Derivatives

Imagine

 You are a farmer

 Your wheat will come in the market
after 10 months
 Today the wheat prices are at the
peak
 You know there are huge
fluctuations in wheat prices ahead
in near future
 What you would wish?
SIMILARLY
Financial markets are marked by a
very high degree of volatility
Is there any way by which we can
lock the price of the asset/security
in advance?
i.e. partially or fully transfer the price
risk by locking in asset price.
Can we call it as risk
management instruments?
Are there any in the market?
YES

These are called derivatives!!

What are derivatives?
 In simple words, derivatives is a
product whose value is derived from
the UNDERLYING ASSET
 Underlying asset can be commodity,
equity, debt or index, currency.
 Derivatives are of two types
 OTC (over the counter)
 Exchange Traded Derivatives
(Permitted by law in India)
 The basic purpose is to transfer the
price risk.
In India

 The National Stock Exchange (NSE) is the largest

exchange in India in derivatives, trading in various
derivatives contracts.
 Equity derivatives segment is called the Futures &
Options Segment or F&O Segment.
 NSE also trades in Currency and Interest Rate
Futures contracts under a separate segment.
 At present, the equity derivatives market is the
most active derivatives market in India. Trading
volumes in equity derivatives are, on an average,
more than three and a half times the trading
volumes in the cash equity markets.
Two Imp terms

 Spot Market
 Also known as Cash Market/ Capital
Market
 Settlement period
 Index
 Nifty 50
 Sensex 30

Stock derivatives & Index Derivatives

 What are different derivative contract
variants?
 Forwards
 Futures
 Options
 Swaps
Forwards
 A forward contract or simply a forward is a contract
between two parties to buy or sell an asset at a
certain future date for a pre-decided price on the
date of the contract.
 The future date is referred to as expiry date and the
pre-decided price is referred to as Forward Price.
 This is different from a spot market contract, which
involves immediate payment and immediate transfer
of asset.
 No money is exchanged when the deal is signed.
The forward contract only specifies the terms of
transaction that will occur in future.
What are forward contract?

 You are the retailer who agree on

feb 2012 to buy 100 tonnes of
wheat on 31st May at the price of
10 per kg (contract price) from a
wheat farmer.
 i.e. you have bought forward
wheat or you are long forward
wheat
 And the farmer has sold forward
wheat or he is short forward wheat
They are called PAY OFFS!
 What are the pay offs to the
forward buyer and the forward
seller?

 For forward buyer payoff is : Spot

price – contract price
 For Forward seller payoff is :
Contract price – Spot Price
Example
 Consider two parties A & B Dealing in stock
of Reliance industries on 16th may
 A is buyer and B is seller
 Future Price = Rs. 795
 Lot Size – 100
 Expiry date 31st May
 Case 1 ---- Closing Price on expiry date is
800
 Case 2 ---- Closing Price on expiry date is
790
 Case 3 ---- Closing Price on expiry date is
795
Typical features of a fwd contract

 These are tailor made contract

 Forwards contracts usually end with
deliveries i.e. physical settlement
which results in huge transaction
cost.
 Alternative settlement type is cash
settlement
What are futures?
 Future contract are standardized
forward contract!
 futures contracts are traded are
settled with differences, whereas,
forwards contracts usually end with
deliveries
 These are traded on organized
exchanges.
 Standardized in terms of quantity,
date and delivery conditions are
standardized.
Future terminology

 Spot price
 Future price
 Contract cycle
 Contract Size
 Contract value
Margins

 Initial margin
 Marking to margin
 Maintenance margin
Contract Specification for S&P Nifty Index Futures
Underlying Index S&P CNX Nifty

Contract Size Permitted lot size is 75

Trading Cycle The future contracts have a maximum of

three month trading cycle - the near month (one), the next
month (two), and the far month (three). New contracts are
introduced on the next trading day following the expiry of
the near month contract.
Expiry Day The last Thursday of the expiry month or
the previous trading day if the last Thursday is a trading
holiday
Settlement Basis Mark-to-market and final settlement are
cash settled on T+1 basis
Settlement Price Daily Settlement price is the closing price
of the futures contracts for the trading day and the final
settlement price is the value of the underlying index on the
last trading day
Continued
 In futures contract a margin is required.
 Futures are marked to margin on daily basis.
 This means that profits and losses on futures are
settled daily.
 There are three future contracts at a time in the
market
 Futures expire on the last Thursday of every
month.
 And so the new future contract is introduced on
the next working day of the last Thursday of the
month.
 In futures, profits and losses are unlimited.
Example:

 On Monday morning you take a long

position in a futures contract @ Rs.
100, that matures on Friday
afternoon
 On Monday evening, the future rises
to RS 105/-
 Mark to margin means three things
wil happen.
 U will receive Rs. 5 at the end of the
Monday.
 Second the existing futures contract
with a price of rs 100 will be
cancelled.
 Third, you will receive a new future
contract at Rs. 105
Future payoffs

 Futures are free to enter into, but

can generate very large losses.

 Futures have linear payoffs. That

means unlimited profits and
unlimited losses
Payoff for buyer of future: Long futures
ST - F
Payoff for seller of the future: short
futures
F - ST
 Kantaben sold a Jan nifty futures
contract for Rs. 240000 on 15th january.
Each nifty futures contract is for delivery
of 100 nifities. On 25th january, the index
closed at 2450. how much profit/loss did
she make?

1. -7000
2. -5000
3. 5000
4. 7000
 Kantaben sold a Jan nifty futures contract
for Rs. 240000 on 15th January. Each nifty
futures contract is for delivery of 100
nifties. On 25th January, the index closed
at 2350. how much profit/loss did she make?

1. -7000
2. -5000
3. 5000
4. 7000
 Kantaben buy a Jan nifty futures contract
for Rs. 240000 on 15th January. Each nifty
futures contract is for delivery of 100
nifties. On 25th January, the index closed
at 2360. how much profit/loss did she
make?
 An investor is bearish about ABC
Ltd. and sells ten one-month ABC
Ltd. futures contracts at
Rs.5,00,000. On the last Thursday
of the month, ABC Ltd. closes at
Rs.510. He makes a _________.
(assume one lot = 100)
 Which of the following is not a
derivative transaction? [1 Mark] (a)
An investor buying index futures in
the hope that the index will go up.
(b) A copper fabricator entering into
futures contracts to buy his annual
requirements of copper. (c) A
farmer selling his crop at a future
date (d) An exporter selling dollars
in the spot market
All open positions in the index
futures contracts are daily settled at
the (a) mark-to-market settlement
price (b) net settlement price (c)
opening price (d) closing price
An American style call option
contract on the Nifty index with a
strike price of 3040 expiring on the
30th June 2008 is specified as ’30
JUN 2008 3040 CA’. (a) FALSE (b)
TRUE
 A dealer sold one January Nifty
futures contract for Rs.250,000 on
15th January. Each Nifty futures
contract is for delivery of 50 Nifties.
On 25th January, the index closed
at 5100. How much profit/loss did
he make ? [2 Marks] (a) Profit of
Rs. 9000 (b) Loss of Rs. 8000 (c)
Loss of Rs. 9500 (d) Loss of Rs.
5000
 Manoj owns five hundred shares of
ABC Ltd. Around budget time, he
gets uncomfortable with the price
movements. Which of the following
will give him the hedge he desires
(assuming that one futures contract
= 100 shares) ? [1 Mark] (a) Buy 5
ABC Ltd.futures contracts (b) Sell 5
ABC Ltd.futures contracts (c) Sell
10 ABC Ltd.futures contracts (d)
Buy 10 ABC Ltd.futures contracts
 An investor is bearish about Tata
Motors and sells ten one-month
ABC Ltd. futures contracts at
Rs.6,06,000. On the last Thursday
of the month, Tata Motors closes at
Rs.600. He makes a _________.
(assume one lot = 100) [2 Marks]
(a) Profit of Rs. 6,000 (b) Loss of
Rs. 6,000 (c) Profit of Rs. 8,000 (d)
Loss of Rs. 8,000
 Trading member Shantilal took
proprietary purchase in a March
2000 contract. He bought 1500
units @Rs.1200 and sold 1400 units
@ Rs. 1220. The end of day
settlement price was Rs. 1221.
What is the outstanding position on
which initial margin will be
calculated? [1 Mark] (a) 300 units
(b) 200 units (c) 100 units (d) 500
units
Options
 An option is a derivative contract between
a buyer and a seller, where one party (say
First Party) gives to the other (say Second
Party) the right, but not the obligation, to
buy from (or sell to) the First Party the
underlying asset.
 In return for granting the option, the party
granting the option collects a payment from
the other party. This payment collected is
called the “premium” or price of the
option.
Options terminology

 Buyer of an option – pays premium, buys the right but not an

obligation to exercise his option on the seller

 Seller of an option – receives the option premium and

thereby obliged to sell/buy the asset if the buyer exercise the
option on him

 Put option – an option gives the buyer the right but not an
obligation to sell an asset by a certain date for certain price

 Call option: an option gives the buyer the right but not an
obligation to buy an asset by a certain date for certain price

 Option price
 Expiration date
 Strike price – price at which the option is exercised; used in
options only
 American options
 European options
 In the money option
 Call option = Spot >Strike
 Put option = Strike > spot
 out of the money option
 Call option = Strike> spot
 Put option = Spot > Strike
 At the money option
 No Profit no Loss
Contract Specification for S&P CNX Nifty Options
Underlying Index S&P CNX Nifty
Security Descriptor OPTIDX NIFTY
Contract Size Permitted lot size is 75
Trading Cycle The Option contracts have a maximum of three
month trading cycle---the near month (one), the next month
(two), and the far month (three). New contracts are
introduced on the next trading day following the expiry of the
near month contract.
Expiry Day The last Thursday of the expiry month or the
previous trading day if the last Thursday is a trading holiday
Settlement Basis Cash Settlement on T+1 basis
Style of Option European
Daily Settlement Not Applicable
Final Settlement price Closing value of the index on the last
trading day.
Final Exercise Settlement

On the day of expiry, all in the money options are exercised by

default.
An investor who has a long position in an in-the-money option on the
expiry date will receive the exercise settlement value which is the
difference between the settlement price and the strike price.
Similarly, an investor who has a short position in an in-the-money
option will have to pay the exercise settlement value.

The final exercise settlement value for each of the in the money
options is calculated as follows:
Call Options = Closing price of the security on the day of expiry –
strike price (if closing price > strike price, else 0)
Put Options = Strike price – closing price of the security on the day
of expiry (if closing price < strike price, else 0)
 An option which gives the holder
the right to sell a stock at a
specified price at some time in the
future is called a ___________. [1
Mark] (a) Naked option (b) Call
option (c) Out-of-the-money option
(d) Put option
 Mr. Ram buys 100 calls on a
stock with a strike of Rs.1,200.
He pays a premium of
Rs.50/call. A month later the
stock trades in the market at
Rs.1,300. Upon exercise he will
receive __________. [2 Marks]
(a) Rs.10,000 (b) Rs.1,200 (c)
Rs.6,000 (d) Rs.1,150
 Ashish is bullish about HLL which
trades in the spot market at Rs.210.
He buys 10 three-month call option
contracts on HLL with a strike of
230 at a premium of Rs.1.05 per
call. Three months later, HLL closes
at Rs. 250. Assuming 1 contract =
100 shares, his profit on the
position is ____. [1 Mark] (a)
Rs.18,950 (b) Rs.19,500 (c)
Rs.10,000 (d) Rs.20,000
 An investor owns one thousand
shares of Reliance. Around budget
time, he gets uncomfortable with
the price movements. One contract
on Reliance is equivalent to 100
shares. Which of the following will
give him the hedge he desires? [2
Marks] (a) Buy 5 Reliance futures
contracts (b) Sell 10 Reliance
futures contracts (c) Sell 5 Reliance
futures contracts (d) Buy 10
Reliance futures contracts
 Spot Price = Rs. 100. Call Option
Strike Price = Rs. 98. Premium =
Rs. 4. An investor buys the Option
contract. On Expiry of the Option
the Spot price is Rs. 108. Net profit
for the Buyer of the Option is ___.
[1 Mark] (a) Rs. 6 (b) Rs. 5 (c) Rs.
2 (d) Rs. 4
 Interest rate swaps
 Currency swaps
Features of swaps
 swaps are not exchange-traded
instruments.
 swaps are customized contracts that are
traded in the over-the-counter (OTC)
market between private parties.
 Firms and financial institutions dominate
the swaps market, with few (if any)
individuals ever participating.
 Because swaps occur on the OTC market,
there is always the risk of
a counterparty defaulting on the swap.
 The most common and simplest swap is a "plain
vanilla" interest rate swap.
 Example: Party A agrees to pay Party B a
predetermined, fixed rate of interest on a notional
principal on specific dates for a specified period of
time.
 Concurrently, Party B agrees to make payments
based on a floating interest rate to Party A on that
same notional principal on the same specified dates
for the same specified time period.
 In a plain vanilla swap, the two cash flows are paid
in the same currency. The specified payment dates
are called settlement dates, and the times between
are called settlement periods.
 Because swaps are customized contracts, interest
payments may be made annually, quarterly,
monthly, or at any other interval determined by the
parties.
 For example, on Dec. 31, 2006, Company A and
Company B enter into a five-year swap with the
following terms:
 Company A pays Company B an amount equal to
6% per annum on a notional principal of $20 million.
 Company B pays Company A an amount equal to
one-year LIBOR + 1% per annum on a notional
principal of $20 million.
 LIBOR, or London Interbank Offer Rate, is the
interest rate offered by London banks on deposits
made by other banks in the Eurodollar markets.
 The market for interest rate swaps frequently (but
not always) uses LIBOR as the base for the floating
rate. For simplicity, let's assume the two parties
exchange payments annually on December 31,
beginning in 2007 and concluding in 2011.
 At the end of 2007, Company A will pay Company B
$20,000,000 * 6% = $1,200,000. On Dec. 31,
2006, one-year LIBOR was 5.33%; therefore,
Company B will pay Company A $20,000,000 *
(5.33% + 1%) = $1,266,000. In a plain vanilla
interest rate swap, the floating rate is usually
determined at the beginning of the settlement
period. Normally, swap contracts allow for payments
to be netted against each other to avoid
unnecessary payments. Here, Company B pays
$66,000, and Company A pays nothing. At no point
does the principal change hands, which is why it is
referred to as a "notional" amount. Figure 1 shows
the cash flows between the parties, which occur
annually (in this example).
Swaps of used for?
 commercial needs and comparative advantage.
 For example, consider a bank, which pays a floating
rate of interest on deposits (e.g. liabilities) and
earns a fixed rate of interest on loans (e.g. assets).
This mismatch between assets and liabilities can
cause tremendous difficulties. The bank could use a
fixed-pay swap (pay a fixed rate and receive a
floating rate) to convert its fixed-rate assets into
floating-rate assets, which would match up well with
its floating-rate liabilities.
 Some companies have a comparative
advantage in acquiring certain types of
financing. However, this comparative
advantage may not be for the type of
financing desired. In this case, the
company may acquire the financing for
which it has a comparative advantage,
then use a swap to convert it to the
desired type of financing.
 For example, consider a well-known U.S.
firm that wants to expand its operations
into Europe, where it is less known. It will
likely receive more favorable financing
terms in the U.S. By using a currency
swap, the firm ends up with the euros it
needs to fund its expansion
Payoff in options

 The losses for the buyer of an

option are limited, however the
potential for earning profits is
unlimited.
 For writer the payoff is exactly
opposite.
 His profits are limitedto the option
premium, and losses are unlimited.
Payoff for the buyer of call option]
Max (ST – K, 0) - Premium
Pay off for writer of the call option
Pay off for buyer of the put option
Max (K - ST, 0) - Premium
Payoff for the writer of the put option
 All options contract expire on
1. Last Friday of the month
2. Last Tuesday of the month
3. Last Thursday of the month
4. None of the above
 New option contracts are
introduced on

1. First trading day of the month

2. Last Tuesday of the month
3. Last Thursday of the month
4. On the next trading day following
the expiry of near month contract