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Dennis Nzau 0723677821
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DERIVATIVE MARKET AND FINANCIAL INNOVATION
Introduction
People can invest their money in different investments opportunities. This can be done either by
buying assets or financial sector. Derivative market offers such platform to investors. Derivatives
market is a financial market that mainly trades on derivatives. These derivatives can be done via
over-the-counter or futures. Some of the products include options, futures, forwards, swaps and
contracts on different markets. Again derivatives allow investors to buy or sell transaction in
future dates. This is because these products depend on another market. The other markets are
called underlying markets. Derivatives depend on almost all underlying market such as stocks
indexes, currency markets and individual stocks.
Trading derivatives markets on futures.
Many investors in derivative markets trade on future markets. This is caused by many available
future contracts to trade on whereby some are affected by daily price fluctuations. This is how
traders make money. Futures are contracts signed by traders to exchange underlying for money
at some future time. For example, if a buyer or a seller decides to trade on future contracts on
crude oil, this means agreeing to trade on specific price at some dates in future. In this case you
will make money depending on weather the signed contract agreed upon increases or decreases
in value relative to where it was purchased or sold. Trader can close out the contract at any time
in future before it expires in case of profit.
Trading derivatives markets on options.
This is another known derivative market. They can either be simple or somehow complex based
on how you decide to trade them. A simple way is through calls or buying puts. When a trade
decides to buy a put, he or she is expecting the price of underlying to go down below price of the
option before it expires. If it decreases in price, then you make profit otherwise you lose the
value that you paid for the option. For example, if XYZ stock is costing $83, but a trader
believes it will fall below $80, then he/she can buy a $80 option put. If the inventory increases
he/she will lose premium paid but if price increases, then his /her option will increase in value
and can be sold for higher premium. Call options trades on a similar way except when trader
purchases a call he/she is expecting the price of the underlying to increase.
Trading derivatives merits contract difference (CFD)
These types of contracts are offered by market brokers and vary from one broker to another.
They are similar instruments labeled with a similar identifying name. for example, if a trader
purchases XYZ stock he or she will not buy through an agreement to buy the stock but he/she
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will enter in an agreement with his/her broker that if the price increases he/she makes money and
if the price decrease, he/she loses money. It acts like betting on another market. With many CFD
markets if a trader believes that the underlying asset will increase then he/she buys the CFD. If
he/she believes that it will lose value, then he/she will sell it. Profit or loss is the difference
between the exit and entry price. Based on trader’s style and capital expected, one market will
suit same traders more than others. One derivative market not better than other since they operate
almost similarly. Each market needs unequal amount of capital depending on entry margin in.
Based on my own work, I would like to innovate futures option contracts on ballast which is
used by cement manufacturing companies.
Ballast options contracts
The buyers for this ballast will be cement manufacturing companies and also contractors.
Therefore, this companies can buy option futures on ballast to protect themselves from the
potential price changes. For example, MJ company needs to buy 1000 tons of ballast in five
months and they estimate the price of the ballast to increase in five months. Therefore, they
can bid a call future option today and trade the option in five months. As a result, the cost of
purchasing ballast in five months is lower by the earnings from the selling call option in
future.
Derivative product pricing
The product I have proposed is five months’ contract option for the ballast call future, it
includes call and put options. The ballast is available in similar form in different quarries hence
affected by climatic changes. The tradable bid here is, if ballast is not available or supply goes
down, the price goes up and if its supply increases then the price goes down. In this case the risk
driver will be weather since ballast cannot be mined especially during rainy seasons. Again
suppliers will not be willing to collect the ballast from producers due to increase in price.
Therefore, I assume the volatility of my derivative products will be similar to those of producing
companies. I, will apply the volatility of ballast to calculate option price.
Chart 1
Sample Company name Price of ballast per kilogram
1 Amnan Cement $81.00
Manufacturing Co. Ltd $79.00
2 CK and son cement Co.Ltd $80.00
Ball and Cement International
3 Company
Average price $80.00
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Chart 2: Volatility of ballast
Season Price of ballast per kilogram
Rainy $ 87.65
Sunny $79.05
Fall 82.65
Volatility( standard deviation) 0.36
Supply of ballast will be affected by seasonality, and this gives investors an opportunity to
create new option future contract for ballast.
Option contracts design
Generally, option markets are in two types, they include: American option and European option.
In case of European option, investors are allowed to exercise it only at maturity time. For
American, they are allowed to exercise it at any time before maturity time. Both markets have
put and call options. Put option gives buyer a right to see underlying assets at the available
price while call gives the buyer opportunity to buy at available price.
Chart: option price for call option
Contract price
Date contract option price Maturity date
10/3/2017 BP5CM10 $70.60 10/09/2017
10/3/2017 BP5CM20 $68.0 10/09/2017
10/3/2017 BP5CM30 $71.55 10/09/2017
10/3/2017 BP5CM40 $65.70 10/09/2017
10/3/2017 BP5CM50 $72.45 10/09/2017
10/3/2017 BP5CM60 $79.85 10/09/2017
10/3/2017 BP5CM70 $55.50 10/09/2017
Option price for put option
Date contract option price maturity date
10/3/2017 BP5CM10 $3.05 10/09/2017
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10/3/2017 BP5CM20 $2.0 10/09/2017
10/3/2017 BP5CM30 $1.05 10/09/2017
10/3/2017 BP5CM40 $0.75 10/09/2017
10/3/2017 BP5CM50 $12.50 10/09/2017
Derivative markets
My derivative market will be china which has wide range of cement manufacturing companies
according to my research. Many real estate investors in China will want to trade on my
derivative product.
Derivative product pricing
My model will be based on Black Scholes-Merton (BSM) and my steps are listed below.
Call Last Bid ask Open puts Last bid ask Open
sale Int sale Int
Ballast41k1 1.8 1.5 1.65 20 Ballast41k 0.21 0.06 0.15 56
1
Ballast41k2 0.95 0.8 0.95 92 Ballast41k 0.45 0.55 0.71 27
2
Ballast41k3 0.55 0.4 0.35 150 Ballast41k 0.0 0.90 1.0 52
3
Ballast41k4 1.6 1.7 2.2 60 Ballast41k 1.05 1.5 1.15 105
4
Ballast41k5 0.5 1.8 2.0 0 Ballast41k 0.0 0.85 6.05 6
5
Ballast41k6 0.0 1.40 1.5 0.5 Ballast41k 1.05 0.75 2.05 3
6
Ballast41k7 1.05 0.25 1.0 30 Ballast41k 2.95 1.7 0.35 0
7
From the data provided above, S0=$38.45, the call option market price at $41 is $1.8,
T=1/12, and I assume that risk-free rate is 4%, so the implied volatility of BALLAST will
be:
1) BSM =C0=S0*N(d1)-Ke*N(d2)=$1.8, and 0<N<1
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2) $1.8=$38.45*N(d1)-$41e1/12*N(d2)
=$38.45*N(d1)-$40.863*N(d2)
3) Since 0<N<1, I assume that N(d1)=0.55, so d1=0
(4) d2=d1-t1/12=-0.05=St(1/12)12= 0.165
Step2, I know find the call option using black schools Merton.
From data provided in chart 1, the average market price of ballast is $80.35
I assume call option strike price is same as market price ($ 80.35), T =2/12, and risk free rate
is 3%. Therefore, call and put future option price for ballast today is;
1) C0=S0*N(d1)-Ke*N(d2)
(d1) = In(S0/K)+(r+1/2st)*T=In(80.35/80.35)+(0.04+1/2*0.17*0.17)*(2/12)= 0.32
st*t1/2 0.17*(2/12)0.5
(d2) = d1-st*t1/2= 0.32-0.17*(2/12) ^0.5=0.065
2) N(d1) = N (0.32) = 0.6524 and N(d2) = N (0.06)= 0.7254
3) C0=$80.35*0.7254 -$80.35e^-0.04*(2/12) *0.7254=$4.62
Step3, all information on step two are placed on option price
1) P=Ke^-rt*N(-d2)-S0*N(-d1)
2) D1=0.32 and d2=0.065
3) N(-d1) =N (-0.32) = 0.5319 and N(-d2) = (-0.065) = 0.5612
4) P=$80.35e^-0.04*(2/12)0.5612-$80.35*0.5319=$3.18
It is clear that price of call and put option at strike $80.35 is $ 4.62 and 3.18
respectively.
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Step 4, Sensitivity Analyses
Resulting price of call will be as follows,
1) C0=S0*N(d1)-Ke^-rt*N(d2)
(d1) =In(S0/K) +(r+1/2st^2)*T=In(80.35/80.35)+(0.04+1/2*0.36^2)*(3/12)=0.37
St*t^1/2 0.36*(2/12) ^0.5
D2 =d1-st*t^1/2=0.37-0.36*(2/12) ^0.5=-0.06
2) N(d1) =N (0.37) =0.7524 and N(d2) =N (-0.06) =0.3791
3) C0=$80.35*0.7524-$80.35e^-0.04*(2/12) *0.3791=$8.82
4) N(-d1) =N (-0.37) =0.5243 and N(-d2) =N (-0.06) = 0.6715
5) P=$80.35e-0.04*(2/12) *0.6715-$80.35*0.5243=$6.08
Conclusion
Volatility is very useful in option pricing. Weather condition really affects supply of ballast as
show in chart 2. Investors who can really on ballast as derivate in future can make good profit
since many markets have not recognized it.
Recommendations
Traders who shall trade in this derivative should have in mind that, even during rainy seasons
premiums can increase or decrease depending on market. Therefore, I recommend this derivative
product for all markets.
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