Options Futures and Other derivatives

A "derivative” : is a financial instrument whose value depends on ( or is derived from) the values of other , more basic, underlying variables.

A derivatives exchange where standardized contracts are traded. These contracts are defined by the exchange

Derivatives have been around for a long time Chicago Board of Trade (1848) & Chicago Mercantile

Exchange (1919)

Derivatives

OTC : Bilateral transactions

Adv of OTCs: Terms not pre-specified

Disadv: ?

Exchange Traded vs OTC derivatives

The management of counter-party (credit) risk is decentralized andlocated within individual institutions,

There are no formal centralized limits on individual positions, leverage, or margining.

There are no formal rules for risk and burden-sharing.

There are no formal rules or mechanisms for ensuring market stabilityand integrity, and for safeguarding the collective interests of marketparticipants, and

The OTC contracts are generally not regulated by a regulatory authority.

Exchange Traded vs OTC derivatives

Agreement between 2 parties to Buy or Sell an asset at a certain future time for a certain future price.

Long Position v Short Position

FCs are used to hedge fcy risk Both sides have made a BINDING COMMITMENT

Forward Contract

Agreement between 2 parties to Buy or Sell an asset at a certain future time for a certain future price.

Normally traded on a xchange

Xchange provides a mechanism for settlement and a guarantee that the contract will be honored.

How is a futures price determined ?

Futures

Gives the holder the right but not the obligation to buy or sell (as the case may be) the underlying asset by or at a certain date for a certain price.

Call Option : BUY Put Option : SELL

American v European options

Options

Gives the holder the right but not the obligation to buy or sell (as the case may be) the underlying asset by or at a certain date for a certain price.

Call Option : BUY Put Option : SELL

American v European options Option Premium

Options

Intel Option Quotes on CBOE Trading lot is 100 shares

Options

Strike price Calls PutsOct - 2006 Jan -2007 Apr - 2007 Oct - 2006 Jan -2007 Apr - 2007

15.00 4.6500 4.9500 5.1500 0.0250 0.1500 0.2750 17.50 2.3000 2.7750 3.1500 0.1250 0.4750 0.7250 20.00 0.5750 1.1750 1.6500 0.8750 1.3750 1.7000 22.50 0.0750 0.3750 0.7250 2.9500 3.1000 3.3000 25.00 0.0250 0.1250 0.2750 5.4500 5.4500 5.4500

Call Options: Price of a call option DECREASES as the Strike Price increases

Put Options: Price of a Put option INCREASES as the Strike Price increases

Buyers of options have LONG posns

Sellers of options ………………………. SHORT posns

Seller of an option is called the WRITER of the option

Options

Hedgers: use derivatives for risk reduction

Speculators : use them to bet

Arbitrageurs : take offsetting posns

Types of Traders in the Derivatives Mkt

Hedging using forwards

Hedging using options

Forwards v Options as a Hedging tool

Hedgers

Speculation using futures:

◦ Spot Price 1000◦ A expects price to rise in future :

◦ Scenario 1: Buys 100 shares @ 1000

◦ Scenario 2 : Buys 100 2 month futures @ 1006

◦ At end of 2 months the price is 1010

Speculators

◦ Scenario 1: Buys 100 shares @ 1000 per share Cash Outflow : __________

◦ Scenario 2 : Buys 100 2 month futures @ 1006 ◦ Margin: 100 per future contract

Cash Outflow ___________

◦ At end of 2 months the price is 1010◦ Profit: Scenario 1◦ Profit: Scenario 2

Speculation using Futures

◦ Bullish security, buy calls

Spot Price : $ 20 2 month Call option with a $22.50 strike price sells for $ 1

Scenario 1 : Buy 100 shares spot @ 20 Cash Outlay : $ 2000.

Scenario 2 : Buy 20 option contracts (2000 shares) @ 22.50 Cash Outlay : $ 2000

Closing Price : $ 27 Profit – Scenario 1 : Profit – Scenario 2 :

Speculation using Options

◦ Options like futures provide a form of leverage

◦ Options v Futures as a tool for speculation ? (Loss Potential)

Speculation using Options

◦ Overpriced futures: buy spot, sell futures?

ABC Ltd. Trades on spot at Rs.1000

One- month ABC futures trade at Rs.1025 and seem overpriced

How does one make a Riskless profit ?

Arbitrageurs

On day one, borrow funds, buy the security on the cash/spot market at 1000. Simultaneously, sell the futures on the security at 1025.

Take delivery of the security purchased and hold the security for a month.

On the futures expiration date, the spot and the futures price converge.

Say the security closes at Rs.1015. Sell the security.

Futures position expires with profit of Rs.10.

The result is a riskless profit of Rs.15 on the spot position and Rs.10 on the futures position.

Return the borrowed funds.

Arbitrageurs

Versatility

Dangers of (mis)using derivatives