DERIVATIVE

Derivative is an instrument whose value is derived from another security or economic variable called
underlying assets. The underlying assets could be a stock ( for example futures on Infosys), currencies(
Dollar Futures),stock index, Futures on BSE Sensex , physical commodity ( oil Futures), interest banking
instruments ( T- bill futures).They can be either exchange traded or traded over the counter.
OVER THE COUNTER EXCHANGE TRADED
Forward Contract Futures
Financial Swaps Options
Forward Rate Agreement (FRA)

Forward Rate Agreement (FRA)
FRA is a forward contract on Interest Price.

Settlement of FRA
Actual Borrowing/Investment does not take place in FRA.
Instead FRA is considered to be a bet on some reference rate usually LIBOR or MIBOR. The one
who wins the bets gets an amount equal to present value of the Rupee difference between
Actual LIBOR and FRA rate.
These are used by borrowers or lenders to protect themselves from unfavorable changes in
interest rates.
The Buyer of FRA is safeguarded against rise in interest rates but suffers a loss if interest rates fall
The seller of FRA is safeguarded against fall in interest rates but suffers when interest rates rise.
If LIBOR > FR the seller owes the payment to the buyer, and if LIBOR < FR the buyer owes the seller the
absolute value of the payment amount determined by the formula below.

Payment=Notional Amount*(Reference Rate-Forward Rate)(FRA Days/360 or 365)
[1+Reference Rate* FRA Days/360 or 365]
Pricing and Arbitrage
The pricing of FRA is set in such a way that there is no scope for arbitrage.



FINANCIAL SWAPS
A Financial swap is a Bunch of forward contract. Here cash flows are exchanged periodically according to
a pre-defined formula. In an interest rate swap one party agrees to pay fixed interest and other party
pays floating interest on notional principal.
Financial Swaps comes in various flavors



Motives of Financial Swap
a) Swaps are designed to reduce the effective cost of preferred funding
b) Swaps are also used to convert the nature of funding
c) Swap based on comparative advantage theory

Pricing and valuation of swap
Swap price refers to the rate applicable for the fixed legs of the swap.




The price of the swap is set in such manner that Value of Swap is NIL to begin with.
V
fixed
=V
floating
Plain Vanilla
swap
This involves swapping fixed versus floating payments based on a notional
principal with netting features.
Currency
Swap
The two legs of theswap are in different currencies and based on initial
exchange rate principal amounts are fixed.howerver periodic interest
payment are without netting.
Equity Swap
One leg has to be return on equity stock or index and other leg
could befixed interest or floating interest, or return on other
equity.
Commodity
Swap
One leg would be the market price of commodity and other
would be a fixed price. The quantity shall be notional and there
is netting feature.
V
swap=
V
floating -
V
fixed
V
fixed
= PV

of the coupon and redemption discounted at market rate
V
floating
= on[RESET DATE]=Par Value

Periodic swap price =

Where d=

R= Periodic LIBOR
Valuation of Currency Swap takes is similar like valuing a normal swap. We just have to convert one leg
into another using exchange rate on the date of valuation.
Overnight Index Swap is a fixed floating swap where the floating leg is based on MIBOR compounded
daily.

FUTURES
Future are derivative instruments which involve a Standardized Contract to Buy/Sell a certain amount of
the underlying asset at an agreed upon price called future price.
Long Position : If a person buys or holds an asset , he is said to be in a Long Position . When trading in long
position contract should be bought , upside betting
Short Position : If a person sells an asset , he is said to be in a Short Position. When trading in short position
contract should be sold , downside betting.
Margin Maintenance
If there is an adverse price movement there is a possibility of default on the part of the trader. To mitigate the
same, the clearing house requires every futures trader to make a security deposit called Initial margin.
This margin balance may fluctuate due to the marking to market feature. There is a minimum margin
requirement called maintenance margin. If the margin balance on a particular day goes below the maintenance
margin , the customer has to bring in an amount called variation margin to achieve the
initial margin , also any amount over and above the initial margin is allowed to be withdrawn.
Calculation of Future Value under various situations
i)When interest is Compounded continuously
Future Value=Present Value*e
risk free rate x time to maturity expressed In years

Present Value= Future Value/ e
rt
= Future Value*e
-rt

Note :Value of e = 2.71828 ;Note :Value of Log e = .4343
ii) Securities providing With No Income
Fair Future Value =Spot Price* e
rt
iii) Securities Providing Known Cash Income(Dividend) expressed in Amount(Rs)
Fair Future Value =(Spot Price-Present Value of Expected Dividend)* e
rt
PV of Expected Dividend=Dividend* e
-rt
iv) Securities Providing Known Cash Income(Dividend) expressed in Percentage or Known Yield
Fair Future Value =(Spot Price* e
(r-y)t
Where,Y=dividend yield p.a. expressed as %
Relation between spot price and futures price
Future price are priced as per the Cost of carry model which is based on the prevention of arbitrage
principal.
As per the model
Theoretical Future Price=Spot Price+Cost of Carry
Cost of carry= Interest saved + storage cost saved-convenience yield foregone
When the cost of carry model is applied in a continuous framework i.e. , when interest rates and
dividend yield are continuously compounded , we have
F=S x e
(r-d)t

v)Securities with Storage cost expressed in Amount
Fair Future Value =(Spot Price+Present Value of Storage Cost)* e
rt
PV of storage cost=Storage cost* e
-rt
vi) Securities with Storage cost expressed in Percentage
Fair Future Value =(Spot Price* e
(r+s)t
)

Where s= storage cost p.a. expressed in%
vii)Securities with Convinience Yield expressed in amount
Fair Fair Future Value =(Spot Price-Present Value of Convinience Yield)* e
rt
PV of Convinience Yield = Convinience Yield * e
-rt

viii) Securities with Convinience Yield expressed in%

Fair Future Value =(Spot Price* e
(r-c)t
)

Where c = convenience yield p.a expressed in percentage
Note: The above valuations could have also be done by using Normal Compounding.

OPEN INTEREST
Open interest denotes number of contracts still outstanding. It is the sum total of all the long positions or
equivalently it is the sum of all short positions that has not been squared off, closed or expired. When a
new series is opened, fresh positions are entered and open interest rises.
Ex
If A buys 2 Futures& B Sells 2 futures on 1
st
Feb Open Interest is 2
If D buys 5 Futures & C sells 5 futures on 2
nd
Feb Open Interest is 2+5=7
Now on 3
rd
Feb A sells 1 Futures & C buys 1 futures Open Interest is 7-1=6

Buy Signal- Rise in future price
Sell Signal- Fall in future price
Take a lot size to be 100 if not given, however for nifty futures, lot size would be 50
Stock future Arbitrage
If the cost of carry model does not holds good (actual F not = theoretical F ), there is a clear cut arbitrage
opportunity .
Whatever be the type of arbitrage, profit will be equal to the amount of mispricing.
CONCEPT OF ARBITRAGE UNDER FUTURE MARKET:

Case Valuation Borrow/Invest Cash Future Arbitrage
Market Market
Actual FV > Fair FV Overvalued Borrow Buy Sell Cash & Carry
Actual FV < Fair FV Undervalued Invest Sell Buy Reverse Cash & Carry
* here we are assuming that arbitrageur holds one share .

Stock index futures
These are futures on well publish index like NIFTY futures, IT index futures , Bank Nifty futures.


Beta management using stock index futures
No. of NIFTY FUTURES Contracts (N) =

=Value of Portfolio (Target Beta-Beta of Portfolio)

Future Price x Lot Size x Beta of Hedging tool

Hedging refers to taking offsetting position in Index futures
i.e If you are long on a security To Hedge you should go short in Index Futures
If you are short on a security To Hedge you should go long in Index Futures

Hedging through currency future
In order to hedge a transaction exposure i.e. a known foreign currency payable/receivable , we can use
futures cover..
Foreign currency receivable
Buy Home Currency (Rupees) Future
No. of Contracts =



On the day of lifting the hedge rupee futures are squared off resulting in profit or loss in FC
Foreign Currency Payable
Sell Home Currency Futures
No. of Contracts =



Speculation through futures
OUTRIGHT Trading 1) Buy futures on a currency you feel will appreciate.
2) Sell futures on the currency you feel will depreciate
SPREAD Trading
It involves simultaneously selling and buying futures. It is non directional and less risky. It is a bet on the
spread i.e. the gap between the futures bought and futures sold.
Inter commodity spread involves buying and selling futures on the same commodity for different
maturities

Intra commodity spread involves buying and selling futures on different commodities for the same
maturity
Gain or Loss Under Futures Contract
Positon in Futures Spot Price on Expiration Profit/Loss
Long Increase Profit
Long Decrease Loss
Short Increase Loss
Short Decrease Profit

Using Futures to change the beta of the portfolio
i) Sale Future if Desired or Target Beta is less than the Existing Beta
ii) Buy Future if Desired or Target Beta is more than the Existing Beta
The number of futures contract to be taken for increasing and reducing beta to a desired level is given by the
following formula
Current Portfolio Value [ Existing Beta of the Portfolio - Desired Beta of the Portfolio]
Value of one Contract Futures

BASIS
Basis = Future Price ( the actual price that is quoted in the future market ) - Spot Price ( the price that is
quoted in the cash market )
F>S Market is said to be in Contango Basis is negative
F<S Market is said to be in backwardation Basis is positive
F=S Market is said to be in Convergence Basis is Zero

OPTIONS
An option is a derivative contract that gives the holder right to buy or sell without an obligation to do so.
The right is exercised if the price moves in favor of the option holder. The option holder (buyer) has to
pay the option premium to the option writer (seller).The price at which the option is exercised is known
as strike price.if the option holder buys or sells the underlying asset then it is said that the option is
exercised or else it is said to have lapsed.
%Which is to be hedge

Type of Options
Buyer (Holder) Seller (Writer)
Call Option Right to buy at the strike price Obligation to sell at strike Price
Put Option Right to sell at the strike price Obligation to buy at strike Price
Pays Premium Receives Premium

Only on maturity date On or before maturity date
Rght to buy an Option European Call Option American Call Option
Right to sell an Option European Put Option American Put Option

Classification of Option Contract On The Basis Of Underlying Asset
Stock Option: Option on the equity shares are known as Stock Options or Equity options. Example: Stock
Option on Infosys Ltd
Index Option: An index option is the option on the index of securities. In India we have these options on Nifty and Sensex
Interest Rate Option: This option is on interest rate. Example: Interest Rate Cap/Floor & Collar.
Currency Option: This option is on currencies.
Reason for buying Options
i) Long Call = Long on Stock Person buying this expects price of underlying to increase
ii) Long Put=Short on Stock-Person buying this expects price of underlying to decrease
iii) Short Call=Short on Stock-Person selling this expects price of underlying to decrease
iv) Short Put= Short on Stock-Person selling this expects price of underlying to Increase
Situations when Options are In/Out/At the Money
When Options are in the money holder is deemed to be having a positive pay off

Market Situation For Holder of Call Options For Holder of Put Options
Market Price> Strike Price In the Money Out of the Money
Market Price<Strike Price Out of the Money In the Money
Market Price =Strike Price At the Money At the Money

Profit/Loss in Options
In determining Profit/Loss we also take into consideration Premium paid.
For Holder of Call Options
Market Scenario Option Exercised Profit/Loss
Market Price>SellingPrice Yes Profit=MP-SP-Premium
Market Price<Strike Price No Loss= Amount of Premium Paid
Market Price =Strike Price Yes/No Loss= Amount of Premium Paid

For Holder of Put Options
Market Scenario Option Exercised Profit/Loss
Market Price>SellingPrice No Loss=Amount of Premium Paid
Market Price<Strike Price No Profit=SP-MP-Premium
Market Price =Strike Price Yes/No Loss= Amount of Premium Paid

Maximum Profit(Loss)/Breakeven Point for Option
Max Profit Max Loss Breakeven Point
Call Buyer Unlimited Amt of Premium Paid Market price =Strike
Price+Premium Paid
Call Seller Amt of Premium
Received
Unlimited Market Price=Strike
Price+Premium Paid
Put Buyer Strike Price-
Premium Paid
Premium Paid Market price =Strike Price -
Premium Paid
Put Seller Premium
Received
Strike Price- Premium Paid Market price =Strike Price -
Premium Paid

Value of an Option
Option Premium is the component of two parts: Intrinsic Value + Time Value of Money i.e. OP = IV + TVM
Intrinsic Value
It can never be negative (always equal to or greater than zero).
Intrinsic Value of Call Option= Maximum of (0, Current Market Price-Exercise Price);
Intrinsic Value of Put Option=Maximum of (0, Exercise Price-Current Market Price).
Time Value of Option: Time Value of Option is the amount by which the option price exceeds the
Intrinsic Value. i.e. TVM=OP-IV
On the expiration date, the time value of option is zero and the premium is entirely represented by the
Intrinsic Value.
Instrument Time Period Value
Call At Expiry Maximum of (Actual Market Price - Strike Price, 0)
Put At Expiry Maximum of (Strike Price - Actual Market Price, 0)
Call Before Expiry Spot Price - Present Value of Strike Price
Put Before Expiry Present Value of Strike Price - Spot Price


Hedging through Options
When buying option contract is hedged, it not only will hedge against adverse movement but it will also
allow the hedger to enjoy the favorable movement. The charge of this movement however will be the
option premium.
In case of hedging by Option selling is theoretically bad , it does not protect us from adverse movement
nor let us enjoy the favorable movement. However there will be a benefit to the extent of premium
received.
Speculation Through Options Option contracts like other derivatives can be used to make profits in
case of a particular price belief.

Three Strategies for Speculation through Option Contract are :-




Valuation of Options
Option Price = Intrinsic Price + Time Value
PUT- CALL PARITY
This is a general relationship between Value of Call and Value of Put provided it has the same exercise
price and same maturity.
P
0
+ S
0 =
C
0
+ PV of E


Where Portfolio X Protective Put Portfolio Y Fiduciary call
P
0
= Put price, S
0
= Stock Price, C
0
= Call price ,E= Strike Price
To prevent arbitrage
Synthetic
Strategies
Combines Stock with Option to result in a new option
a) Protective Put
b) Covered call writing
Combination
Strategy
Combines Call and Put to Exploit Volatile & Non Volatile Price Belief
a) Volatile Price Belief
b) Non Volatile Price Belief
Spread
Strategies
Simultaneous Buying and Selling Option, resulting in Limited Profit/Loss
a) Butterfly Spread
b) Bull and Bear Spread
Cost of Protective Put = Cost of Fiduciary Call
In Case of Dividend Paying Stock,the equation is given by
P
0
+ S
0 =
C
0
+ PV of E



Where, S
0
is Ex Dividend Stock Price= S
0
PV of Dividend Amount= S
0
/e
dt



Binomial Mode
The binomial mode breaks down the time to expiration into the potentiality a very large number of time
intervals, or steps. A tree of stock prices is initially produced working forward from the present to
expiration. At each step it is assumed that the stock price will move up or down by an amount calculated
using volatility and time to expiration.

Option Premium = Current Market Price - Amount Of Borrowing
Where, Number Of Share to be purchased: [Also referred as / Hedge Ratio/Option Delta]





=

Amount of Borrowings: B=

(^S2-C2)
r= rate of interest per option period.
Option Pricing can be explained by three methods
a) Risk-free portfolio approach

b) Replicating portfolio approach

C) Risk-neutralizing approach


RISK NEUTRAL METHOD-FOR CALL
Risk Neutral Method gives the same value of Option Premium as given by Binomial Model.

Value/Premium/Price of Call As On Today =

How to calculate probability:
Alt 1: Expected% Risk free return= (% increase in price X probability of price increase ) - ( % decrease in
price X probability of price decrease)
Expected % Risk Free Return = [% increase in price X p] - [% decrease in price X (1-p)]
Alt 2: when c.c is not used: P=



Alt 3: when c.c is used : P=



Alt 4: P=[

]
Where u = 1 + % change in asset price if prices go up i.e. S1 S
Where d = 1 + % change in asset price if prices go down i.e. S2 S
r = rate of interest per option period
Where p and (1-p) are the probability of price increase and price decrease respectively.
S = Current Market Price;
S
1
=Higher Price; S
2
=Lower Price
C
1
= Value of Call Option as on expiry at Higher Price i.e. Max [S
1
- Exercise Price, 0]
C
2
= Value of Call Option as on expiry at Lower Price i.e. Max [S
2
- Exercise Price, 0]


RISK NEUTRAL METHOD-FOR PUT

Risk Neutral Method gives the same value of Option Premium as given by Binomial Model.
Value/Premium/Price Of Put As On Today =

How to Calculate Probability : Same As Above
C
1
= Value of Put Option as on expiry at Higher Price i.e. Max [Exercise Price - S
1
, 0]
C
2
= Value of Put Option as on expiry at Lower Price i.e. Max [Exercise Price - S
2
, 0]


Black Scholes Model
The model is based on a normal distribution of underlying asset returns which is the same thing as saying
that the underlying asset prices themselves are log-normally distributed. A lognormal distribution has a
longer right tail compared with a normal , or bell-shaped , distribution. The lognormal distribution allows
for a stock price distribution of between zero and infinity (i.e. no negative prices) and has an upward bias
( representing the fact that a stock price can only drop 100% but can rise by more than 100%)



The BSM model is given by





Option Strategies
Straddles :It Involves either buying or Selling both calls and options at the same time.It can be of two types
i)Long Straddle: Buying a Call and Put at the same exercise price. This is done when trader is unsure of
direction of change in price but expects a significant movement in price.This strategy results in loss if the
price movement is little.
ii)Short Straddle:Just opposite of Long straddle.Involves sellingof call and put at same strike price.Yields profit
when prices are less volatile.
There are two break even prices for straddle strategies
(Strike Price +Premium & Strike Price Premium)
Strangle:It is similar to Straddle except that out of money Call & Put are purchased at different strike
price.This is done to reduce the cost of strategy.Here also we have long strangle and short strangle which
includes buying and selling call & Put but at different strike prices
The breakeven for Strangles is
Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid
Lower Breakeven Point = Strike Price of Long Put - Net Premium Paid
Bull Call Spread:This strategy involves buying a Call at a lower strike price and selling same number of calls at
higher strike price.This is done when a moderate rise in price is expected.
Breakeven Point = Strike Price of Long Call + Net Premium Paid
Bull Put Spread:This strategy involves selling a put at higher strike price and buying a put at a lower strike
price. The trader writes put with expectation of a moderate rise in price but safeguards himself against a
significant fall in price by buying a put at lower strike price.
Breakeven Point = Strike Price of Short Put - Net Premium Received
Bear Put Spread:This strategy involves buying a Put at a higher strike price and selling same number of put at
lower strike price.This is done when a moderate fall in price is expected.
Breakeven Point = Strike Price of Long Put - Net Premium Paid
Bear Call Spread:This strategy involves buying a Call at a higher strike price and selling same number of call at
lower strike price This is done when a moderate fall in price is expected.
Breakeven Point = Strike Price of Short Call + Net Premium Received
Butterfly Spread:The butterfly spread is a neutral strategy that is a combination of a bull spread and
a bear spread. It is a limited profit, limited risk options strategy There are 3 striking prices involved in a
butterfly spread and it can be constructed using calls or puts.
Long Call Butterfly Spread:It is entered when the investor thinks that the underlying stock will not rise or
fall much by expiration. Using calls, the long butterfly can be constructed by buying one lower striking in-
the-money put, writing two at-the-money puts and buying another higher striking out-of-the-money
put.
Upper Breakeven Point = Strike Price of Higher Strike Long Call - Net Premium Paid
Lower Breakeven Point = Strike Price of Lower Strike Long Call + Net Premium Paid
Long Put Butterfly Spread: It is entered when the investor thinks that the underlying stock will not rise
or fall much by expiration. Using calls, the long butterfly can be constructed by buying one lower
striking in-the-money call, writing two at-the-money calls and buying another higher striking out-of-the-
money call.
Upper Breakeven Point = Strike Price of Highest Strike Long Put - Net Premium Paid
Lower Breakeven Point = Strike Price of Lowest Strike Long Put + Net Premium Paid

Strip: It involves buying a number of at-the-money calls and twice the number of puts of the same with
an expectation of increased volatility and more likely significant downward fall in price in underlying
A strip strategy has 2 breakeven points
Upper Breakeven Point = Strike Price of Calls/Puts + Net Premium Paid
Lower Breakeven Point = Strike Price of Calls/Puts - (Net Premium Paid/2)
Strap: It involves buying a number of at-the-money puts and twice the number of calls of the same with
an expectation of increased volatility and more likely significant upward rally in price in underlying
A strap strategy has 2 breakeven points
Upper Breakeven Point = Strike Price of Calls/Puts + (Net Premium Paid/2)
Lower Breakeven Point = Strike Price of Calls/Puts - Net Premium Paid



Table - Strategies using Hybrid option combinations
Strategy Calls Puts
Straddle Buy 1 Call Option
Buy 1 Put of same
exercise price
Strangle Buy 1 OTM Call Buy 1 OTM Put
Bull Spread
Buy 1 Call Option
Sell 1 Call Option of
higher Exercise price
---
Bear Spread ---
Buy 1 Put Option
Sell 1 Put Option of
Lower Exercise price
Butterfly Spread
Buy 1 ITM Call
Sell 2 ATM Calls
Buy 1 OTM Call
---
Strip Buy 1 Call Buy 2 Put at same exercise price
Strap Buy 2 Call Buy 1 Put at same exercise price






Synthetic Futures Using Options
Synthetic Long Futures can be constructed by going Long Call & Short Put on same exercise price
Synthetic Short Futures can be constructed by going Long Put & Short Call on same exercise price
Option Geek Parameters
(a) Delta ( Sensitivity to Change in Price of the Underlying Asset ) : Delta is a measure of sensitivity of the price of
an option to a unit change in the price of the underlying asset. Delta is always positive for Call and Negative for
Put. Far out-of-the-money options have delta values close to 0 while deep in-the-money options have
deltas that are close to 1.
It is Calculated as Change in Option Premium
Change in Price of Underlying
(b) Gamma ( Sensitivity to Change in Delta ) : It is a measure of the rate of change of the delta with respect to
the price of the underlying asset.
It is Calculated as Change in Delta
Change in Price of Underlying
(c) Vega ( Sensitivity to Change in Volatility of Asset Price ) : It is a measure of impact of changes in the underlying
volatility on option price in simple words it is the measure of rate of change in option price with respect to the
percentage change in volatility of the underlying assets price.
It is Calculated as Change in Option Premium
Change in Volatility of Price
(d)Theta ( Sensitivity to Change in Time to Expiry ) : It is the rate of change in value of the option with respect to time to
maturity.It is the measurement of Options Time Decay
It is Calculated as Change in Option Premium
Change in Time to Expiry
(e) Rho ( Sensitivity to Change in Interest Rate ) : It is the rate of change in option price with respect to change
in interest rate
It is Calculated as Change in Option Premium
Change in Rate of Interest