Chapter 2

Derivatives: An Introduction

Derivatives and Indian markets

Option, Future, Forward, Swap are the prominent derivatives. In India, index future were the first derivative contracts launched in the year 2000. Index future are a tool to speculate as well as to hedge the risk of the portfolio. As the positive response to index futures, stock options and stock futures were introduced in the year 2001 on BSE and NSE. Stock option is the option contract on individual shares whereas stock futures contract is the future s contract on individual shares. On commodity derivatives exchanges in India, only futures are allowed for trading, but in certain foreign countries, both options and future are allowed for trading.

Derivatives - Introduction
Derivatives are those financial instruments which derive the value from the underlying assets on which they have been created. The underlying asset may be a commodity, a currency, securities(shares and debentures), or index. The most common derivatives are: Option contract Futures contract Forward contracts Index futures swaps

 Derivatives are used by different investors with different purpose like hedging, speculation, arbitrage. The trading in these instruments involves a high degree of risk which might lead to a counter party default. For exchange traded derivatives, counter party default risk is negligible because of the rules of exchange. Exchange mainly regulates the following: Decision about the underlying assets in which transactions are to be done Margin requirements Type of derivatives offered Settlement of transactions Lot size

Why Exchange traded Derivatives Are Free From Counter Party Default Risk??
An Exchange Traded Derivatives TransactionOption & Futures is traded Through a member of the exchange called the broker of exchange. Every Broker is required to maintain Security deposit Bank Guarantee Margin Deposit

Different Derivatives Transactions

OPTION CONTRACT An option contract is an agreement between two parties to buy or sell the underlying asset stock/share , index ,currency ,commodity for which a settlement is to be executed in future, only after an option is exercised by the holder of the option.

In case of the exchange traded options, the following is regulated by exchange:

Underlying asset Lot size Strike date/expiration date Margins.

Following are the features of these transactions:

Strike price/exercise price. Duration/strike date/exercise date. Premium. Call option vs put option. American vs european option. Expiration of the option. Status of options Contract.

 STRIKE PRICE/EXERCISE PRICE: It is

the price at which the buyer of the option can exercise his right to buy/sell the underlying asset on the expiry date.

Duration/strike Date/Exercise Date : Options

transactions are executed for a particular duration, at the end of which the right of the buyer ceases to exist. Premium: It is the price which is paid upfront by the buyer of the option to seller of the option. It is mutually decided by both the parties on the date of the contract.

 Call Option vs Put Option : Call option is the option in which the buyer of the option has the right to buy the underlying asset on the exercise date or earlier than this, depending upon the type of contract. American vs European Option: In an american option the buyer of the option can exercise his right on any day until the expiry date.

 Expiration of the option : When the buyer of the option doesnt exercise his right to buy/sell the underlying asset(securities),the options transaction simply expire, that is , it remains unexercised. Margin Deposit: In an options contract, the seller of the option has the obligation to honor the contract as soon as the option is exercised by the buyer of the option.

 Margin Deposit : In an option contract, the seller of the option has the obligation to honor the contract as soon as the option is exercised by the buyer of the option. Settlement of the Options transaction : the margin deposited is according to the rule of exchange and keeps on changing from time to time. The buyer of the option is not required to deposit margin money as there cannot be any default by buyer of the option.

Margin deposit-initial margin and mark-to-market margin

Initial margin deposit:
The seller of the options is required to deposit the margin money with his broker, and in turn, the broker is required to deposit the margin money with the stock exchange. The initial margin is usually equal to 20% of the transaction value. Initial margin is subject to a daily settlement, which is called mark-to-margin adjustment to initial margin deposit.

 Illustration: on 3rd June 2011 option with series CE,RIL(250),1000,july is sold by Mr. Avinash at a premium of Rs.12 per shares and spot price of RIL is Rs 980 per share. If initial margin deposit is at 20% of the transaction value, then margin deposit will be as follows: (i) Transaction value Rs 2,50,000(250*1,000) (ii) Initial margin deposit 20% of Rs 2,50,000 i.e. Rs 50,000 to be deposited by the seller of the option by the next day, i.e. 4th June 2011.

Mark-to-Market Margin
Mark-to-market margin is likely daily settlement of the open position in an options contract as if the open position is being squared up. The seller of the options cannot withdraw any amount from the margin deposit account till the option is either squared or settled, or expires on the expiry date.

 Illustration: continuing with the previous illustration, if the premium for this option moves as follows: Date premium 6th june 14 7th june 15 8th june 9 9th june 10 10th june 16 13th june 12 Here, the sellers initial margin deposit account will be adjusted for hypothetical loss/profit on daily basis and he will be required to maintain the initial margin deposit at an initial level, i.e. Rs 50,000. if the premium exceeds the initial premium, then it is hypothetical loss for the seller of the option, otherwise it is hypothetical profit. Hypothetical loss is deducted from the margin deposit and hypothetical profit is added to it.

Status of option contract

An option contract might have any of the following three status: In-the-money: In case of call option, when the spot price is more than the exercise price. But in case of put option it occurs when spot price is less than the exercise price. At-the-money: In call option, when the spot price is equal to the exercise price and it is same as in the put option also. Out-of-the-money: in call option, when the spot price is less than exercise price. But in put option, when the spot price is more than the exercise price.

Pay off from option contract

Pay off of the option contracts are generally viewed from the angle of the buyer of the options contract, it is nothing but the gain or loss arising out of the options contract and splited into two: Intrinsic value Time value The calculation of intrinsic value and time value is done at the time of entering into the contract for an options transaction. However, when it is calculated on a subsequent date, it is termed as profit or loss.

Intrinsic value & Time value

It helps in fixing the premium as well as creating a demand for the option. It is the difference between spot price and strike price and it is present only when an option is In-the-money, otherwise it is zero. Intrinsic value of call option= maximum(spot pricestrike price, or zero) Intrinsic value of put option=maximum(strike price-spot price, or zero) Time value is absolute difference between the intrinsic value and premium , which means net gain/loss for the buyer of the option.

Following parameters are the part of contract specification

Type of option: it implies call European (CE), put European (PE), call American (CA) put American (PA). Underlying assets including lot size: it is decided by the exchange which implies the minimum quantity for each contract. Strike price: it is the price at which the buyer of the option can exercise his right to buy or sell the underlying asset. Expiry date/ duration: it is the time period by the end of which buyer of the option can exercise his right.

Illustration: (i) Option contract series- CA, RIL (250), Rs 1,010,July here it is CA option on the shares of reliance Industries Limited(RIL) and the lot size is 250 shares. The strike price is Rs 1,010 and expiry month is July. (ii) Option contract series-CE, RIL (250), Rs 1,010, July Here ,it is CE option on the shares of RIL and the lot size is 250 shares. The strike price is Rs 1,010 and expiry month is July. (iii) Option contract series- CA, RIL (250), RS 1,010, July Here, it is CA option on the shares of RIL and the lot size is 250 shares. The strike price is Rs 1,050 and expiry month is July.

Square-up
Square-up means closing down the open interest in a particular product/contract series before the expiry. Illustration : on 1st June, 2011 client X takes a long on twelve lot of put option on Infosys(200) for june Rs 310, and the counter party is Z. on 6th June 2011, client Z buys seven lot of put option on Infosys for June Rs 3100 from client X. On the June 2011 X sells remaining lots to W.

 Here, on 1st June 2011, both, clients X and Z have open interest of twelve lot of put option on Infosys for June Rs 3100. The open interest at exchange level is also twelve lot. On 6th June, both the clients have squared-up their position only for seven lots as X is selling the seven lots purchased on 1st June, and Z is buying seven lots sold on 1st june . As a result the open interest for both the parties on 6th June is five lot of put option on Infosys for June Rs 3100. The open interest at exchange level is also five lot. On 8th june, client X has further squared up the remaining five lots resulting into zero open interest for him. However, client W has created an open interest for client X is nil, for client Z five lot, for client W five lot, and the aggregate open interest at exchange level is also five lot.

Factors affecting price of option contract

The premium paid by the buyer of the options is called price of the option and the price fixation is done mutually by both the parties according to the demand and supply. Volatility: it means fluctuation in the price of the underlying asset(shares). This volatile nature creates a risk for the seller of the option, due to which he demands a high price for the option contract. Expiration date: the time duration between the date of transaction(contract) and the expiry date has an effect on the fixation of price for the option contract. A longer time gap between these creates a high chance of options reaching the position of being in-the-money.

 Strike price: whenever strike price of a call option is less than the current market price, the price change from the option contract will be very high and vice versa. Market trend: market trend are identified as bullish or bearish. In a bullish trend the investors expect the price to rise in the future as a result of which the demand for call option will rise, hence the price of call option also increase. Dividend : payment of dividend or expectation of dividend during the duration of the option has a influence on the price of the option-premium. Interest rate: interest rate affect the opportunity cost of the seller of the call option and the buyer of the put option in both of this situation, the fund get blocked, for which the respective party has to bear the opportunity cost.

 Others: apart from the above mentioned factors, the following factors also influence the price of option contract: Inflation Default risk Political risk Government policies Monsoon Demand and supply position Credit and monetary policy

Exotic option
A conventional option contract with certain additional features attached to it is called exotic option. Asian option: it is type of exotic option whose payoff depend on the average price of the underlying asset during some future period preceding the expiry of the option. Barrier option: A Provision in an option contact on account of which option comes into existence only when price of the underlying asset reaches the particular level, it is called option being knock-in. similarly, a provision in the option contract on account of which option ceases to exist as soon as spot price of the underlying asset falls below a particular level, this is called option being knockout.

 Bermuda (bermudan) option: it is exotic option which can be exercised during a pre-specified duration during the complete life of the option. It is neither American nor European in nature with respect to the exercise of option rather having benefits of both these. Binary option: an option which provides a fixed pay-off if option happens to be in-the-money otherwise it is zero. It is also called digital option. Chooser option: an exotic option in which buyer of the option has the right to consider it either a call option or put option during a prespecified window period prior to expiry . It is called as you like it option. Knock-in and knock-out option: A Provision in an option contact on account of which option comes into existence only when price of the underlying asset reaches the particular level, it is called option being knock-in. similarly, a provision in the option contract on account of which option ceases to exist as soon as spot price of the underlying asset falls below a particular level, this is called option being knock- out.

Futures Transaction
It is an agreement between two parties to buy or sell the underlying asset for which all the parameters of the transaction are decided on the date of transaction, for settlement on a future date. Both buyer and seller of futures have rights as well as obligations therefore there is no requirement of a premium payment by either of the parties. The product series of a future transaction comprises the underlying asset including lot size and value month. In Indian stock market, only about 250 securities have been specified for futures transaction. As both buyer and seller have the obligation, therefore, both are required to deposit the margin money with the exchange through the respective broker (in indian capital market).

Parameters of future contract specification

The underlying asset including lot size: The underlying asset may be a stock/share or an index. The lot size is decided by the exchange which implies the minimum quantity for each contract. Value month/duration: it is the time period at the end of which all the open futures transactions are to be settled. At present the most common duration for futures is one, two and three months and the value date is the last Thursday of the concerned month.

 Illustration: For example, on 4th June 2011, a july futures on RIL is specified as follows: RIL (250) July with strike price Rs 1,020, whereas the spot price is Rs 1,000. Here for RIL the lot size is 250 shares. July is the month of expiry. Here the value date is decided by the concerned exchange. Both of these are parts of the product series. The product series is specified by the exchange, and the strike price is decided mutually by the parties for the futures transaction. Here, the strike price is Rs 1,020, which is greater than the spot price. Hence , the futures on RIL for July is at a premium.

Features of Futures Transaction

Underlying assets: the assets, for which transactions are done, like commodity, currency, shares, and debentures are called underlying assets. Exercise price: it is the price at which a transaction is to be settled on a future date, i.e. the expiry date of the futures transaction. This price is decided mutually by both the parties on the date of transaction. Duration and value date: it is the time period at the end of which all the open futures transactions are to be settled. At present the most common duration for futures is one, two and three months and the value date is the last Thursday of the concerned month.

 Margin : both the parties, that is the buyer and seller of the futures contract are required to deposit the initial margin on the date of contract with the stock exchange ; this is called initial margin. Settlement: majority of the futures transactions are settled by taking or giving the difference in cash on the value date. The cash difference is the difference between strike price and settlement price on the value date. Square up: Square-up means closing down the open interest in a particular product/contract series before the expiry. Position: futures contracts are defined as long on futures and short on futures. Whenever a party purchases a futures contract it is called long on futures and when a party sells the futures contract, it is called short on futures.

 Standardized: all the futures transactions are entered on the exchange and different parameters like: underlying assets, lot size, duration and value date, margin, mode of settlement. All these are decided and regulated by the concerned stock exchange. No expiration: in a futures contract, both the parties have rights as well as obligations, therefore, one of the parties will have benefit and the other will have loss on the value date.

Margin Deposit Initial Margin & Mark to Market Margin

Initial Margin Deposit:
Both the buyer & the seller of the Futures is required to deposit margin money with his broker, & in turn the broker is required to deposit the margin money with the stock exchange.

illustration: On 3rd june 2011 ,future with series

RIL(250),JULY is purchased by Mr. Avinash & sold by Mr. Mohit with an exercise price 1,000/-.

 If initial margin deposit is at 20% of the transaction value, then the margin deposit will be as follows: 1. Transaction value 2,50,000 ( 250*1,000) 2. Initial margin deposit 20% of 2,50,000 i.e 50,000 to be deposited by Mr. Avinash as well as by Mr. Mohit individually to the respective broker & in turn the brokers of the parties will maintain the margin with the stock exchange.

Mark to Market Margin

Initial Margin deposit in adjusted for hypothetical loss/profit on daily basis. Both the parties are required to deposit additional Margin money so as to maintain the initial margin deposit which should be equal to at least the initial deposited amount. Illustration: Continuing with the above given illustration , if the settlement price happens to be as follows:

DATE

SETTLEMENT PRICE

DATE

SETTLEMENT PRICE

6th june

1,010

7th june

1,050

8th june

1,020

9th june

980

10th june

1,000

13th june

970

Forward Transaction
These transactions are for buying and selling an underlying asset, like shares, here, the transaction is done with the settlement taking place on some future date mutually decided by the parties. It is a customized contracts. Transactions are reported to the exchange to give them a validity mark and to provide a coverage for a counter-party risk. These transactions are done on over the counter exchange. Both the parties are required to deposit margin according to the rules of the exchange and both have rights as well as obligations.

Features of Forward Transaction

Underlying assets: Exercise price Duration and value date Margin Settlement Square-up Position Customized No expiration

Differences between Futures and Forward contaracts

POINT OF
DIFFERENCE Underlying asset This is specified by the concerned stock ex-change. This is specified by both the parties mutually

FUTURE CONTRACT

FORWARD CONTRACT

Quantity

Minimum quantity & multiples are decided by the exchange in the form of lot size.
Stock exchange fixes the duration & value date. They are traded on the stock exchange. Regulated according to the rule of stock exchange. They are standardized.

Quality is decided by both the parties mutually.

Parties decide these mutually. They are traded on otc exchange. Regulated according to the rule of otc exchange. They are customized.

Duration & value Date Exchange Regulation Nature

Similarity between Futures and Forward Transaction

Derivative product: both the futures and forward transaction are derivative products. They generate a value according to the movement of prices of the underlying assets. Tools for hedging: hedging is a mechanism to counter balance or minimize the risk arising from investment in securities. Tools to speculate: both of these provide an opportunity to speculate in the underlying asset. With the help of long position in them, one can gain when prices rise in the future, and when prices decline the short position creates value.

Differences Between Option & Future/Forward Contract

Point of Difference Right risk obligation premium settlement Option Contract Only buyer of the option has the right. Only for seller of the option. Only for seller of the option. Buyer of the option is required to pay it upfront. It can simply expire without being exercised. Future/Forward Contract Both the parties have right. For both the parties. For both the parties. None of the required to pay for it. Here settlement is must , it never expires.

nature
margin

It is a pure hedging tool.

In this only the seller of the option is required to deposit it.

It is not a pure hedging tool.

Both the parties are required to deposit the margin.

Index Based Derivatives

Certain derivatives are created on index of the market like BSE sensex ( sensivity index ), Nifty of NSE. in index based derivatives the underlying asset is the index of the market. These are used for both speculation as well as for hedging the risk. To provide a perfect change for speculation/hedging the index should have a wide representaion of the overall market.

These Derivatives are:

INDEX FUTURE. INDEX OPTION.

INDEX FUTURES : Index Future is a transaction to buy or sell a particular index for which a transaction is entered for settlement on a pre-specidied future date.

Features of Index Future

Absolute derivative product. A tool to speculate. A tool to hedging the risk. Settlement by differences. Based on widely accepted index. Regulated by stock exchange. Margin deposit. Open interest.

INDEX OPTION:
In an index option transaction, the buyer of the option pays the premium to the seller of the option to obtain the right to buy or sell the inderlying index on or before the expiry date.

SWAP
It is a transaction whereby two parties parties exchange either a currency, a loan, or an interest obligation with regard to certain loan. Swap transactions are of following types: Foreign exchange swap Interest rate swap ( plain vanilla swap ) Cross currency swap ( total loan swap )

 Foreign Exchange Swap: In this kind of swap transaction, two parties agree to exchange certain money value represented in different currencies at present, With the commitment to do the reverse of this in the future.these are done to hedge the risk arising out of fluctuation in the exchange rate of the currencies.

 Interest rate SWAP: In this kind of swap transaction, two parties agree to exchange interest obligation for a certain loan amount. One party pays the interest obligation for loan taken by another Party,and later pays it for the loan taken by the former.

 Cross Currency Swap: It is an agreement between two parties, in which they exchange the principal amount of the loan as well as interest obligation. It is done to gain from the comparative advantage of each other. The following mechanism is adopted for this :

 Each party will raise a loan according to the objective of another party. Loan amounts are exchanged by both the parties in the beginning of swap. On respective interest due date, both make the payment for interest boligation of each other.

 On the maturity date of the loan both exchange the principal amount to be repaid by them. The benefit arising out of the swap transaction Is exchanged according to the mutual agreement.