Derivatives

FORWARD CONTRACT
An agreement to buy or sell an asset
(underlying) at a certain future date (maturity)
at certain time at a specified price (contract
price).
Entered into between two financial institutions
or between a financial institutional and its client.
It is normally a OTC contract.
One of the party agrees to buy the underlying
asset i.e., assumes a long position.
The other party agrees to sell the underlying
asset i.e., assumes a short position.
Settled on maturity

FORWARD CONTRACT FEATURES

They are bilateral contracts

Each contract is custom designed i.e. the
terms of a forward contract are mutually
agreed upon between the two parties.
Each contract is unique in terms of
contract size, expiration date, asset type
and asset quality
The contract prices are not available on
public domain
The contract has to be settled by delivery
of the asset

FORWARD CONTRACT
The specified price is called delivery price.
Delivery price is so chosen to ensure that the
value of the FC is zero to both parties on entering
the contract.
The value of the FC changes as the market price
change i.e., the FC may have a positive or
negative value to either parties.
If the value of long contract is positive, the value
of short contract is negative.
The forward price = delivery price at the time of
the contract.
After entering into contract the forward price may
not be equal to delivery price.
Both parties face default risk extreme form of
credit risk

FORWARD CONTRACT - EXAMPLE

Spot price = So
Forward price = St
Delivery price = K
Suppose So = 44.25
S30 = 44.20
S60 = 44.50
S90 = 45.00
You are an exporter and you expect to
receive $1 million in 3 months. You would
like to hedge your risk and take a forward
cover by taking a short position at a
delivery price of Rs.45/$ in 90 days.

FORWARD CONTRACT EXAMPLE

Case 1:On due date the So = Rs.44.50/$
You have gained 0.5/$ by entering the
contract, thus you will make a profit of
Rs.0.5 million from the short position.
The party with the long contract will lose
Rs.0.5 million.
Case 2:- On due date the So = Rs.45.50/$
You have lost Rs.0.5million from the short
position.
The party with the long contract will gain
Rs.0.5 million.

FORWARD CONTRACT Pay off from PAYOFF

long contract = S K
t

Pay off from short contract = K - St

Profit

Profit

o
K

Long position

St

Short position

St

FORWARDS - ADVANTAGES
No cost in forward markets as against spot
market.
Spot market involves storage and insurance
cost especially in commodity.

FORWARD DISADVANTAGES

Counter party risk/ credit risk

Finding counter party
Settlement procedure

WHEN WOULD YOU ENTER INTO ONE

When you have assets which you may want to sell into the
future, but lock in the price today

Or you are a trader who believes that prices

of the commodity you are buying through the
contract are likely to be higher than what is
agreed as per the contract

FUTURES CONTRACT

Standardized contract for deferred delivery.

Traded on organized futures exchange.
There is a clearing association that acts as
middle man between the contracting parties.
The contract seller is called short.
The contract buyer is called long.
Both parties post a performance bond called
margins initial margins and variation
margins.
Margins are held by the clearing association.
Margins
Buyer
house member

Broker
Clearing house

Clearing

FUTURES CONTRACT
Daily profit/loss known as marking to market is
calculated.
Profit/loss is adjusted against margins.
If margins fall below the certain level, additional
margins are asked for/margin call are required to be
put.
Margins of buyers and brokers cannot fall below
maintenance margin. Members maintain original
margins based on gross/net basis.
Parties need not know each other.

TYPES OF FUTURE CONTRACT

Commodity futures
1) Metals like Tin, steel, Copper,
gold, silver etc.
2) Agriculture products like wheat
Coffee, pepper, meat, live stock.
Quality specifications must.
Delivery place and time specified

Financial futures
Stocks, indices, currencies,
interest rate.

PROBLEM ON MARGINS

Contact : Oct Long futures

Initial margin : 5%
No of contracts : 2
Commodity : Gold
Contract size : 100 gms
Opening price : Rs.400
Maintenance margin : 75% of initial margin

Day

Fu
price

Op pri

400.00

Aug 10

397.00

11

396.10

12

398.20

13

397.10

15

396.70

16

395.40

17

393.30

18

393.60

19

391.80

22

392.70

23

387.00

24

387.00

25

388.10

Daily
G/L

Cum
G/L

Margin a/c
balance

Variation
margin

Day

Fu
price

Daily
G/L

Cum
G/L

Margin a/c
balance

Op pri

400.00

Aug 10

397.00

(600)

(600)

3400

11

396.10

(180)

(780)

3220

12

398.20

420

(360)

3640

13

397.10

(220)

(580)

3420

15

396.70

(80)

(660)

3340

16

395.40

(260)

(920)

3080

17

393.30

(420)

(1340)

2660

18

393.60

60

(1280)

4060

19

391.80

(360)

(1640)

3700

22

392.70

180

(1460)

3880

23

387.00

(1140)

(2600)

2740

24

387.00

(2600)

4000

25

388.10

220

(2380)

4220

Margin a/c
balance

4000

1340

1260

WHEN WOULD YOU CONSIDER

OR

You hold a stock, you believe it will fall in the near

term, but you dont want to sell the stock. You can
sell the future and benefit from the fall.
There is a huge difference between the spot price
and the future price and wish to benefit from this
differential called the cash future arbitrage

FORWARD VS FUTURES

FORWARD

Parties known to each other.

OTC contract.
Contract is not liquid.
Margins not required
Contract closed by meeting obligation
Contract closed only on due date.
Customized contract
No long and short on same contract

FUTURE
Parties may not know each other
Exchange traded
liquid
Margins required.
Alternatives to close contract.
Exit from contract
Standardized contract
Contract is any time.
Can square up deals.

OPTIONS
An option is a legal contract which gives the holder the right to buy or
sell a specialized amount of underlying asset at a fixed price with in a
specified period of time.
you want to buy an asset sometime into the future
you believe that the price of the asset might rise into the
future, but not very sure,
you will want to lock in a price today.
What if the price in the open market is much lower than what
you anticipated,
you still want to benefit !
A call option gives you a right to buy

CALL OPTION EXAMPLE

You want to buy BOB shares next month.

You have a feeling that BOB shares will rise from
here on but not very sure
If it doesnt rise, great!. You can buy BOB shares at
the prevailing low price.
If it rises fantastic! You can buy BOB shares at the
agreed lower price from the option seller and sell
them in the open market for a profit.
If it falls, you dont want to buy at the agreed price,
you would rather go to the open market and buy at
the prevailing lower prices

PUT OPTION

I believe a particular asset I hold will fall into

the future
but not very sure.

How do I ensure that I get a goo d price even

when the asset falls

PUT OPTION

I can buy a put option Gives me a right to sell

But I dont want to sell at a lower price if the asset
doesnt fall or if it rises.
Dont worry, the put option, when I buy gives me
the right only and not the obligation.
If I want to sell at the agreed price I sell, else I am
free to ignore the contract!

OPTIONS MEANING
1. Legal contract
2. Buyers & Seller of the options contract
3. Option exchange or over the counter exchange
4. Buyer will have a right to buy / sell the underlying asset at a
fixed price
5. Seller will have an obligation to buy / sell the underlying asset
6. Buyer will have to pay a price called option premium to buy
the right
7. Contract should be completed on or within a specified time.

OPTION TYPES

Option
Types

Buyer
(Long position)

Seller
(Short position)

Call

Right to buy asset

Obligations to sell asset

Put

Rights to sell asset

Obligations to buy asset

OPTION TYPES

AMERICAN
OPTIONS

EUROPEAN
OPTIONS

Can be exercised at

Can be exercised on

any time on or before

the expiration date

expiration

SPECIFICATIONS OF OPTIONS

1. Expiration Date
(a) Date on which option expires
(b) Expiration dates are in cycles
2. Strike price
(a) Price at which options are written
(b) Strike prices are specified by the
exchange
(c) Strike prices differ with expiration period

PROFIT AND LOSS OF CALL OPTIONS

PROFITABILITY OF OPTIONS

S>X

Call Option
In the Money

Put Option
Out of the Money

S=X

At the Money

At the Money

S<X

Out of the Money In the Money

PROFITABILITY OF OPTIONS

SWAPS
The word swap means exchange.
An interest rate swap
Two parties agree to exchange interest rate cash
flows, based on a specified notional amount from
a fixed rate to a floating rate (or vice versa) or
from one floating rate to another.
Interest rate swaps are commonly used for both
hedging and speculating.

SWAPS (CONTD.)

SWAPS (CONTD.)

FORWARD RATE
(FRA)(long) agrees
FRA is a AGREEMENT
contract where a borrower
to borrow in future at a certain interest rate a
certain amount (notional or otherwise) from a
lender.
The agreement entered at time to
The agreement commences from time t1 and valid
till t2.
The price is the interest rate.

FORWARD RATE
AGREEMENT
If the interest
rate increases(FRA)
at time t

the lender
is required to pay the amount equivalent to
differential interest rate or lend at agreed interest
rate up to time t2.
1

If the interest rate decreases at time t1 the

borrower is required to pay the amount
equivalent to differential interest rate or borrow
at agreed interest rate up to time t2.

FRA - EXAMPLE
Reliance communication is planning to borrow Rs.100 crores
from the market in 6 months time for one year. The interest
rate market is highly volatile and reliance is worried of the
interest rate on its borrowing.
Reliance enters into a FRA with BOB for 100 crores at 7%,
commencing 6 months from now. Reliance borrows in the
market at the end of 6 months for one year at LIBOR.
The LIBOR rates during the one year period is :
Time from months) Time to (months)
Beginning
Ending

LIBOR

7.25%

6.80%

12

7.25%

Months

Interest pay (Rs)

Crores

CF from BOB (Rs)

Crores

Net CF (Rs)
crores

0.60412

0.02079

0.58333

0.60412

0.02079

0.58333

0.60412

0.02079

0.58333

0.60412

0.02079

0.58333

0.56667

(0.01666)

0.58333

0.56667

(0.01666)

0.58333

0.56667

(0.01666)

0.58333

0.56667

(0.01666)

0.58333

0.60412

0.02079

0.58333

10

0.60412

0.02079

0.58333

11

0.60412

0.02079

0.58333