Derivatives

What is Derivative?
• Derivative is a financial instrument or security whose payoffs depend
on a more primitive or fundamental good. Examples: futures,
forwards, swaps, options etc.
• The underlying assets include stocks, currencies, interest rates,
commodities, debt instruments, electricity prices, insurance payouts,
the weather, etc.
• Financial derivative is a financial instrument whose payoffs depend on
the financial instruments or security
Forward and Futures
• Forwards: A forward contract is a customized contract between two
entities, where settlement takes place on a specific date in the future
at today’s 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
Options
• Options are of two types – call option and put option
• Call Option: It give the holder 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.
• Put Option: give the holder the right to sell a given quantity of the
underlying asset at a given price on or before a given date.
• An American option can be exercised at any time during its life
• A European option can be exercised only at maturity
 Options Cont…

• Every option has an option price, an exercise

price, and an exercise date.
– The price paid by the buyer to the writer is
referred to as the option premium.
– The exercise price or strike price is the price
specified in the option contract at which the
underlying asset can be purchased or sold.
Positions of the Buyer and Seller in Call and Put
Options
Option Type Buyers of Option Writer of Option
(Long Position) (Short Position)

Call Right to Buy Asset Obligation to

Sell Asset

Put Right to Sell Asset Obligation to

Buy Asset
Concept of Money ness
Condition Call Option Put Option

S0 > E In-the-Money Out-of-the

Money
S0 < E Out-of-the In-the-Money
Money
S0 = E At-the-Money At-the-Money
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
Example
Option Exercise Stock Call Classifica Intrinsic Time
price price Option tion value Value
price
1 80 83.5 6.75 In-the-mo 3.5 6.75-3.5
ney

2 85 83.5 2.5 Out-of 0 2.5

the
money
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.
 Long Call
Profit from buying one European call option: option
price = Rs. 5, strike price = Rs. 100, option life = 2
months

30 Profit (Rs)

20

10 Terminal
70 80 90 100 stock price (Rs)
0
-5 110 120 130
Short Call
Profit from writing one European call option: option
price = Rs.5, strike price = Rs. 100

Profit (Rs)
5 110 120 130
0
70 80 90 100 Terminal
-10 stock price (Rs)

-20

-30

12
 Long Put
Profit from buying a European put option: option
price = Rs.7, strike price = Rs.70

30 Profit (Rs)

20

10 Terminal
stock price (Rs)
0
40 50 60 70 80 90 100
-7

13
Short Put
Profit from writing a European put option: option price
= Rs.7, strike price = Rs.70

Profit (Rs)
Terminal
7
40 50 60 stock price (Rs)
0
70 80 90 100
-10

-20

-30

14
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.
 Some Concepts
• Buyer is said to have a long position and seller has a short position
• The act of buying is called going long and the act of selling is called going short
• When one trader buys and other sells a forward contract, the transaction generates
on contract of trading volume
• At any moment in time, there is some number of future contracts obligated for
delivery and this number is called open interest
• Settlement price: the price just before the final bell each day
• used for the daily settlement process
Forward Contracts vs Futures
Contracts

FORWARDS FUTURES
Private contract between 2 parties Exchange traded
Not standardized Standard contract
Usually 1 specified delivery date Range of delivery dates
Settled at maturity Settled daily
Delivery or final cash Contract usually closed out
settlement usually occurs prior to maturity
Some credit risk Virtually no credit risk
Forward and Future Prices

18
Objective
• How forward and future prices are related to spot prices?
• Forward contracts are easy to analyse as there is no daily settlement
and a single payment at maturity

19
Notation for Valuing Futures and Forward
Contracts

S0: Spot price today

F0: Futures or forward price today
T: Time until delivery date
r: Risk-free interest rate for
maturity T

20
 Forward Price: Securities
Providing No Income
If the spot price of 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=390, T=1, and r=0.05 so that
F = 390(1+0.05) = 409.50

21
 When Interest Rates are Measured
with Continuous Compounding
F0 = S0erT
This equation relates the forward price and the spot price for any investment asset that
provides no income and has no storage cost.

If F0 > S0erT: Investor may buy the asset by borrowing an amount equal to S0 for a period of
T at the risk free rate, and take a short position in forward contract. At the time of maturity,
the assets will be delivered for a price of F and amount borrowed will be repaid by paying an
amount equal to S0erT and the deal would result in a net profit of F0 - S0erT
If F0 < S0erT: Investor would short the assets, invest the proceeds for the time period T at an
interest arte r and long a forward contract. When the contract matures the asset would be
purchased for a price of F and the short position in the asset would be closed out. This would
result in a profit of S0erT - F0

22
An Arbitrage Opportunity?
• Suppose that:
• The spot price of a non-dividend-paying stock
is Rs. 40
• The 3-month forward price is Rs. 43
• The 3-month interest rate is 5% per annum
• Is there an arbitrage opportunity?
Suppose that:
• The spot price of nondividend-paying stock is
Rs. 40
• The 3-month forward price is Rs. 39
• The 1-year interest rate is 5% per annum
(continuously compounded)
Is there an arbitrage opportunity?
23
Example
Forward Price: 43 Forward Price: 39
Action Now: Action Now:
Borrow Rs. 40 at 5% for 3 months Short 1 unit of asset to realize Rs. 40
Buy one unit of asset Invest Rs. 40 at 5% for 3 months
Enter into the forward contract to sell asset in 3 Enter into a forward contract to buy asset in 3 months
months for Rs. 43 for Rs. 39
Action in 3 months Action in 3 months
Sell asset for Rs. 43 Buy asset for Rs. 39. Close the short position
Use Rs. 40.50 to repay loan and interest Receive Rs. 40.50 from investment
Profit: Rs. 2.50 Profit: Rs. 1.50

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Example (Income is known)
• Consider a forward contract to purchase a coupon bearing bond
• Current price of coupon bearing bond: Rs. 900
• Maturity Period: 9 months
• Coupon payment in 4 months: Rs. 40
• 4-month and 9-month risk free rate: 3% and 4% per annum
• Suppose the forward price: Rs. 910

25
 What the arbitragers will do?
Forward Price: Rs. 910 Forward Price: Rs. 870
Action Now Action Now
Borrow Rs. 900 (Rs. 39.60 for 4 months and Rs. 860.40 Short 1 unit of asset to realize Rs. 900
for 9 months) to buy the bond The present value of Invest Rs. 39.60 for 4 months and Rs. 860.40 for 9
coupon payment: 40e-0.03*4/12 = Rs. 39.60 months
Buy 1 unit of asset Enter into the forward contract to buy asset in 9
Enter into the forward contract to sell the bond for Rs. months for Rs. 870
910
Action after 4 months Action after 4 months
Receive Rs. 40 as coupon Receive Rs. 40 from 4 months investment
Use Rs. 40 to repay first loan with interest Pay Rs. 40 on asset
Action after 9 months Action after 9 months
Sell asset for Rs. 910 Receive Rs. 886.60 from 9 months investments
Use 860.40e0.04*0.75 =Rs. 886.60 to repay second loan Buy asset for Rs. 870
with interest
Profit: Rs. 23.40 Profit: Rs. 16.60

26
 When an Investment Asset Provides a
Known Income (preference Share,
coupon bearing bonds)
F0 = (S0 – I )erT
where I is the present value of the income from investment during the life of
future contract
Example: So =Rs. 900, I = 40e-0.03*4/12 = Rs. 39.60, r=0.04 and T= 0.75
So: F0 = (900-39.60)e0.04*0.75 = Rs. 886.60
If F0 > (S0 – I )erT an arbitrager can lock in a profit by buying the asset and
shorting the a forward contract on the asset.
If F0 < (S0 – I )erT an arbitrager can lock in a profit by shorting the asset and
taking a long position in a forward contract

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 When an Investment Asset Provides a
Known Yield
The income is known when expressed as a percentage of the asset’s price at the time
income is paid.
(r–q )T
F0 = S0 e
where q is the average yield during the life of the contract (expressed with
continuous compounding)
Example: Let: asset price: Rs. 25, Risk free rate: 10% and T=0.5, Income: 2%
of the asset price once during 6 months period.
In continuous compounding it will be: 2(ln(1+0.04/2)= 3.96% i.e. q=0.0396
F0 = 25e(0.10-0.0396)*0.5 = Rs. 25.77

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Valuing a Forward Contract
• A forward contract is worth zero when it is first negotiated
• Later it may have a positive or negative value
• Suppose that K is the delivery price and F0 is the forward price for a
contract that would be negotiated today
• By considering the difference between a contract with delivery price K
and a contract with delivery price F0 we can deduce that:
• the value of a long forward contract is
(F0 – K )e–rT
• the value of a short forward contract is
(K – F0 )e–rT
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 Futures and Forwards on Currencies
• A foreign currency is analogous to a security providing a
yield
• The yield is the foreign risk-free interest rate
• It follows that if rf is the foreign risk-free interest rate

• This is the well-known interest rate parity relationship

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Option Valuation
Upper and Lower Bounds for Option Prices

• If an option price is above the upper bound and below the lower
bound, there are profitable opportunities for arbitrageurs.
• Upper Bounds (Call Option): c ≤ S0 and C ≤ S0, if these relationship
does not hold then an arbitrageurs can easily make risk less profit by
buying the stock and selling the call option
• Upper Bound (Put Option): p ≤ K and P ≤ K, for European option p ≤
Ke-rt, If this is not true then risk less profit can be made by writing the
option and investing the proceeds of the sale at the risk-free interest
rate.
Lower Bounds for calls on Non-Dividend paying Stocks

c ≥ S0 –Ke -rT

• Suppose that
c=3 S0 = 20
T=1 r = 10%
K = 18 D=0

• Is there an arbitrage opportunity?

Answer
• S0- Ke-rt = 3.71
• Arbitrageur can buy the call and short the stock
• Cash Inflow = 20-3 = 17
• Invest for one year at 10% per annum
• Total money = 17e0.1=Rs. 18.79
• If stock price is greater than 18 he can exercise the option to buy the stock and close the
short position and profit will be : rs. 18.79 – Rs. 18 = 0.79
Lower Bound for European Puts on Non-Dividend paying Stocks

p ≥ Ke -rT
–S0
• Suppose that
p= 1 S0 = 37
T = 0.5 r =5%
K = 40 D =0

• Is there an arbitrage opportunity?

Answer
• Ke-rt – S = Rs. 2.01
• It is more than the put price.
• The arbitrageurs can borrow Rs. 38 for six months to buy both put and the stock
• He is required to pay 38e0.05*0.5= rs. 38.96
• If the stock price is below 40, the arbitrageur exercises the option to sell the stock for Rs. 40
repays the loan and makes a profit of Rs 40 – Rs. 38.96 = Rs. 1.04
 Put-Call Parity
• Consider the following 2 portfolios:
– Portfolio A: European call on a stock + PV of the
strike price in cash
– Portfolio C: European put on the stock + the stock
• Both are worth MAX(ST , K ) at the maturity of the
options
• They must therefore be worth the same today. This

means that c + Ke
-rT
= p + S0
 Arbitrage Opportunities
• Suppose that
c=3 S0 = 31
T = 0.25 r = 10%
K =30 D=0
• What are the arbitrage possibilities
when p = 2.25 ?
Answer
• c + Ke -rT = p + S0
• 3+ 30e-0.1*3/12= Rs.32.26
• P + S0 = 2.25 + 31 = Rs. 33.25
• Arbitrage Strategy: Buying call and shorting both put and stock generating a positive cash flow of: -3 + 2.25
+31 = Rs. 30.25
• Invest it at risk free interest rate, amount grows to 30.25e0.1*0.25=Rs.31.02
• Is stock price at expiration of option is greater than 30 the call will be exercised and if it is less than 30, then
the put will be exercised.
• Net profit = 31.02 -30 = rs 1.02
The Impact of Dividends on Lower
Bounds to Option Prices
 Swap

A swap is an agreement to exchange cash flows at

specified future times according to certain specified
rules.
Interest Rate Swap
• The most popular (plain vanilla) interest rate swap is one where LIBOR
is exchanged for a fixed rate of interest.
• In an interest rate swap, one company agrees to pay to another
company cash flows equal to interest at a predetermined fixed rate on
a notional principal for a predetermined number of years. In return, it
receives interest at a floating rate on the same notional principal for
the same period of time from the other company.
Interest Rate Swap
• The floating rate in most interest rate swap agreements is the London
Interbank Offered Rate (LIBOR). It is the rate of interest at which a
bank with a AA credit rating is able to borrow from other banks.
• Example: consider a 10-year bond with a rate of interest specified as
6-month LIBOR plus 0.5% per annum. The life of the bond is divided
into 20 periods, each 6 months in length. For each period, the rate of
interest is set at 0.5% per annum above the 6-month LIBOR rate at the
beginning of the period. Interest is paid at the end of the period.
Example
• Consider a hypothetical 3-year swap initiated on March 15, 2016, between
Company X and Company Y.
• Suppose X agrees to pay Y an interest rate of 5% per annum on a principal of
Rs.100 million, and in return Y agrees to pay X the 6-month LIBOR rate on the
same principal.
• X is the fixed-rate payer; Y is the floating rate payer.
• We assume the agreement specifies that payments are to be exchanged every 6
months and that the 5% interest rate is quoted with semi-annual compounding.
 Example: Cash Flows to Company
X
---------Millions of Rupees---------
LIBOR FLOATING FIXED Net
Date Rate Cash Flow Cash Flow Cash Flow
Mar.15, 2016 4.2%
Sept. 15, 2016 4.8% +2.10 –2.50 –0.40
Mar.15, 2017 5.3% +2.40 –2.50 –0.10
Sept. 15, 2017 5.5% +2.65 –2.50 +0.15
Mar.15, 2018 5.6% +2.75 –2.50 +0.25
Sept. 15, 2018 5.9% +2.80 –2.50 +0.30
Mar.15, 2019 6.4% +2.95 –2.50 +0.45
Example
• The principal itself is not exchanged. For this reason it is termed the
notional principal, or just the notional.
• If the notional principal were exchanged at the end of the life of the
swap, the nature of the deal would not be changed in any way.
• The notional principal is the same for both the fixed and floating
payments. Exchanging Rs. 100 million for Rs. 100 million at the end of
the life of the swap is a transaction that would have no financial value
to either company X or Y.
 Uses of an Interest Rate Swap

• Converting a liability from

– fixed rate to floating rate
– floating rate to fixed rate

• Converting an investment from

– fixed rate to floating rate
– floating rate to fixed rate
Using a swap to transform a liability
• Company X has borrowed Rs. 100 million at LIBOR+0.1%,
wants to transform a floating rate loan into a fixed rate loan.
After it has entered into a swap:
• Loan payment: LIBOR+0.1%
• Add:Paid under swap + 5%
• Less:Received under swap - LIBOR
• Net Payment 5.1%
Using a swap to transform a liability
Con…
• For Y swap is used to transform fixed rate into floating rate.
Suppose it has 3-year Rs.100 million loan on which it pays 5.2%
• Loan payment 5.2%
• Add: Paid under swap +LIBOR
• Less: Received under swap - 5%
• Net payment LIBOR+0.2%
Using the swap to transform an asset (nature
of an asset)
• Suppose Company X owns Rs.100 million in bonds that will
provide 4.7% per annum over the next 3 years. Now company X
enters into a swap, wants to switch its assets from fixed to
floating rate.
• Investment income 4.7%
• Less: Paid under swap -5%
• Add: Received under swap +LIBOR
• Net income LIBOR-0.3%
Using the swap to transform an asset
(nature of an asset) Con…
• Company Y is transforming an asset earning floating to fixed.
Suppose Y has an investment Rs.100 million that yields
LIBOR-0.20. After it has entered into the swap:
• Investment income LIBOR-0.20
• Less: Paid under swap - LIBOR
• Add: Received under swap + 5%
• Net Investment income 4.8%
The Comparative Advantage Argument
AAA Company and BBB Company wish to borrow Rs.10 million for 5 years
• AAA wants to borrow floating
• BBB wants to borrow fixed

Fixed Floating

AAA 4.0% 6-month LIBOR − 0.10%

BBB 5.2% 6-month LIBOR + 0.6%
The Comparative Advantage Argument
• BBB has a comparative advantage in floating market and AAA
has a comparative advantage in fixed rate market.
• They can enter into a swap that AAA ends up with floating rate
funds and BBB ends up with fixed rate funds.
• Suppose AAA agrees to pay interest at 6 month LIBOR on
Rs.10 million and BBB agrees to pay 4.35% per annum on
Rs.10 million.
Comparative Advantage Argument
AAA BBB

Loan payment 4% LIBOR+0.6%

Add: Paid under swap + LIBOR + 4.35%

Less: Received under -4.35% -LIBOR

swap
Net Payment LIBOR-0.35% 4.95%
(Before) (LIBOR-0.10%) (5.2%)
(0.25% gain) (0.25% gain)
Comparative Advantage Argument
• The swap agreement appears to improve the position of both company.
• Total gain is: 0.25+0.25=0.50%
• If “a” is the difference between the interest rates in fixed market and if “b’’
is the difference between the interest rates in floating market.
• Total gain is; a-b
• a = 1.2% (5.2%-5%)
• b= 0.7% ( LIBOR+0.6%-(LIBOR-0.1%))
• a-b = 1.2-0.7=0.5%
Criticism of the Comparative Advantage
Argument
• The 4.0% and 5.2% rates available to AAACorp and BBBCorp in fixed
rate markets are 5-year rates
• The LIBOR−0.1% and LIBOR+0.6% rates available in the floating rate
market are six-month rates
• BBBCorp’s fixed rate depends on the spread above LIBOR it borrows
at in the future
Currency Swaps
• Exchanging principal and interest payments in one currency for
principal and interest payments in another currency.
• In an interest rate swap the principal is not exchanged
• In a currency swap the principal is usually exchanged at the beginning
and the end of the swap’s life
Fixed-for-fixed currency swap
• This involves exchanging principal and interest payments at a fixed
rate in one currency for principal and interest payments at a fixed rate
in another currency.
• Usually the principal amounts are chosen to be approximately
equivalent using the exchange rate at the swap’s initiation. When they
are exchanged at the end of the life of the swap, their values may be
quite different.
Example
• Consider a 5-year currency swap agreement between X and Y entered into on
February 1, 2015. We suppose that X pays a fixed rate of interest of 5%in sterling
and receives a fixed rate of interest of 6%in dollars from Y. Interest rate payments
are made once a year and the principal amounts are $15 million and £10 million.
This is termed a fixed-for-fixed currency swap because the interest rate in each
currency is at a fixed rate.
Dollar 6%
X Y

Steriling 5%
 Cash Flow to X
Dollar Sterling
cash flow cash flow
(millions) (millions)
February 1, 2015 -15.00 +10.00
February 1, 2016 +0.90 -0.50
February 1, 2017 +0.90 -0.50
February 1, 2018 +0.90 -0.50
February 1, 2019 +0.90 -0.50
February 1, 2020 +15.9 -10.50
Typical Uses of a Currency Swap
• Conversion from a liability in one currency to a liability in
another currency

• Conversion from an investment in one currency to an

investment in another currency
Use of a Currency Swap to Transform
Liabilities and Assets
• A swap can be used to transform borrowings in one currency to borrowings in
another. Suppose that X can issue $15 million of USdollar-denominated bonds at
6% interest. The swap has the effect of transforming this transaction into one
where X has borrowed £10 million at 5% interest.
• The initial exchange of principal converts the proceeds of the bond issue from US
dollars to sterling. The subsequent exchanges in the swap have the effect of
swapping the interest and principal payments from dollars to sterling.
• The swap can also be used to transform the nature of assets. Suppose that X can
invest £10 million in the UK to yield 5% per annum for the next 5 years, but feels
that the US dollar will strengthen against sterling and prefers a
US-dollar-denominated investment. The swap has the effect of transforming the
UK investment into a $15 million investment in the US yielding 6%.
Comparative Advantage Arguments for Currency Swaps
General Electric wants to borrow 20 miilion AUD and Qantas wants to borrow
15 million USD (Exchange rate is $0.75 per AUD)

USD AUD
General Motors 5.0% 7.6%
Qantas 7.0% 8.0%

GE has a comparative advantage in USD and Qantas has a comparative

advantage in AUD. So that GE borrows USD and Qantas borrows AUS
then they enter into a currency swap to transform GE’s loan into a AUD
and Qantas loan into a USD.
Total gain to all parties: 2%-0.4% = 1.6%
62