derivatives and commodity exchanges

8/3/2019 Derivatives and Commodity Exchanges

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Dr. Monika Goel

[email protected]

DERIVATIVES AND COMMODITYEXCHANGES


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What is Risk? The concept of risk is simple. It is the potential for

change in the price or value of some asset orcommodity. The meaning of risk is not restricted

just to the potential for loss. There is upside risk

and there is downside risk as well.


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Examples of RISK/Uncertainity??? Case-1 An Indian Garments company has received

an order to supply I,00,000 units of shirts fromUSA. The price of $ 500,000 is receivable

after six months. The current exchange rate isRs.39.76/$. At the current exchange rate, thecompany would get: 39.76 500,000 = Rs1,98,80,000. But the company anticipatesappreciation of Indian rupee over time. Does

the company loose/gain due to appreciation inthe Indian Rupee? How does companyminimise the risk?


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Case 2 You have imported machinery for $ 100,000 on 180

days credit at zero interest. The dollar quotes at Rs39. Is this deal risk free?

This deal is not free of risk because after six monthswhen you pay the loan, if the dollar quotes anythingmore than Rs39., say Rs 40, you will end up payingmore [Rs 1 extra for every $ 1, which is equivalent toRs 100,000 additional cost]. On the other hand, if thedollar quotes anything less than Rs 39, you will stand

to gain The question here is not whether you stand to gain or

loose it is the riskyou are taking


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Case 03

You have surplus cash for investment. Youthink of investing in Wipro, currently quoting atRs 3,500, which you believe will rise to Rs3,950 in six months. Is this deal risk free?

This deal is not free of risk because there isno guarantee that Wipros shares would touchRs 3,950 in six months time.

The share prices could rise beyond Rs 3,950

or could also fall below Rs 3,500 giving youno return on investment and you could standto loose some portion of your investment


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How do you protect yourself ?

Use Derivative instruments. What is derivatives?

See the next example.


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Example

You [along with two friends] want to go for theAero India January 2008 air show, for whichtickets are sold out. Through one of yourclose friends, you obtain a recommendationletter, which will enable you to buy threetickets. The price of a ticket is Rs 1,000.

Which is the commodity that you are supposeto buy?

In order to buy the________ what are

required now? Money/recommendation letter (instrument) or

both?


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Financial instruments

The recommendation letter is a derivativeinstrument. It gives you a right to buy the ticket

The underlying asset is the ticket

The letter does not constitute ownership of theticket

It is indeed a promise to convey ownership

The value of the letter changes with changes inthe price of the ticket. It derives its value fromthe value of the ticket


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Different risk coverage Firms are exposed to several risks in the ordinary

course of operations and borrowing funds.

For some risks, management can obtainprotection from an insurance company(fire,loss ofprofit,loss of stock,marine insurance)

Similarly, there are capital market products availableto protect against certain risks. Such risks includerisks associated with a rise in the price ofcommodity purchased as an input, a decline in a

commodity price of a product the firm sells, a risein the cost of borrowing funds and an adverseexchange rate movement. The instruments that canbe used to provide such protection are calledderivative instruments


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Meaning

A financial contract of pre-determinedduration, whose value is derived from thevalue of an underlying asset

A derivative contract is a financial instrumentwhose payoff structure is derived from the

value of the underlying asset

These instruments include futures contracts,

forward contracts, options contracts, swapagreements, and cap and floor agreements


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What do derivatives do?

Derivatives attempt either to minimize the loss arising fromadverse price movements of the underlying asset

Or maximize the profits arising out of favorable pricefluctuation.

The derivative market thus helps people meet diverseobjectives such as:

Hedging

Profit making through price changes

Profit making through arbitrage


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uses

Price discovery Most price changes are first reflected in the derivative market.

That way derivative market feeds the spot market

For instance, if the dollars are going down, it means that theprofessional investors are expecting dolor price to go down in

the future this is a good sign for you to buy in the spotmarket

Risk transfer A derivative market is like an insurance company

Derivative instruments redistribute the risk amongst market

players However, if you want protection against adverse price

movements, you must pay a price, ie the premium


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Types of Derivatives(UA: Underlying Asset)

Based on the underlying assets derivatives areclassified into.

Financial Derivatives (UA: Fin asset)

Commodity Derivatives (UA: gold etc)

Index Derivative (BSE sensex)


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Derivative Instruments. Forward contracts

Futures Commodity

Financial (Stock index, interest rate & currency )

Options

Put Call

Swaps.

Interest Rate

Currency


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Underlying Asset Class It is important to understand the underlying asset

class before using derivatives

Asset classes can be classified into two broadcategories- financial which includes currencies

and commodities

Financial asset classes can be broadlycategorised into interest rates, equities andcurrencies

Commodities range from agricultural commoditiesto minerals and metals


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Derivative Positions and Types ofDerivative Market Players :

Speculators :Naked open position taking adirectional call on the markets

Hedgers : Hedge against underlying asset class

Arbitrageurs : Arbitrage position within an assetclass


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Hedging or Leveraging Derivatives are viewed as a hedging instrument The holder of an underlying asset can hedge

fluctuations in prices of the asset usingderivatives

However derivatives are increasingly being usedfor taking up leveraged positions in an underlyingasset

This enables higher returns for taking on higherrisk


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How does one make money in afutures contract?

The long makes money when the underlying assetsprice rises above the futures price.

The short makes money when the underlying assets

price falls below the futures price.

Concept of initial margin

Degree of Leverage = 1/margin rate.


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Exchange Traded and OTCDerivatives

Derivatives traded on an exchange such as NSEare exchange traded derivatives

Derivatives not traded on exchange are over thecounter derivatives eg- Overnight index swaps

(OIS)

Exchange traded derivatives are standardised incontract size, settlement, maturity

OTC derivatives can be structured to suit differentneeds

Equity and bond derivatives are usually exchangetraded while interest rate swaps, currency

derivatives and exotics are usually OTC


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OTC or Forward Contracts. A one to one bipartite contract, which is to be

performed in future at the terms decided today.

Eg: Jay and Viru enter into a contract to trade in onestock on Infosys 3 months from today the date of thecontract @ a price of Rs4675/-

Note: Product ,Price ,Quantity & Time have beendetermined in advance by both the parties.

Delivery and payments will take place as per the termsof this contract on the designated date and place. Thisis a simple example of forward contract.


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Risks in a forward contract Liquidity risk: these contracts a biparty and not

traded on the exchange. Default risk/credit risk/counter party risk.

Say Jay owned one share of Infosys and the pricewent up to 4750/- three months hence, he profits by

defaulting the contract and selling the stock at themarket.


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Futures.

Future contracts are organized/standardized contracts

in terms of quantity, quality, delivery time and place forsettlement on any date in future. These contracts aretraded on exchanges.

These markets are very liquid

In these markets, clearing corporation/house becomesthe counter-party to all the trades or provides theunconditional guarantee for the settlement of tradesi.e. assumes the financial integrity of the whole

system. In other words, we may say that the credit riskof the transactions is eliminated by the exchangethrough the clearing corporation/house.


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The key elements of a futures contract are:

Futures price

Settlement or Delivery Date Underlying (infosys stock)


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Illustration.

Let us once again take the earlier example where Jayand Viru entered into a contract to buy and sell Infosysshares. Now, assume that this contract is taking placethrough the exchange, traded on the exchange andclearing corporation/house is the counter-party to this, it

would be called a futures contract.


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Example An investor buys a NIFTY futures contract forRs.2,80,000 (lot size 200 futures). On the settlement

date, the NIFTY closes at 1,378. Find out his profit orloss, if he pays Rs.1,000 as brokerage. What would bethe amount of profit or loss, if he has sold the futurescontract ?

In this case , the total value is Rs.2,80,000 and lot is 200,So, the NIFTY Futures on the transaction date is 1400 (i.e.2,80,000/200). Now on the settlement date, the NIFTYis1378 therefore, it has reduced by 22 points. The loss tothe investor is Loss = (1400 1378) x 200 + 1000 = 4400 + 1000 = 5400

In case, he has sold the futures contract, his profit wouldhave been Profit = (1400-1378) x 200 Rs. 1000 = 4400 1000 = 3400

Assumption : The brokerage of Rs.1000 would bepayable in both the cases.


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Pricing of Futures

Futures should theoretically trade at a fair price The fair price is the price adjusted for cost of

carry for delivery at a later date

The cost of carry is the interest cost on the

amount actually paid for an asset on a spotpurchase

Cost of carry is adjusted for any dividendsreceivable in case of equities

Cost of carry = Interest cost over periodexpected dividend yield

The fair price of a future contract is always at apremium to the spot price


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Example A futures contract is available on a company that pays

an annual dividend of Rs.5 and whose stock iscurrently priced at Rs.200. Each futures contract callsfor delivery of 1,000 shares of stock in one year, dailymarking to market, an initial margin of 10% and a

maintenance margin of 5%. The corporate treasurybill rate is 8%.

(i) Given the above information, what should the price ofone futures contract be?

(ii) If the company stock price decreases by 7%,what will be the change, if any, in futures price ?

(iii) As a result of the company stock price decrease, willan investor that has a long position in one futurescontract of this company realises a gain or loss? Why

? What will be the amount of this gain or loss ?


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Solution

(i) Annual dividend (D) = Rs.5Current Stock Price(S) = Rs.200Initial Margin = 10%Maintenance Margin = 5%Corporate Treasury bill rate (C) = 8%Price of One Future Contract

F = S + (S x C) D = 200 + (200 x 0.08) 5 = Rs. 211(ii) If the company stock prices decrease by 7%, then price of

futures contract

F = [200 x (1 0.07)] + [200 x (1- 0.07) x 0.08] 5 = 186 +14.88 5 = Rs. 195.88

(iii) An investor with a long position in one future contract agreesto buy 1,000 shares of the company in one year at Rs.211.Therefore, this investor will benefit only if the future pricesincrease.

In this case, the future prices has decreased and the investorwill therefore realize a loss of (Rs. 195.88 Rs. 211) x 1,000 =() Rs. 15,120.


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Positions in a futures contract Long - this is when a person buys a futures

contract, and agrees to receive delivery at afuture date. Eg: Virus position

Short - this is when a person sells a futures

contract, and agrees to make delivery. Eg: JaysPosition


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Options An option is a contract giving the buyer the right, but

not the obligation, to buy or sell an underlying asset ata specific price on or before a certain date. An option isa security, just like a stock or bond, and is a bindingcontract with strictly defined terms and properties.


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Options Lingo Underlying: This is the specific security / asset on

which an options contract is based. Option Premium: Premium is the price paid by the

buyer to the seller to acquire the right to buy or sell.It is the total cost of an option. It is the differencebetween the higher price paid for a security and thesecurity's face amount at issue. The premium of anoption is basically the sum of the option's intrinsicand time value.


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Strike Price or Exercise Price :price of an option is thespecified/ pre-determined price of the underlying asset atwhich the same can be bought or sold if the option buyer

exercises his right to buy/ sell on or before the expirationday.

Expiration date:The date on which the option expires isknown as Expiration Date

Exercise: An action by an option holder taking advantageof a favourable market situation .Trade in the option forstock.


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Exercise Date: is the date on which the option is actuallyexercised.

European style of options: The European kind of option

is the one which can be exercised by the buyer on theexpiration day only & not anytime before that.

American style of options: An American style option isthe one which can be exercised by the buyer on or before

the expiration date, i.e. anytime between the day ofpurchase of the option and the day of its expiry.

Index options in India are European options while stockoptions are American options

Option Holder


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Option Holder

Option seller/ writer

Call option: An option contract giving the owner the

right to buy a specified amount of an underlyingsecurity at a specified price within a specified time.

Put Option: An option contract giving the owner theright to sell a specified amount of an underlyingsecurity at a specified price within a specified time


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Option Pricing :

Black Scholes formula is the most widely used forpricing options

The factors going into the pricing of options arethe share price(S), time to expiry (t), risk free rate

of interest r, and risk of underlying assetmeasured by standard deviation or volatility

These are also called the greeks as changes inany one of these variables affect the option price

Options contracts can be classified into out of themoney, at the money and in the money


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The Greeks Delta is the change in option price to the change

in the underlying

Gamma is the rate at which an options deltachanges as the price of the underlying changes

Theta is the time decay factor and is the rate atwhich option loses value as time passes

Vega or Kappa is the change in option price tochange in the volatility of the option

Rho is the change in value of option to change ininterest rates

Intrinsic Value: The intrinsic value of an option is defined as


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Intrinsic Value: The intrinsic value of an option is defined asthe amount by which an option is in-the-money, or theimmediate exercise value of the option when the underlyingposition is marked-to-market.

For a call option: Intrinsic Value = Spot Price - Strike Price

For a put option: Intrinsic Value = Strike Price - Spot Price


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Profit/Loss Profile of a Longcall Position

0

-3

100 103

Profit

Loss

Priceof

AssetXYZ

atexpiration

Option Price = Rs3

Strike Price = Rs100

Time to expiration = 1month


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Profit /Loss Profile for a Short Call Position

100 103

0

Profit

Loss

Price of theAsset XYZatexpiration

+3

Initial price of the asset = Rs100Option price= Rs3Strike price = Rs100

Time to expiration = 1 month


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Profit/LossProfile for a Long Put Position

0

-2

98 100

Price ofthe AssetXYZ atexpiration

Profit

Loss

Initial price of the asset XYZ = Rs100

Option Price = Rs2

Strike price = Rs100


/


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Profit/Loss Profile for a Short Put

Position

0

+2

94 100

Price ofthe AssetXYZ atexpiration

Profit

Loss

Initial price of the asset XYZ =Rs100Option Price = Rs2Strike price = Rs100


Summary


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Summary

The profit and loss profile for a short putoption is the mirror image of the long put

option. The maximum profit from thisposition is the option price. The theoriticalmaximum loss can be substantial should the

price of the underlying asset fall.Buying calls or selling puts allows investor to

gain if the price of the underlying asset rises;

and selling calls and buying puts allows theinvestors to gain if the price of the underlyingasset falls.

S k I d O i


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Stock Index Option

Trading in options whose underlying instrument is the stockindex.

Here if the option is exercised, the exchange assignedoption writer pays cash to the options buyer. There is nodelivery of any stock.

Dollar Value of the underlying index = Cash index value *Contract multiple.

The contract multiple for the S&P100 is $100. So, for eg, ifthe cash index value for the S&P is 720,then dollar value will

be $72,000

For a stock option the price at which the buyer


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For a stock option, the price at which the buyerof the option can buy or sell the stock is thestrike price. For an index option, the strike index

is the index value at which the buyer of theoption can buy or sell the underlying stockindex. For Eg: If the strike index is 700 for anS&P index option, the USD value is $70,000. If

an investor purchases a call option on theS&P100 with a strike of 700, and exercises theoption when the index is 720, then the investorhas the right to purchase the index for $70,000when the USD value of the index is $72000. Thebuyer of the call option then receive$2000 fromthe option writer.

Binomial Model for Option


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Binomial Model for OptionValuation

Current Price of the stock = S Two possible values it can take next year :- uS or dS ( uS>

dS)

Amount B can be borrowed or lent at a rate of r. The

interest factor (1+r) may be represented , for sake ofsimplicity , as R.

d


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Value of a call option, just before expiration,

if the stock price goes up to uS is

Cu = Max(uS-E,0)Value of a call option, just before expiration,

if the stock price goes down to dS is

Cd = Max(dS-E,0)The value of the call option is

C=^S+B

^ = (Cu-Cd)/ S (u-d)

B = uCd-dCu/(u-d)R

Illustration:


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Illustration:

S=200, u=1.4, d=.9 E=220 r=0.15 R=1.15

Cu = Max(uS-E,0) = Max(280-220,0)=60

Cd = Max(dS-E,0) = Max(180-220,0)=0

^=Cu-Cd/(u-d)S = 60/(1.4-.9)200=0.6

B=uCd-dCu/(u-d)R= -0.9(60)/0.5(1.15) = -93.91(A negative value for B means that funds areborrowed).

Thus the portfolio consists of 0.6 of a share plus a

borrowing of 93.91( requiring a payment of93.91(1.15) = 108 after one year.

C=^S+B= 0.6*200-93.91 = 26.09


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Swaps

An agreement between two parties toexchange one set of cash flows for another.In essence it is a portfolio of forwardcontracts. While a forward contract involves

one exchange at a specific future date, aswap contract entitles multiple exchangesover a period of time. The most popular are

interest rate swaps and currency swaps.Kunal Rawal: mam please register my

email id [email protected]


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Interest Rate Swap

A B

Fixed Rate of 12%

LIBOR

A is the fixed rate receiver and variable rate payer.

B is the variable rate receiver and fixed rate payer.

Rs50,00,00,000.00Notional Principle

Counter Party Counter Party

The only Rupee exchanged between the parties are the net


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y p g pinterest payment, not the notional principle amount.

In the given eg A pays LIBOR/2*50crs to B once every sixmonths. Say LIBOR=5% then A pays be 5%/2*50crs= 1.25crs

B pays A 12%/2*50crs=3crs

The value of the swap will fluctuate with market interest rates.

If interest rates declinefixed rate payer is at a loss, If interest

rates risevariable rate payer is at a loss. Conversely if rates risefixed rate payer profits and floating rate payer looses.


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Review Questions

Distinguish between Index futures and index options.

Initial margin and maintenance margin.

Financial derivatives and commodity derivatives.

Short notes

Types of swaps

Comment Counter party risk is faced in forward

transactions.


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Illustration Two companies Rita Ltd. and Gita Ltd. are considering to enter

into a swap agreement with each other. Their correspondingborrowing rates are as follows:

Name of Company Floating Rate Fixed Rate

Rita Ltd. LIBOR 11%

Gita Ltd. LIBOR + 0.3% 12.5%

Rita Ltd. requires a floating rate loan of 8.million while Gita Ltd.requires a fixed rate loan of 8 million.

(i) Show which company had advantage in floating rate loansand which company has a comparative advantage in fixed loans.

(ii) If Rita Ltd. and Gita Ltd. engage in a swap agreement and thebenefits of the swap are equally split, at what rate will Rita Ltd.be able to obtain floating finance and Gita Ltd. be able to obtainfixed rate finance ?

Ignore bank charges.


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Solution

Assuming LIBOR say for 10% company Gita Ltd.floating rate is 0.3% per cent more expensive thancompany Rita Limited rate; but its fixed rate is 12.5%which is more expensive than Rita Ltd.. Hence thecompany Rita Ltd. has a more comparativeadvantage in fixed rate loans and company Gita Ltd.has a comparative advantage in floating rate loans.

(b) Net Potential Gain = (LIBOR - (LIBOR + 0.3) +(12.5 - 11) = - 0.3 + 1.5 = 1.2 per cent i.e. 0.6 per centbenefit to each company

Net floating rate cost to Rita Ltd. would be = LIBOR -.6% And net fixed rate cost to Gita Ltd. would be12.5% - .6% = 11.9%

So the swapping the interest rate obligations, bothcompanies would be benefitted to the extent of .6%.

derivatives and commodity exchanges

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