arbitrage/Speculation/Hedging?

What is Risk?

No single definition. In theory of finance, risk is defined as variability of returns. Measure of financial risk:

Standard Deviation

Is risk bad?

No, risk is not bad. Risk-return framework.

No gain without pain. One cannot expect higher return unless one exposes oneself to higher level of risks. Risk averse Risk neutral Risk seeker

Investors differ in their risk bearing capacity.

Categories of Risk

Pure Risk vs. Speculative Risks:

Pure Risk: situation in which possibilities are loss and no loss. Speculative Risk: either profit or loss is possible.

Systematic Risk vs. Non-systematic Risk:

Systematic Risk: Risk that cannot be diversified. Also called market risk. Non-systematic Risk: Risk that can be eliminated by diversification. Also called Unique/Specific risk

Categories of Risk

Fundamental Risk: affects entire economy or large sections of it. Examples: War, inflation, etc. Particular Risk: affects individuals. Enterprise Risk: encompasses all major risks faced by a firm.

Pure, speculative, strategic, operational & financial risks.

Methods of Handling Risk

Avoidance Loss Control Loss prevention Loss reduction Retention Active retention: Individual is aware of risk and deliberately plans to retain it. Passive retention: Ignorance, indifference. Non-insurance Transfers Transfer of risks by contracts. Hedging price risks. Limited liability company. Insurance

What is Risk Management?

Does it mean reduction of risk? Risk Management (RM) is a process that identifies loss exposure faced by a firm and selects the most appropriate techniques for treating such exposures. Points to note:

It is a dynamic process. Does not talk about risk reduction.

What are Derivatives?

A derivative is an instrument whose value depends on the values of other more basic underlying variables. The underlying could be a stock, commodity, index, etc. Example: NSE allows trading in derivatives on stocks like HDFC Bank, ACC, etc and indices like Nifty.

Types of Derivatives

Futures Contracts Forward Contracts Swaps Options

Futures Contract

A futures contract is an agreement to buy or sell an asset at a certain time in the future for a certain price. By contrast in a spot contract there is an agreement to buy or sell the asset immediately (or within a very short period of time).

Futures Price

The futures prices for a particular contract is the price at which you agree to buy or sell. It is determined by supply and demand in the same way as a spot price. Long position: one who has agreed to buy. Short position: one who has agreed to sell.

Forward Contracts

Forward contracts are similar to futures except that they trade in the over-the-counter market. Limitations of Forwards:

Credit risk. Non-transparent price determination.

Forward contracts are popular on currencies and interest rates. Why?

Options Contracts

A call option is an option to buy a certain asset by a certain date for a certain price (the strike price). A put option is an option to sell a certain asset by a certain date for a certain price (the strike price).

Uses of Derivatives

To hedge risks.

Hedging: An investment made in order to reduce the risk of adverse price movements in a security, by taking an offsetting position in a related security.

To speculate (take a view on the future direction of the market).

Speculation: A trading strategy where one side of a position is taken (and thus risk bearing) where the trader expects to make a positive profit.
Arbitrage: A trading strategy which generates (weakly) positive profits with probability one.

To lock in an arbitrage profit.

Uses of Derivatives

To change the nature of a liability. To change the nature of an investment without incurring the costs of selling one portfolio and buying another futures contract.

Types of Traders

Hedgers: Use derivatives to reduce the risks they face from potential future movements in a market variable. Speculators: Use them to bet on future movements of a market variable. Arbitrageurs: Use them to lock in a risk-less profit.

Role of different types of traders

Hedgers: provide depth to the market. Speculators: provide liquidity and volume to the market. Arbitrageurs: assist in price discovery and correct price abnormalities.

Is speculation bad?

Should speculators be banned? No, speculators are necessary for markets to work.

Hedging Example- Options

An investor owns 1,000 Microsoft shares currently worth $28 per share. A two-month put with a strike price of $27.50 costs $1. The investor decides to hedge by buying 10 contracts (of 100 shares each).

Value of Microsoft Shares with and without Hedging

40,000

Value of Holding ($)

35,000

No Hedging
30,000 Hedging

25,000
Stock Price ($) 20,000 20 25 30 35 40

Hedging Example- Futures

An investor owns 1,000 Microsoft shares currently worth $28 per share. A two-month futures contract of $28.25 is available. The investor decides to hedge by taking short position.

If after 2 months spot price is below $28.25 investor is protected. But if after 2 months spot price is above $28.25 investor doesnt benefit.

Speculation Example

An trader with Rs 4,000 to invest feels that Hero Hondas stock price will increase over the next 2 months. The current stock price is Rs. 800 and the price of a 2-month call option with a strike of Rs. 815 is Rs. 10. What alternative strategies are available?

Speculation Example

Strategy 1 Buy 5 shares of Hero Honda. After 2 months stock price becomes Rs. 830. Trader sells 5 shares. Trader makes profit of Rs. 5*30 = Rs. 150.

Speculation Example

Strategy 2 Buy 400 two-month call options of Hero Honda. After 2 months stock price becomes Rs. 830. Trader exercises call options. Makes profit of Rs. 400*15 - 4000 = Rs. 2000

Speculation Example

Use of derivatives amplifies the profits which can be had from directly dealing in the market variable. What about losses? They too get amplified!

Problem

Futures can be used for either speculation or hedging. How? If you have an exposure to the price of an asset, futures can be used for hedging. If you dont have an exposure to the price of an asset, entering into futures is speculation.

Arbitrage Example-1

Suppose that: The spot price of gold is Rs.10000. The quoted 1-year futures price of gold is Rs. 11100. The 1-year interest rate is 10 % per annum. No income or storage costs for gold. No transaction costs. Is there an arbitrage opportunity?

Arbitrage Example-1
If the spot price of gold is S & the futures price is for a contract deliverable in T years is F, then F = S (1+r )T where r is the 1-year risk-free rate of interest. In our examples, S=10000, T=1, and r=0.10 so that F = 1000(1+0.10) = 11000

Arbitrage Example-1

What will you do? Borrow Rs. 10000 @ 10% p.a from bank. Buy gold. Go short on gold futures contract of price Rs. 11100. At end of one year, sell gold at Rs. 11100, give Rs. 1000 as interest to bank and walk away with Rs. 100 as risk free profit! So you have found a Money Making Machine!

Arbitrage Example-2

Suppose that: The spot price of gold is Rs.10000. The quoted 1-year futures price of gold is Rs. 10900. The 1-year interest rate is 10 % per annum. No income or storage costs for gold. No transaction costs. Is there an arbitrage opportunity?

Arbitrage Example-2

What will you do? Sell gold at Rs. 10000. Invest Rs. 10000 @ 10% p.a in a bank. Go long on gold futures contract of price Rs. 10900. At end of one year, get Rs. 11000 from bank. Buy gold at Rs. 10900 and walk away with Rs. 100 as risk free profit! So you have again found a Money Making Machine!

Do such machines exist?

Yes, they do. But for very short periods. As soon as traders start building up positions the price of futures contracts will change to eliminate the arbitrage opportunity. Another important consideration are transactions costs.