DERIVATIVE RISK MANAGEMENT

BY
CA UMESH KOLAPKAR

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 Derivatives

Futures Options Forwards Swaps

Call Put

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 Options

Meaning
Options grants the right, but not the
obligation,to buy or sell a futures contract
at a predetermined price for a specified
period of time.

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Two Types of Options

PUT OPTION


Gives buyer right to sell underlying Assets

CALL OPTION


Gives buyer right to buy underlying Assets

Note: In both cases the underlying Assets includes futures

contract in commodity markets & Shares as well index in capital
markets.

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TERMS USED IN OPTIONS
Strike Price (Exercise Price): The predetermined price of
the underling Assets i.e. price at which underlying assets
can be bought or sold.

Premium: The cost of the right to buy or sell a underlying

Assets – cost of the option. The buyer loses the premium
regardless of whether the option is used or not.

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TERMS USED IN OPTIONS
 Option Writer: Person selling the option, and
is exposed to margin requirements
 Underlying Assets: It is corresponding
Assets(Future Contract )which can be
transacted by exercising the transaction.
 Exercise: Action taken by the buyer of an
option whose intention is to deliver or take
delivery of the underlining Assets
 Expiration Date: Last date on which an
option can be exercised or offset
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TERMS USED IN OPTIONS
 Delta : First derivative, considers
sensitivity of options to price of
future contract (Hedge Ratio)
 Gamma : Considers sensitivity of options
to changes in Delta (Curvature)
 Theta : Considers sensitivity of options
to time factor (time decay)
 Vega : Considers sensitivity of options to
market volatility.
 Rho : Considers sensitivity of portfolio
to interest rates. 7
Call Option

A call option gives the holder the right,

but not the obligation, to buy a specific
underlying assets(futures contract) at a
specific price

“To call from them”

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Gold Example (Call)
Suppose that on June 1, a farmer is approached by a
goldsmith for purchasing 1 tola of gold at Rs.9,000 per tola .
The Goldsimth is almost certain that he wants the gold but is
unable to arrange finance for six months. The farmer
proposes to grant a six-month option at Rs.9,000 per tola in
exchange for a Rs.90 per tola.
Purchaser = The Goldsimth (Option-Call buyer)
Grantor = The Farmer (Option-Call seller)
Exercise price = Rs.9,000 per tola (Strike price)
Expiration date = December 1
Call Premium = Rs.90 (paid by goldsmith – call
buyer)

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PUT OPTION

A put option gives the holder the right, but

not the obligation, to sell a specific
underlying Assets (futures contract )at a
specific price

“To put it on them”

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Gold Example (Put)
Suppose that on June 1, a farmer approaches a goldsmith for
selling 1 tola of gold at Rs.9,000 per tola . The Farmer is almost
certain that he wants to sell the gold but is unable to arrange the
delivery for six months. The Goldsmith proposes to grant a six-
month option at Rs.9,000 per tola in exchange for a Rs.90 per
tola.
Purchaser = The Goldsimth (Option-Put seller)
Grantor = The Farmer (Option-Put buyer)
Exercise price = Rs.9,000 per tola (Strike price)
Expiration date = December 1
Call Premium = Rs.90 (paid by farmer-option
buyer)

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Options are popular because:

1) Price Insurance.
2) Limited financial obligation.
3) Marketing flexibility.

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Put and Call Options
 Put Option:
 The right to sell an Underlying Assets( futures
contract)
 Provides protection against falling prices
 Sets a minimum price target
 Call Option:
 The right to buy a an Underlying Assets
futures contract
 Protects against rising prices (e.g. feed costs)
 Allows participation in seasonal price rises

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How Is the Premium For
An Option Determined?
Question: What would you be willing to pay for
the right to sell a futures contract at Rs.300 if the
current futures price is Rs.280?

Answer: If the premium is Rs.5, you could make

a profit by exercising the option (sell @ Rs.300)
and buy a futures contract for Rs.280 at the same
time. Profit is Rs.15. Maximum premium one
could pay is Rs.20.

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Factors Affecting Option Premium

 Changes in the price of the underlying futures

contract- E.g. gold futures
 Strike Price – E.g. Rs.10,000 per tola
 Time until expiration
 Volatility of the underlying futures contract
 Dividends
 Risk free interest rates.

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Components of Premium

Intrinsic Value
+
Time Value
=
Premium

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INTRINSIC VALUE

“Positive” difference between the strike price

and the underlying commodity futures price.
 FOR A CALL OPTION – strike price below

futures price
 FOR A PUT OPTION – strike price exceeds
futures price
Note: Futures price means current price of underlying futures contract.

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Intrinsic Value:
An Example
May Corn Futures Price= Rs.329
What is the Intrinsic Value for a:
Q: Rs.310 Call Option?
A: Rs. 19
Q: Rs.340 Put Option?
A: Rs. 11
Q: Rs.340 Call Option?
A: Rs. 0
Time Value for Mar 07 and Apr 07
Options on Jan 1, 2007
Mar 07 Futures = 209.25 Apr 07 Futures = 237
 Mar 07 210 Call Option  Apr 07 240 Call Option

 Premium = 8.625  Premium = 20.5

 Intrinsic Value = 0  Intrinsic Value = 0

 Time Value = 8.625  Time Value = 20.5

 Mar 07 210 Put Option  Apr 07 240 Put Option

 Premium = 9.5  Premium = 23.25
 Intrinsic Value = 0.75  Intrinsic Value = 3
 Time Value = 8.75  Time Value = 20.25

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Time Decay

Time value
0.50

0.25

0
180 90 0
Days to expiration
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Call Option

In-the-Money (ITM)
Strike price < Futures price

At-the-Money (ATM)
Strike price = Futures price

Out-of-the-Money (OTM)
Strike price > Futures price
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Put Option

In-the-Money (ITM)
Strike price > Futures price

At-the-Money (ATM)
Strike price = Futures price

Out-of-the-Money (OTM)
Strike price < Futures price
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Call/Put Options

Deep-In-the-Money (DITM)
No Chance of Out-of-the-Money

Close-to-the-Money (CTM)
Strike price near Futures price

Deep-Out-of-the-Money (DOTM)
No Chance of In-the-Money
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 Options Exercise Mode

 American Style Options – Buyer of the options can

choose to exercise, prior to the
expiry date.

 European Style Options – Buyer of the options can

choose to exercise only on the
date of expiry.

 American Premium ≥ European Premium

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What Happens to An Option
Which You Own?
 It Can Expire
 Unexercised Options Die
 You Must Still Pay the Option Premium
 You can Exercise the Option
 Put: Sell the Futures Contract
 Call: Buy the Futures Contract
 Offset, By Selling the Put or Call Option

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Reasons Why a Producer Might Buy
Options
Action Reason

Buys a Put Needs price protection (floor)

for crops.
Buys a Call Needs price protection
(ceiling) on feed requirements.
Buys a Call Has sold crops and believes
prices are going to rise.

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Payoff diagram – Long Call

Profit

Strike Price
Future Price
0

Loss
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Payoff diagram – Long Put

Profit Buy Put

$0.50
@$.25/Bu
$0.25 Beans
Price at
Expiration
0
$7.00 $7.25 $7.50 $7.75 $8.00

$0.25

$0.50 ITM ATM OTM

Loss
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Payoff diagram – Short Call

Profit

Future Price
0
Strike Price

Loss
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Payoff diagram – Short Call

Profit

Future Price
0
Strike Price

Loss
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SPREADS
1. Vertical Bull Call Spreads
2. Vertical Bull Put Spreads
3. Vertical Bear Call Spreads
4. Vertical Bear Put Spreads
5. Long Butterfly Spreads

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6. Short Butterfly Spreads
7. Calendar Spreads – Involving Call Options
8. Calendar Spreads – Involving Put Options
9. Straddles
10.Strangles

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Vertical Bull Call Spreads
Vertical Bull Put Spreads
For April 2007 (same expiry)

Rs.790 Sell (Call / Put)

Rs.720 Buy (Call / Put)

 Useful in moderately bullish market

 Limited Profit / Loss

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Vertical Bear Call Spreads
Vertical Bear Put Spreads
For April 2007 (Same expiry)

Rs.850 Buy (Call / Put)

Rs.750 Sell (Call / Put)

 Useful in moderately bearish market

 Limited Profit / Loss

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Butterfly- Long

4 Options
 2 short options of same strike price
 1 long options of lower strike price
 1 long options of higher strike price

 Maximum profit is when futures price is as per middle

strike price
 Maximum loss is equal to premium paid

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Butterfly - Short

4 Options
 2 long options of same strike price
 1 short options of lower strike price
 1 short options of higher strike price

 Maximum profit is premium received when futures price

are outside the strike price
 Maximum loss when futures price is as per middle strike
price

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Calendar Spreads

Rs.720 Rs.720
Sell options Buy options
(March ’07) (April ’07)

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Straddles

For April 2007

Rs. 910 Buy Call & Put

 When market is volatile

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Stranglers

For April 2007

Rs. 1000 Buy Call

Rs. 910 Buy Put

 When market is volatile

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OPTIONS PRICING
Black – Scholes Formula
C = SN(d1) – Ee-rt N(d2)

P = Ee-rt N(-d2) - SN(-d1)

d1= In (S/ E) + (r+sd2/ 2) T

Sd*sqr(T)
d2 = d1- Sd*sqr(T)
Where,
S = Spot Price
N(d) = probability that a deviation less than “d“ will occur in a normal
distribution with a mean zero & standard deviation is 1
E = Exercise Price or Strike Price
e = 2.71828

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OPTIONS PRICING

Put – Call Parity

Formula:
C + PV (x) = P + S
Where,
C = present value of the call
P = present value of the put
S = present value of the underlying
PV(x) = present value of the strike price discounted from the expiration
date at a suitable risk free rate.

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THANK YOU

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