Gyaan@ Finstreet Derivatives:Anoverview

A derivative is a financial instrument that offers a return based on the return of some other underlying asset i.e. its return is derived from another instrument. The underlying asset can be equity, commodity, forex, bonds, interest rates or any other asset. For example, paddy farmers may wantoselltheircropatafuture datetoeliminatetheriskofachangeinpricesbythatdate.Sucha transaction may be called a derivative, forward contract in particular. The price of the derivative is drivenbythespotpriceofpaddywhichistheunderlying. Whyderivatives? Derivatives initially emerged as hedging devices against fluctuations in commodity prices and commoditylinked derivatives remained the sole form for almost three hundred years. Financial derivatives came into the limelight in the mid 1970's due to the growing instability in the financial markets. Since then financial derivatives have become very important and account for about two thirds of the total transactions in the derivatives market. In recent years the derivatives market has grown tremendously in terms of variety of instruments available, their complexity and also their turnover. MajorFactorsResponsiblefortheGrowthofFinancialDerivatives

Integrationofinternationalmarketswithnationalfinancialmarkets Increasedvolatilityinassetpricesinfinancialmarkets Development of more sophisticated risk management tools, providing economic agents a widerchoiceofriskmanagementstrategies Innovations in the derivatives markets have led to the diversification of risk over a large numberoffinancialassets,leadingtohigher Improvementintechnologyandcommunicationfacilitiesandsharpdeclineincosts Themodernizationofcommercialandinvestmentbanking

TypesofDerivatives: Basicallyderivativecontractscanbeclassifiedintotwogeneralcategories: Forward Commitments: A forward commitment is a legally binding promise to perform some action inthefuture.ForwardCommitmentsincludesForwardContracts,Futures,Swaps Contingent claims: A contingent claim is a claim whose payoff depends on occurrence of a specific event. Options are contingent claims that depend on a stock price at some future date, rather than forwardcommitments.TheyincludeOptions,Warrants,LEAPS. ForwardContracts: A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. Oneofthepartiestothecontractassumesalongpositionandagreestobuytheunderlyingasseton acertainspecifiedfuturedateforacertainspecifiedprice.Theotherpartyassumesashortposition and agreesto sellthe assetonthesamedatefor thesameprice.Othercontractdetailslikedelivery date, price and quantity are negotiated bilaterally by the parties to the contract. The forward contractsarenormallytradedoutsidetheexchanges. 2|P a g e

Thesalientfeaturesofforwardcontractsare: Theyarebilateralcontractsandhenceexposedtocounterpartyrisk. Each contract is custom designed, and hence is unique in terms of contract size, expiration date andtheassettypeandquality. Thecontractpriceisgenerallynotavailableinpublicdomain. Ontheexpirationdate,thecontracthastobesettledbydeliveryoftheasset. If the party wishes to reverse the contract, it has to compulsorily go to the same counterparty, whichoftenresultsinhighpricesbeingcharged. However forward contracts in certain markets have become very standardized, as in the case of foreign exchange, thereby reducing transaction costs and increasing transactions volume. This processofstandardizationreachesitslimitintheorganizedfuturesmarket. Forward contracts are very useful in hedging and speculation. The classic hedging application would be that of an exporter who expects to receive payment in dollars three months later. He is exposed to the risk of exchange rate fluctuations. By using the currency forward market to sell dollars forward,hecanlockontoaratetodayandreducehisuncertainty. Similarly an importer who is required to make a payment in dollars two months hence can reduce hisexposuretoexchangeratefluctuationsbybuyingdollarsforward. Forwardmarketsworldwideareafflictedbyseveralproblems: Lackofcentralizationoftrading, Illiquidity,and In the above issues, the basic problem is that of too much flexibility and generality. The forward market is like a real estate market in which any two consenting adults can form contracts against each other. This often makes them design terms of the deal which are very convenient in that specification,butmakesthecontractsnontradable. Counterpartyrisk Counterparty risk arises from the possibility of default by any one party to the transaction. When one of the two sides to the transaction declares bankruptcy, the other suffers. Even when forward markets trade standardized contracts, and hence avoid the problem of illiquidity, still the counterpartyriskremainsaveryseriousissue. FuturesContract: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. But unlike forward contracts, the futures contracts are standardized and exchange traded. To facilitate liquidity in the futures contracts, the exchange specifies certain standardfeatures ofthecontract.Itis astandardizedcontractwithstandard underlyinginstrument, astandardquantityandqualityoftheunderlyinginstrumentthatcanbedelivered,(orwhichcanbe used for reference purposes in settlement) and a standard timing of such settlement. A futures 3|P a g e

contract may be offset prior to maturity by entering into an equal and opposite transaction. More than99%offuturestransactionsareoffsetthisway. Futuresterminology Spotprice:Thepriceatwhichanassettradesinthespotmarket. Futuresprice:Thepriceatwhichthefuturescontracttradesinthefuturesmarket. Contract cycle: The period over which a contract trades. The index futures contracts on the NSE have onemonth, twomonths and threemonth expiry cycles which expire on the last Thursday of the month. Thus a January expiration contract expires on the last Thursday of January and a FebruaryexpirationcontractceasestradingonthelastThursdayofFebruary.OntheFridayfollowing thelastThursday,anewcontracthavingathreemonthexpiryisintroducedfortrading. Expiry date: It is the date specified in the futures contract. This is the last day on which the contractwillbetraded,attheendofwhichitwillceasetoexist. Contract size: The amount of asset that has to be delivered under one contract. For instance, the contractsizeonNSEsfuturesmarketis50Nifties. Basis: In the context of financial futures, basis can be defined as the futures price minus the spot price. There will be a different basis for each delivery month for each contract. In a normal market, basiswillbepositive.Thisreflectsthatfuturespricesnormallyexceedspotprices. Cost of carry: The relationship between futures prices and spot prices can be summarized in terms ofwhatisknownasthecostofcarry.Thismeasuresthestoragecostplustheinterestthatispaidto financetheassetlesstheincomeearnedontheasset. Initial margin: The amount that must be deposited in the margin account at the time a futures contractisfirstenteredintoisknownasinitialmargin. Markingtomarket: In the futures market, at the end of each trading day, the margin account is adjusted to reflect the investors gain or loss depending upon the futures closing price. This is called markingtomarket. Maintenance margin: This is somewhat lower than the initial margin. This is set to ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call and is expected to top up the marginaccounttotheinitialmarginlevelbeforetradingcommencesonthenextday. PayOffforafuturescontract(Shortposition): Fortheexampleshownaboveweanalysethepayoffgraph. The figure shows the profits/losses for a short futures position. The investor sold futures when the indexwasat4000. If the index goes down, his futures position starts making profit. If the index rises, his futures positionstartsshowingprofits.

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PayoffforShortFutures
4000 2000 0 2000 0 4000

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PayOffforafuturescontract(Longposition): Fortheexampleshownaboveweanalysethepayoffgraph. The figure shows the profits/losses for a short futures position. The investor bought futures when theindexwasat4000. If the index goes rises, his futures position starts making profit. If the index goes down, his futures positionstartsshowinglosses.

PayOffforLONGFutures
3000 2000 1000 0 1000 0 2000 3000 4000

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Therearefourwaystoterminateafuturescontract: 1. A short can terminate the contract by delivering the goods, a long by accepting delivery and paying the contract price to the short. This is called delivery. The location for delivery (for physical

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assets), terms of delivery, and details of exactly what is to be delivered are all specified in the contract.Deliveriesrepresentlessthan1%ofallcontractterminations. 2. In a cashsettlement contract, delivery is not an option. The futures account is markedtomarket basedonthesettlementpriceonthelastdayoftrading. 3. You may make a reverse, or offsetting, trade in the futures market. This is similar to the way we described exiting a forward contract prior to expiration. With futures, however, the other side of your position is held by the clearinghouseif you make an exact opposite trade (maturity, quantity, and good) to your current position, the clearinghouse will net your positions out, leaving you with a zero balance. This is how most futures positions are settled. The contract price can differ between the two contracts. If you initially are long one contract at $370 per ounce of gold and subsequently sell (take the short position in) an identical gold contract when the price is $350/oz., $20 times the number of ounces of gold specified in the contract will be deducted from the margin deposit(s) in your account. The sale of the futures contract ends the exposure to future price fluctuations on the firstcontract.Yourpositionhasbeenreversed,orclosedout,byaclosingtrade. 4. A position may also be settled through an exchange for physicals. Here you find a trader with an opposite positiontoyour ownanddeliverthegoodsand settleupbetweenyourselves,off thefloor of the exchange (called an expit transaction). This is the sole exception to the federal law that requires that all trades take place on the floor of the exchange. You must then contact the clearinghouseandtellthemwhathappened.Anexchangeforphysicalsdiffersfromadeliveryinthat thetradersactuallyexchangethegoods,thecontractisnotclosedontheflooroftheexchange,and the two traders privately negotiate the terms of the transaction. Regular delivery involves only one traderandtheclearinghouse. OPTIONS: An option gives the holder of the option the right to do something. An option contract gives its owner the right, but not the legal obligation, to conduct a transaction involving an underlying asset at a predetermined future date (the exercise date) and at a predetermined price (the exercise or strike price). Options give the option buyer the right to decide whether or not the trade will eventually take place. The seller of the option has the obligation to perform if the buyer exercises the option. The owner of a call option has the right to purchase the underlying asset at a specific priceforaspecifiedtimeperiod. Buyerofanoption:Thebuyerofanoptionis theonewho bypayingtheoptionpremiumbuysthe rightbutnottheobligationtoexercisehisoptionontheseller/writer. Writer of an option: The writer of a call/put option is the one who receives the option premium andistherebyobligedtosell/buytheassetifthebuyerexercisesonhim. Therearetwobasictypesofoptions,calloptionsandputoptions. Call option: A call option gives the holder the right but not the obligation to buy an asset by a certaindateforacertainprice. Put option: A put option gives the holder the right but not the obligation to sell an asset by a certaindateforacertainprice. 6|P a g e

Optionprice/premium:Optionpriceisthepricewhichtheoptionbuyerpaystotheoptionseller.It isalsoreferredtoastheoptionpremium. Expiration date: The date specified in the options contract is known as the expiration date, the exercisedate,thestrikedateorthematurity. Strike price: The price specified in the options contract is known as the strike price or the exercise price. Inthemoneyoption:Aninthemoney(ITM)optionisanoptionthatwouldleadtoapositivecash flow to the holder if it were exercised immediately. A call option on the index is said to be inthe money when the current index stands at a level higher than the strike price (i.e. spot price > strike price).Iftheindexismuchhigherthanthestrikeprice,thecallissaidtobe deepITM.Inthecaseof aput,theputisITMiftheindexisbelowthestrikeprice. Atthemoney option: An atthemoney (ATM) option is an option that would lead to zero cash flow if it were exercised immediately. An option on the index is atthemoney when the current indexequalsthestrikeprice(i.e.spotprice=strikeprice). Outofthemoney option: An outofthemoney (OTM) option is an option that would lead to a negative cash flow if it were exercised immediately. A call option on the index is outofthemoney when the current index stands at a level which is less than the strike price (i.e. spot price < strike price).Iftheindexismuchlowerthanthestrikeprice,thecallissaidtobedeepOTM.Inthecaseof aput,theputisOTMiftheindexisabovethestrikeprice. PayoffprofileforbuyerofCALLoptions:LongCALL Long call a call option gives the buyer the right to buy the underlying asset at the strike price specifiedintheoption.Theprofit/lossthatthebuyermakesontheoptiondependsonthespotprice of the underlying. If upon expiration, the spot price exceeds the strike price, he makes a profit. Higher the spot price more is the profit he makes. If the spot price of the underlying is less than the strikeprice,heletshisoptionexpireunexercised.Hislossinthiscaseisthepremiumhepaid. Thefigureshowstheprofits/lossesfromalongpositionon theindex. The investorbought theindex at 4000.So the investor will break even at 4100(he paid INR 100 as premium). If the index goes up, heprofitsi.e.above4100heprofits.Iftheindexfallshehastobornelossesi.e.below4100heloses. At4100heneithergainsnorloses.ThegainforwriteroftheoptionisonlyINR100(premiumpaidby thebuyer).SimilarlywecananalyseforPUToptions.

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 PayoffprofileforwriterofPUToptions:ShortPUT Payoff profile for writer of put options: Short put A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option. For selling the option, the writer of the option charges a premium. The profit/loss that the buyer makes on the option depends on the spot priceoftheunderlying.Whateveristhebuyersprofitisthesellersloss.Ifuponexpiration,thespot price happens to be below the strike price, the buyer will exercise the option on the writer. If upon expirationthespotpriceoftheunderlyingismorethanthestrikeprice,thebuyerletshisoptionun exercisedandthewritergetstokeepthepremium. Figure gives the payoff for the writer of a three month put option (often referred to as short put) withastrike of 4100soldatapremiumof100.Weobservethatat4000the writerbreaks even and when Nifty goes below this he loses. Writers profits remain constant at INR 100(premium price) for theindexvalue(Nifty)>=4100. Warrants: Options generally have lives of up to one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longerdated options are called warrants andaregenerallytradedoverthecounter. LEAPS: The acronym LEAPS means LongTerm Equity Anticipation Securities. These are options havingamaturityofuptothreeyears.Thesearegenerallytradedoverthecounter.

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 SWAP: Swaps are agreements to exchange a series of cash flows on, periodic settlement dates over certain timeperiod(e.g.quarterlypaymentsovertwoyears).Inthesimplesttypeofswap,onepartymakes fixedrateinterestpaymentsonthenotionalprincipalspecifiedintheswapinreturnforfloatingrate payments from the other party. At each settlement date, the two payments are netted so that only one (net) payment is made. The party with the greater liability makes a payment to the other party. The length of the swap is termed the tenor of the swap and the contract ends on the termination date. A swap can be decomposed into a series of forward contracts (FRAs) that expire on the settlementdates. For Example, If you lend me $5,000 at a floating rate and I lend you $5,000 at a fixed rate, we have createdaswap.Thereisnoreasonforthe$5,000toactuallychangehands,thetwoloansmakethis pointless.AteachpaymentdateIwillmakeapaymenttoyoubasedonthefloatingrateandyouwill makeonetomebasedonthefixedrate.Again,itmakesnosensetoexchangethefullamounts;the one with the larger payment liability will make a payment of the difference to the other. This describesthepaymentsofafixedfarfloatingor"plainvanilla"swap. Currency swap: A currency swap can be viewed the same way. If I lend you INR 1,000,000 at the Rupees rate of interest and you lend me the equivalent amount of dollars at today's exchange rate at the dollars rate of interest, we have done a currency swap. We will "swap" back these same amounts of currency at the maturity date of the two loans. In the interim, I borrowed dollars, so I makedollarinterestpayments,andyouborrowedRupeesandmustmakeinterestpaymentsinINR. 1.PartyApaysafixedrateonINRreceived,andPartyBpaysafixedrateonUSDreceived(Fixedfor FixedCurrencySwap)

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2. Party A pays a floating rate on INR received, and Party B pays a floating rate on USD received (FloatingforFloatingCurrencySwap) Interest Rate Swaps: The plain vanilla interest rate swap involves trading fixed interest rate paymentsforfloatingratepayments.Thepartywhowantsfloatingrateinterestpaymentsagreesto pay fixedrate interest and has the payfixed side of the swap. The counterparty, who receives the fixed payments and agrees to pay variablerate interest, has the payfloating side of the swap and is calledthefloatingratepayer. Eg: Consider a 3year swap deal, between Infosys and Microsoft. Microsoft agrees to pay to Infosys aninterestrateof5%perannumonanotionalprincipalof$100million,andinreturnInfosysagrees to pay Microsoft the 6 month LIBOR rate on the same principal. Microsoft is the fixedrate payer, Infosysisthefloatingratepayer. The floating rate quoted is generally the London Interbank Offered Rate (LIBOR), flat or plus a spread.Let'slookatthecashflowsthatoccurinaplainvanillainterestrateswap. Since the notional principal swapped is the same for both counterparties and is in the same currency units, there is no need to actually exchange the cash. Notional principal is generally not swappedinsinglecurrencyswaps. The determination of the variable rate is at the beginning of the settlement period, and the cash interestpaymentismadeattheendofthesettlementperiod.Sincetheinterestpaymentsareinthe samecurrency,thereisnoneedforbothcounterpartiestoactuallytransferthecash.Thedifference between the fixedrate payment and the variablerate payment is calculated and paid to the appropriatecounterparty.Netinterestispaidbytheonewhoowesit. Attheconclusionoftheswap,sincethenotionalprincipalwasnotswapped,thereisnotransferof funds. You should note that swaps are a zerosum game. What one party gains, the other party loses. CrossCurrencySwap: Here we have floating rate (usually LIBOR) in one currency is exchanged for a fixed rate in another currency. This is a combination of fixedforfloating interest rate swap and a fixedforfixed currency swapandisknownascrosscurrencyswap. 1. Party A pays a floating rate on INR received, and Party B pays a fixed rate on USD received (FloatingforFixedCurrencySwap) 2.PartyApaysafixedrateonINRreceived, andPartyB paysafloating rateon USDreceived(Fixed forFloatingCurrencySwap) Swaption: A Swaption is an option to enter into a swap. The option to enter into an offsetting swap provides an option to terminate an existing swap. Consider that, in the case of the previous 5year pay floating swap, we purchased a 3year call option on a 2year pay fixed swap at 3%. Exercising thisswapwouldgiveustheoffsettingswaptoexitouroriginalswap.

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