What is a derivative?

• A derivative is a financial instrument that

offers a return based on the return of
some other underlying asset.
• A financial instrument that has a value derived
from the value of something else ie an
underlying asset (stock, corn, bonds, currencies,
livestock etc)
Types of Derivatives
• Derivative contracts are created on and
traded in two distinct but related types of
markets: exchange-traded and over the
counter.
• Exchange-traded contracts have standard
terms and features and are traded on an
organized derivatives trading facility,
usually referred to as a futures exchange
or an options exchange.
Types of Derivatives
• Over-the-counter contract are any
transactions created by two parties
anywhere else.
• Derivatives contracts can be classified into
i. Forward contracts
ii. Futures contracts
iii. Option contracts
iv. swaps
FORWARD CONTRACTS
• The forward contract is an agreement
between two parties in which one party,
the buyer, agrees to buy from the other
party, the seller, an underlying asset at a
future date at a price established at the
start.
FORWARD CONTRACT
• One of the parties to a forward contract
assumes a long position and agrees to
buy the underlying asset on a certain
specified future date for a certain specified
price.
• The other party assumes a short position
and agrees to sell the asset on the same
date for the same price.
FORWARD CONTRACT
• The parties to the transaction specify the
for- ward contract’s terms and conditions,
such as when and where delivery will take
place and the precise identity of the
underlying. In this sense, the contract is
said to be customized.
• Each party is subject to the possibility that
the other party will default.
FORWARD CONTRACT
• Forward contracts in the financial world
take place in a large and private market
consisting of banks, investment banking
firms, governments, and corporations.
FORWARD CONTRACT
• These contracts call for the purchase and
sale of an underlying asset at a later date.
The underlying asset could be a security
(i.e., a stock or bond), a foreign currency,
a commodity, or combinations thereof, or
sometimes an interest rate.
PAYOFFS FROM FORWARDS
CONTRACTS
LONG POSITION SHORTPayoff
POSITION
Payoff
1 • 2

0 0
K ST K ST

K=Delivery price ST=Price of asset at maturity

PAYOFFS
• The payoff from a long position in a
forward contract on one unit of an asset is
ST- K

• From a short position the payoff is K-S T

• These payoffs can be positive or negative

The Problems of Forward
Markets
a) lack of centralization of trading,
b) illiquidity, and
c) counterparty risk
Example 1
• Consider a stock that pays no dividend
and is worth $60, you can borrow or lend
money for 1 year at 5%. What should the
1-year forward price of the stock be?
Example 2
• An investor enters into a long forward
contract to buy £100 000 for US dollars at
an exchange rate of 1.9000 US dollars per
pound. How much does the investor gain
or lose if the exchange rate at the end of
the contract is
• (a) 1.8900 and (b) 1.9200?
Example 3
• A trader enters into a short cotton forward
contract when the futures price is 50 cents
per pound. The contract is for the delivery
of 50,000 pounds. How much does the
trader gain or lose if the cotton price at the
end of the contract is (a) 48.20 cents per
pound; (b) 51.30 cents per pound?
FUTURES CONTRACT
• A contract to buy or sell a specified
amount of a designated commodity,
currency, security, or financial instrument
at a known date in the future and at a price
set at the time the contract is made.
FUTURES CONTRACT
• Futures transactions are standardized and
conducted in a public market, are
homogeneous, have a secondary market
giving them an element of liquidity, and
have a clearinghouse, which collects
margins and settles gains and losses daily
to provide a guarantee against default.
CONT’D
• A futures trader who has established a
position can re-enter the market and close
out the position by doing the opposite
transaction (sell if the original position was
long or buy if the original position was
short).
• The party has offset the position, no longer
has a contract outstanding, and has no
further obligation.
MARGIN
• Initial margin is the amount of money in a
margin account on the day of a transaction
or when a margin call is made.
• Maintenance margin is the amount of
money in a margin account on any day
other than when the initial margin applies.
MARGIN
• Minimum requirements exist for the initial
and maintenance margins, with the initial
margin requirement normally being less
than10 percent of the futures price and the
maintenance margin requirement being
smaller than the initial margin requirement.
MARGIN
• Variation margin is the amount of money
that must be deposited into the account to
bring the balance up to the required level.
• The settlement price is an average of the
last few trades of the day and is used to
determine the gains and losses marked to
the parties’ accounts.
MARKING TO MARKET
• The futures clearinghouse engages in a
practice called marking to market, also
known as the daily settlement, in which
gains and losses on a futures position are
credited and charged to the trader’s
margin account on a daily basis.
MARKING TO MARKET
• Thus, profits are available for withdrawal and
losses must be paid quickly before they build
up and pose a risk that the party will be unable
to cover large losses.
• The margin balance at the end of the day is
determined by taking the previous balance and
accounting for any gains or losses from the
day’s activity, based on the settlement price, as
well as any money added or withdrawn.
EXAMPLE
• Suppose a trader takes a long position in
an oil futures contract at $60 per barrel.
• The prices on day 2, 3 and 4 are $65, $55
and $58
FORWARDS VS FUTURES
OPTIONS
• an option is a financial derivative contract
that provides a party the right and not an
obligation to buy or sell an underlying asset
at a fixed price by a certain time in the future.
• The party holding the right is the option
buyer; the party granting the right is the
option seller. There are two types of options,
a call and a put.
OPTIONS
• A call is an option granting the right but not the
obligation to buy the underlying; a put is an
option granting the right but not the obligation
to sell the underlying.
• To obtain this right, the option buyer pays the
seller a sum of money, commonly referred to
as the option price. On occasion, this option
price is called the option premium or just the
premium. This money is paid when the option
contract is initiated.
BASIC CHARACTERISTICS OF
OPTIONS
• The fixed price at which the option holder
can buy or sell the underlying is called the
exercise price, strike price, striking price,
or strike denoted as X or K. The use of this
right to buy or sell the underlying is
referred to as exercise or exercising the
option.
BASIC CHARACTERISTICS OF
OPTIONS
• Like all derivative contracts, an option has
an expiration date, giving rise to the notion
of an option’s time to expiration (t).
• When the expiration date arrives, an
option that is not exercised simply expires.
CONT’D
• What happens at exercise depends on
whether the option is a call or a put. If the
buyer is exercising a call, she pays the
exercise price and receives either the
underlying or an equivalent cash
settlement.
CONT’D
• Options contracts specify a designated
number of units of the underlying. For
exchange-listed, standardized options, the
exchange establishes each term, with the
exception of the price.
• The price is negotiated by the two parties.
CONT’D
• For an over-the-counter option, the two
parties decide each of the terms through
negotiation.
• The buyer is subject to the possibility of
the writer defaulting.
EXERCISE STYLES
• European- style
• American- style

• European options
• American call options
A LONG POSITION IN A CALL OPTION

• The pay-off from a long position in a

European call option is;
• max[0;St -K]
• This reflects the fact that the option will be
exercised if St >K, and will not be
exercised if St <K
MONEYNESS CALL OPTIONS
• St >K the option is said to be “in the
money”

• St =K, the option is said to be “at the

money”

• St <K, the option is said to be “out of the

money”
PAYOFF DIAGRAMS
• 1 Payoff
Long call

0
K ST
EXAMPLE 1
• Suppose an investor buys a European call
option with a strike price of $60 to
purchase 100 Delta shares which are
currently trading @ $58 per share.
• You are also given the following:
• Expiration date of the option is 4 months
• Premium per share is $5
QUESTION

• Draw the pay-off diagram for the call

option and comment.
PUT OPTION
• Gives the owner the right to sell the
instrument to the option writer at the strike
price on or before the expiration date.
Put option
• In the money if X > ST

• Out of the money X < ST

• At the money X = ST
EXAMPLE 2
• You are given the following information.
• Current stock price per share $85
• Strike price $90
• Premium per share $7
• Stock price at expiration $84
• Expiration date 3 months time
QUESTIONS
a) draw the pay-off diagram for the put
option
b) calculate the break even point for the put
option
c) Should the holder of the put option
exercise her option. Show all workings
EXAMPLE 3
• You are given the following information
• Strike price=$70
• Premium=$3
• Expiration date= 4 months from today
CONT’D
• S0= $75
• S1= $73
• S2= $70
• S3= $68
• S4= $71
QUESTION

• Calculate the payoff. Should the investor

exercise his option. Show all workings.
Economic and Commercial
Advantages of Derivatives
a) Derivatives allow the sharing or
redistribution of risk
b) Derivatives can allow businesses to
manage effectively exposures to external
influences on their business over which
they have no control.
c) For speculation.
Participants in a Derivative
Market
1. HEDGERS
• These are the investors with a present or
anticipated exposure to the underlying
asset which is subject to price risks.

• Hedgers use the derivative markets

primarily for price risk management of
assets and portfolios.
2.Speculators
• These are individuals who take a view on
the future direction of the markets.
• They take a view whether prices would
rise or fall in future and accordingly buy or
sell futures and options to try and make a
profit from the future price movements of
the underlying asset.
3. ARBITRAGEURS
• are in business to take advantage of a
discrepancy between prices in two
different markets.
END !!!!
Take note of diagrams
Formulars
Understand the difference between types of
derivatives.

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