Derivatives

Futures, Options and Swaps

Derivatives: Basics
A financial instrument whose value depends on

or is derived from the value of some other

commodities or financial instruments, called
underlying asset, such as stocks, bonds, wheat,
snowfall, and stock market indices
This is different from an outright purchase of the
underlying asset because the profit and loss
situation associated with a derivative instrument
is just the opposite of an underlying asset
One partys loss is anothers gain
The purpose is to transfer or reduce risks

Forwards

They are the simplest forms of derivatives

A forward or forward contract is a customized or

private agreement between a buyer and a seller

to exchange a commodity or financial instrument
for a specified amount of cash on a pre-arranged
future date. It is not traded in the market
Spot and forward quotes for the USD/GBP exchange rate, July 20,
2007
Bid
Offer
Spot
2.0558
2.0562
1-month forward
2.0547
2.0552
3-month forward
2.0526
2.0531
6-month forward
2.0483
2.0489

Payoffs from Forwards

pay off from a long position in a forward

contract on one unit of an asset is ST K

pay off from a short position is K ST

ST is the spot price and K is the delivery price at

the maturity of the contract

Futures
A futures contract is a forward contract that

has been standardized and sold through an

organized exchange
A wide variety of commodities and assets
form the underlying assets in futures
contracts
The commodities include pork bellies, live
cattle, sugar, wool, lumber, copper, aluminum,
gold and tin
Financial assets include stock indices,
currencies and treasury bonds

Terminologies and
Concepts
Seller has the short position
Buyer has the long position
The specific date on which

exchange takes place is called

the settlement or delivery date
The seller benefits from declines
in the price
The buyer benefits from
increases in the price
A clearing corporation or house
acts as the guarantor that both
parties will meet their
obligations; it is the counterparty
to both sides of the transaction

Operations of Clearing Corporations

Both parties to a futures contract place a deposit with

the corporation which is known as posting margin in a

margin account
Clearing corporation also posts daily gains and losses on
the contract to the margin accounts known as marking to
market
To ensure that the initial margin account never becomes
negative a maintenance margin
If the balance in the margin account falls below the
maintenance margin, the investor gets a margin call to
top up the margin account to the initial margin level the
next day. The extra funds deposited are known as
variation margin

An example
Assume that on June 5 an investor buys two

December gold futures contracts (each

contract is of 100 ounces) at a price of $600
per ounce. The initial margin is $2000 per
contract and the minimum margin is $3000 in
total.

Day

June 5
June 6
June 9
June 10
June 11
June 12
June 13
June 16
June 17
June 18
June 19
June 20
June 23
June 24
June 25
June 26

Futures
price
600
597
596.1
598.2
597.1
596.7
595.4
593.3
593.6
591.8
592.7
587
587
588.1
588.7
591.0
592.3

Daily
(loss)

gain Cumulative Margin

gain (loss) account
balance
4000
(600)
(600)
3400
(180)
(700)
3220
420
(360)
3640
(220)
(580)
3420
(80)
(660)
3340
(260)
(920)
3080
(420)
(1340)
2660
60
(1280)
4060
(360)
(1640)
3700
180
(1460)
3880
(1140)
(2600)
2740
0
(2600)
4000
220
(2380)
4220
120
(2260)
4340
460
(1800)
4780
260
(1540)
4060

Margin call

1340

1260

Risk Transfer through Hedging &

Speculation
Hedging
Seller/Short Position

Buyer/Long Position

Dealer of long term securities

holding an inventory of bonds

Pension Fund Manager planning

to purchase bonds in future

Goal: to hedge against possible

decline in bond prices

Goal: to insure against possible

price increases

Speculation: They bet on price movements to

make profit
Seller/Short Position

Buyer/Long Position

They bet that prices will fall

They bet that prices will rise

Comparison between Forwards

and Futures
Forwards

Futures

Nature of Contract

Nonstandardized/custo
mized contract

Standardized in
terms of contract
size, trading
parameters,
settlement
procedures

Trading

Informal OTC market Traded on

or private contracts exchanges
between parties

Settlement

Single, pre-specified Daily settlementin the contract

marking to market
and final settlement

Risk

Counter party risk

No counter party
risk

Arbitrage and the Determination of

Futures Price
On the date of settlement or delivery spot

prices and futures prices of the underlying

assets are almost the same
Arbitrageurs drive down the prices of futures
to the level of the spot prices of the
underlying assets
The practice of buying and selling financial
instruments in order to benefit from
temporary price differences is called arbitrage
and the people who are engaged in it are
called arbitrageurs.

An exmaple
Suppose, that the stock price is $200 in NY

while 100 in London while the exchange rate

is 2.0300 dollars/pound. An arbitrageur can
simultaneously buy 100 shares of the stock in
NY and sell them in London and make a riskfree profit of 100 [($2.03100) - $200] =
$300

Options
Like futures, options are also agreement between

two parties, a seller, called an option writer, and a

buyer, called an option holder
Option writers incur obligations while option
holders obtain rights
There are two basic options: puts and calls
There are four types of participants in option
market
Buyers of calls (holders)
Sellers of calls (writers)
Buyers of puts (holders)
Sellers of puts (writers)

Call Options
A call option is the right to buy or call away a given quantity

of underlying asset at a predetermined price, called the

strike price or exercise price, on or before a specific date
The writer of the call option must sell the shares if and when
the holder chooses to use the call option
The holders of the call are not obligated to buy the shares;
rather they have the option to buy and will do so if it is
beneficial
When spot price is above the strike price, exercising the call
option is profitable for the holder and the option is said to be
in the money
If spot and strike prices are same, the option is at the money
when the strike price exceeds the market price of the
underlying asset, the option is termed out of money

Put Option
A put option gives the holder the right but not the

obligation to sell the underlying asset at a

predetermined price on or before a fixed date
The holder can put the asset in the hands of the
option writer
The writer is obliged to buy the shares should the
holder choose to sell them
The put option is in the money when the options
strike price above the market price
It is out of money when strike price is below the
market price
Only the option writer is required to post margin with
a clearing corporation

Types of Calls and Puts

American options can be exercised on any date

from the time they are written till they expire

American option holders during the holding period can
continue to hold the option,
sell the option to someone else or
exercise the option

European options can be exercised only on the day

of expiration
European option holders during the holding period can
continue to hold the option,
sell the option to someone else

Functions of Options
Options transfer risk from the buyer to the seller
They can be used for both hedging and speculation
For a hedger who wants to purchase an asset in

future, a call option ensures that the cost of buying

the asset wont rise above the strike price
For a hedger who plans to sell an asset in future, a
put option ensures that the price at which the asset
can be sold will not go below the strike price
For a speculator a call option will be in the money
when betting on a fall in interest in future
For a speculator a put option will be in the money
when betting on a rise in interest in future

Who writes Options?

Speculators for a fee they are willing to take

the risk and bet that prices will not move

against them
Market makers - are primarily dealers who
engage in the regular purchase and sale of
underlying asset and thus are insured against
any losses that may arise
Options can be bought and sold in many
combinations; e.g. Simultaneous purchase of
an at the money call and sale of an at the
money put. If price of the underlying asset
increases, calls value increases while put

Pricing of Options
option price = intrinsic value + time value of the

option
Intrinsic value the value of the option if it is
exercised immediately
The intrinsic value is the difference between the price
of the underlying asset and the strike price.
If the option is not exercised then intrinsic value = 0
Time value relates to the time of the options
expiration
At expiration value of an option is its intrinsic value
and time value is zero.
The longer the time to expiration, the bigger the likely
pay off.

An Example of Time Value of Option

Consider an European at-the-money call option

with strike price of $100 that will expire in 3

months. The stock price has equal probability of
rising or falling by $10 each month. The expected
pay off from time value is

Months

Possible outcomes
1

1st

+10

+10

+10

+10

-10

-10

-10

-10

2nd

+10

-10

-10

+10

+10

-10

-10

+10

3rd

+10

+10

-10

-10

+10

+10

-10

-10

Payoffs

30

10

-10

10

10

-10

-30

-10

Volatility in the Prices of

Underlying Asset
The likelihood that an option will pay off

depends on the volatility or standard deviation

of the price of the underlying asset
If there is no volatility of a stock price, i.e. the
price is fixed, then no one is going to pay for
the option since it will never pay off
Whenever the price rises higher, the call
options value increases

IBM Puts and Calls on Feb 20,

2012
Stock Price at Close = 99.35
A. April Expiration
Strike Price
Call Price
80
20.20
90
10.40
95
5.80
100
2.55
105
0.75
110
0.15
A. Strike Price of 95
Expiration month
April
July
October

Calls
Intrinsic
Value
19.35
9.35
4.35
0
0
0

Time Value Put Price

0.85
1.05
1.45
2.55
0.75
0.15

5.80
7.70
9.4

Calls
4.35
4.35
4.35

0.20
0.75
2.35
5.80
-

1.45
3.35
5.05

Puts
Intrinsic
Value
0
0
0
0.65
5.65
10.65

0.75
1.75
2.6

Time Value
0.20
0.75
1.70
0.15
Puts
0
0
0

0.75
1.75
2.60

Swaps
A swap is an agreement between two

companies to exchange cash flows in future

The agreement defines the dates of cash
flows and the way in which they are to be
calculated
Usually, the calculation of cash flows involves
the future value of an interest rate, an
exchange rate or other market variable
The most common type of swap is a plain
vanilla interest rate swap

Plain Vanilla Interest Rate

Swap
A

company agrees to pay cash flows at a

predetermined fixed interest rate on a notional
principal for a number of years.
In return, it receives interest at a floating rate on
the same notional principal for the same period of
time
Notional principal or notional - this principal is
used only to calculate interest payment that needs
to be exchanged. It is actually never paid or
received by any of the parties involved in a swap

Example
3-year swap between Microsoft and Intel on

March 5, 2010
Microsoft agrees to pay Intel at an interest rate of
5 percent per annum on a notional principal of
$100 million and in return Intel agrees to pay
Microsoft the 6-month LIBOR on the same
Date of
Fixed rate Floating
Floating
Net
principal
exchange payment
rate
rate
transfer
payment

from
Microsoft

Sept. 5,
2010

$2.5 million

4.2% on
March 5,
2010

$2.1 million

-$0.4
million

March 5,
2011

$2.5 million

4.8% on
$2.4 million
Sep 5, 2010

-$0.1
million

Swaps for Transforming

Liability
For Microsoft a floating rate loan could be

transformed into a fixed rate loan

Suppose it borrows $100 million at a floating
rate of LIBOR plus 10 basis points and then gets
into the swap
The cash flows are:
It pays LIBOR plus 0.1 to outside lender
It receives LIBOR under the swap
It pays 5% under the swap

The net cash outflow is 5.1%

Swaps for Transforming

Liability

Similarly, for Intel a fixed rate loan can be

transformed into a floating rate loan

Suppose, Intel has a 3-year $100 million loan
outstanding on which it pays 5.2%
The cash flows are
It pays 5.2% to outside lender
It receives 5% under the swap
It pays LIBOR under the swap

The net cash outflow is LIBOR plus 0.2 percent.

Swaps for Transforming

Assets
Suppose

Microsoft owns bonds worth $100

million which provides interest at 4.7% per
annum over the next three years
After the swap agreement, cash flows are
It receives fixed interest payment at 4.7%
It pays fixed interest payment at 5% under the

swap
It receives floating interest payment at LIBOR

The net cash flows it receives is LIBOR minus 0.3

percent
this transforms a fixed interest rate asset into a
floating interest rate asset.

Swaps for Transforming

Assets
Similarly for Intel swap can transform an asset

earning a floating rate of interest into an asset

earning a fixed rate of interest
Suppose, Intel has an investment of $100 million
that yields LIBOR minus 20 basis points
The swap generates the following cash flows:
It receives LIBOR minus 0.2 from outsider
It pays LIBOR under the swap
It receives 5% under the swap

It receives a net cash inflow of 4.8 percent

Financial Intermediary
Usually a financial intermediary acts as a

counterparty to the parties in a swap

The financial intermediary earns a fee of 0.030.04% of the notional principal on a pair of
offsetting transactions
If one company defaults, the financial
intermediary has to honor the agreement with
the other company
Financial institutions act as market makers
and opt for warehousing swaps

Example
Maturity
(years)
2

Bid p.a.

Offer p.a.

6.03

6.06

Swap
p.a.
6.045

6.21

6.24

6.225

6.35

6.39

6.370

6.47

6.51

6.490

6.65

6.68

6.665

10

6.83

6.87

6.850

rate

The comparative Advantage

Argument

The argument explains the popularity of swaps

A company would borrow from the market where it

has a comparative advantage

Consider 2 companies AAA and BBB, where their
name suggests their credit ratings.
The interest rate offered to them at fixed and
floating rate markets are
AAA & BBB borrow from fixed rate and floating
rate markets, respectively
Fixed rate

Floating rate

AAA

4.0%

6-month LIBOR 0.1%

BBB

5.2%

6-month LIBOR + 0.6%

The comparative Advantage

Argument
If they get into a swap where AAA pays LIBOR and

receives 4.35% from BBB

AAAs cash flows
It pays 4% to outsider
It receives 4.35% from BBB under the swap
It pays LIBOR under the swap

AAAs net cash outflow is LIBOR minus .35 which is lower

than the rate offered to him in the floating rate market

BBBs cash flows
It pays LIBOR plus 0.6
It receives LIBOR under the swap
It pays 4.35% under the swap

BBBs net cash outflow is 4.95% which is lower than

5.2%

Other Swaps
Currency Swap
Currency swap in its simplest form involves exchanging
principal and interest payments in one currency for
interest and principal payments in another currency.
It could be fixed-for-fixed or fixed-for-floating currency
swap
Equity Swap
Here the total returns (dividends plus capital gains)

realized on an equity index is exchanged for either a

fixed or floating rate of interest
It is used by portfolio managers to convert return from
a fixed or floating investments to the returns from
investing in an equity index and vice versa

Problems
Of the following options, which would you expect to

have the highest option price?

A European 3-month put option on a stock whose market

price is $90 where the strike price is $100. The standard

deviation of the stock price over the past five years
have been 15 percent.
A European 3-month put option on a stock whose market
price is $115 where the strike price is $100. The
standard deviation of the stock price over the past five
years have been 15 percent.
A European 1-month at-the-money put option on a stock
whose market price is $100. The standard deviation of
the stock price over the past five years have been 15
percent.

Problems
What kind of an option should you purchase if

you anticipate selling $1 million of Treasury

bonds in one year and wish to hedge against
the risk of interest rate increase?
You sell a bond futures contract and one day
later the clearinghouse inform you that it had
credited funds to your margin account. What
happened to interest rates over the day?

Problems
Suppose you have $8000 to invest and you use the

futures market to leverage your exposure to the

copper market. Copper is selling at $3 a pound and
the margin requirement for a futures contract for
25000 pounds of copper is $8000.
If you expect the copper price to go up in future what

would be your strategy/position in the futures market?

Calculate your return if copper price rise to $3.1 a
pound
How does it compare with the return you would have
made if you had simply purchased $8000 worth of
copper and sold it a year later?
Compare the risk involved in each of these strategies

Problems
You are given the following information on 3

firms. Firms A and B want to be exposed to

floating interest rate while firm C would prefer
to pay a fixed interest rate. Which pair(s) of
firms (if any) should borrow in the market they
do not want and then enter into a fixed-forfloating interest Fixed
rate swap.
rate
Floating rate
Firm A

7%

LIBOR+50 bps

Firm B

12%

LIBOR+150 bps

Firm C

10%

LIBOR+150 bps

Problem
Basis swaps are swaps where both payment

streams are based on floating interest rates.

Why might anyone be interested in entering a
floating-for-floating interest rate?