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Module 1: Introduction

CONTENTS

Definition of derivative contracts


Types of derivatives
Underlying assets
Derivative markets in India
Regulation of derivatives in India
Reasons for derivatives trading

What is a Derivative?
A derivative is an instrument whose value
depends on, or is derived from, the value
of an asset that underlies the contract.
Examples: futures, forwards, swaps,
options, exotics

Why Derivatives Are


Important
Risk Transfer: Derivatives play a key role in transferring risks
in the economy
Large Variety of Underlying Assets: The underlying assets
include stocks, currencies, interest rates, commodities, debt
instruments, electricity, insurance payouts, weather, etc
Embedded Derivatives: Many financial transactions have
embedded derivatives
Real Options & Capital Budgeting: The real options approach
to assessing capital investment decisions has become
widely accepted
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How Derivatives Are Traded


On exchanges such as the Chicago Board
Options Exchange, NSE, BSE
In the over-the-counter (OTC) market
where traders working for banks, fund
managers and corporate treasurers
contact each other directly

Size of OTC and Exchange-Traded Markets


(Figure 1.1, Page 3)

Source: Bank for International Settlements. Chart shows total principal amounts for
OTC market and value of underlying assets for exchange market
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The Bankruptcy of Lehman Bros.


Lehman Bros. filed for bankruptcy on September 15,
2008. This was the biggest bankruptcy in US history
Lehman was an active participant in the OTC
derivatives markets and got into financial difficulties
because it took high risks and found it was unable to
roll over its short term funding
It had hundreds of thousands of transactions
outstanding with about 8,000 counterparties
Unwinding these transactions has been challenging
for both the Lehman liquidators and their
counterparties
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Forward Contracts
An agreement to buy/sell an asset at a
specified future date at a specified
price
The party who agrees to buy the asset
is said to have a long position
The party who agrees to sell the asset
is said to have a short position
In OTC forwards are traded between
financial institutions
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Forward Contracts
Originated primarily to protect cos. from:
Revenue-side risks
Cost-side risks

Foreign Exchange Quotes for GBP,


May 24, 2010

Spot

Bid
1.4407

Offer
1.4411

1-month forward

1.4408

1.4413

3-month forward

1.4410

1.4415

6-month forward

1.4416

1.4422

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Forward Price
The forward price may be different for
contracts of different maturities (as shown by
the table)

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Payoffs from Forwards


Payoffs can be +ve or ve
As there is no cost of entering into a
forward contract the payoff itself is the
traders net gain / loss

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Example 1
On May 24, 2010 the treasurer of an MNC
enters into a long forward contract to buy
1 million in six months at an exchange
rate of $1.4422/
This obligates the corporation to pay
$1,442,200 for 1 million on November
24, 2010
What are the possible outcomes?
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Profit from a Long Forward Position


(K= Forward price, ST = Price at maturity) = ST - K

Profit

Price of Underlying
at Maturity, ST

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Profit from a Long Forward


Party having a long position has
limited downside but unlimited
upside
Price of the asset at maturity
cannot be < 0
In such case the long party loses a
maximum amount = Forward price
(K) agreed earlier
Price at maturity can increase
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Profit from a Short Forward Position (K=


Forward price, ST = Price at maturity) = K - S T
Profit

Price of
Underlying
at Maturity,
ST

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Profit from a Short Forward


Party having a short forward
position has limited upside but
unlimited downside
Price of the asset at maturity
cannot be < 0
In such case the short party gains
a maximum amount = Forward
price (K) agreed earlier
Price at maturity can increase
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Futures Contracts
Agreement to buy or sell an asset for a
specified price at a specified future time
A standardised forward contract
A forward contract is traded OTC, while a
futures contract is traded on an exchange

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Why are Futures Required?


Counterparty risk
Exit mechanism
Standardised quantity

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Exchanges Trading Futures


US: CME Group (formerly Chicago
Mercantile Exchange and Chicago Board
of Trade), NYMEX
Brazil: BM&F
TIFFE (Tokyo)
India:
Derivative Segment of BSE
F&O Segment of NSE
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Examples of Futures Contracts


Agreement to:
Buy 100 oz. of gold @ US$1400/oz. in
December
Sell 62,500 @ 1.4500 US$/ in March
Sell 1,000 bbl. of oil @ US$90/bbl. in
April

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Options
An option contract gives the holder the
right to buy/sell the underlying asset by a
specified future date for a specified price
2 types: Call & Put options
A call option gives the holder right to buy
A put option gives the holder right to sell
The writer of the option has the obligation
to take the opposite position of the holder
The holder may not exercise the right
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Google Call Option Prices (June 15, 2010; Stock Price is


bid 497.07, offer 497.25); See Table 1.2 page 8; Source: CBOE

Strike
Price

Jul 2010
Bid

Jul 2010
Offer

Sep 2010
Bid

Sep 2010
Offer

Dec 2010
Bid

Dec 2010
Offer

460

43.30

44.00

51.90

53.90

63.40

64.80

480

28.60

29.00

39.70

40.40

50.80

52.30

500

17.00

17.40

28.30

29.30

40.60

41.30

520

9.00

9.30

19.10

19.90

31.40

32.00

540

4.20

4.40

12.70

13.00

23.10

24.00

560

1.75

2.10

7.40

8.40

16.80

17.70

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Google Put Option Prices (June 15, 2010; Stock Price


is bid 497.07, offer 497.25); See Table 1.3 page 9;
Source: CBOE

Strike
Price

Jul 2010
Bid

Jul 2010
Offer

Sep 2010
Bid

Sep 2010
Offer

Dec 2010
Bid

Dec 2010
Offer

460

6.30

6.60

15.70

16.20

26.00

27.30

480

11.30

11.70

22.20

22.70

33.30

35.00

500

19.50

20.00

30.90

32.60

42.20

43.00

520

31.60

33.90

41.80

43.60

52.80

54.50

540

46.30

47.20

54.90

56.10

64.90

66.20

560

64.30

66.70

70.00

71.30

78.60

80.00

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Options vs Futures/Forwards
A futures/forward contract obligates both
parties to buy or sell at a specified price
An option obligates only one party, writer, to
buy or sell at a specified price; gives the
holder only the right to buy or sell & not the
obligation

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Types of Traders
Hedgers
Speculators
Arbitrageurs

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Hedging Examples

(pages 10-12)

A US company will pay 10 million for


imports from Britain in 3 months and
decides to hedge using a long position in a
forward contract.
An investor owns 1,000 Microsoft shares
currently worth $28 per share. A two-month
put with a strike price of $27.50 costs $1.
The investor decides to hedge by buying
10 contracts
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Value of Microsoft Shares with and


without Hedging (Fig 1.4, page 12)
40,000

Value of Holding ($)

35,000
No Hedging

30,000

Hedging

25,000
Stock Price ($)
20,000
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26

28

30

32

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Speculation Strategies: Example A


A forex market player expects in February that
the GBP will appreciate against the USD in the
next 2 months. He wants to invest USD for
creating a position in GBP 250000. The current
exchange rate is GBP 1 = USD 2.0470. The
price of April futures is 1 GBP = USD 2.0410. 1
futures contract = GBP 62500 & requires
deposit of an initial margin of USD 5000.
Discuss the possible strategies and evaluate
them if the spot price of GBP in April is USD
2.1000 & USD 2.0000.
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Speculation Strategies: Example A


1. Purchase GBP 250000 spot and hold the
same for 2 months and sell the same for
USD at the end
2. Create a long position in 4 futures
contracts maturing in April (each futures
contract is for purchase of GBP 62500).
The price of April futures is 1 GBP = USD
2.0410 and 1 futures contract requires
depositing an initial margin of USD 5000.
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Speculation Strategies: Example A

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Observations on Speculation Strategies: Eg. A


The first strategy requires an initial investment of
USD 511750 (= 250000 X 2.0470).
The second strategy requires only depositing the
initial margin amount of USD 20000 (= 5000 X 4).
Initial investment in the futures is much less than
that in the spot-purchase-&-hold strategy. So the ROI
and also the losses (%) in the futures strategy is
many times higher.
The benefit of futures contract is that it allows to
earn almost similar gains at low initial investment
(entry cost is low) but with higher volatility in relative
terms (ROI)
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Speculation Strategies: Example B


An investor has INR 2,000 for investment and
expects that the price of a stock will increase over the
next 2 months. The current price of the stock is INR
20. Further the price of a 2-month call option with a
strike of INR 22.50 is INR1.00. 1 call option contract
includes 100 options with 1 call option for 1 share.
Discuss alternative strategies & evaluate them when
the ending stock price is INR 27 & INR15.

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Speculation Strategies: Example B


1. Buy 100 shares in the cash market & hold the
shares until the end of the 2 month period.
After 2 months liquidate the holding.
2. Buy 20 call option contracts (1 contract = 100
call options, with 1 call option for 1 share) =
20X100 = 2000 call options (on 2000 shares)

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Speculation Strategies: Example B


Profits (Losses) from Strategies 1 & 2
Ending Price after 2 months
Strategy

INR 15

INR 27

Range

1. Buy 100 shares

100X(15-20) =
INR (500)

100X(27-20) =
INR 700

INR
1200

ROI in Strategy
1

(500) / 2000 =
-25%

700 / 2000 =
35%

2. Buy 2000 call


options

2000X1 = INR
(2000)

2000 X (2722.50)
-2000X1= INR
7000

INR
9000

(2000) / 2000 =
-100%

7000 / 2000 =
350%
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450%

ROI in Strategy
2

60%

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Observations on Speculation Strategies


The profits & losses of the call option strategy are
much higher than the holding-the-stock strategy
The volatility of profits in the call option strategy
is much more than the holding-the-stock strategy
When the stock price rises the holding-the-stock
strategy starts earning profit before the call
option strategy
When the stock price rises the profit in the call
option strategy increases much faster than the
holding-the-stock strategy
The upside potential & impact of the call option
strategy is much more than the downside
potential & impact compared to the holding-the37
stock strategy

Speculation Strategies: Caution


Holding-the-stock is a
conservative strategy & the call
option strategy is an aggressive
strategy

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Arbitrage: Why &


What?

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Arbitrage
All theories on asset pricing or derivatives
pricing create a set of conditions for arriving
at the price such that NO ARBITRAGE will
take place
NO ARBITRAGE CONDITION
The price thus derived will be (theoretically)
the most stable price
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Arbitrage
Arbitrage is the economic process which
tries to keep the prices where they should be
by eliminating all differences
However just because the possibility of
arbitrage is there, the prices will not always
be where they should be

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Arbitrage: A Simple Example


A stock is quoted as GBP100 in LSE &
USD140 in NYSE
The current USD-GBP exchange rate is
1.4300
Is there any arbitrage opportunity?

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Arbitrage
Some conditions in which price distortions may
still be there:
Taxes
Transportation costs
Negligible arbitrage gains compared to other
forms of business opportunities

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Possibilities Leading to Volatility


Traders can switch from being hedgers to
speculators or from being arbitrageurs to
speculators
It is important to set up controls to ensure that
traders use derivatives only for their intended
purpose

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Underlying
The value & the utility of a derivative arises
out of the underlying
The underlying could be a real asset like a
commodity, or a financial asset like equities
or currencies or something abstract like
stock index, interest rates, weather or
electricity
Accordingly there are commodity
derivatives, stock derivatives, currency
derivatives, index derivatives, interest rate
derivatives, credit derivatives & weather
derivatives
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Derivatives Based on Underlying


1.Commodity derivatives:
Operators try to hedge their interests from the
rise / fall in commodity prices due to supplydemand variations caused by various factors
May result in cash / physical settlement
2.Stock derivatives:
Derivatives based on equity shares of very
good companies for hedging volatility in
market values
Both futures & options are traded
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Derivatives Based on Underlying


3. Currency derivatives:
Forwards, Futures and Options on major
currencies
Mainly for hedging exchange rate volatility
4. Index derivatives:
Futures contracts on major stock indices
Used to hedge / manage volatility of market
values
Futures contracts must have minimum
contract value as prescribed by the
regulators
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Derivatives Based on Underlying


5. Interest Rate Derivatives:
These derivatives are designed to hedge
exposure to interest rate volatility
Mainly used to protect bond portfolios or
lending-borrowing transactions
2 types: FRA (OTC), Interest rate futures
(exchange traded)
6. Credit Derivatives:
Designed for bankers & lenders to protect
from credit risks/default risks Credit
Default Swap
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Derivative Markets in India


Types of derivatives: Commodity
derivatives, exchange traded equity
derivatives, interest rate derivatives
& currency derivatives
Introduction of index futures in NSE
& BSE in June 2000
Introduction of index options, stock
options & stock futures in July 2001
at both BSE & NSE
Interest rate futures introduced in
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Derivative Markets in India


Commodity derivatives were reintroduced in
India in the early 2000s in the form of
commodity futures
National level exchanges: National Commodities
& Derivatives Exchange Ltd. (NCDEX) 2003,
Multi Commodity Exchange of India Ltd. (MCX)
2003, & National Multi-Commodity Exchange of
India Ltd. (NMCEIL) 2001. National level
exchanges are multi-commodity exchanges
Several Regional exchanges are there regional
exchanges are single product exchanges
All these offer commodity Futures &50 not options

Derivative Markets in India


Currency futures introduced in NSE in
August 2008
Lot size is USD 1000
Contracts are for USD-INR to be
quoted & settled in INR; settlement
in cash (INR)
Maximum maturity 12 months
Currency futures are also available in
BSE & MCX
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Regulation of Derivatives in India


Definition of securities in the
SCRA, 1956 has been amended
to include derivative contracts
So equity based derivatives are
regulated in India by SCRA, 1956
& SEBI Act, 1992
Currency derivatives (exchange
traded) are regulated by RBI as
well as SEBI
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Regulation of Derivatives in India


All commodity derivatives in India
are based on agricultural
commodities
Commodity forward contracts are
regulated by Forward Markets
Commission (FMC) under the
Forward Contracts (Regulation) Act,
1952
Ministry of Consumer Affairs, Food &
Public Distribution is the ultimate
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Reasons for Derivatives Trading


To hedge risks
To speculate on the basis of future trends of
the market
To profit from arbitrage opportunities
To alter the nature of a liability & still holding it
To alter the nature of an investment / portfolio
without bearing the costs of selling the
existing one & buying another
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Interest Rates
In derivatives pricing generally principles
of continuous compounding are followed
This is because in practical terms the
trading of securities/assets happens
more/less at continuous intervals of time
Continuous compounding allows for
situations in which cash flows can occur at
any time on a continuous time-frame
Mathematically continuous rates are
easier to deal with than discrete rates
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Conversion Formulae
Define
Rc : Interest rate pa with continuous compounding
Rm: Interest rate pa with compounding m times
per year

Rm
Rc m ln 1

Rm m e Rc / m 1

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Conversion Formulae
Eg. 1: An interest rate is quoted at 10%pa with
half-yearly compounding. What will be the
equivalent rate with continuous compounding?
Eg. 2: An interest rate is quoted at 8%pa with
continuous compounding. What will be the
equivalent rate with (a) Quarterly compounding
(b) Monthly compounding

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THANK YOU

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TRANSACTION COSTS - COMPONENTS

Brokerage (max. 2.25%)


Service Tax on Brokerage (12.36%)
Securities Transaction Tax (0.01%)
Stamp Duty (0.002%)
Stock Exchange Levy (0.002%)
SEBI Charges (0.0001%)
Margin required for selling options

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