The Hindu Business Line : Demystifying derivatives

The following Thursday everyone trooped into the conference room to take their respective places. Goatee walked over to the white board and switched on the LCD projector.

“Good afternoon everyone! We are here to continue our discussion of derivatives and hedging strategies.”

“Morning Ganguly,” said the MD. “Welcome back after your paternity leave. I must say that you have delayed having a child for a considerable period after marriage.”

“I guess they kept evading the issue,” said Goatee, not able to resist the pun. Everyone burst into laughter including Ganguly who turned beetroot red.

Call versus put

“Before you begin I have a question” said Balaji. “Last time you mentioned that call options give a right to the buyer and impose an obligation on the seller, whereas put options give a right to the seller and impose an obligation on the buyer. My question is why cannot both parties be given a right?”

“If I said that I must correct myself. Both call and put options give the right to the option buyer and impose an obligation on the option seller. The difference between calls and puts is that in the case of calls the buyer of the option has the right to buy the underlying asset whereas in the case of puts he has the right to sell the underlying asset.”

“As for your question, let us look at it this way. Assume that after a call option contract is entered into, the price of the asset goes up. The buyer of the option would like to acquire the asset at the price stipulated in the contract. However, given a choice, the seller of the option would rather sell the asset in the spot market at a higher price rather than deliver it to the buyer at the contract price. Thus if both parties were to be given rights, no transaction would ever take place. Consequently both parties can have obligations imposed on them like in the case of forward and futures contracts, or else one party can be given a right and an obligation can be imposed on the counterparty, which is what happens in the case of option.”

Gyan on arbitrage

“Sorry to digress” said the MD. “But this has been eating my head. In the case of forward and futures contracts, how is the price determined for the transaction that is scheduled to take place at a future date?”

“It is done by ruling out arbitrage,” said Goatee.

“What is arbitrage?” asked Balaji.

“Arbitrage, as an American would say, is the presence of a free lunch,” said Goatee.

“I wouldn’t say that you can totally rule out a free lunch,” said Balaji. “Some public sector companies provide free lunches.”

“The public sector lives in a world of its own. My professor in college used to say that in India if something is not rational then it has to be national.”

Ganguly, Wilma and the MD burst out laughing. Balaji looked more confused.

“Let me explain Balaji,” said Goatee. “Suppose you had Rs 10,000 with you. You can invest in RBI Relief bonds which yield 8 per cent return. There is no risk of non-payment because the Central Government is the only institution vested with the power to print money. Now assume that instead you choose to invest the money in Reliance debentures. Would you accept an 8 per cent rate of return?”

“No!” said Balaji.

“Naturally, because there is a risk of non-payment in this case. Now suppose somebody offered you an opportunity to borrow at a rate of 6 per cent. What would people do.? Everyone would borrow at 6 per cent and invest in the Relief bonds to earn an assured profit of 2 per cent. Such a state of affairs obviously cannot exist. This is what is meant by arbitrage.”

“Sometimes we find that the price of a share is different on the BSE and NSE. Can we buy in one exchange and sell in the other to make arbitrage profits?” asked Curd Rice.

“You can if you have a stockpile of securities as well as cash. The reason is that both the exchanges have a T+2 settlement cycle. Consequently you cannot wait to take delivery at one exchange before delivering at the other.”

“What is T+2 settlement?” asked Balaji.

“It means that if you transact on a particular day, then delivery of shares to the buyer and payment of cash to the seller will take place two business days later.”

“Is arbitrage really feasible?” asked the MD.

Bid-ask spreads

“In practice it is unlikely that people like us can make much money. You need a large pool of funds at your disposal. Besides people like us have to incur transactions costs such as commission and bid-ask spreads. Brokerage houses have an advantage. They do not have to pay commissions to themselves.”

“What are bid-ask spreads?” asked Balaji.

“The price at which a dealer will buy an asset from you is called the bid, whereas the price at which he will sell to you is called the ask. Obviously the dealer will make a profit by setting the ask higher than the bid. The difference between the two is called the spread.”

“You went to Singapore recently Balaji?” asked Ganguly.

Balaji nodded.

“When you landed at the airport you may have noticed that the foreign exchange dealer would have quoted a buying as well as a selling rate for each currency, like 40.50-41.60 for the US dollar. The buying rate is the bid while the selling rate is the ask.”

Futures, forward prices

“Ok, before we digress any further let me clarify how futures and forward prices are determined so as to preclude arbitrage,” said Goatee.

“Assume that the spot price of an asset is S, and the price of a forward contract to sell the asset after one year is F. Assume that money can be borrowed at r per cent per annum. If F is greater than S(1+r), then a person can borrow and buy the asset and go short in a forward contract. One year later he will deliver at F. He has to repay S + rS, which represents principal plus interest to the guy he borrowed from. Overall he stands to make an arbitrage profit of F – S(1+r). This is called Cash and Carry arbitrage.

“On the other hand, if F is less than S(1+r) he can short sell the asset and go long in a forward contract to realise an arbitrage profit. This is called Reverse Cash and Carry Arbitrage. To rule out both forms of arbitrage we require that F = S(1+r).”

“What is a short sale?” asked Balaji.

“I am afraid that you must wait for next week,” said the MD. “We are once again running out of time. I do not want to discourage any questions since all of us are benefiting immensely from this discussion. So let us meet on Monday to take this forward.”

Racy@TheHindu.co.in

http://Racycases.blogspot.com

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