Introduction

to
Derivatives

What are Derivatives ?

Derivatives are instruments which
derive their value from their
underlying assets
e.g. Mutual fund Units

Basis of underlying
markets
D e r iv a tiv e s
C o m m o d ity
D e riv a tiv e s
T a n g i b le
C o m m o d it ie s

F in a n c ia l
D e riv a tiv e s
Real
E s ta te

I n t a n g i b le
C o m m o d it ie s
E q u ity
D e r iv a t iv e s
I n d e x p ro d u c ts
In d ex F u tu re s
I n d e x O p t io n s

D e r iv a t iv e s o n
S e c u r it ie s
O p t io n s o n
I n d i v id u a l S t o c k s

F o r e ig n
Exchange
D ebt
D e r iv a t iv e s
I n te re s t ra te
P ro d u c ts
IRS

G O I Se cs,
B o n d s,
T - b i l ls

Derivatives Products
Forwards
Futures
Options

What is Forward ?
Forward contract is one to one bi-partite,
customised, tailor-made contract to be
performed in the future, at the terms decided
today - OTC Contracts.
(e.g. forward currency market in India)

Advantage - Forwards
Forward contracts offer tremendous
flexibility to the parties to design the
contract in terms of the price,
quantity, quality (in case of
commodities), delivery time and place.

Disadvantages

Forward contracts suffer from

Poor Liquidity and

Default Risk.

Forwards To Futures

Futures contracts are organised/

standardised contracts, which are
traded on the exchanges.
These
contracts,
being
standardised and traded on the
exchanges are very liquid in nature.
In
futures
market,
clearing
corporation/ house provides the
settlement guarantee.

Forward / Future Contracts

Features

Forward Contract

Future Contract

Operational
Mechanism

Not traded through

exchange

Traded through
exchange

Counterparty Risk

Exists

Liquidation Profile

Poor Liquidity

Price Discovery

Poor; price
discovery spread
geographically.

Assumed by Clearing
Corporation/house.
Very high Liquidity
Better; Fragmented
markets are brought
to the common platform.

Forward Vs. Future contracts

Every futures contract is a forward contract.
Futures contracts:
are entered into through exchange,
traded on exchange and clearing
corporation/house provides the
settlement guarantee for trades.
are of standard quantity; standard quality.
have standard delivery time and place.
Futures are all about standardization.
Futures are all about
institutionalization of the scattered
(forward) market.

Inter linkages
Forwards

Futures

Options

Standardized
& Traded on
Exchange

Attach
A Right

The Global Derivatives

Industry : Chronology of
Instruments

1874
1972
1973
1975
1981
1982
1983

Commodity Futures
Currency Futures
Equity Options
Interest Futures
Currency Swaps
Index Futures, Interest Rates
Swaps, Currency Options
Option on Index, Options on
Futures

Introduction to Futures
CHOICES
1)
2)
3)
4)

Index Futures
Scrip Futures
Option on Index
Option on Scrips

Payoff profile of futures contracts

100

Profit

Gain / Loss

50

0
5000

Buyer

Loss
5050

Seller
5100

-50

-100

Price

5150

5200

OPTIONS - Product of the FUTURE

What they are ?

Options are deferred delivery

contracts that give the buyers
the right, but not the obligation,
to buy or sell a specified
underlying at a set price on or
before a specified date

Options
Deferred
delivery
contracts
Give the buyer the right
Not the obligation
To Buy or
Sell
A specified underlying
At a set price
On or
Before a specified date

1, 2, 3
months + Cash
settlement

Call Options
Put Option
Any Asset
Strike Price
European Option
American Option

Option Terminology-I
Call Option
Right to buy
Put Option
Right to sell
Option Holder / Buyer
The party who has the right but not the
obligation
Option Writer / Seller
The counter-party who has the obligation
but not the right
Underlying Asset
The Commodity, Index, FX Rate or Financial
instrument on which the option exists.

Option Terminology-II
Option Premium

Price paid by the buyer to acquire the right

The value of the option.

Strike Price OR Exercise Price

Price at which the underlying may be

purchased

Expiration Date

Last date for exercising the option

Exercise Date

Date on which the option is actually

exercised

Types of Options
American Option

can be exercised any time on or

before the expiration date

European Option

can be exercised only on the

expiration date

Option Class and Series

All options of the same type (calls or puts)
and same expiration are referred to as an
Option Class.
An Option Series consists of all the options
of a given class with the same expiration
date and strike price. In other words, an
option series refers to a particular contract
that is traded.

Types of Options
In-the-Money
At-the-Money
Out-of-the-Money

Value of option (Premium)

at-the-money calls and puts
out-of-the-money puts

in-the-money puts

35

40

45

50

55

60

65

35

40

45

50

55

60

65

in-the-money calls
out-of-the-money calls
Cash price = 50 being constant & move the Strikes

Intrinsic value and options

Market Scenarios

Call option

Put options

Market price > strike

price

In-the-money

Out-of-the-money

Market price = strike

price

At-the-money *

At-the-money*

Market price < Strike

price

Out-of-the-money

In-the-money

* When market price is very near to the strike price, option is

called near the money option.

Sensex Options
Contract Specifications
Ticker symbol:
Underlying Index:
Contract Multiplier:
Strike Price Intervals:
Premium Quotation:
Expiration day:
Contract Month:
Exercise Style:

BSX
BSE 30 Sensex
INR: 100
50 Sensex Points,
Min. 5 strikes
Sensex Points
Last Thursday of the
contract month
1,2 & 3months
European

Sensex Options
Contract Specifications
Settlement Style:
Trading Hours:
Tick Size:

Cash

9.30 a.m. to 3.30 p.m.

0.1 Sensex Points
INR 10
Settlement Value: Closing Value of
Sensex on expiry day
Exercise Notice Time:
Exercise session on last
trading day.
All in the money options deemed to be exercised on
the expiration day unless holder communicates
otherwise.

Why do we need
derivatives..
Price discovery.
Hedging.
Stability in the underlying
market.

Books & Visitations

Options, Futures & Other Derivatives by J

C Hull
Options Trading Strategies by McMilan
Derivatives by Edward Ma
Futures and Options by Vohra & Bagri
Futures & Options by R Mahajan
http://www.bseindia.com
http://www.cme.com
http://www.cboe.com
http://www.cbot.com
http://www.LIFFE.com
http://www.numa.com
http://www.jpmorgan.com

FORWARD
your
FUTURE
with lots of
OPTIONS