Introduction To Derivatives: B. B. Chakrabarti
Introduction To Derivatives: B. B. Chakrabarti
B. B. Chakrabarti
Professor of Finance
Indian Institute of Management, Calcutta
What is a Derivative Security?
A Derivative Security is a security whose
value depends on the values of other, more basic
underlying variables.
Example:
An Indian exporter is likely to receive USD 1000
after one month goes to a bank and contracts to
sell the USD money for Rs.61 per USD.
This contract is an example of derivative
contract where the underlying is the foreign
currency (USD)
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Derivatives Markets
Two types:
Exchange traded and Over-the-counter (OTC)
Exchange traded
Exchanges mostly use electronic trading.
Contracts are standard, virtually no credit risk
Example: Futures, Options
Over-the-counter (OTC)
A computer- and telephone-linked network of dealers at
financial institutions, corporations, and fund managers
Financial institutions often act as market makers.
Contracts can be non-standard and there is some amount of
credit risk
Example: Swaps, FRAs, Exotic options
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Types of Derivatives
Forward Contracts - OTC
Futures Contracts Exchange traded
Swaps - OTC
Options Exchange traded / OTC
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Forward Contract
A forward contract is an agreement to buy or
sell an asset at a certain future time for a certain
price.
It can be contrasted with a spot contract, which
is an agreement to buy or sell an asset today.
The contract is between two financial
institutions or between a financial institution
and one of its corporate clients.
It is not traded on an exchange.
Forward contracts are particularly popular on
currencies and interest rates.
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Terminology
Long position agrees to buy the underlying
asset on a certain specified future date for a
certain specified price.
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Example of Forward Contract
Suppose on April 01,2016 the treasurer of
an export company in India knows that it
will receive USD 1 million in 6
months (i.e. on October 01,2016) and
wants to become indifferent against
exchange rate moves.
He can undertake currency forward contract
with a bank now to sell USD 1 million in 6
months at a particular INR/USD forward rate.
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Spot and Future Quotes for
INR/USD (Not Actual Values)
Bid Price Offer Price
Spot 61.85 62.10
6 month 62.80 63.15
Forward
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Payoffs From Long Forward
Contracts
Payoff from
Long Position
K
Price of Underlying
at Maturity, ST
Price of Underlying
at Maturity, ST
K
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Swaps
A swap is an agreement to exchange cash flows
at specified future times according to certain
specified rules.
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Options
A call option is an option to buy a certain
asset by a certain date for a certain price.
A put option is an option to sell a certain
asset by a certain date for a certain price.
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Payoff Diagram Long Call
Payoff from
Long Call
K ST
-C
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Payoff Diagram Short Call
Payoff from
Short Call
C
K ST
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Payoff Diagram Long Put
Payoff from
Long Put
K
ST
-P
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Payoff Diagram Short Put
Payoff from
Short Put
P
K ST
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Types of Traders
Hedgers
Speculators
Arbitrageurs
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Hedging
Hedgers are essentially spot market players.
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Speculation
Speculators wish to take a position in the
market either by betting that the price will go
up or down.
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Arbitrageurs
Arbitrage involves locking in a riskless profit by
simultaneously entering into transactions in two
markets.
Example:
Consider a stock that is traded in both New York and London.
Suppose that the stock price is $172 in New York and 100
in London at a time when the exchange rate is $1.7500
per pound.
An arbitrageur could simultaneously buy 100 shares of the stock
in New York and sell them in London
He will obtain a risk-free profit of:
100*($1.75*100 $172) or $300 in the absence of transactions
costs.
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Problem No. 1
An investor enters into a short forward
contract to sell 100,000 British pounds for
US dollars at an exchange rate of 1.9000
US dollars per pound. How much does the
investor gain or loose if the exchange rate
at the end of the contract is (a) 1.8900 and
(b) 1.9200?
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Problem No. 1 (Ans.)
a. Gain = $1,000
b. Loss = $2,000
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Problem No. 1 (Explanation)
Part a:
The trader sells 100,000 British pounds for
1.9000 US dollar per pound when the exchange
rate is 1.8900 US dollar per pound.
The gain is 100,000*(1.9000 1.8900) = $1,000
Part b:
The trader sells 100,000 British pounds for
1.9000 US dollar per pound when the exchange
rate is 1.9200 US dollar per pound.
The loss is 100,000*(1.9200 1.9000) = $2,000
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Problem No. 2
You would like to speculate on a rise in the
price of a certain stock. The current stock
price is $29, and a three-month call with a
strike of $30 costs $2.90. You have $5,800
to invest. Identify two alternative
strategies, one involving an investment in
the stock and the other involving
investment in the option. What are the
potential gains and losses from each?
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Problem No. 2 (Ans.)
Strategy 1: Buy 200 shares
Strategy 2: Buy 2000 options
If share price does well strategy 2 will give
better gain
If share price does badly strategy 2 will
give greater loss
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Problem No. 3
Suppose that sterling-USD spot and forward
exchange rates are as follows:
Spot 2.0080
90-day forward 2.0056
180-day forward 2.0018
What opportunities are open to an arbitrageur in
the following situations?
a. A 180-day European call option to buy 1 for $1.97
costs 2 cents.
b. A 90-day European put option to sell 1 for $2.04
costs 2 cents.
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Problem No. 3 (Ans. Part A)
The trader buys a 180-day call option and takes a short position in a 180-
day forward contract
If ST is the terminal spot price,
The profit from the call option is
= max (ST 1.97,0) 0.02
The profit from the short forward contract
= 2.0018 ST
The profit from the strategy is therefore
= max (ST 1.97,0) 0.02 +2.0018 ST
= max (ST 1.97,0) +1.9818 ST
This is
1.9818 ST when ST < 1.97
0.0118 when ST > 1.97
Hence profit is always positive
The time value for money has been ignored in these calculations.
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Problem No. 3 (Ans. Part B)
The trader buys a 90-day put option and takes a long position in a 90-day
forward contract
If ST is the terminal spot price,
The profit from the put option is
= max (2.04 ST,0) 0.02
The profit from the long forward contract
= ST 2.0056
The profit from the strategy is therefore
= max (2.04 ST,0) 0.02 + ST 2.0056
= max (2.04 ST,0) + ST 2.0256
This is
ST 2.0256 when ST > 2.04
0.0144 when ST < 2.04
Hence profit is always positive
The time value for money has been ignored in these calculations.
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Problem No. 4
The price of gold is currently $600 per
ounce. The forward price for delivery in
one year is $800. An arbitrageur can
borrow money at 10% per annum. What
should the arbitrageur do? Assume that
the cost of storing gold is zero and that
gold provides no income.
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Problem No. 4 (Ans.)
The arbitrageur could
Borrow money to buy 100 ounces of gold today and
Short futures contracts on 100 ounces of gold for delivery in one
year
This means gold
Purchased for $600 per ounce
Sold for $800 per ounce
The return = 33.3% per annum >> 10% cost of borrowing
fund
The arbitrageur should do this as much he can.
Unfortunately this type of opportunity rarely arise in
practice.
Even if this arises this does not sustain.
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Problem No. 5
A bond issued by Standard Oil worked as follows. The
holder received no interest. At the bonds maturity the
company promised to pay $1,000 plus an additional
amount based on the price of oil at that time. The
additional amount was equal to the product of 170 and
the excess (if any) of the price of a barrel of oil at
maturity over $25. the maximum additional amount paid
was $2,550 (which corresponds to a price $40 a barrel).
Show that the bond is a combination of regular bond, a
long position in call options on oil with a strike price of
$25 , and a short position in call options on oil with a
strike price of $40.
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Problem No. 5 (Ans.)
Suppose ST is the price of oil at the bonds maturity
In addition to $1,000 the standard oil bond pays:
ST < $25 : 0
$40 > ST > $25 : 170(ST 25)
ST > $40 : 2,550
This is the payoff from 170 call options on oil with a
strike price of 25 less the payoff from 170 call options on
oil with a strike price of 40
The bond is a combination of regular bond, a long
position in 170 call options on oil with a strike price of
$25 , and a short position in 170 call options on oil with a
strike price of $40
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