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asp (derivatives)
A farmer prays for rain in his dried out paddy
field in the drought affected area
A farmer examines rice in a paddy field
near a farm house
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Risk is a characteristic feature of all
commodity and capital markets. Over
time, variations in the prices of
agricultural and non-agricultural
commodities occur as a result of
interaction of demand and supply
The last two decades have witnessed
a many-fold increase in the volume of
international trade and business due
to the ever growing wave of
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As a result, financial markets have
experienced rapid variations in
interest and exchange rates, stock
market prices thus exposing the
corporate world to a state of growing
financial risk.

Increased financial risk causes losses

to an otherwise profitable
organization. This underlines the
importance of risk management to
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Derivatives provide an effective
solution to the problem of risk caused
by uncertainty and volatility in
underlying asset.

Derivatives are risk management

tools that help an organization to
effectively transfer risk.

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What are Derivatives?

Derivatives are instruments

which have no independent
value. The value is derived from
the value of another asset. Which
is known as the underlying.
The underlying asset may be
financial or non-financial.
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When the price of the underlying
changes, the value of the derivative
also changes.

A Derivative is not a product. It is a

contract that derives its value from
changes in the price of the
Example : 1
The value of a gold futures contract
is derived from the value of the
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Example 2: A farmer growing a crop
in the month of January. His crop is
likely to harvest in the month of April.
If there is a demand for crop due to
shortage in yield, after the harvest,
farmer may get higher price. If the
supply of crop is more, farmer may sell
his crop for lower rate. Therefore there
is a risk in the later situation. In such
situation, farmer may enter into a
contract and lock the price.
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If the prices or the crop go up, he
may lose, but if there is a fall in
prices of crop, he will stand to gain.
The contract specifies the quantity,
price and the date of delivery.
This will enable the farmer to
minimize or reduce the risk, which
otherwise will be face due to
uncertain price fluctuations of the
future price of the crop.
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The term derivatives, refers to a
broad class of financial instruments
which mainly include forwards,
futures, options and swaps. These
instruments derive their value from
the price and other related variables
of the underlying asset. They do not
have worth of their own and derive
their value from the claim they give
to their owners to own some other
financial assets or security.
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A simple example of
derivative is butter, which is
derivative of milk. The price
of butter depends upon price
of milk, which in turn depends
upon the demand and supply
of milk. The general
definition of derivatives
means to derive
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Definition of Financial
Section 2(ac) of Securities Contract
Regulation Act (SCRA) 1956 defines
Derivative as:
a) a security derived from a debt
instrument, share, loan whether
secured or unsecured, risk instrument
or contract for differences or any
other form of security;
b) a contract which derives its value
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Underlying Asset in a
Derivatives Contract
As defined above, the value of a
derivative instrument depends upon
the underlying asset. The underlying
asset may assume many forms:
i. Commodities including grain, coffee
orange juice;
ii. Precious metals like gold and silver;
iii. Foreign exchange rates or
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iv. Bonds of different types, including
medium to long term negotiable debt
securities issued by governments,
companies, etc.
v. Shares and share warrants of companies
traded on recognized stock exchanges
and Stock Index
vi. Short term securities such as T-bills;
vii. Over- the Counter (OTC) money market
products such as loans or deposits.
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Foreign Exchange
Interest Rates

Stocks Underlying Assets Bonds

Crude Oil
Precious Metals
The Derivatives markets can be traced
back to the middle Ages. They
originally developed to meet the needs
of farmers and merchants.
The Chicago Board of Trade (CBOT)
was the first derivatives market
established in 1848 to bring farmers
and merchants together. Initially, its
main task was to standardize the
quantities and qualities of the grains
that were traded. Within a few years,
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Speculators soon became interested
in the contract and found trading the
contract to be an attractive
alternative to trading the gain itself.
The Chicago Board of Trade now
offers futures contracts on many
different underlying assets, including
corn, oats, soybeans, soybean oil,
wheat, silver, treasury bonds, and
treasury notes.
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The Chicago Mercantile Exchange:
In 1874, the Chicago Produced
Exchange was established. This
provided a market for butter, eggs,
poultry, and other perishable
agricultural products. In 1898, the
butter and egg dealers withdrew from
this exchange to form the Chicago
Butter and Egg Board.
In 1919, this was renamed the
Chicago Mercantile Exchange (CME)
and was reorganized for futures
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Since then, the exchange has
provided a futures market for many
commodities including pork bellies
(mutton/chicken) (1961), live cattle
(1964) live hogs (pig) (1966) and
feeder cattle (1971). In 1982, it
introduced a futures contract, and a
Eurodollar futures contract on the
S&P 500 Stock Index.
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The International Monetary Market
(IMM) was formed as a division of the
Chicago Mercantile Exchange in 1972
for futures trading in foreign currencies.
The currency traded on the IMM now
include the British Pound, the Canadian
futures Dollar, the Japanese Yen, the
(Swiss Franc, the German mark)
European Euro and the Australian dollar.
The IMM also trades a gold futures
contract, a treasury bill futures contract,
and a Eurodollar futures contract.
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Derivatives have a fairly long history in India too. The
first organized futures market came up in 1875 with
the establishment of BOMBAY COTTON TRADE
Subsequently, many futures exchanges, predominantly
commodity-based futures sprang up (bounced), like.,
Most of them did not last till the second world war in
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After the country attained independence,
derivative markets came through a full circle
from prohibition of all sorts of derivatives
trades to their recent reintroduction.
Securities Laws (Amendment) Act, 1999 permits legal frame
work for derivatives trading in India.
2000 Trading in index futures began on BSE and NSE
Trading in options on index and stocks commenced trading
on BSE and NSE
2002 Trading on single stock futures began on BSE and NSE
Introduction of interest rate futures on NSE, Introduction
Rupee of options, Futures trading-is permitted on almost all
2003 commodities but options on commodities still prohibited
and commencement of NCDEX and MCX commodity
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Other Exchanges:
Many other exchanges throughout the
world now trade futures contracts.
Prominent among them are
Chicago Rice and Cotton Exchange (CRCE,
New York Futures Exchange (NYFE),
London International Financial Futures
Exchange (LIFFE),
Toronto Futures Exchange (TFE),
Singapore International Monetary
Exchange (SIMEX) and
National Commodity and Derivative
The Indian financial market woke up
to this new generation of financial
instruments and the Indian
Derivatives Market odyssey in
modern times commenced with the
FOREX derivatives in 1997 has also
seen the introduction of many
derivatives on different underlyings.

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The following factors have been driving the
growth of financial derivatives:
1.Increased volatility in asset prices in

2.Increased integration of national financial

markets with the international markets,

3.Marked improvement in communication

facilities and sharp decline in their costs,
4.Development of more sophisticated risk
management tools, providing economic
agents a wider choice of risk management
5.Innovations in the derivatives markets,
which optimally combine the risks and
returns over a large number of financial
assets, leading to higher returns, reduced
risk as well as trans-actions costs as
compared to individual financial assets.
Features of Derivates Market:
1. Derivatives are popular
instruments traded globally.
2. Gain or loss depends on the
underlying assets value.
3. Change in value of underlying
asset will have effect on values of
4. They are traded on exchange.
5. They are liquid and transaction
cost is lower.
Why derivatives ?
1. Earn money on shares that
are lying idle:
So Investor dont want to sell the
shares that investor bought for long
term, but he want to take advantage of
price fluctuations in the short term. He
can use derivative instruments to do so.
Derivatives market allows investor to
conduct transactions without actually
selling his shares also called as
physical settlement.
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Benefit from arbitrage:

When an investor buy low in one

market and sell high in the other
market, it called arbitrage trading.
Simply put, investors are taking
advantage of differences in prices in
the two markets.

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Protects investor securities
Protects investor securities against
fluctuations in prices. The derivative
market offers products that allow
investor to hedge themselves against
a fall in the price of shares that they
possess. It also offers products that
protects the investor from a rise in the
price of shares that he/she plan to
purchase. This is called hedging.
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Risk Averse Investor
Arisk averse investoris
aninvestorwho prefers lower returns
with knownrisksrather than higher
returns with unknownrisks. In other
words, among
variousinvestmentsgiving the same
return with different level ofrisks, this
investoralways prefers the alternative
with least interest.
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Transfer of risk:
The most important use of these
derivatives is the transfer of market risk
from risk-averse investors to those with an
appetite for risk.
Risk-averse investors use derivatives to
enhance safety, while risk-loving investors
like speculators conduct risky, contrarian
trades to improve profits.
This way, the risk is transferred. There are
a wide variety of products available and
strategies that can be constructed, which
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1. Derivatives help in discovery of future as well as
current prices:
. Corporations use Derivatives: Corporate are risk averse.
They do not like risk and uncertainties in their financial
planning. Financial uncertainties expose them to unexpected
losses and thereby reduce the value of their
investments.Companies use currency forwards and other
derivatives to hedge their exports, imports and other foreign
exchange exposure.
.They use commodity derivatives to hedge raw material
consumption and inventories as well as their output prices and
.Example: An electrical goods manufacturer might use copper
futures to hedge the cost of copper which is a major raw
material for it.
.A gold mining company might use gold futures to hedge the
selling price of its output. Companies also use interest rate
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2. Mutual funds and investment institutions
use Derivatives

Investment Institutions use currency forwards

and other derivatives to hedge their
international asset and liability portfolios.
They use commodity futures to invest in asset
classes, in which they find it difficult to invest
directly. Investment institutions also sell
options to earn premium income and enhance
the returns on the portfolio.
Hedge funds and other aggressive investors
use derivatives to speculate in various financial
markets or to arbitrage between different
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3. Financial Service Firms, Banks and other
Dealers use Derivatives.
Banks and securities firms use derivatives to
hedge their inventories of securities.
Example: A stock broker might carry large
inventories of shares as part of his trading
activities. He might use stock index futures to
eliminate the market risk of these inventories.
Banks often act as dealers in derivative markets to
earn dealer spreads by buying a derivative from
one customer and selling the same to another at a
higher price. They may also seek to make profits by
carrying on arbitrage between different markets.
Some firms may also speculate on different prices
and earn trading profits by taking positions.
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4. How Individuals use

Many individuals do
speculate on asset prices.
Individual who manage their
own investment portfolios
might also use derivatives for
the same reason as
investment institutions
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Economic benefits of
Reduces risk
Enhance liquidity of the underlying asset
Lower transaction costs
Enhances the price discovery process.
Portfolio Management
Provides signals of market movements
Facilitates financial markets integration

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Misuses of Derivatives
1. Speculative and Gambling Motives: One
of the most important arguments against the
derivatives is that they promote speculative
activities in the market.

. Throughout the world the trading volume in

derivatives have increased in multiples of
the value of the underlying assets and hardly
one to two percent derivatives are settled by
the actual delivery of the underlying assets.

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2. Increase in Risk:
The derivatives are supposed to be efficient
tool of risk management in the market. But
this is one sided argument.

it has been observed that the derivatives

market especially OTC markets, privately
managed and negotiated and thus, they are
highly risky,

The studies in this respect have shown that

derivatives not resulted in the reduction in
risk, and rather these have raised of new
types of risk.
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3. Instability of the financial system:
derivatives have increased risk not only for
their users but also for the whole financial

The fears of micro and macro financial crisis

have caused to the unchecked growth of
derivatives which have turned many market
players into big losers.

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4. Price Stability: the derivatives that their
major contribution is towards price stability
and price discovery in the market whereas
some others have doubt about this. Rather
they argue that derivatives have caused wild
fluctuations in the asset prices and moreover,
they have widened the range of such
fluctuations in the prices.

The derivatives may be helpful in price

stabilization only if there exist a properly
organized, competitive and well-regulated
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5. Increased Regulatory Burden: The
derivatives create instability in the financial
system as a result, there will be more burden
on the government or regulatory authorities to
control the activities of the trades in financial

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UNIT 1: Introduction to Derivatives
Development and Growth of Derivative
Markets, Types of Derivatives,
Uses of Derivatives, Fundamental linkages
between spot & Derivative Markets, The Role
of Derivatives Market, Uses & Misuses of

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(in general)

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OTC and Exchange Traded
1. OTC
Over-the-counter (OTC) or off-exchange trading is to trade
financial instruments such as stocks, bonds, commodities or
derivatives directly between two parties without going
an exchange or other intermediary.
The contract between the two parties are privately

The contract can be tailor-made to the two parties liking.

Over-the-counter markets are uncontrolled, unregulated

and have very few laws. Its more like a freefall.
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2. Exchange-Traded Derivatives:
Exchange traded derivatives contract (ETD) are those
derivatives instruments that are traded via specialized
Derivatives exchange or other exchanges. A derivatives
exchange is a market where individuals trade
standardized contracts that have been defined by the

The world's largest derivatives exchanges (by number of

transactions) are the Korea Exchange.

There is a very visible and transparent market price for

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Classification of derivatives according to
the nature of the market in which the
derivatives is traded.
Futures contracts on Forward contracts on
stocks, currencies and stocks, currencies and
commodities. commodities.
Exchange traded options OTC Options on stocks,
on stocks, currencies, currencies and
and commodities. commodities.
Swaps note futures and Interest rate swaps,
interest rate futures. floors and forward rate
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Types of Derivative


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What is a Forward?
A forward is a contract in which one party
commits to buy and the other party commits
to sell a specified quantity of an agreed upon
asset for a pre-determined price at a specific
date in the future.

It is a customized contract, in the sense that

the terms of the contract are agreed upon by
the individual parties.

Hence, it is traded OTC.

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Forward Contract
Agree to sell
Farmer 500kgs wheat Bread
at Rs.40/kg Maker
after 3

3 months
500kgs Bread
Farmer wheat

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Risks in Forward
Credit Risk Does the other party have the
means to pay?

Operational Risk Will the other party make

delivery? Will the other party accept delivery?

Liquidity Risk Incase either party wants to

opt out of the contract, how to find another
counter party?

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Long position - Buyer

Short position - seller

Spot price Price of the asset in the spot

market.(market price)

Delivery/forward price Price of the asset at

the delivery date.

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What are Futures?
A future is a standardized forward contract.

It is traded on an organized exchange.

- quantity of underlying
- quality of underlying(not required in financial
- delivery dates and procedure
- price quotes
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Futures Contract
Long Market
Rs.10 Price/Spot




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Futures Contract
Rs.12 Day1
Rs.2 Rs.10
B C Rs.12

Short L
Rs.10 Rs.12

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Futures Contract
Short Day1
Rs.12 Rs.10
Rs.2 Day2
B C Day3
Short Long
Long Rs.12
Rs.14 Rs.14
Rs.2 68
Futures Contract

A Market
Profit Day1
Rs.2 Rs.10

S L Rs.14
Rs.10 S
Rs.14 Profit
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Types of Futures
Stock Futures Trading
(dealing with shares)

Commodity Futures Trading

(dealing with gold futures, crude oil

Index Futures Trading

(dealing with stock market indices)

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A margin is an amount of a money that must
be deposited with the clearing house by both
buyers and sellers in a margin account in
order to open a futures contract.

It ensures performance of the terms of the


Its aim is to minimize the risk of default by

either counterparty.
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Amount required 2,400 X 269.80 = 6,47

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Initial Margin (IM)-
Deposit that a trader must
make before trading any
futures. Usually, 10% of
the contract size.
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Advantages of derivatives
over Equity Trading
The financial derivative instruments futures and
options have the following advantages.
derivatives can be uses as convenient substitute
for other investments, leaving risks and rewards
Derivatives can be used to hedge the risk and can
help manage the risks inherent in a business.
Derivatives can used speculatively to increase risk
and reward through leverage (control).
Derivatives are also the basis for modern financial
Forward v/s Futures Contract
Traded on organized
Over the Counter Products
Customized Contract Standardized Contract
No Involvement of
Clearing House Guarantee
Clearing House
No Margins Margins are Must
Less Liquidity High Liquidity
Regulated by agencies like
Self Regulated
SEBI etc.
Counter Party Risk No Counterparty Risk
Settled by actual delivery Cash Settled
Settled on the Maturity Daily Settlement
Profits or losses realized Profits or losses realized daily
on the Maturity
What are Options?
Contracts that give the holder the option
to buy/sell specified quantity of the
underlying assets at a particular price on
or before a specified time period.

The word option means that the holder

has the right but not the obligation to
buy/sell underlying assets.

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European American
Style Style

Call Put Call Put

Option Option Option Option

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Types of Options (cont.)
Broadly the OPTIONS are two types,
they are European style options and
American style options.
European style options can be
exercised only on the maturity date of
the option, also known as the expiry
American style options can be
exercised at any time before and on the
expiry date.
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Options Terminology
Underlying: Specific security or asset.
Option premium: Price paid.
Strike price: Pre-decided price.
Expire date: Date on which option expires.
Exercise date: Option is exercised.
Open interest: Total numbers of option
contracts that have not yet been expired.
Option holder: One who buys option.
Option writer: One who sells option.
Put-call ratio: The ratio of puts to the calls
traded in the market.
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Types of Options
Options are of two types call and put.
Call option give the buyer the right, but not
the obligation to buy a given quantity of the
underlying asset, at a given price on or
before a particular date by paying a
Put options give the seller the right, but not
obligation to sell a given quantity of the
underlying asset, at a given price on or
before a particular date by receiving a
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Call Option Example
Right to buy
OPTION Current Price =
Premium =
Rs.25/share 100 Reliance Rs.250
shares at a
Amt to buy price of Rs.300
Call option = per share after Expiry
Rs.2500 3 months. date
Suppose after a month,
Market price is Rs.400, Suppose after a month,
then the option is market price is Rs.200, then
exercised i.e. the shares the option is not exercised.
are bought. Net Loss = Premium amt =
Gross gain = 40,000- Rs.2500
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Call Option Example
Right to buy
OPTION Current Price =
Premium =
Rs.0.95/share 2,400 ITC Rs.278
shares at a
Amt to buy price of Rs.295
Call option = per share after Expiry
Rs.2280 1 month. date

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Open Interest
Definition:Open interest is the total number of
outstanding contracts that are held by market participants
at the end of each day. Open interest measures the total
level of activity into the futures market.

Description:If both parties to the trade are initiating a

new position (one new buyer and one new seller), open
interest will increase by one contract. If both traders are
closing an existing or old position (one old buyer and one
old seller), open interest will decline by one contract. If one
old trader passes off his position to a new trader (one old
buyer sells to one new buyer), open interest will not

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Increasing open interest means that new
money is flowing into the marketplace. The
result will be that the present trend (up, down
or sideways) will continue. Declining open
interest means that the market is liquidating
and implies that the prevailing price trend is
coming to an end. Therefore, open interest
provides a lead indication of an impending
change of trend.

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Put Option Example
Premium = Right to sell Current Price =
Rs.25/share 100 Reliance Rs.250
shares at a
Amt to receive on Strike
price of Rs.300
put option = Price
Rs.2500 per share after
3 months.
Suppose after a
month, Market price Suppose after a month,
is Rs.200, then the market price is Rs.300, then
option is exercised the option is not exercised.
i.e. the shares are Net Loss = Premium amt =
sold. Rs.2500
Net gain = 30,000-
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Options Terminology
Moneyness: Concept that refers to the
potential profit or loss from the exercise of
the option. An option maybe in the money,
out of the money, or at the money.


In the money Spot Price > Strike price Spot price < strike price

At the money Spot Price = Strike price Spot Price = Strike price

Out of the Spot price < strike price Spot price > strike price

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For Call Option
In- the Money Option : A option is said to
be In- the money, when the underlying stock
price is greater than the strike price. (S>k).

A call option is said to be anin the money

callwhen the current market price of the
stock is above the strike price of the call
option. It is an "in the money call" because
the holder of the call has the right to buy the
stockbelowits current market price.
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At-the Money: A option is said to be At- the
money, when the underlying stock price is
equal to the Strike price. (S=k).
Out-of Money:- A option is said to be Out-
of money, when the underlying stock price is
less than the strike price. (S<k).

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For Put Option
In- the Money Option : A option is said to
be In- the money, when the underlying stock
price is less than the strike price. (S<k).
At-the Money: A option is said to be At- the
money, when the underlying stock price is
equal to the Strike price. (S=k).
Out-of Money:- A option is said to be Out-
of money, when the underlying stock price is
greater than the strike price. (S>k).
What are SWAPS?
In a swap, two counter parties agree to enter
into a contractual agreement wherein they
agree to exchange cash flows at periodic

Most swaps are traded Over The Counter.

Some are also traded on futures exchange


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Types of Swaps
There are 2 main types of swaps:

Plain vanilla fixed for floating swaps

or simply interest rate swaps.

Fixed for fixed currency swaps

or simply currency swaps.

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What is an Interest Rate
A company agrees to pay a pre-determined
fixed interest rate on a notional principal
for a fixed number of years.

In return, it receives interest at a floating

rate on the same notional principal for the
same period of time.

The principal is not exchanged. Hence, it is

called a notional amount.
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Floating Interest Rate
LIBOR London Interbank Offered Rate
It is the average interest rate estimated by
leading banks in London.
It is the primary benchmark for short term
interest rates around the world.
Similarly, we have MIBOR i.e. Mumbai
Interbank Offered Rate.
It is calculated by the NSE as a weighted
average of lending rates of a group of banks.

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Interest Rate Swap Example
Aim - 8 8.5% Aim -

5m 7 5m LIBOR
+ 1%
% Notional
Amount = 5
Bank million Bank
A Fixed
7% 10%
Variable Variable LIBOR
LIBOR + 1%
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Using a Swap to Transform a
Firm A has transformed a fixed rate liability
into a floater.
A is borrowing at LIBOR 1%
A savings of 1% (8% - 7%)

Firm B has transformed a floating rate liability

into a fixed rate liability.
B is borrowing at 9.5% (8.5% + 1%)
B savings of 0.5%. (10% - 9.5%)

Swaps Bank Profits = 8.5%-8% = 0.5%

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What is a Currency Swap?
It is a swap that includes exchange of
principal and interest rates in one currency for
the same in another currency.

It is considered to be a foreign exchange


It is not required by law to be shown in the

balance sheets.

The principal may be exchanged either at the

beginning or at the end of the tenure.
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However, if it is exchanged at the end of the
life of the swap, the principal value may be
very different.

It is generally used to hedge against

exchange rate fluctuations.

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Direct Currency Swap
Firm A is an American company and wants to
borrow 40,000 for 3 years.

Firm B is a French company and wants to

borrow $60,000 for 3 years.

Suppose the current exchange rate is 1 =


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Direct Currency Swap Example
Firm 7 Firm
Aim -
Aim - EURO 5% (French)

7% 40 5%

Bank A Bank B

6% 5%
$ $
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Comparative Advantage
Firm A has a comparative advantage in
borrowing Dollars.

Firm B has a comparative advantage in

borrowing Euros.

This comparative advantage helps in reducing

borrowing cost and hedging against exchange
rate fluctuations.

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The participants in a derivatives market are of
three types.

Participants in

Speculato Arbitrage
rs urs
Traders in Derivatives Market
There are 3 types of traders in the
Derivatives Market :
A hedger is someone who faces risk
associated with price movement of an
asset and who uses derivatives as
means of reducing risk. They provide
economic balance to the market.
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A trader who enters the
futures market for pursuit of
profits, accepting risk in the
speculation. They provide
liquidity and depth to the

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A speculator is a person who is willing to take a risk by
taking futures position with the expectation to earn
profits. Speculator aims to profit from price
The speculator forecasts the future economic
conditions and decides which position (long or short)
to be taken that will yield a profit if the forecast is

Example, suppose a speculator forecasts that price of

silver will be Rs 3000 per 100 grams after one month.
If the current silver price is Rs 2900 per 100 grams, he
can take a long position in silver and expects to make
a profit of Rs 100 per 100 grams.

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This expected profit is associated with risk
because the silver price after one month may
decrease to Rs 2800 per 100 grams, and may
lose Rs 100 per 100 grams.

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Position Speculator uses
fundamental analysis of economic
conditions of the market and is known
as fundamental analyst.
Technical Analyst whereas the one
who predicts futures prices on the
basis of past movements in the prices
of the asset is known as technical
Local Speculator A speculator who
owns a seat on a particular exchange
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Scalpers usually try to make profits from holding
positions for short period of time. They bridge the
gap between outside orders by filling orders that
come into the brokers in return for slight price
Pit Traders like scalpers take bigger positions and
hold them longer. They usually do not move quickly
by changing positions overnights. They most likely
use outside news
Floor Traders usually consider inter commodity
price relationship. They are full members and often
watch outside news carefully and can hold positions
both short and long. Day traders speculate only
about price movements during one trading day.
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Day Traders speculate only about
price movements during one trading

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A person who simultaneously enters into transactions
in two or more markets to take advantage of the
discrepancies between prices in these markets.

Arbitrage involves making profits from relative


Arbitrageurs also help to make markets liquid, ensure

accurate and uniform pricing, and enhance price

They help in bringing about price uniformity and

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An arbitrageur tries to earn riskless profits
from discrepancies between futures and spot
prices and among different futures prices.
Example, suppose that at the expiration of the
gold futures contract, the futures price is Rs
9200 per 10 grams, but the spot price is Rs
9000 per 10 grams. In this situation, an
arbitrageur could purchase the gold for Rs 9000
and go short a futures contract that expires
immediately, and in this way making a profit of
Rs 200 per 10 grams by delivering the gold for
Rs 9200 in the absence of transaction costs

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Reasons to use derivatives
Derivative markets have attained an
overwhelming popularity for a variety of
Hedging: Interest rate volatility
Stock price volatility
Exchage rate volatility
Commodity prices volatility


High portion of leverage

Speculatio Huge returns
Reasons to use Derivatives:
Also derivatives create...

a complete market, defined as a market in which

all identifiable payoffs can be obtained by trading
the securities available in the market.

and market efficiency, characterized by low

transaction costs and greater liquidity.
Uses of derivatives
1. Foreign-Exchange Risks:

One of the more common corporate uses

of derivatives is for hedging foreign-
currency risk, orforeign-exchange risk,
which is the risk that a change in currency
exchange rates will adversely impact
business results.

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2. Commodity or Product Input
Companies that depend heavily on raw-material
inputs or commodities are sensitive, sometimes
significantly, to the price change of the inputs.

Airlines, for example, consume lots of jet fuel.

Historically, most airlines have given a great deal of
consideration to hedging against crude-oil price
increases - although at the start of 2004 one major
airline mistakenly settled (eliminating) all of its crude-
oil hedges: a costly decision ahead of the surge in oil
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3. Risk management
Derivatives allow firms to:
Separate out the financial risks that they
Remove or neutralize the risk exposures
they do not want.
Retain or possibly increase the risk
exposures they want.
Using derivatives, firms can transfer, for a
price, any undesirable risk to other parties
who either have risks that offset or want to
4. Leverage

Leverage is the ability to control large

amounts of an underlying asset with a
comparatively small amount of capital.
As a result, small price changes can lead
to large gains or losses.
Leverage makes derivatives:
Powerful and efficient
Potentially dangerous
Leveraging with futures
A speculator believes interest rates are going to
To realize a gain, she might:
Buy bonds worth, say, Rs.1 million.
Buy Treasury bond futures for the purchase of
Rs.1 million of Treasury bonds.
To buy the bonds, speculator needs Rs.1 million.
To buy the Treasury bond futures, speculator
needs initial margin of about Rs.15,000.
speculator gains the same exposure in both
cases. That is, speculator stands to realize an
equivalent gain/loss should interest rates fall/rise.
The Role of Derivative Markets

The existence of derivative markets in the

United States economy and indeed throughout
most modern countries of the world
undoubtedly leads to a much higher degree of
market efficiency. Derivatives facilitate the
activities of individual arbitrageurs so that
unequal prices of identical goods are arbitraged
until they are equal. Because of the large
number of arbitrageurs, this is a quick and
efficient process.

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Arbitrage on this large a scale makes markets
less capable of being manipulated, less costly
to trade in, and therefore more attractive to
investors. (The opportunity to hedge also
makes the markets more attractive to investors
in managing risk.)

This is not to say that an economy without

derivative markets would be inefficient, but it
would not have the advantage of this arbitrage
on a large scale.

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It is important to note that the derivative
markets do not necessarily make the India or
world economy any larger or wealthier. The
basic wealth, expected returns, and risks of
the economy would be about the same
without these markets. Derivatives simply
create lower cost opportunities for investors to
align their risks at more satisfactory levels.
This may not necessarily make them
wealthier, but to the extent that it makes
them more satisfied with their positions, it
serves a valuable purpose.
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Myths & Realities about
In less than three decades of their coming in
to vogue, derivatives markets have become
the most important market in the world. Today
Derivatives have become the part and parcel
of the day-to-day life for ordinary people in
major parts of the world. While, this is true for
many countries, there are still apprehension
(fear/uneasiness) about the introduction of

There are many myths for derivatives but the

realities are different especially for the
exchange traded derivatives, which are well
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What are these myths behind
this derivative?
Derivatives increase speculation and
do not serve any economic purpose.
Indian market is not ready for
Derivative trading.
Disasters are proved that
Derivatives are very risky and highly
leveraged instruments.
Derivatives are very complex and
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Forwards are futures, which are not
standardized. They are not traded on
a stock exchange. The contracts are
customized / Tailor-made contracts
between two entities or parties,
where settlement takes place as a
specific date in the future at
predetermined price.

Normally traded outside the

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Futures are contracts that represent an
agreement to buy or sell a set of assets at
a specified time in the future for a
specified amount.
The contracts details are the quality and
quantity of the underlying asset and the of
expiry date etc.,
They are standardized to facilitate trading
on a futures exchange. Some futures
contracts may call for physical delivery of
the asset, while others are settled in cash.
Some of the most popular assets on which
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Pricing options:

Explained with the help of following


COV = MPS [N (d)] EP [antilog (-rt)] [N (d2)]

COV= Call option value
MPS = Current price of underlying asset
N(d) = Cumulative density function
EP = Exercise price of option
R = Continuity compounded risk less rate of
interest on an annual basis.
T = Time remaining before the expiration of option
N(d2) = Cumulative density function of d2



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Business outcomes are surprising and have
risk and uncertainty elements. To avoid the
risk arising out of price fluctuations in future,
various strategies are devised keeping in view
the timing and pricing dimensions of the

Ex:1:- Suppose a farmer anticipates fall in

prices of his crop three months hence. He will
try to cover his future risk by entering into a
future contract at a price set on todays date.
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Ex:2:- Suppose a textile manufacturer
anticipates future losses due to
government policy, he will lock his future
position by entering into two simultaneous
contracts of buying raw material from one
country and to export the finished product
to another country.
These are examples of hedging where an
investor in anticipation of some price
change (adverse or favourable) enters into
a future contract/s and lock in the position

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In broader sense, a hedging is an act of
protecting one from future losses due to some
reason. In a future market, the use of future
contracts/instrument in such a way that risk is
either avoided or minimized is called hedging.
The anticipated future losses may occur due
to fluctuations in the price, foreign exchange
or interest rate.
This concept considers that hedging activity is
based on price risk.

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Hedging Types
There are two categories of:

Hedging Hedge
types Long
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Short Hedge
Having a short position (selling a futures) in
futures is known as a short hedge. It happens
when an investor plans to buy or produce a
cash commodity sells futures to hedge the
cash position.
It is appropriate when hedger owns an asset
and expects to sell in future on a particular
Generally, Selling some asset without having
the same is known as short-selling. Which
means having a net sold position, or a
commitment to deliver.
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For example suppose a US exporter expects
to receive Euros in three months. He will gain
if the euro increases in value relative to the
US dollar and will sustain loss if the euro
decreases in value relative to US dollar.

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Supposing an oil producer made a contract on
10 Oct, 2006 to sell 1 million barrel crude oil
on a market price as on 10 Jan 2007.
The oil producer supposing that spot price on
10 Oct, 2006 is $ 50 per barrel and Jan crude
future price on NYMEX is $ 48.50 per barrel.
The company can hedge its position by short
selling October futures.
If the oil borrower closed his position on 10
Jan 2007 the effect of the strategy should be
to lock in a price close to $ 48.50 per barrel.

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Suppose the spot price on 10 Jan 2007 be $
47.50 per barrel. The company realizes the
$ 48.50 $ 47.50 = $ 1.00 per barrel
Total profit = $ 1.00 X 1 million
$ 1 million in total from the short future

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Long hedge

A long hedge is taking long position in

futures contract. A long hedge is done
in anticipation of future price increases
and when the company knows that it
will have to buy a certain asset in the
future at anticipated higher price and
wants to lock in a price now.

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The objective of a long hedge is to
protect the company against a price
increase in the underlying asset prior
to buy the same either in spot or
future market.
A net bought position is actually
holding an asset which is known as
inventory hedge.
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Cross Hedging
A cross hedge is a hedge where
characteristics of futures and spot prices do
not match perfectly which is known as
mismatch, may occur due to following reasons:
The quantity to be hedged may not be equal
to the quantity of futures contract.
Features of assets to be hedged are different
from the future contract asset.
Same futures period (maturity) on a particular
asset is not available.
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Ex:1:- Suppose a wire manufacturer requires
copper in the month of June but in exchange
the copper futures trade in long delivery in Jan,
March, July, Sept. in this case hedging horizon
does not match with the futures delivery date.

Ex:2:- Suppose that the copper required by the

manufacturer is substandard quality but the
available trading is of pure 100% copper and in
quantity aspect too, copper may be traded in
different multiples than required actually.
These are examples of cross hedging.

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The difference between the spot
price and future price is known as

Basis = Cash (spot price)

Future price
Basis is said to be positive if the spot
price is higher than the future price
and negative in case of reverse.
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In case of difference in future price and spot
price, basis risk is bound to occur.
Strengthening of the basis occurs when
change in the spot price is more than the
change in the future price.
If the change in spot price is less than the
change in futures price, the basis is known as
weakening of basis.

The following Table gives the clear picture of

the price changes.
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OCT 10, 65 68 -3
NOV 15, 67 71 -4
CHANGE +2 +3 -1

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