NPTEL Course

Course Title: Security Analysis and Portfolio Management

Dr. Jitendra Mahakud
Module- 19
Session-37
Introduction to Derivatives
37.1 What is Derivative?
Derivative is a financial instrument or security whose payoffs depend on a more
primitive or fundamental good. Examples: grains, coffee, orange, gold, silver, foreign
exchange, bonds and stocks. Financial derivative is a financial instrument whose payoffs
depend on the financial instruments or security
Forward and Futures Contracts
A forward contract is a customized contract between two entities, where settlement
takes place on a specific date in the future at todays pre-agreed price. A future contract is an
agreement between two parties to buy or sell an asset at a certain time in the future at a
certain price. Futures contracts are special types of forward contracts in the sense that the
former are standardized exchange-traded contracts

Options: Options are of two types - calls and puts. Calls give the buyer the right but not the
obligation to buy a given quantity of the underlying asset, at a given price on or before a
given future date. Puts give the buyer the right, but not the obligation to sell a given quantity
of the underlying asset at a given price on or before a given date.
Warrants: Options generally have lives of up to one year, the majority of options traded on
options exchanges having a maximum maturity of nine months. Longer-dated options are
called warrants and are generally traded over-the-counter.
Baskets: Basket options are options on portfolios of underlying assets. The underlying asset
is usually a moving average or a basket of assets. Equity index options are a form of basket
options.
American vs European Options: An American option can be exercised at any time during
its life. A European option can be exercised only at maturity
Options vs Futures/Forward:

A futures/forward contract gives the holder the obligation to buy or sell at a certain
price

An option gives the holder the right to buy or sell at a certain price

Swaps
Swaps: Swaps are private agreements between two parties to exchange cash flows in the
future according to a prearranged formula. They can be regarded as portfolios of forward
contracts. The two commonly used swaps are :
Interest rate swaps: These entail swapping only the interest related cash flows between the
parties in the same currency.
Currency swaps: These entail swapping both principal and interest between the parties, with
the cashflows in one direction being in a different currency than those in the opposite
direction.

37.2 Use of Derivatives

To hedge risks

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

To lock in an arbitrage profit

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

37.3 Factors Contributing Growth of Derivatives

Increased volatility in asset prices in financial markets

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Increased integration of national financial markets with the international markets

Marked improvement in communication facilities and sharp decline in their costs

Development of more sophisticated risk management tools, providing economic

agents a wider choice of risk management strategies

Innovations in the derivatives markets, which optimally combine the risks and returns
over a large number of financial assets leading to higher returns, reduced risk as well
as transactions costs as compared to individual financial assets.

37.4 Futures Contracts

Concepts used in Future Contracts

Buyer- Long Position, Seller-Short Position

Act of Buying- Going Long, Act of Selling- Going Short

Trading Volume: Number of Trades in 1 day.

Open interest: the total number of contracts outstanding

Settlement price: the price just before the final bell each day used for the daily
settlement process

Standardized Contract Term

Tick size: Minimum price fluctuation

Daily Price Limit: Restriction for the price movement in a single day

Delivery Date

Strike Price

Sum of all outstanding long and short future market positions is always equal to zero

Closing a Future Position

Delivery: Through physical delivery or cash settlement

Offset: Through reversing trade. The trader transacts in the future market to bring his
net position in a particular futures contract back to zero.

Exchange-for-Physicals: Two traders agree to a simultaneous exchange of a cash

commodity and future contracts based on that cash commodity. It is known as ex-pit
transaction.

Basis

Basis is the relationship between the spot price and future price of the asset.

Basis =Current Spot Price Future Price

Normal Market: Prices for more distant futures are higher than for nearby futures.
Future Price > Spot Price

Inverted Market: Distant Futures prices are lower than the prices for contracts nearer
to the expiration. Future price < Spot Price

When the future contract is at expiration, the future price and the spot price of asset
must be same. Basis is zero. This behaviour of basis over time is known as
convergence

Expected Basis: It arises because of carrying cost and uncertainty.

Hypotheses which explain the expected basis are as follows:
(i) Normal backwardation: Expected basis is negative as the future prices tend to be
downward estimate of its spot price. Speculators generally buy and hedgers generally
write.
(ii) Contango: Speculators generally sell and hedgers generally buy.
(iii) Expectation principles: Expected basis is zero. Future prices are an unbiased estimate of
expected future spot prices

Spread

Spread is the difference between two future prices

If the two prices are for the future contracts on the same underlying good, but with
different expiration dates, the spread is an intra commodity spread

If the two future prices that form a spread are future prices for two underlying goods
then the spread is an inter commodity spreads

Hedging

Hedger is a trader who enters the market in order to reduce the preexisting risk

Hedging is viewed as the purchasing insurance

For hedging all the factors should match

Time span covered

Amount of the assets

Particular characteristics of the good

Long & Short Hedges

A long futures hedge is appropriate when you know you will purchase an asset in the
future and want to lock in the price

A short futures hedge is appropriate when you know you will sell an asset in the
future & want to lock in the price

Suppose that: F1 : Initial Futures Price, F2 : Final Futures Price, S2 : Final Asset Price.
You hedge the future purchase of an asset by entering into a long futures contract, then cost
of Asset=S2 (F2 F1) = F1 + Basis (Long Hedge)
You hedge the future sale of an asset by entering into a short futures contract. Price
Realized=S2+ (F1 F2) = F1 + Basis (Short Hedge)

Optimal Hedge Ratio

Proportion of the exposure that should optimally be hedged is
h=
where

S
F

S is the standard deviation of S, the change in the spot price during the hedging period,
F is the standard deviation of F, the change in the futures price during the hedging period
is the coefficient of correlation between S and F.

37.5 Options

Intrinsic Value and Time Value

Option Premium = Intrinsic Value (Parity Value) + Time value (Premium over parity)

Intrinsic value refers to the amount by which it is in-the-money

Option which is out-of-the money has a zero intrinsic values

For a call option which is in the money, the intrinsic value is the excess of stock price
over the exercise price

For a put option which is in the money, the intrinsic value is the excess of exercise
price over the stock price

Covered and Naked Calls

If a call writer owns the asset underlying the call, he is said to have written a covered
call. If a call is written where the writer does not have the asset underlying the call option the
call is said to be a naked call.
Call and Put Options at Expiration
If the price of the underlying asset is lower than the exercise price on the expiration of
a call option, the call would expire unexercised. When at expiration the price of the
underlying asset is greater than the exercise price, the put will expire unexercised.

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Questions and Answers

1. What is Derivative and explain the ways Derivatives are used?
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Derivative is a financial instrument or security whose payoffs depend on a more

primitive or fundamental good.

Examples: grains, coffee, orange, gold, silver, foreign exchange, bonds and stocks

Financial derivative is a financial instrument whose payoffs depend on the financial

instruments or security

Ways Derivatives are used

To hedge risks

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

To lock in an arbitrage profit

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

2. How to use Of Derivatives in Portfolio Management?

The Use of Derivatives In Portfolio Management

Restructuring asset portfolios with forward contracts

shorting forward contracts

tactical asset allocation to time general market movements instead of

company-specific trends

hedge position with payoffs that are negatively correlated with existing
exposure

converts beta of stock to zero, making a synthetic T-bill, affecting portfolio

beta

Protecting portfolio value with put options

purchasing protective puts

keep from committing to sell if price rises

asymmetric hedge

portfolio insurance

Caution on Use: Either hold the shares and purchase a put option, or sell the shares
and buy a T-bill and a call option

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Factors Contributing Growth of Derivatives

Increased volatility in asset prices in financial markets

Increased integration of national financial markets with the international markets

Marked improvement in communication facilities and sharp decline in their costs

Development of more sophisticated risk management tools, providing economic

agents a wider choice of risk management strategies

Innovations in the derivatives markets, which optimally combine the risks and returns
over a large number of financial assets leading to higher returns, reduced risk as well
as transactions costs as compared to individual financial assets.

3. Write short note on: Forward and Futures Contracts

Forward and Futures Contracts:

Forwards: A forward contract is a customized contract between two entities, where

settlement takes place on a specific date in the future at todays pre-agreed price.

Futures: A futures contract is an agreement between two parties to buy or sell an asset
at a certain time in the future at a certain price. Futures contracts are special types of
forward contracts in the sense that the former are standardized exchange-traded
contracts

Difference between Forward and Futures Contracts

FORWARDS

FUTURES

Private contract between 2 parties

Not standardized
Settled at maturity

Exchange traded
Standardized
Range of delivery dates

Usually one specified delivery date

Settled daily

Delivery or final cash settlement usually

occurs

Contract usually closed out prior to

maturity

Some credit risk

Virtually no credit risk

4. Write a short note on Long & Short Hedges

Ans.

A long futures hedge is appropriate when you know you will purchase an asset in the
future and want to lock in the price

Long Hedge Example:

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Suppose that
F1 : Initial Futures Price
F2 : Final Futures Price
S2 : Final Asset Price
You hedge the future purchase of an asset by entering into a long futures contract
Cost of Asset=S2 (F2 F1) = F1 + Basis

A short futures hedge is appropriate when you know you will sell an asset in the
future & want to lock in the price

Short Hedge Example:

Suppose that
F1 : Initial Futures Price
F2 : Final Futures Price
S2 : Final Asset Price
You hedge the future sale of an asset by entering into a short futures contract
Price Realized=S2+ (F1 F2) = F1 + Basis
5. Write a short note on Swaps
Ans.

Swaps: Swaps are private agreements between two parties to exchange cash flows in
the future according to a prearranged formula. They can be regarded as portfolios of
forward contracts. The two commonly used swaps are :

Interest rate swaps: These entail swapping only the interest related cash flows
between the parties in the same currency.

Currency swaps: These entail swapping both principal and interest between the
parties, with the cash flows in one direction being in a different currency than those in
the opposite direction

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