Introduction

The origin of derivatives can be traced back to the need of farmers to protect themselves against fluctuations in the price of their crop. In 1848, the Chicago Board Of Trade, or CBOT, was established to bring farmers and merchants together. In 1925 the first futures clearing

Definition
A derivative is a product whose value is derived from the value of one or more underlying variables or assets in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. The Forwards Contracts (Regulation) Act, 1952, regulates the forward/futures contracts in commodities all over India.

What do derivatives do?

Derivatives attempt either to minimize the loss arising from adverse price movements of the underlying asset Or maximize the profits arising out of favorable price fluctuation. Since derivatives derive their value from the underlying asset they are called as derivatives.

Types of Derivatives (UA: Underlying Asset)

Based on the underlying assets derivatives are classified into.
Financial Derivatives (UA: Fin asset) Commodity Derivatives (UA: gold etc) Index Derivative (BSE sensex)

How are derivatives used?

Derivatives are basically risk shifting instruments. Hedging is the most important aspect of derivatives and also their basic economic purpose Derivatives can be compared to an insurance policy. As one pays premium in advance to an insurance company in protection against a specific event, the derivative products have a payoff contingent upon the occurrence of some event for which he pays premium in advance.

What is Risk?
The concept of risk is simple. It is the potential for change in the price or value of some asset or commodity. The meaning of risk is not restricted just to the potential for loss. There is upside risk and there is downside risk as well.

Forward contracts Futures

Derivative Instruments.

Commodity Financial (Stock index, interest rate & currency )

Options
Put Call

Swaps.
Interest Rate Currency

A one to one bipartite contract, which is to be performed in future at the terms decided today. Eg: Jay and Viru enter into a contract to trade in one stock on Infosys 3 months from today the date of the contract @ a price of Rs4675/Note: Product ,Price ,Quantity & Time have been determined in advance by both the parties. Delivery and payments will take place as per the terms of this contract on the designated date and place. This is a simple example of forward contract.

Forward Contracts.

Risks in a forward contract

Liquidity risk: these contracts a biparty and not traded on the exchange. Default risk/credit risk/counter party risk. Say Jay owned one share of Infosys and the price went up to 4750/three months hence, he profits by defaulting the contract and selling the stock at the market.

Futures.
Future contracts are organized/standardized contracts in terms of quantity, quality, delivery time and place for settlement on any date in future. These contracts are traded on exchanges. These markets are very liquid In these markets, clearing corporation/house becomes the counter-party to all the trades or provides the unconditional guarantee for the settlement of trades i.e. assumes the financial integrity of the whole system. In other words, we may say that the credit risk of the transactions is eliminated by the exchange through the clearing corporation/house.

The key elements of a futures contract are:

Futures price Settlement or Delivery Date Underlying (infosys stock)

Illustration.
Let us once again take the earlier example where Jay and Viru entered into a contract to buy and sell Infosys shares. Now, assume that this contract is taking place through the exchange, traded on the exchange and clearing corporation/house is the counter-party to this, it would be called a futures contract.

Positions in a futures contract

Long - this is when a person buys a futures contract, and agrees to receive delivery at a future date. Eg: Virus position Short - this is when a person sells a futures contract, and agrees to make delivery. Eg: Jays Position

How does one make money in a futures contract?

The long makes money when the underlying assets price rises above the futures price. The short makes money when the underlying assets price falls below the futures price. Concept of initial margin Degree of Leverage = 1/margin rate.

An option is a contract giving the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An option is a security, just like a stock or bond, and is a binding contract with strictly defined terms and properties.

Options

Options Lingo
Underlying: This is the specific security / asset on which an options contract is based. Option Premium: Premium is the price paid by the buyer to the seller to acquire the right to buy or sell. It is the total cost of an option. It is the difference between the higher price paid for a security and the security's face amount at issue. The premium of an option is basically the sum of the option's intrinsic and time value.

Strike Price or Exercise Price :price of an option is the specified/ predetermined price of the underlying asset at which the same can be bought or sold if the option buyer exercises his right to buy/ sell on or before the expiration day. Expiration date: The date on which the option expires is known as Expiration Date Exercise: An action by an option holder taking advantage of a favourable market situation .Trade in the option for stock.

Exercise Date: is the date on which the option is actually exercised. European style of options: The European kind of option is the one which can be exercised by the buyer on the expiration day only & not anytime before that. American style of options: An American style option is the one which can be exercised by the buyer on or before the expiration date, i.e. anytime between the day of purchase of the option and the day of its expiry.

Bermuda Option They are similar in style to American style options in that there is a possibility of early exercise, but instead of a single exercise date there are predetermined discrete exercise dates.

Asian style of options: these are in-between European and American. An Asian option's payoff depends on the average price of the underlying asset over a certain period of time. Option Holder Option seller/ writer Call option: An option contract giving the owner the right to buy a specified amount of an underlying security at a specified price within a specified time. Put Option: An option contract giving the owner the right to sell a specified amount of an underlying security at a specified price within a specified time

In-the-money: For a call option, inthe-money is when the option's strike price is below the market price of the underlying stock. For a put option, in the money is when the strike price is above the market price of the underlying stock. In other words, this is when the stock option is worth money and can be turned around and exercised for a profit.

 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.

For a call option: Intrinsic Value = Spot Price - Strike Price For a put option: Intrinsic Value = Strike Price - Spot Price

Example of an Option
Elvis and crocodiles.

Long Position: The term used when a person owns a security or commodity and wants to sell. If a person is long in a security then he wants it to go up in price. Short position: The term used to describe the selling of a security, commodity, or currency. The investor's sales exceed holdings because they believe the price will fall.

Positions

Summary
The profit and loss profile for a short put option is the mirror image of the long put option. The maximum profit from this position is the option price. The theoritical maximum loss can be substantial should the price of the underlying asset fall. Buying calls or selling puts allows investor to gain if the price of the underlying asset rises; and selling

Swaps
An agreement between two parties to exchange one set of cash flows for another. In essence it is a portfolio of forward contracts. While a forward contract involves one exchange at a specific future date, a swap contract entitles multiple exchanges over a period of time. The most popular are interest rate

Interest Rate Swap

Counter Party
LIBOR

Counter Party B

Fixed Rate of 12% Rs50,00,00,000.00 Notional Principle

A is the fixed rate receiver and variable rate payer. B is the variable rate receiver and fixed

The only Rupee exchanged between the parties are the net interest payment, not the notional principle amount. In the given eg A pays LIBOR/2*50crs to B once every six months. Say LIBOR=5% then A pays be 5%/2*50crs= 1.25crs B pays A 12%/2*50crs=3crs The value of the swap will fluctuate with market interest rates. If interest rates decline fixed rate payer is at a loss, If interest rates rise variable rate payer is at a loss. Conversely if rates rise fixed rate payer

How Swaps work in real life

10.5% Maruti Fixed

BOA

LIBOR +3/8%

LIBOR +3/8%

BOT

What is a Hedge
To Be cautious or to protect against loss. In financial parlance, hedging is the act of reducing uncertainty about future price movements in a commodity, financial security or foreign currency . Thus a hedge is a way of insuring an investment against risk.

What is Speculators
Speculators wish to bet on future movements in the price of an asset. Derivatives can give them an extra leverage to enhance their returns. For example, if a speculator believes XYZ Company stock is overpriced, they may short the stock, wait for the price to fall, and make a profit. It's possible to speculate on virtually every security,

What is Arbitrageurs

Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. The largest market for derivatives Largely unregulated with respect to disclosure of information between the parties. No central counterparty. Subject to counterparty risk, since each counterparty relies on the other to perform. Examples: Swaps Forward rate agreements Exotic options Exchange-traded derivatives (ETD) are derivatives products that are traded via specialized derivatives exchanges. Exchange acts as an intermediary to all related transactions Margin posted from both sides of the trade to act as a good faith deposit Provide investors access to risk/reward and volatility characteristics related to an underlying commodity. Examples: Futures Options on Futures

OTC Markets: Product Overview

Two parties agree on the terms of obligations. Derivatives on unique products are suited to the OTC market. Counterparty risk can be a significant factor in the pricing. Function best when non-standardized agreements are needed -- that is, when delivery dates, locations, quantities or quality adjustments are necessary. The guarantee that supports an OTC position is as good as the credit-worthiness of the weaker of the two parties. International Swaps and Derivatives Association (ISDA) agreements or similar bilateral documents required to support trading. These are typically heavily negotiated.

Credit Default Swaps (CDS)

Definition: CDS are a financial instrument for swapping the risk of debt default. Credit default swaps may be used for emerging market bonds, mortgage backed securities, corporate bonds and local government bond The buyer of a credit default swap pays a premium for effectively insuring against a debt default. He receives a lump sum payment if the debt instrument is defaulted. The seller of a credit default swap receives monthly payments from the buyer. If the debt instrument defaults they have to pay the agreed amount to the buyer of the credit default swap

The market for these securities is enormous. Since 2000, it has ballooned from $900 billion to more than $45.5 trillion.