Transcript Futures And Options: A Conceptual Framework

MBA & MBA – Banking and Finance
(Term-IV)
Course : Security Analysis and Portfolio Management
Unit III: Financial Derivatives
FINANCIAL DERIVATIVES
• Fluctuations in the prices of financial assets
expose the dealers in such assets to risk. The
dealers would like to hedge the risk involved in
their financial transactions. Financial derivatives
have evolved as instruments for hedging the risk
involved in buying, holding and selling various
kinds of financial assets.
• Basically, they are financial instruments for the
management of risk arising from the uncertainty
prevailing in financial markets regarding asset
prices.
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FINANCIAL DERIVATIVES
• Financial Derivatives are those assets whose
value is derived from the value of underlying
assets
• Underlying assets may be equity, commodity,
or currency
• Derivatives have no independent value
• Derivatives are promise to convey ownership
• Derivatives may be exchange traded or
privately negotiated over the counter
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Types of Derivatives
• Forwards
• Futures
• Options
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FORWARD CONTRACTS
• A forward contract is customised contract
between two entities where settlement
takes place on a specific date in the future
at today’s pre agreed price
• Two parties irrevocably agree to settle a
trade at a future date, for a stated price and
quantity
• No money changes hands
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Futures Contracts
FUTURES
• A future contract is an agreement between
two parties to buy or sell an asset at a certain
time in the future at a certain price. These are
special types of forward contracts in the sense
that the former are standardised exchangetraded contracts.
• Traded over an Exchange
• Standardized Forward Contract
• Contract to buy or sell a specified asset at a
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LIMITATATIONS OF FORWARD CONTRACTS
• Private Bilateral agreement, Involves Counter
Party Risk
• Cannot take Reverse Position, Lack of Liquidity
• Lack of Standardization
These limitations can be overcome by use of
Future Contracts
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COMPARISON OF FORWARDS AND FUTURES
BASIS
FORWARDS
FUTURES
Standardization
Non standardized
products
No liquidity
Standardized
Risk of non
performance
Nil
No such risk
Liquidity
Risk
Margin Money
P & L Settlement
At the time of
maturity
Highly liquid
Paid to clearing
corporation
Daily cash
settlement
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OPTIONS CONTRACTS
• Options may be defined as a contract,
between two parties whereby one party
obtains the right, but not the obligation, to
buy or sell a particular asset, at a specified
price, on or before a specified date
• Give the buyer the right but not the obligation
to buy/sell a specified underlying asset
• At a set price
• On or before a specified period
• One who receives the right is the Option
buyer/holder
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BASIS
COMPARISON OF FUTURES AND OPTIONS
Obligatory
Premium
Risk – Return
Exposure
Performance of
the contract
FUTURES
OPTIONS
Obligatory on both Not obligatory for
the parties
the buyer/holder
No premiumpaid Buyer pays
premiumto seller
Buyer exposed to Downside risk
entire downside
limited for buyer
risk and potential but infinite
for upside returns potentials for
upside returns
Obligatory to
Can be on or before
perform on the
the maturity date
expiry date
depending upon
whether option is
american or
european
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Types of Options
• Call Option
• Put Option
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Call Option
• A Call Option gives the buyer 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.
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PUT OPTION
• Put Option gives the buyer the right but not
the obligation to sell a given quantity of the
underlying asset at a given price on or
before a given date.
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Comparison of Call & Put Option
Call Option
Put Option
Buyer / Holder
(privileged
person)
Right to buy an
asset
Seller/ Writer
(Bearing risk)
Right to Sell
Obligation to
Buy
Obligation to
Sell
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Styles of Options
• European Style : They can be exercised on
specified future date only. ( Last Thursday of
expiry month in India )
• American Style : They can be exercised on or
before a specified future date.( They are
difficult to administer but more beneficial to
the buyer.
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Terminology to be used for Options
Pricing
• Spot Price : The current price of the stock
• Exercise Price/Striking Price: The fixed price at
which the option holder can by and / or sell
the underlying asset.
• Exercise Date : When option is exercised
• Expiry Date : Last Date when option can be
exercised
• Option Premium :It is the price the buyer
pays the writer for an option contract.
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Advantages Of Options
• Leverage
• Unlimited Profit Potential
• Fixed Risk
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Example
• A stock’s prevailing market price is Rs.250 (S0).
A call option contract having exercise price (E)
of 260 and 3 months maturity is available at
an option premium of Rs.3(c).
• Interpretation
Out of pocket cost right now is Rs.3
If market price 3 months hence S1= 270
Exercise the call option
Net pay off = (270 - 260 – 3 )
= 7 (gain)
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• If S1= 250
Do not exercise the call option
No benefit / No loss
Net payoff = 3 (loss)
Net loss will remain max 3 irrespective of S1
• If S1= 290
Net pay off = (290 - 260 – 3 )
= 27 (gain)
There is potential for unlimited gain
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Diagrammatic Representation
Gain Area
260 263
Loss
Break even
point
Stock Price
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• If S1> E
Exercise Call Option
• If S1< E
Do not exercise call option
A call option will be exercised if S1> E or S1= E
Net payoff = S1- E -c
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Option Pricing
FACTORS AFFECTING OPTION PRICE
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Stock price (on expiration date): The value of call option, other things being
constant, increases with the stock price.
Strike/ Exercise price: Other things being constant, the higher the exercise
price, lower would be the value of a call option.
Time to Expiration: Other things being constant, longer the time to expiration
date the more valuable the call option. The holder gets more time for
exercising the option
Variability of the stock price: Other things being constant, the higher the
variability of the stock price, the greater the likelihood that the stock price
will exceed the exercise price.
Risk Free Rate of Interest: The higher the interest rate , the greater the
benefit will be from delayed payment and vice-versa. So, the value of a call
option is positively related to the interest rate.
Dividends: The call option price is lower at the ex-dividend date compared to
the pre-dividend date.
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