DERIVATIVES

&
RISK MANAGEMENT
 What are Derivatives?
 A derivative is a financial instrument whose value is derived
from the value of another asset, which is known as the
underlying.

 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 underlying.

Example :
The value of a gold futures contract is derived from the
value of the underlying asset i.e. Gold.
 The underlying assets for
derivatives are
 Common shares/stock.
:
 Commodities ( Grains, Coffee beans, Pulses, Vegetables
etc.,)
 Precious metals ( Gold , Silver )
 Debt securities
 Interest rates
 stock index value( BSE Sensex, NSE Nifty )
Derivatives helps in reducing the risk which may arise from
change in the prices of above mentioned type of assets.
The basic purpose of derivative is to transfer the risk.
 Definition of Financial Derivatives
The Securities Contracts (Regulation) Act, 1956 defines
“derivatives” as under :

“Derivatives” includes
1. Security derived from a debt instrument, share,
loan whether secured or unsecured, risk instrument
or contract for differences or any other form of
security.
2. A contract which derives its value from the prices,
or index of prices of underlying securities.
 Traders in Derivatives Market
There are 3 types of traders in the Derivatives Market :
 HEDGER
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.

 SPECULATOR
A trader who enters the futures market for pursuit of profits, accepting
risk in the endeavor.
They provide liquidity and depth to the market.
 ARBITRAGEUR
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 mispricing.

 Arbitrageurs also help to make markets liquid, ensure accurate and

uniform pricing, and enhance price stability

 They help in bringing about price uniformity and discovery.

TYPES OF DERIVATIVE MARKETS
OTC – Over the counter traded derivatives
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 through
an exchange or other intermediary.
• The contract between the two parties are privately negotiated.

• 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.
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 exchange.

There is a very visible and transparent market price

for the derivatives.
Uses/ Advantages/Applications of
Derivatives ( Factors contributing to
growth of derivatives)
 Reduces Risk :

One of the most important services provided by the derivatives

is to control, avoid, shift and manage efficiently different types
of risks through various strategies like hedging, arbitraging,
and speculation etc.

Derivatives helps the holders to shift or modify the risk

characteristics on their portfolios. Derivatives are highly useful
in volatile financial market conditions like highly flexible
interest rates, volatile exchange rates and monetary chaos.
Use/ Advantages of Derivatives
 Enhance liquidity of the underlying asset

In derivatives trading no immediate full amount of the

transaction is required since most of them are based
on margin trading. As a result, large number of
traders, speculators , arbitrageurs operate in such
markets.
So, derivatives trading enhances liquidity and
reduce transactions costs in the market for underlying
assets.
Use/ Advantages of Derivatives
 Enables the price discovery process.
Derivatives serve as barometers of the future
trends in prices which result in the discovery of
new prices both on spot and futures market.
Further, they help in providing the information
regarding the future markets trading of various
commodities and securities to the society
which enable to form correct equilibrium in the
markets.
Use/ Advantages of Derivatives
 Portfolio Management

Derivatives assist the investors, traders and managers of

large pools of funds to devise such strategies so that they
may make proper asset allocation to increase their yields
and achieve their investment goals. so derivatives helps
the investors to achieve their investment goals. That’s
why, derivatives also encourages investment activities
among the people.
Use/ Advantages of Derivatives

• Increases trading volume in the country

The derivatives trading encourage the competitive trading

in the markets , different risk taking preference of the
market operators like speculators, hedgers, traders,
arbitrageurs, etc. resulting in trading volume in the
country.

Derivatives also attract young investors, professionals

and other experts who act as catalysts to the growth of
financial markets.
Use/ Advantages of Derivatives
• Develop the market towards ‘Complete
Markets’

Derivative trading develop the market towards

‘complete markets’. Complete market concept
refers to that situation where no particular
investor be better of than of others.
 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 customised contract, in the sense that the terms of the

contract are agreed upon by the individual parties.

 Hence, it is traded OTC.

Forward Contract Example
I agree to sell Bread
Farmer 500kgs wheat at
Maker
Rs.40/kg after 3
months.

3 months Later

500kgs wheat Bread

Farmer Maker
Rs.20,000
Long forward position and short
forward position
LONG FORWARD POSITION – the party who has entered
into a contract for buying shares/commodities that party
is said to have taken the long position.

SHORT FORWARD POSITION- the party who has entered

into a contract for selling shares/commodities that party
is said to have taken the long position.
 Risks in Forward Contracts
 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 – In case either party wants to opt out of the contract,
how to find another counter party?
 Terminology
 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.

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

 It is traded on an organized exchange.

 Standardizations-
- quantity of underlying
- quality of underlying(not required in financial futures)
- delivery dates and procedure
- price quotes
 Terminology
 Contract size – The amount of the asset that has to be delivered
under one contract. All futures are sold in multiples of lots which is
decided by the exchange board.
Eg. If the lot size of Tata steel is 500 shares, then one futures contract is
necessarily 500 shares.

 Contract cycle – The period for which a contract trades.

The futures on the NSE have one (near) month, two (next) months,
three (far) months expiry cycles.

 Expiry date – usually last Thursday of every month or previous day

if Thursday is public holiday.
 Terminology
 Strike price – The agreed price of the deal is called the strike price.

 Cost of carry – Difference between strike price and current price.

 COMPARISON FORWARD FUTURES

• Trade on organized exchanges No Yes

• Use standardized contract terms No Yes

• Use associate clearinghouses to

guarantee contract fulfillment No Yes

• Require margin payments and daily

settlements No Yes

• Markets are transparent No Yes

• Marked to market daily No Yes

• Closed prior to delivery No Mostly

• Profits or losses realised daily No Yes

 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.
 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 premium.
 Puts give the buyer 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 paying a premium.
 Types of Options (cont.)
 The other two types 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 date.

 AMERICAN STYLE OPTIONS can be exercised at any time before

and on the expiry date.
 Call Option Example
CALL OPTION Current Price = Rs.250
Premium =
Right to buy 100
Rs.25/share
Reliance shares at Strike Price
Amt to buy Call a price of Rs.300
option = Rs.2500 per share after 3
months. Expiry
date
Suppose after a month,
Market price is Rs.400, then Suppose after a month, market
the option is exercised i.e. price is Rs.200, then the option is
the shares are bought. not exercised.
Net gain = 40,000-30,000- Net Loss = Premium amt
2500 = Rs.7500 = Rs.2500
 Put Option Example
PUT OPTION Current Price = Rs.250
Premium =
Right to sell 100
Rs.25/share
Reliance shares at Strike Price
Amt to buy Call a price of Rs.300
option = Rs.2500 per share after 3
months. Expiry
date
Suppose after a month,
Market price is Rs.200, then Suppose after a month, market
the option is exercised i.e. price is Rs.300, then the option is
the shares are sold. not exercised.
Net gain = 30,000-20,000- Net Loss = Premium amt
2500 = Rs.7500 = Rs.2500
LONG CALL & LONG PUT
LONG CALL means when call option contract is purchased.
As there is two parties option writer and option holder so
long call position is taken by the option holder.

LONG PUT means when put option contract is purchased.

As there is two parties option writer and option holder so
long put position is taken by the option holder.
SHORT CALL & SHORT PUT
SHORT CALL means when call option contract is sold. As
there is two parties option writer and option holder so
short call is taken by the writer.

SHORT PUT means when put option contract is sold. As

there is two parties option writer and option holder so
short put position is taken by the option writer.
 Features of Options
 A fixed maturity date on which they expire. (Expiry date)
 The price at which the option is exercised is called the exercise price
or strike price.
 The person who writes the option and is the seller is referred as the
“option writer”, and who holds the option and is the buyer is called
“option holder”.
 The premium is the price paid for the option by the buyer to the
seller.
 A clearing house is interposed between the writer and the buyer
which guarantees performance of the contract.
 Options Terminology
 Underlying: Specific security or asset.
 Option premium: Price paid.
 Strike price: Pre-decided price.
 Expiration 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.
 Intrinsic value : The intrinsic value of an option is defined as the amount,
by which an option is in-the-money, or the immediate exercise value of the
option when the underlying position is marked-to-market.
 Options Terminology (cont.)
 Option class: All listed options of a type on a particular instrument.
 Option series: A series that consists of all the options of a given class
with the same expiry date and strike price.
 Put-call ratio: The ratio of puts to the calls traded in the market.
 Options Terminology (cont.)
 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.

Call Option Put Option

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

At the money Spot price = strike Spot price = strike

price price

Out of the Spot price < strike Spot price > strike
money price price
 What are SWAPS?
 Swaps are private arrangements between two parties to exchange
cash flows in future according to pre-determined formula.(Swaps are
generally arranged by the intermediaries like banks).

 Swaps are traded “Over The Counter”

 Swaps are over-the-counter contracts between businesses or

financial institutions..
 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.
 What is an Interest Rate Swap?
 In interest swap, two parties agree to pay each other’s interest
obligation for their mutual benefits.

For e.g., 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 or vice- versa.

 The principal is not exchanged. Hence, it is called a notional

amount.
 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.
 Using a Swap to Transform a Liability
 Firm A has transformed a fixed rate liability into a floater.
 A is borrowing at MIBOR + 1%

 Firm B has transformed a floating rate liability into a fixed rate

liability.
 B is borrowing at 8.5%

 Swaps Bank Profits = 8.5%-8% = 0.5%

 Interest Rate Swap Example
MIBOR +1 % MIBOR +1 %
SWAPS
Co.A BANK Co.B
Aim - VARIABLE 8% 8.5% Aim - FIXED

5 lakh 7% 5 lakh MIBOR

+ 1%
Notional Amount =
5 lakh

Bank A Bank B
Fixed 7% Fixed 10%
Variable MIBOR Variable MIBOR + 1%
 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 transaction.

 The principal may be exchanged either at the beginning or at the end

of the tenure.
 Cont’d….
 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.

Direct Currency Swap Example
 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 = $1.50.

 Direct Currency Swap Example
7%
Firm A Firm B
Aim - DOLLAR
Aim - EURO 5%
$60th 7% €40th 5%

Bank A Bank B

€ 6% € 5%
$ 7% $ 8%
 CHANDIGARH UNIVERSITY
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.
 Derivative Markets in India
FINANCIAL DERIVATIVE MARKET COMMODITY FUTURE MARKET

REGULATED BY REGULATED BY

FORWARD
SEBI RBI MARKET
STOCK EXCHANGES (BSE,NSE) OVER-THE-
COMMISSION
COUNTER (OTC) ( Now merged
with SEBI w.e.f
September,2015
STOCK INDEX STOCK INDEX
OPTION FORWARD )
FUTURE FUTURE OPTION OPTION
 COMMODITY FUTURE MARKET
NATIONAL COMMODITY EXCHANGES REGIONAL EXCHANGES

16 REGIONAL EXCHANGES

NCDEX MCX NMCE ICEX ACE

DERIVATIVE MARKETS IN INDIA :

 Derivatives trading commenced in Indian market in 2000

with the introduction of Index futures at BSE, and
subsequently, on National Stock Exchange (NSE).

 Since then, derivatives market in India has witnessed

tremendous growth in terms of trading value and number
of traded contracts.
FINANCIAL DERIVATIVE MARKET
Financial derivative market in India is market where only
financial derivatives are traded i.e., equity derivatives,
currency derivatives, Bonds etc.

In India financial derivatives are traded through

established stock exchanges and over the counter which
is not a established exchange.

Stock exchanges under the financial derivative market are

BSE,NSE & Over-the-counter.
BSE (Bombay Stock Exchange) :
 The BSE created history on June 9, 2000 when it launched
trading in Sensex based futures contract for the first time.

 It was followed by trading in index options on June 1,

2001; in stock options and single stock futures (31 stocks)
on July 9, 2001 and November 9, 2002, respectively.
Currently, the number of stocks under single futures and
options is 109.
 Index Futures- Sensex June 9,2000
 Index Options- Sensex June 1,2001
 Stock Option on 109 Stocks July 9, 2001
 Stock futures on 109 Stocks November 9,2002
 Weekly Option on 4 Stocks September 13,2004
 Chhota (mini) SENSEX January 1, 2008
 Futures & Options on Sectoral indices namely BSE FMCG,
BSE Metal, BSE Bankex and BSE Oil & Gas.
NSE (National Stock Exchange)

 NSE started trading in index futures, based on popular S&P CNX

Index, on June 12, 2000 as its first derivatives product.

 Trading on index options was introduced on June 4, 2001.

 Futures on individual securities started on November 9, 2001. The

futures contracts are available on 233 securities stipulated by the
Securities & Exchange Board of India (SEBI).

 Trading in options on individual securities commenced from July 2,

2001.
The options contracts are european style and cash settled and are
available on 233 securities. Trading in interest rate futures was
introduced on 24 June 2003 but it was closed subsequently due to
pricing problem.
Derivatives contracts traded at NSE with underlying assets are-

 Index Futures- S&P CNX Nifty June 12,2000

 Index Options- S&P CNX Nifty June 4,2001
 Stock Option on 233 Stocks July 2, 2001
 Stock futures on 233 Stocks November 9,2001
 Interest Rate Futures- T – Bills and 10 Years Bond June
23,2003
 CNX IT Futures & Options August 29,2003
 Bank Nifty Futures & Options June 13,2005
 CNX Nifty Junior Futures & Options June 1,2007
 CNX 100 Futures & Options June 1,2007
 Nifty Midcap 50 Futures & Options October 5,2007
 Mini index Futures & Options - S&P CNX Nifty index January 1,
2008
 long Term Option contracts on S&P CNX Nifty Index March
3,2008
Over-the-counter
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 through
an exchange or other intermediary.
• The contract between the two parties are privately negotiated.
• The contract can be tailor-made to the two parties’ liking.
• Over-the-counter markets are uncontrolled, unregulated and
have very few laws.
• The derivative contracts traded are forward, option & swaps
which are taken between private parties ( Banks or Financial
Institutions etc. ).
Commodity Future Market
Commodity Exchanges is recognised exchange or a place where
trading of commodities takes place. Commodity Exchange was
working under the provisions of Forward Market Commission but
from Sep, 2015 it is taken over by SEBI( Securities & Exchange
Board of India). So now SEBI is the regulatory body to control the
activities of commodity exchanges
At present there are 6 National commodity exchanges and 16
regional commodity specific exchanges operating in Indian
commodity futures market. These exchanges are recognised to
regulate trading in a variety of commodities approved by
Forward Market Commission under the Forward Contracts
(Regulation) Act, 1952.
Multi Commodity Exchange of India Ltd.:-
Based in Mumbai, MCX is an independent commodity
exchange of India. It was incorporated in 2003. MCX
offers futures trading in more than 40 commodities
across various segments such as energy, bullion, metal
and various agricultural commodities.

National Commodity and Derivative Exchange Ltd.:

NCDEX was incorporated as public limited company under
the Company Act 1956 on April 23, 2003. Headquartered
in Mumbai, the exchange facilitates futures trading in
precious metals, energy, metals and agricultural
commodities
National Multi Commodity Exchange of India Ltd.:

Founded in 2002, NMCE is India’s third largest commodity

exchange. It was the first commodity exchange of India to be
granted permanent recognition by government in the 2003.

Indian Commodity Exchange Ltd.:

Incorporated in 2009, ICEX is 4th National on line derivative

exchange of India which has established a transparent, time-
tested and reliable trading platform. It has its headquarter in
Mumbai and many regional offices across the country which
cover agricultural region with a objective to encourage
farmers, traders and actual users participation to hedge their
position against the extensive price fluctuations.
ACE Derivatives and Commodities Exchange Ltd.:
ACE Derivative Exchange was set up in 2010 as fifth National
Commodity Exchange of India. It has its registered office at
Ahmadabad and corporate office at Mumbai. It facilitates
futures trading in oils & Oilseeds, pulses, Guar Gum, Sugar and
in Fiber .
The following commodities are being traded in these
exchanges.
Bullion: Gold, Siler, Platinum
Base Metals: Copper, Nickel, Lead, Zinc, etc.
Energy Products: Crude Oil, Heating Oil, Gasoline, Natural Gas
etc.
Agricultural Products: Fibre, Pulses, Vegetables &Grains, Edible
Oils, Oilseeds and Oil Cake etc
 FAQs
 Meaning and purpose of derivatives
 Names of underlying assets of derivatives.
 Factors contributing to growth of derivatives
 Advantages of derivatives
 Who is the regulatory authority of derivative markets.(SEBI)
 Applications/uses of derivatives (long question)
 Various advantages of derivatives (long question)
 in detail the various type of derivatives. (long question
FAQs
 Operators/traders involved in futures Market.
 need of speculators in derivatives market
 What is hedging?
 What is forward contract ? Explain long forward position and
short forward position.
 What is futures contract? Explain difference between forward
and futures.
 What is options contract?
 Features of options. Parties in options contract.
 What is call option and put options ? What is long call and short
call?
 What is long put and short put
FAQs
 What is European style options and american style options?
 Explain with an example when the option is in the money, out of
money and at the money?
 When the spot price and strike money are equal then what it is
called?
 When it is advantageous to exercise the contract? Prove it by
giving an example.
 When it is disadvantageous to exercise the options contract?
Prove it by giving an example.
 the difference between futures and options.
 the difference between options and swaps.
FAQs
 What are swaps? Explain its types (plain vanilla and currency
swap with examples
 What is exchange traded and over the counter markets?
 Difference between financial derivative market and commodity
futures market.
 Types of derivative markets in India
 Types of derivative exchanges in India
Question. 1
Case Case 2 Case 3 Case 4 Case 5 Case 6
1
Spot price at 80 90 100 110 120 130
expiration
Strike price 100 100 100 100 100 100
Consider the above cases of call option.
Find in each case
(i) whether the option is in-the-money, at-the-money or out-of-the-money
and (ii) value of option (to its owner) at expiration.
Case In, out or at Value
1 Out 0
2 Out 0
3 At 0
4 In 10
5 In 20
6 In 30

If the above cases are of put option.

then Find in each case
(i) whether the option is in-the-money, at-the-money or out-of-the-money
and (ii) value of option (to its owner) at expiration.
Question. 1
Case Case 2 Case 3 Case 4 Case 5 Case 6
1
Spot price at 80 90 100 110 120 130
expiration
Strike price 100 100 100 100 100 100
Consider the above cases of call option.
Find in each case
(i) whether the option is in-the-money, at-the-money or out-of-the-money
and (ii) value of option (to its owner) at expiration.
If premium is Rs.25