Derivatives

We would have heard a lot about Derivatives & Derivatives Trading. But not many of us are very sure about what a Derivative is. This article is an attempt to help you learn about Derivatives. The word 'Derivative' in Financial terms is similar to the word Derivative in Mathematics. In Maths, a Derivative refers to a value or a variable that has been derived from another variable. Similarly a Financial Derivative is something that is derived out of the market of some other market product. Hence, the Derivatives market cannot stand alone. It has to depend on a commodity or an asset from which it is derived. The price of a derivative instrument is dependent on the value of the asset from which it is derived. The underlying asset can be anything like stocks, commodities, stock indices, currencies, interest rates etc. As you know, the financial markets come with a very high degree of risk/volatility. By using the derivative products, it is possible for us to partly or fully reduce the risk and to reduce the impact of fluctuations in the asset prices. Let me explain how derivatives are used with a real time example... Say, you go to an electronics shop to buy a TV. After searching around you decide on a model which costs Rs. 25000/-. The shop owner says that he would be able to deliver the TV to your house in one week if you place an order with a small initial amount today. Once the shop owner delivers the TV you are expected to pay the full amount. This is effectively a "Forward" contract where you are agreeing to the terms of delivery and a payment in a future date. Say, I go to another electronics shop to buy a TV. After searching around I decide on a model that costs Rs. 26000/- Though I like the model I am not too sure if this is the best model for me and at the same time I am predicting the price of TV sets to come down in one week. Along with this I am also worried that if I do not buy this TV, somebody else may buy it. Thus, I talk to the salesman to put aside this TV for two weeks so that I can arrange cash and come for purchase. The salesman in return asks for a small non refundable deposit which I pay to block the TV in my name. If the price of the TV falls then I may not opt to buy the same TV but if I want I can always walk in to the shop after a few days make the payment and take the TV. This is effectively an "Options" contract, wherein I have the option of executing it at my will and wish. The shop owner took a non refundable deposit, which is to compensate for the few days that he may have to hold on to his item without selling it. Even if I do not go to buy the TV he would have made a meager profit.

The Important Categories of Derivatives:

The Derivative products can be categorized into the following main types: 1. Forwards 2. Futures

3. Options 4. Swaps 5. Warrants and 6. Leaps & Baskets

Use of Derivatives:
Hedging: One main use of Derivatives is as a tool for transferring/reducing risk on a commodity/item. Say you are a manufacturer who uses Rice as the ingredient in your product. You would not want the price or availability of Rice to affect your production in any way. You can decide to enter into a contract with a Rice farmer to buy a specified quantity of Rice in a future date say after 3 months at a specified price. Here you are hedging to reduce your risk of availability. The farmer would also be avoiding a risk of lack of prospective buyers. By entering into agreement with you, he has reduced that risk and he has a buyer who would be buying his product on the agreed date at the agreed price. Of course there are some external factors that may cause the agreement to become null. For e.g., if due to a flood all his crops are destroyed, you cannot expect the farmer to honour the agreement. Similarly if you go bankrupt the farmer would have to find a new buyer for his products. So Derivatives can act as a tool to mitigate risk but it cannot help us avoid it altogether. Also this risk reduction will happen only between the two parties who are entering into the agreement. Any other manufacturer may end up without rice supplies or any other farmer may end up without buyers.

Types of Derivatives:
1. OTC (Over The Counter) OTC Derivatives are contracts that are traded/negotiated directly between the contracting parties. The OTC Derivative market is the largest market for derivatives and it is also the most unregulated. There is always an inherent risk of either of the parties not honouring the agreement. 2. ETD (Exchange Traded Derivatives) ETD are those that are traded via regulated/specialized trading exchanges. A derivative exchange acts as the intermediary for all transactions and requires an initial margin to be put up by both the parties of the trade to serve as a guarantee. In India NSE is one of the largest ETD exchange.

Problems with Derivatives:

1. Possibility of Huge Losses - The unregulated use of Derivatives can result in huge losses due to the use of Leverage or Borrowing. It is a well known fact that Derivatives allow investors to gain huge sums of money from small movements in the underlying asset's price. However, investors can lose huge amounts of money if the asset moves in the opposite direction. There have been a lot of instances where investors have lost significant amounts of money due to Derivatives. 2. Counterparty Risk - This is the risk that arises if either of the contracting parties fails to

honour his end of the contract. This is very common in OTC Derivative products. 3. Posing high risk to small/inexperienced investors - Since the Derivative markets give an opportunity for an individual to earn huge profits, its often lucrative to small/inexperienced investors as well. Speculation in the Derivatives market requires great knowledge of the market and the future price movements on the asset over which the derivative is formed to ensure profit. This is the reason why small investors are generally advised to stay away from them... There are a large number of Derivative categories. Covering all that in this article would make this too big to read. Hence I would be posting a new article that explains only about those categories.

Derivative Categories
A Derivative is a financial product that is derived out of the value of an underlying asset. Derivatives are very popular and are widely used financial instruments. Derivative products can be classified into the following main types: 1. Forwards 2. Futures 3. Options 4. Swaps 5. Warrants 6. Leaps & 7. Baskets Out of these Futures & Options are actively traded on organized stock exchanges whereas Forwards are traded in OTC Exchanges.

Forwards Contract:
A forward contract is the simplest of the Derivative products. It is a mutual agreement between two parties, in which the buyer agrees to buy a quantity of an asset at a specific price from the seller at a future date. The Price of the contract does not change before delivery. These type of contracts are binding, which means both the buyer and seller must stay committed to the contract. This means they are bound to deliver or take delivery of the product on which the forward contract was agreed upon. Forwards contracts are very useful in hedging. Important Characteristics of Forwards Contracts:

1. They are Over the counter (OTC) contracts 2. Both the buyer and seller are bound by the contractual terms 3. The Price remains fixed

Limitations of Forwards contracts: 1. Lack of centralized trading. Any two individuals can enter into a forwards contract 2. Lack of Liquidity 3. Counterparty risk - The case wherein either the buyer or seller does not honour his end of the contract.

Futures Contract:
A futures contract is an agreement to buy or sell an asset at a certain time in the future at a specific price. The Contractual terms of the futures contracts are very clear. The Futures market was designed to solve the shortcomings in the forwards contracts. Unlike forwards, futures are traded in organized exchanges. They also use a clearing house that provides the necessary protection to both the buyer and the seller. The price of the futures contract can change prior to delivery. Hence, both participants must settle daily price changes as per the contract values. An Example of a futures contract would be an agreement to 100 tonnes of Steel at Rs. 10000/per tonne at some date say in December 2008. If no interim payments are made and if the price of Steel moves violently, a considerable credit risk could build up. To avoid this a margin system is used by the exchanges. As per the margin system, both parties must deposit a small sum with the exchange. This amount will be a small percentage of the total contract. This amount is called the initial margin. As the steel value changes, the contract value also changes. If the contract value changes, the margin must be topped up by an amount corresponding to the change in price of steel. The margin money is the property of the person who deposits it and would be returned to them if the contract gets cancelled/completed. Characteristics of Futures contract: 1. They are traded in organized exchanges 2. Credit risk is eliminated with the margin system. Both parties deposit a portion of the contract with the clearing house. 3. Both the buyer and seller are bound by the contract terms and are expected to honour their end of the contract.

Options Contract:
An options contract is nothing but the right to buy or sell something at a specified price within a period of time. The feature of the options contract for a buyer is that, the buyer has the right to buy, but he may choose to buy or may even choose to cancel the contract. Hence the buyers

maximum loss is only the initial amount that was paid to gain the rights. Unlike buyers, the options contracts for sellers is an obligation. If a seller enters into an agreement, he has to deliver the asset on the specified date and the price agreed upon. Thus the loss for a seller could be much worse. The right to buy is called a "CALL" option while the right to sell is called a "PUT" option. Please note that an option is only a right to do something. It is not an obligation to carry out the action. For a buyer it is only a right and not an obligation, but for a seller it is an obligation. For Example, you want to buy Gold. You form an options contract with a Gold merchant to buy 1000 grams of Gold at the rate of say Rs. 1000/- per gram of gold on December 1st 2008. The total value of the contract would sum up to 10,00,000/- (10 lacs) As part of getting into the contract you make an initial payment of say 2% of the contract value to the merchant. You make a payment of Rs. 20 thousand (Rs. 20,000/-) and the contract gets formed. Now you are the buyer and the merchant is the seller. Now there could two possible scenarios: 1. Assuming on 1st December the price of gold is Rs. 1050/- per gram, then to buy thousand grams of gold you would need Rs. 10,50,000/- rupees which is Rs. 50,000/- more than your options contract. Hence if you exercise your right to buy, you stand to make a profit of Rs. 50,000/- At the same time, the seller has an obligation since he has agreed on the contract and he has to sell the gold to you at a loss of Rs. 50,000/- when compared to the market rate. 2. Assuming on 1st December the price of gold is Rs. 950/- per gram, then to buy thousand grams of gold you would need Rs. 9,50,000/- which is Rs. 50,000/- less than your options contract. Hence if you exercise your right to buy, you stand to lose Rs. 50,000/- You can buy the same quantity of gold in the market at a lesser price. Hence you can choose to let your contract expire and limit your losses to only Rs. 20,000/- The Seller on the other hand does not make any transaction but still stands to keep the Rs. 20,000/- you paid him to form the contract. This 1000 rupees per gram that you agreed upon with the merchant is called the "Strike" Price. The initial deposit of Rs. 20,000/- you paid him is called the "Option premium". Partcipants in an Options market: 1. Buyers of Calls 2. Sellers of Calls 3. Buyers of Puts 4. Sellers of Puts People who buy options are called "Holders" and those who sell options are called "Writers" Call Holders and Put Holders (The Buyers) are not obligated to buy or sell. They have the right to do so if they wish. Similarly Call writers and Put Writers (The Sellers) are obliged to buy or sell. This means that they need to buy or sell if the Call holder decides to exercise his right to

buy. Characteristics of Options Contracts: 1. Unlike other derivative products that are price fixing contracts, options are price insurance type of contracts 2. Options have been basically OTC products. But of late, due to its popularity, exchange traded options are also being widely used. 3. The options are very favourable to the Holders or the Buyers. Widely used terms in Options contracts: In-the-Money - An ITM option is one that would lead to a positive cash flow to the holder if it were exercised immediately. For e.g., If you have an options contract to buy shares of XYZ limited at Rs. 100/- per share and it is currently trading at Rs. 120/- per share then your options contract is said to be In the Money. At-the-Money - An ATM option is when the prevailing price of the asset and your option price are more or less same. Out-of-the-Money - An OTM option is when the prevailing price of the asset is lesser than the option price. An Example call Option with respect to the Share Market: You buy 10 call options for the company XYZ pvt ltd, at the strike price of Rs. 325/- at a premium of Rs. 10 per option. The option is valid till 30th Oct 2008. Two things can happen here: 1. You can make a profit: Say on the date of expiry the share of XYZ pvt ltd is trading at Rs. 380/- per share, then you can opt to exercise your call option. Hence you would be getting 10 shares of XYZ ltd at Rs. 325/which you can sell at Rs. 380/Your Input cost per share = 325 Premium per share = 10 Market value during Selling = 380 Your Profit per share = 380 - (325+10) = Rs. 45 /Net Profit = Rs. 450/Here Rs. 325 is the Strike price and Rs. 380 is the spot price.

2. You can incur a Loss:

Say on the date of expiry the shares of XYZ pvt ltd is trading at Rs. 275/- per share, then you can opt to let the contract expire. Since you are the buyer or the call holder you can opt to either buy or let the contract expire. Since the share is available in the market at a lesser price than the strike price, it is not wise to exercise the option. Hence you ignore it. Your input cost = Rs. 10/- (The premium you paid per option) Loss incurred = Rs. 100/- (Because you do not make any other payment apart from the premium) Loss you would have incurred if you had exercised the option: Cost per share = 325 Premium per share = 10 Market value during selling = 280 Your loss per share = (325+10) - 280 = Rs. 55/Net Loss: Rs. 550/Incurring a loss of Rs. 100/- is better than incurring a loss of Rs. 550/- hence your decision of letting the contract expire was a wise decision.

An Example Put Option with respect to the Share Market: You buy 10 put options for the company XYZ pvt ltd, at the strike price of Rs. 300 per share at a premium of Rs. 10 per option. The option is valid till 30th Oct 2008. Two things can happen here: 1. You can make a profit: Say on the date of expiry, the shares of XYZ is trading at Rs. 265/- per share, then you can opt to exercise your contract. You can buy 10 shares of XYZ from the market and then sell your shares to the option writer since he has an obligation to buy if you intend to sell. Your premium = 10 Your input cost per share = 265 Price at which the Put option is exercise = 300 Profit per share = 300 - (265 + 10) = 25

Net Profit = Rs. 250/2. You can make a Loss: Say on the date of expiry, the shares of XYZ is trading at Rs. 325/- per share, then you can opt to let the contract expire. Since the share is trading at a price more than the option price, you can choose to let the contract expire. Your premium = 10 Loss incurred = Rs. 100/- (The premium paid) Even in this case, this loss would be compensated by the fact that you can sell off the shares that you have in the market at a higher price than the option strike price.

Swaps:
A Swap is an agreement between two parties to exchange future cash flows according to a predefined formula. These streams of cash flow are called the "Legs" of the swap. Usually, when the swap contract is formed at least one of these series of cash flows are determined by a random or uncertain value like interest rate or equity price etc. Most swap contracts are traded OTC which are tailor made for the counterparties. Some are also traded in organized exchanges. The five generic types of swaps are: 1. Interest rate swaps 2. Currency swaps 3. Equity swaps & 4. Commodity swaps Interest Rate Swaps: In Interest rate swaps, each party agrees to pay either a fixed or a floating rate in a particular currency to the other party. The fixed or floating rate is multiplied with the Notional Principal Amount (NPA) say Rs. 1 lac. This notional amount is not exchanged between the parties involved in the Swap. This NPA is used only to calculate the interest flow between the two parties. The most common interest rate swap is where one party 'A' pays a fixed rate to the other party 'B' while receiving a floating rate which is pegged to a reference rate like LIBOR. LIBOR - London Inter Bank Offer Rate For e.g., a Swap arrangement between two people could be like, 'A' pays a fixed rate of 3% to 'B'

on a principal of Rs. 1 lac every month and 'B' in turn would pay 'A' at the rate of LIBOR + 0.5%. The cash flow that 'B' can expect from 'A' is fixed whereas the value that 'A' would receive would vary based upon the LIBOR. If the LIBOR that month is 2% then 'A' would receive an interest of 2.5% that month. The fixed rate of 3% is termed as the 'Swap Rate' Note: The LIBOR is taken as just an example. The swaps may be pegged with any reference rate that is common to both parties. At the point of Initiation of the Swaps the swap is priced in such a way that the "Net Present Value" is '0'. If one party wants to pay 50 bps (Basis points or 0.5%) above the Swap rate, then the other party may have to pay the same 50 bps above LIBOR Net Present Value - NPV is defined as the total present value of a series of cash flows. The term NPV is used widely in the financial terms and it is used by people to decide on whether to invest in an instrument or not. A NPV > 0 indicates a good investment opportunity and a NPV < style="font-style: italic;font-size:130%;" >Currency Swaps: The Currency Swap involves exchanging principal and fixed rate interest payments on a loan in one currency for principal and fixed rate interest payments on an equal loan in another currency. Just like interest rate swaps, the currency swaps also are motivated by comparative advantage. Unlike Interest rate swaps, currency swaps include payment of Principal amount as well. For e.g., - Party 'A' Receives a 8% rate of interest on Rs. 1 crore every 6 months - Party 'B' Receives a 11% interst on USD $25,00,000/- Cash flow is exchanged every 6 months for 5 years - Principal amount is exchanged at both the beginning and end of the contract.

Equity Swaps:
An Equity Swap is a special type of swap where the underlying asset is a stock or a group of stocks or even a stock market index. The key differentiator in equity swaps is the fact that the floating leg of the payment is dependent on the performance of the underlying stock. One party would receive fixed amounts regularly while the other would receive a payment depending on the performance of the Stock upon which the Equity swap is created.

Commodity Swaps:
A commodity swap is similar to Equity swaps wherein the floating payment would depend on the price of the underlying commodity. for e.g., A commodity swap may be created on Gold. Party 'A' would receive fixed payments from 'B' every month, whereas the payment 'B' received would vary every month based on the price movement of Gold in the market. A vast majority of commodity swaps use "OIL" as the underlying commodity.

Warrants:

Options generally have a life of upto One year. Most options that are traded on exchanges have a life of 9 months. Longer dated options are called Warrants and are generally traded OTC. A Warrant is a certificate issued to a buyer who is entitled to buy a specific amount of securities at a specific price (Usually greater than the current market price) for an extended period which may range from a few years to more... In the case where the price of the security is more than the Warrant's exercise price, the holder of the warrant can exercise his right to buy it and sell it in the open market and make a profit. If the warrant does not get used, it would just expire or remain unused until the life of the Warrant.

LEAPS:
Leaps stand for - Long Term Equity Anticipation Securities. These are options that have a maturity of upto 3 years. Usually the Equity Leaps would expire in January. For e.g., if you want to buy an equity leap this month Oct 2008, it may expire in Jan 2009, 2010 or 2011. Here the contracts that expire in 2010 and 2011 may be considered as Leaps due to the maturity duration. The further the expiration date, the costlier the Leap.

Baskets:
A Basket is an economic term for a group of several securities created for the purpose of simultaneous buying/selling. For e.g., Index funds can be considered as a basket of all securities that are listed in a particular Exchange weighted appropriately.