Introduction to Derivatives

Dr Jaideep Jadhav

Why study Derivatives?

By far the most significant event in finance during the past
decade has been the extraordinary development and
expansion of financial derivatives...

These instruments enhance the ability to differentiate risk

and allocate it to those investors most able and willing to
take it - a process that has undoubtedly improved
national productivity growth and standards of living.
-Alan Greenspan, Chairman, Board of Governors of the Federal Reserve
System

Source: BIS, http://imarticus.org/wp-content/uploads/2015/03/financialservices-q4-1.compressed.pdf

Business Growth in Derivatives segment

Note: Notional Turnover = (Strike Price + Premium) * Quantity
Index Futures, Index Options, Stock Options & Stock Futures were introduced in June 2000, June 2001, July 2001 and November 2001 respectively

Year

Index Futures
No. of
Turnov
contracts er
( cr.)

Stock Futures
No. of Turnov
contract er
s
( cr.)

2012-13

35496604

2011-12

146188740

2010-11

165023653

2009-10

178306889

2008-09

210428103

2007-08

156598579

2006-07

81487424

2005-06

58537886

40727273 1044627.
51
15834461 4074670.
7
73
18604145 5495756.
9
70
14559124 5195246.
0
64
22157798 3479642.
0
12
20358795 7548563.
2
23
10495540 3830967
1
1513755 80905493 2791697

2004-05

21635449

772147

47043066 1484056 3293558

2003-04

17191668

554446

2002-03

2126763

2001-02
2000-01

853453.4
7
3577998.
41
4356754.
53
3934388.
67
3570111.
40
3820667.
27
2539574

Index Options Stock Options Total

Average Daily
No. of Notiona No. of Notiona No. of
Turnover Turnover
( cr.)
contract l
contract l
contracts ( cr.)
s
Turnov s
Turnov
er
er
( cr.)
( cr.)
244953528 6287824. 14343757
29
864017736 22720031 36494371
.64
650638557 18365365 32508393
.76
341379523 8027964. 14016270
20
212088444 3731501. 13295970
84
55366038 1362110. 9460631
88
25157438 791906 5283310

386091.3
0
977031.1
3
1030344.
21
506065.1
8
229226.8
1
359136.5
5
193795

335521162 8571996.43

1,15,837.79

120504546
4
103421206
2
679293922

31349731.7
4
29248221.0
9
17663664.5
7
657390497 11010482.2
0
425013200 13090477.7
5
216883573 7356242

125902.54

12935116 338469

5240776

180253

157619271 4824174

121943

5045112

168836

77017185

2546982

32368842 1305939 1732414

52816

5583071

217207

56886776

2130610

43952

10676843 286533

442241

9246

3523062

100131

16768909

439862

1025588

21483

1957856 51515

175900

3765

1037529

25163

4196873

101926

90580

2365

90580

2365

19220
10107
8388
1752
410
11

115150.48
72392.07
45310.63

52153.30
29543

Crude Oil Prices ( 2008-2012)

Source: wsj.com

Jaideep Jadhav

Derivatives

Derivative is a product whose value is derived from the value

of one or more basic variables, called underlying. The
underlying asset can be
Equity
Index
Foreign exchange (FX)
Commodity or any other asset
Hedging devices against fluctuations in commodity prices &
commodity-linked derivatives remained the sole form of such
products for almost three hundred years
Came into spotlight in post-1970 period due to growing
instability in the financial markets

Forms of Derivatives

Forwards
Futures
Options
Swaps

Derivative Contracts

Over the Counter (OTC)

Customized

Exchange traded

Standardized

Key Terms

Agreement or an Option
Buy or Sell
Price: Exercise Price (Strike Price)
Time: Expiry Date
Premium
Long vs Short Position
American vs European Options

History of Derivatives
Mahabharata

(Option)

1st Party Duryodhana

2nd Party Yudhishtir

Draupadi
Expiry End of the game of dice
Premium Shame
Underlying

Ending the Introduction with a Word of Caution

A Derivative is like a razor. You can use it to

shave yourselfOr you can use it to commit
suicide.
James Morgan, a coloumnist for the FT

Forward Contracts

A forward contract is an agreement to buy or

sell an asset at a certain price at a certain
future time
Forward contracts trade in the over-thecounter market
They are particularly popular on currencies
and interest rates

FUTURES

History of Futures Market

Futures contract evolved out of the forward

market.

Enabled participants to sell/buy products well

before delivery dates

History of Futures Market

This market came into existence when a

centralized exchange was created (CBOT)

The purchase & sale is channeled to a central

location where all purchase and sales orders are
executed between two brokers

Contracts started trading in secondary

markets, allowing buyers and sellers to
manage risk

Exchanges Trading Futures

Chicago Board of Trade

Chicago Mercantile Exchange
London Intl financial futures exchange ( LIFFE )
Eurex (Europe)
BM&F (Sao Paulo, Brazil)
TIFFE (Tokyo)
NSE & BSE (India)
NCDEX & MCX (India)

Futures exchange

Not-for-profit association of members

Sole function is to provide facilities for members to

conduct trading activities in a fair and equitable
manner

Does not buy or sell futures for its own account

Does not determine prices for futures

Futures exchange

Exchange memberships (seats) are owned

by individuals

Only members of the exchange can transact

orders on the exchange floor.

Ambience of the
Marketplace

Trades occur by open outcry of the floor

traders

Traders stand in a sunken pit and bark their

offers to buy or sell at certain prices to others
Traders often use hand signals to signal their
wishes concerning quantity, price, etc.
On the pulpit, representatives of the
exchanges Market Report Department enter
all price changes into the price reporting
system

Ambience of the
Marketplace (contd)

The perimeter of the exchange is lined

with hundreds of order desks, where
telecommunications personnel from
member firms receive orders from clients

NYMEX

Trading Pit

Trading Pit

Automated Trading

Futures Contracts

A futures contract is an agreement to buy or sell an

asset at a certain time in the future for a certain price
Similar to forward contract, except that forward contract
is traded OTC and futures contract is traded on an
exchange.
By contrast in a spot contract there is an agreement to
buy or sell the asset immediately (or within a very short
period of time)
Presently Index futures on S&P CNX NIFTY, Bank
NIFTY and CNX IT , Stock futures on certain specified
Securities (216) & Interest Rate Futures are available
for trading at NSE
All the financial futures contracts are settled in cash

Futures Price

The futures prices for a particular contract is

the price at which you agree to buy or sell
It is determined by supply and demand in the
same way as a spot price

Nupur Hetamsaria

Newspaper

Futures
Delivery Month

All contracts of a month expire on the last

Thursday of the month.

Open high low close

Value
No of contracts

Futures

Exchange traded
Subject to little or no risk
Standardized (Terms are not negotiable)
Quantity (Contract size)
Expiration Date
Underlying Asset and its Quality (Basis Grade)
Delivery point (Location)
Trading Hours
Tick Size ( Min. Price Fluctuation)
Daily Limits ( limits specified by Ex to prevent large
fluctuations due to speculations and protect interest of
traders)
The only term established by the buyer/seller is the price.

HEDGING OR
RISKMANAGEMENT

Executive
Summary

RISK

Forwards

option

Future

Derivatives

swaps

Derivatives are modern financial instruments in hedging or risk management.

Futures Contract Liquidity

By offering homogenous contracts (versus

customized forwards) more individuals will find it as
an acceptable risk management instrument

Increased trading will attract other who wish to

participate in the secondary futures market.

Liquidity breeds liquidity

Who would trade in Futures?

Futures trading will be of interest to those who wish to:
1) Price Risk Transfer- Hedging
2) Invest- Speculating
3) Arbitrage

4) Leverage

Leverage
Shares Stock ( F& O)
Initial Price

250

260

Initial Investment
(Margin)
Squaring price

250

39

260

270

Net gain

10

10

4.00%

25.64%

ROI

Terminology

The party that has agreed to buy has a long

position
The party that has agreed to sell has a short
position
If held until expiration delivery or cash settlement
will occur
However this depends on the rules of the
contract set by the exchange

Clearinghouse
.
Forwards Market
Buyer

Funds

Seller

Goods
Futures Market
Buyer

Funds
Goods

Clearing
House

Funds
Goods

Seller

Clearinghouse

Guarantees performance on all futures obligations

Adopts the position of buyer to every seller and seller to

every buyer

Membership requirements for a clearing house are

stringent in regard to integrity and and financial
status.

Futures Trading

When a party enters a futures contract a

deposit must be made with the clearing
house

Referred to as the initial margin requirement

Margin

The primary purpose of margin is to provide a

financial safeguard to ensure traders will
perform on their contractual obligations

The amount of margin may vary from contract

to contract and broker to broker

Initial Margin

Both buyer and seller must conform

Clearinghouse sets base requirements

Usually equal to the maximum allowable

daily fluctuation of the contract.

Maintenance Margin

As the price of the underlying changes the

long and short are required to deposit
addition margin as the value of their position
depreciates

The amount of margin required is called the

maintenance margin

Maintenance Margin

Calculated based on the daily settlement of

the contract

Also referred to marking-to-market

Generally about 75% of the initial margin

Maintenance Margin

When the trader is required to replenish the margin

account this is referred to as a margin call

The additional amount the trader must deposit is

known as the variation margin

Must be deposited before the open on the following

day of trading

Margin Example

Assume that the initial margin on a wheat

contract is $0.20 per bushel and the
maintenance margin is $0.15 per bushel.

The contract size is 10,000 bushels

A trader must post $2000 per contract

Margin Example

The trader buys (long) 1 contract and makes

a deposit of $2000.

The price closes down $0.03, reducing the

traders equity to $0.17 per bushel or $1700

Since the equity is in excess of the

maintenance margin no action need be taken

Margin Example

On the following day of trading, the price

closes down another $0.03, reducing the
traders equity to $0.14 per bushel or $1400

The trader will be required to deposit $600 of

variation margin. Enough to increase the
balance back to the initial margin.

Margin Settlements

Margin settlements covering a large portfolio

may be significant.

Profits and losses are realized each day

This daily settlement contributes to the

reduced risk inherent in futures

Financial Markets (pages 89-90)

Exchange traded

Traditionally exchanges have used the open-outcry system,

but electronic trading has now become the norm
Contracts are standard; there is virtually no credit risk

Over-the-counter (OTC)

A computer- and telephone-linked network of dealers at

financial institutions, corporations, and fund managers
Contracts can be non-standard; there is some credit risk

Financial Futures Markets

Forwards Market

Location

Futures Exchange

No fixed location (or OTC)

Size of contract

Fixed (Standard)

Depends on the terms of contract

payment Fixed (Standard)

Depends on the terms of contract

Maturity/
date

Counterparty

Clearing house

Market place

Central exchange floor with worldwide Over

the
telephone
worldwide network
network

Valuation

Marked-to-market everyday

No unique method of valuation

Variation margins

Daily

None

Regulations
in trading

Regulated
concerned

Credit risk

Almost non-existent

Depends on the counterparty

Settlement

Through clearing house

Depends on terms of contract

Liquidation

Mostly by offsetting the positions; Mostly settled by actual delivery.

very few by delivery
Some by cancelation at a cost

Transaction costs

Direct costs such as commission, Direct costs are generally low,

clearing charges, exchange fees are indirect costs are high in the form
high; indirect costs, bid-ask spreads of high bid-ask spread.
are low.

by

Known bank or client

the

with

exchanges Self-regulated

OPTIONS

OPTIONS
Hyundai

is launching SONATA
Price is Rs 15 Lakh
You can book the car by paying
Rs 50K

OPTIONS

contd

By booking the car, what have you

bought?
When booking matures, can Hyundai
force you to buy SONATA?
Can you force Hyundai to sell
SONATA?

OPTIONS
gives

the buyer the right

Not the obligation
To buy or sell
A specified underlying
At a set price
On or before a specified date

Call Option
A call option gives the holder ( buyer ), the right to buy specified quantity
of the underlying asset at the strike price on or before expiration date. The
seller however, has the obligation to sell the underlying asset if the buyer of
the call option decides to exercise his option to buy.
Ex. An Investor buys one call option on Infosys at the strike price of Rs.3500
at a premium of Rs.100. If the market price of Infosys on the day of expiry
is more than Rs.3500, the option will be exercised. The Investor will earn
profits once the share crosses Rs.3600 (Strike Price + Premium i.e
3500+100). Suppose stock price is Rs.3800, the option will be exercised
and the investor will buy 1 share of Infosys from the seller of the option at
Rs.3500 and sell it in the market at Rs.3800 making a profit of Rs.200
(Spot price-Strike price-premium).
In another Scenario, if at the time of expiry stock price falls below Rs.3500
say suppose it touches Rs.3000, the buyer of the call option will choose not
to exercise his option. In this case the investor loses the premium (Rs.100),
paid which shall be the profit earned by the seller of the call option.

Strike Prices
In-the-money
Option

with positive cash flow

At-the-money
Exercise

Out-of Option

(ITM)
(ITM)

Price = Market Price

the-money (ITM)
with negative cash flow

Strike Prices
In-the-money

(ITM)

- Option with positive cash flow

At-the-money

(ATM)

- Exercise Price = Market Price

Out-of-the-money

(OTM)

- Option with negative cash flow

In -of-The Money-Calls
950 1050
1150

At-The-Money Strike Out -of-The Money-Calls

1250
1350
1450
1550
Spot Price

950

1050

1150

Out -of-The Money-Calls

1250

1350

1450

At-The-Money Strike In-of-The Money-Calls

1550

Contd..
Expiration

Date

- Last date for exercising the option

or the date on which option expires
Exercise

Date

- Date on which the option is actually

exercised

Contd..
-

Assignment
When the holder of an option exercises his right to
buy/ sell, a randomly selected option seller (at the
client level) is assigned the obligation to honor the
underlying contract
Open Interest
- The total number of options contracts
outstanding in the market at any given point of
time

Buying of a Call Option

View: Bullish
Buy a one month Nifty Call

With the Strike of 1250

Premium of Rs 100

NiftySpot

Value of
1250 call
Premium
Paid
Net Profit/
Loss

1000
Below
Strike
0

1100
Below
Strike
0

1200
Below
Strike
0

1250
At Strike

1350
1400
Break Even Above
Strike
100
150

1500
Above
Strike
250

-100

-100

-100

-100

-100

-100

-100

-100

-100

-100

-100

50

150

Net Profit/ Loss

200

150

100

50

0
1000

1100

1200

1250

-50

-100

-150
Net Profit/ Loss

1350

1400

1500

Selling of a Call Option

View: Bearish
Sell / Write a one month Nifty Call

With the Strike of 1250

Premium of Rs 100

NiftySpot 1000
Below
Strike
Value of 0
1250 call

1100
Below
Strike
0

1200
Below
Strike
0

1250
At Strike
0

1350
Break
Even
-100

1450
Above
Strike
-200

1550
Above
Strike
-300

Premium
Received

100

100

100

100

100

100

100

Net
Profit/
Loss

100

100

100

100

-100

-200

Net Profit/ Loss

150

100

50

0
1000
-50

-100

-150

-200

-250

1100

1200

1250

1350

1450

1550

Put Option
A put option gives the holder (buyer) the right to sell specified quantity of
the underlying asset at the strike price on or before a expiry date. The seller
of the put option however, has the obligation to buy the underlying asset at
the strike price if the buyer decides to exercise his option to sell.
Ex. An Investor buys one put option on Reliance at the strike price of Rs.300
at a premium of Rs.25. If the market price of Reliance, on the day of expiry
is less than Rs.300, the option can be exercised. The investors Break even
point is Rs.275 (Strike price-premium paid) i.e., investor will earn profits if
the market falls below 275. Suppose stock price is Rs.260, the buyer of the
put option immediately exercises his option selling the Reliance share at
Rs.300 to the option writer thus making a net profit of Rs.15 (Strike price
Spot price Premium paid)
In another Scenario, if at the time of expiry, market price of Reliance is
Rs.320, the buyer of the option will choose not to exercise his option to sell
as he can sell in the market at a higher rate, In this case the investor loses
the premium paid (Rs.25) which shall be the profit earned by the seller of
the Put Option.

Buying of a Put Option

View: Bearish
Buy a one month Nifty Put

With the Strike of 1250

Premium of Rs 100

Nifty
Spot

Value of
1250 Put

1000

1100

Below Below
Strike Strike
250
150

1150

1250

1350

1450

1550

Below
Strike
100

At
Strike
0

Break
Even
0

Above
Strike
0

Above
Strike
0

Premium -100
Paid

-100

-100

-100

-100

-100

-100

Net
Profit/
Loss

50

-100

-100

-100

150

Net Profit/ Loss

200

150

100

50

0
1000
-50

-100

-150

1100

1150

1250

1350

1450

1550

Selling of a Put Option

View: Bullish
Sell / Write a one month Nifty Put

With the Strike of 1250

Premium of Rs 100

Nifty
Spot

1000

1100

1150

1250

Below
Strike
-250

Below
Strike
-150

Break
Even
-100

Premium 100
Paid

100

Net
Profit/
Loss

-50

Value of
1250 Put

-150

1350

1450

1550

At Strike Above
Strike
0
0

Above
Strike
0

Above
Strike
0

100

100

100

100

100

100

100

100

100

Net Profit/ Loss

150

100

50

0
1000
-50

-100

-150

-200

1100

1150

1250

1350

1450

1550

Some Confusing Terms

Payoff: The profit/loss that arises by way of

exercise/non-exercise of the option (before
deducting/adding the premium)
Profit/ Loss: Payoff +/- Premium
Intrinsic Value: It is the value that an option
takes when it is in-the-money.
Time Value: It is the difference between the
option premium and the Intrinsic Value.

Newspaper

Expiry

Strikeprice

Time until the Options Contract is valid

Also Called Exercise Price. Is the Price at which You can

Buy or Sell regardless of the market price

Open high low close (of the premium)

Open Interest & Volume

Open Interest is a measure of how many

Futures or options contract exist at any
particular time.
Options are created and destroyed
depending on how trades are matched up
Volume Simply measures how many trades
occurred.

Factors Influencing Option Prices

Exercise Price ( X)
Current Price of underlying asset (S)
Time to maturity(T)
Price volatility of underlying stock ( )
Risk free interest rate(Rf)
Dividend yield

Futures
Mr. X buys Nifty futures at 1250
Nifty
1,000
1,100
1,200
1,300
1,400
1500

Payoff
-250
-150
-50
50
150
250

Payoff
300

200

100

0
1,000

-100

-200

-300

1,100

1,200

1,250

1,300

1,400

1500

Futures
Mr. X sells Nifty futures at 1250
Nifty
1,000
1,100
1,200
1,250
1,300
1,400

Payoff
250
150
50
0
-50
-150

Payoff
300
250
200

150
100
50
0
1,000
-50
-100
-150
-200

1,100

1,200

1,250

1,300

1,400

MTM Margining System

Mr. X buys Nifty futures at 1050
Date
23rd July
24th July
25th July
TOTAL

Closing
1100
1000
1200

MTM a/c
+50
-100
+200
+150

In Futures Pricing
In equation Terminology

F S C S (1 r ) t
Where,
F = Future Price S = Spot Price
C = Cost of Carry r = Rate of Interest
T = Time to expiry

Example
Spot Nifty (S) = 1250
Interest rate cost (r)= 10%
Time to expiration (t) = 1 month
1/12
= 1250(1+.10)
= 1260

Difference in Futures and Options

Futures contracts are different from options in that:

The buyer of an option can abandon the option if
he or she wishes
The buyer of a futures contract cannot abandon
the contract
A futures/forward contract gives the holder the
obligation to buy or sell at a certain price
An option gives the holder the right to buy or sell
at a certain price

Options vs Forwards

Forward contracts lock in a price for a future

transaction
Options provide insurance. They limit the
downside risk while not giving up the upside
potential
For this reason options are more attractive to
many corporate treasurers than forward
contracts

Types of Traders

Hedgers
Speculators
Arbitrageurs
Some of the largest trading losses in
derivatives have occurred because
individuals who had a mandate to be
hedgers or arbitrageurs switched to being
speculators
Fund Manager at J P Morgan

Forex Risk Hedging Behaviour of Select

Indian Firms (year 06-07)

Put/call ratio

technical indicator demonstrating investors'

sentiment
proportion between all the put options and all
the call options purchased on any given day
calculated for any individual stock, as well as
for any index, or can be aggregated

a lower reading (~0.6) of the ratio reflects a

bullish sentiment among investors as they
buy more calls, anticipating an uptrend
Conversely, a higher reading (~1.02) of the
ratio indicates a bearish sentiment in the
market

Put Call Ratio-Index Options

30-Aug-2012 | 27-Sep-2012 | 25-Oct-2012 |

Symbol
Put
Call
MINIFTY
16,380.00
1,440.00
NIFTY
35,099,800.00
28,320,250.00
BANKNIFTY
298,625.00
474,625.00

Ratio
11.38
1.24
0.63

News
Mini Case I : Ranbaxy posts surprise Q2 loss of Rs586 cr
Forex loss on derivatives at Rs599 crore; North America sales more than double
Ranbaxy Laboratories Ltd, Indias largest drug maker, posted an unexpected quarterly loss of
Rs.586 crore ($106 million) as foreign exchange losses ballooned although sales in its key US
market more than doubled.
Ranbaxy, controlled by Japans Daiichi Sankyo Co. Ltd, recorded a loss of Rs.599 crore on
foreign currency derivatives in the fiscal second quarter ended June, compared with a gain of
Rs.112 crore a year earlier, it said.
Net sales rose 54.5% to Rs.3,174 crore, Ranbaxy said.
Analysts had forecast net profit at Rs.321 crore on net sales of Rs.2,906 crore, according to
Thomson Reuters I/B/E/S.
The depreciation of the Indian rupee against the dollar, though favourable to Ranbaxys export
business, had an adverse impact on the company, it said.
Sales and profitability grew in the quarter with overall improvement across major regions, aided
further by exclusivity sales in some of the key markets, Arun Sawhney, chief executive, said in
a statement.
Sales in North America, Ranbaxys biggest market, grew 140% to Rs.1,471 crore in April-June,
primarily due to the generic version of Lipitor, Pfizer Inc.s cholesterol-lowering blockbuster
drug.
Ranbaxy settled a compliance-related dispute with the US drug regulator early this year and can
now ship products from its Indian factories to the worlds largest drug market.
Indian drugmakers including Ranbaxy, Dr Reddys Laboratories Ltd and Sun Pharmaceutical
Industries Ltd account for about one-third of the applications to sell generic drugs in the US and
are expected to double their sales in that market to about $5 billion over the next five years.
But they face intense competition, rising lawsuits from rival drugmakers and a stricter US health
regulator in their race for the lucrative off-patent market.
Valued at $3.9 billion, Ranbaxy stock dropped 2.7 % to Rs.501.80 on Thursday. The stock is up
about 24% this year, in line with the benchmark healthcare indexs 24.4% rise.

Reference books