What are Financial Derivative Products?

By A. D. D. Akmeemana

Continued from last week

Options are available for fundamental instruments like stocks and bonds and derivatives like futures and swap contracts. Here we will discuss a few very basic option strategies.

Options are traded in exchanges and they are standardised contracts. European type options are different from American type options that American type options can be exercised at any time before they expire. European type can be exercised at the expiration only.

There are two kinds of options, call and put. One can buy either a call or a put option and also sell (write) a call or a put option. An investor can enter into any combination of strategies too, of different maturities and strike prices, which mean that there are many strategies available to an investor or a hedger. Call option gives the investor the right to buy the underlying asset and there is no obligation on the part of the buyer. The seller of the option called the writer is obligated to sell (call option) or buy (put option) the asset whenever the buyer exercises the option.

The buyer (call or put) has to pay a price for this right which is called the premium. A call option gives the buyer the right to purchase the underlying asset at the strike price no matter what the market price is. And a Put option gives the buyer the right to sell the underlying asset at the strike price at any time before the expiry.

The following hypothetical case explains the mechanics of an option transaction.

The market price of a stock is Rs. 50 and there is a call option priced at Rs. 5. The strike price is Rs. 55 and expires in three months. For the same stock there may be several options with different expiry dates, strike prices and premiums. One can buy or sell this option and does not have to have a long or a short position in the stock to do so.

If you expect the price of the stock to increase within three months you can buy a call option by paying Rs. 5 per share.

If the price goes up before the expiry - say to Rs. 65, the call buyer can exercise the option. He pays Rs. 55 to purchase the underlying stock and sells at Rs. 65.

He will make a profit of Rs. 5, selling price minus the exercise price and the premium. He does not have to exercise the option but simply can sell the option; the profit will almost be the same because the market value of the option will increase with price of the underlying stock. Due to arbitrage activities, there will be no arbitrage opportunities to take advantage of due to price difference in the commodities market and the options market.

The writer of the call option will lose Rs. 5 and it is a zero sum game. If the price comes down below Rs. 60 the buyer will not exercise and allow the option to lapse. His loss is Rs. 5 and the gain of the writer is Rs. 5. if the investor is of the opinion that the price of the stock will come down, he can buy a put option to make a profit. If the price goes below Rs. 55 he will buy the stock in the market at the market price and sell at the strike price Rs. 55.

Options are very complicated and call and put options can be combined to create many complicated strategies depending on the requirements of the parties concerned. Some strategies available for speculators and hedgers are, buy a naked (without a short position in the stock)call , write a naked call, buy a naked put, writing covered calls, buy the stock and the put, bull and bear spread strategy, box spread, straddles, butterfly spreads, condor spreads, ratio and calendar spreads.

Swaps

At your birthday party you receive many presents. When you open them in the presence of your friends you noticed that two identical saris of the same colour were given by two friends. After noticing this, one of your friends tells you "don't worry I have the same sari of a different colour and we can exchange." The basic principal of swap is the same. In finance one exchanges one stream of cash flow for another stream of cash flow, swap cash flows. But in finance swaps are unbelievably complicated; only highly sophisticated and very large corporations with knowledgeable and experienced people should get involved in these transaction.

Futures contracts tend to be short term instruments and available only for certain commodities. To avoid this and other shortcomings of futures contracts corporations have developed swap transactions. The first swap transaction was created by the World Bank and IBM when they swapped cash flows denominated in Swiss Francs and Deusche Marks. There are many kinds of swaps, some of them are equity index, interest rate and currency swaps.

Hypothetical

Example

The Bank of Sri Lanka has invested a large sum of money in treasury securities with an average yield say 12%. The Bank of Sri Lanka would like to participate in the Colombo Stock Exchange activities but it has no correct infrastructure or the expertise.

There is a brokerage house, which has a large inventory of equities and wants to diversify in to fixed income securities. Both do not want to part with their stock and bond portfolios. They can come to a swap contract for mutual benefit. They can agree to swap the cash flows of a nominal principal say of Rs. 100,000,000 for five years.

The Bank of Sri Lanka will get an income related to the appreciation of Colombo all share price index, The broker will get a 12 per cent income. At the contract day index is the 100. On the first settlement day after six months, the l index is 110. Nothing happens to the portfolios of each participant. On the settlement day after six months.

The Bank of Sri Lanka will get the income of Rs. 10,000,000 and the Bank of Sri Lanka will have to pay Rs. 6,000,000 to the dealer. But the settlement is the net difference, 4,000,000 Bank of Sri Lanka receive from the broker. This settlement will take place every six months for five years. This is a very basic, plain vanilla swap contract. But real contracts are very complicated and depend only on the parties' requirements and the imagination of the parties.

Strike price

We will now take a practical example where we can combine some of the derivative strategies to hedge a position. Lanka Energy (Imaginary Company) wants 10,000,000 barrels of crude oil in three months for the generation of electricity. Currently the price $120 and it expects the price to go up. If the price goes down the company will be happy and it is exposed only to upward price movement. What can you do? One option is to do nothing and buy at market rate and absorb the risk. Optionally, the company can sign a derivative contract to hedge the exposure too.

The company can have a forward contract or an exchange traded futures contract to cover the upside exposure.

The company can sign an agreement to a forward or a futures contract to buy crude at say 125 in three months. If the prices go up to 150 the company pays 125. But now you are exposed to downward price movements because of the contract. If the price goes down to 50 you are exposed to a loss of 75. This exposure can also be covered easily by buying put option.

The purchaser has the right to sell at the strike price. If the strike price is 120 the company can sell the crude you have to buy in the futures contract at 125. The company is now free to buy at market price which is now 50. So you have cowered both upside and downside exposures.

Derivatives are financial instruments that companies can use for hedging or speculative purposes. These objectives can be achieved if carried out diligently by experienced and knowledgeable people. Otherwise it might give disastrous results.

The writer is a former Financial Analyst on Wall Street, New York.

Concluded