Derivatives Introduction, TypesandUsage

Derivatives
Introduction, Types, and Usage

Introduction
Definition:
A derivative is a financial instrument whose value depends on, or is
derived from, the value of another variable.
• Examples: futures, forwards, swaps, options, exotics…
• The term was first coined in 1976

• The first documented usage goes back to ancient times attributing the
use to a Greek philosopher named Thales (Bernstein, 1992)
The Underlying Variables
Bonds
Stocks Currencies
Derivatives
Interest
Commodities
Rates
Indices
How Derivatives are Traded?
• On exchanges like CME, CBOE, NSE, BSE, MCX, etc. as standard listed
contracts
• In the over-the-counter (OTC) market where traders working for

banks, fund managers and corporate treasurers contact each other
directly
OTC Markets
Before 2008
• Largely unregulated
• Banks acted as market makers quoting bids and offers
• Master agreements usually defined how transactions between two parties would be
handled
• But some transactions were cleared through central counterparties (CCPs). A CCP
stands between the two sides to a transaction in the same way that an exchange
does
OTC Markets
Since 2008
• OTC market has become regulated. Objectives:
• Reduce systemic risk (see Business Snapshot 1.2, page 5)
• Increase transparency
• In the U.S and some other countries, standardized OTC products must be traded on
swap execution facilities (SEFs) which are electronic platforms similar to exchanges
• CCPs must be used to clear standardized transactions between financial institutions
in most countries
• All trades must be reported to a central repository
OTC Markets
Bilateral vs Central Clearing
CCC
CCP
CCP
Uses 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
Common Types of Derivatives
• Forwards
• Futures
• Options
• Swaps
FOREX Quotes for USD
BID OFFER (ASK)
Spot Price 83.017 83.037
1-month Forward Price 7.5 9.5
2-month Forward Price 21 23
3-month Forward Price 31 33
* Sell @ BID price and Buy @ ASK price

What is Forward Price
• The forward price for a contract is the delivery price
that would be applicable to the contract if were
negotiated today (i.e., it is the delivery price that would
make the contract worth exactly zero)
• The forward price may be different for contracts of

different maturities (as shown by the table)
Terminology
• Long Position
• The party who has agreed to buy the underlying
is said to have taken the long position.
• Short Position
• The party who has agreed to sell the underlying
is said to have taken the short position.
Example
• On Feb 17, 2024, the treasurer of a corporation enters into a long
forward contract to buy £1 million in six months at an exchange rate
of 104.561
• This obligates the corporation to pay Rs. 104,561,000 for £1 million on
November 17, 2024
• What are the possible outcomes?

Long Forward Position
(K= delivery price=forward price at time contract is entered into)
Profit
Price of Underlying at
K Maturity, ST
Short Forward Position
(K= delivery price=forward price at time contract is entered into)
Profit
Price of Underlying
K at Maturity, ST
Futures Contracts
• Agreement to buy or sell an asset for a certain price at a
certain time
• Similar to forward contract
• Whereas a forward contract is traded OTC, a futures contract
is traded on an exchange
• Trade on margins and are marked-to-market (daily settled)
Examples of Futures Contracts
Agreement to:
• Buy 100 oz. of gold @ US$1300/oz. in
December
• Sell £62,500 @ 1.4500 US$/£ in March
• Sell 1,000 bbl. of oil @ US$50/bbl. in April
Gold: An Arbitrage Opportunity?
Suppose that:
The spot price of gold is US$1,200
The 1-year forward price of gold is US$1,300
The 1-year US$ interest rate is 5% per annum
Is there an arbitrage opportunity?
Gold: Another Arbitrage Opportunity?
Suppose that:
- The spot price of gold is US$1,200
- The 1-year forward price of gold is US$1,200
- The 1-year US$ interest rate is 5% per annum
The Forward Price of Gold
(ignores the gold lease rate)
If the spot price of gold is S and the forward
price for a contract deliverable in T years is F,
then
F = S (1+r )T
where r is the 1-year (domestic currency) risk-
free rate of interest.
In our examples, S = 1200, T = 1, and r =0.05 so
that
F = 1200(1+0.05) = 1,260
Oil: An Arbitrage Opportunity?
Suppose that:
- The spot price of oil is US$50
- The quoted 1-year futures price of oil is US$60
- The storage costs of oil are 2% per annum
Oil: Another Arbitrage Opportunity?
Suppose that:
- The spot price of oil is US$50
- The quoted 1-year futures price of oil is US$40
- The storage costs of oil are 2% per annum
Practice …
During the summer you get an opportunity to spend some time as an
intern with a Gramin bank, whose majority clientele is wheat farmers.
Your mentor, knowing you have studied DRM at BITS Pilani, asked for
your expertise in designing financial contracts that can protect farmers
against the adverse price movement of wheat. Thus, you have to design
and price the contracts maturing in 1yr.
You find out that the current price of wheat is Rs. 2,125 per quintal and
interest rates are at 6%. However, you also find out that it is relatively
expensive to store wheat for one year. Assume that this cost, which
must be paid upfront, runs at about Rs. 57 per quintal.
Types of Traders
• Hedgers
• Speculators
• Arbitrageurs
Hedging Examples
• A US company will pay £10 million for imports from Britain
in 3 months and decides to hedge using a long position in a
forward contract
• An investor owns 1,000 Microsoft shares currently worth
$28 per share. A two-month future is available with a strike
price of $29.50. The investor decides to hedge by shorting
10 contracts
Speculation Example
• An investor with Rs. 200,000 to invest feels that a stock price will
increase over the next 2 months. The current stock price is Rs.
200 and the expected price after 2 months is Rs. 260. Futures are
trading at 10% margin
• What could be the strategy?
Arbitrage Example
• A stock price is quoted as £100 in London and $150 in
New York
• The current exchange rate is 1.5300
• What is the arbitrage opportunity?
Dangers
• Traders can switch from being hedgers to speculators or from being
arbitrageurs to speculators
• It is important to set up controls to ensure that trades are using
derivatives in for their intended purpose
• Soc Gen (see Business Snapshot 1.5 on page 25) is an example of
what can go wrong
32
Hedge Funds (see Business Snapshot 1.3, page 12)
• Hedge funds are not subject to the same rules as mutual funds
and cannot offer their securities publicly.
• Mutual funds must
• disclose investment policies,
• make shares redeemable at any time,
• limit use of leverage
• Hedge funds are not subject to these constraints.
• Hedge funds use complex trading strategies are big users of
derivatives for hedging, speculation and arbitrage

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Derivatives

Introduction, Types, and Usage

• The term was first coined in 1976

• In the over-the-counter (OTC) market where traders working for

• 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

Spot Price 83.017 83.037

1-month Forward Price 7.5 9.5

2-month Forward Price 21 23

3-month Forward Price 31 33

* Sell @ BID price and Buy @ ASK price

• The forward price may be different for contracts of

• What are the possible outcomes?

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