By :DR.

SHARAN SHETTY
PhD ( Banking & Finance)
MBA ( Finance)
B. Com (Hons)

1/4/2019 Derivatives Market 1

 CONTENTS
• What is Derivatives?
• What are the uses?
• What are the types?
• Forward Contract
• Futures Contract
• Options
• Swaps

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 DERIVATIVES

• Derivative is a financial product ,whose

value is derived from the value of some
other variable for some underlying values.

• A derivative is essentially a contract which

has its value derived as a function of some
underlying variables.

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Derivatives:
• Derivative is a product whose value is derived from the
value of one or more basic variables, called bases
(underlying asset, index, or reference rate), in a
contractual manner.
• The underlying asset can be equity, forex, commodity or
any other asset. For example, wheat farmers may wish
to sell their harvest at a future date to eliminate the risk
of a change in prices by that date. Such a transaction is
an example of a derivative. The price of this derivative is
driven by the spot price of wheat which is called
"underlying Asset".

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Different Types Of Assets in
Derivatives
• Derivatives can be based on different
types of assets such as :
 Commodities
 Equities
 Bonds
 Interest rates
 WPI’s/CPI’s
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 USES OF DERIVATIVES

• The main use of derivatives is to reduce

RISK for one party.

• HEDGING
• SPECULATION
• ARBITRAGE

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 DERIVATIVES

OTC EXCHANGE TRADED

FORWARD FUTURE
SWAPS OPTIONS

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Common Derivative contract
types

• FORWARD
• FUTURES
• OPTIONS
• SWAPS

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Forward Contract:

• A forward contract is an agreement to

buy/sell an asset on a specified date for
a specified price. It is very useful in
hedging and speculations. A very
serious limitation of forward contracts
is counterparty risk arising from
possibility of default of any one party to
the transaction.

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Futures Contract:

• A future contract is an agreement

between two parties to buy/sell an
asset at a certain time in future at a
certain price. It may be offset prior to
maturity by entering into an equal but
opposite transaction. It eliminates
counterparty risk and offers more
liquidity

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Futures Terminology

• Spot Price The price at which an

instrument/asset trades in the spot
market.
• Future Price The price at which the
futures contract trade in the future
market.

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Futures Terminology

• Expiry Date It is the date specified in

the futures contract. This is the last
day on which the contract will be
traded, at the end of which it will
cease to exist.
• Contract Size The amount of asset
that has to be delivered under one
contract. For instance, the contract
size of the NSE future market is 200
Nifties.
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Futures Terminology

• Basis Basis is defined as the futures

price minus the spot price. There will
be a different basis for each delivery
month for each contract. In a normal
market, basis will be positive. This
reflects that futures prices normally
exceed spot prices.

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Futures Terminology

• Contract Cycle The period over which a contract

trades. For instance, the index futures contracts
typically have one month, two months and three
months expiry cycles that expire on the last
Thursday of the month. Thus, a January expiration
contract expires on the last Thursday of January and
a February expiration contract ceases trading on the
last Thursday of February. On the Friday following
the last Thursday, a new contract having three
month expiry is introduced for trading.

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Futures Terminology

• Cost of Carry The relationship between

futures prices and spot prices can be
summarised in terms of the cost of
carry. This measures the storage cost
plus the interest that is paid to finance
the asset, less the income earned on
the asset.

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Futures Terminology

• Initial Margin The amount that must be

deposited in the margin account at the time a
futures contract is first entered into is the
initial margin.
• Marking to Market In the futures market, at
the end of each trading day, the margin
account is adjusted to reflect the investor’s
gain or loss depending upon the futures
closing price. This is called marking to
market.
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Futures Terminology

• Maintenance Margin This is somewhat

lower than the initial margin. This is set
to ensure that the balance in the margin
account never becomes negative. If the
balance in the margin account falls
below the maintenance margin, the
investor receives a margin call and is
expected to top up the margin account
to the initial margin level before trading
commences on the
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next day.
Derivatives Market 17
Practical Question:

• Example 1 On January 15, X bought a

January Nifty futures contract that cost
him Rs 5,38,000. For this he had to pay
an initial margin of Rs 43,040 to his
broker. Each Nifty futures contract is
for the delivery of 200 Nifties. On
January 25, the index closed at 2,720.
How much profit/loss did he make?

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Practical Question:
• Solution 1 X bought one futures
contract costing him Rs 5,38,000. At a
market lot of 200, this means he paid Rs
2,690 per Nifty future. On the futures
expiration day, the futures price
converges to the spot price. If the index
closed at 2,720 this must be the futures
close price as well. Hence, he would
have made of profit of (Rs 2,720 – Rs
2,690) × 200 = RsDerivatives
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6,000 Market 19
Practical Question:

Example 2 X sold a January Nifty futures

contract for Rs 5,38,000, on January 15.
For this he had to pay an initial margin of
Rs 43,040 to his broker. Each Nifty
futures contract is for the delivery of 200
Nifties. On January 25, the index closed
at 2,520. How much profit/loss did he
make?

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 Practical Question:
• Solution 2 X sold one futures contract
costing in Rs 5,38,000. At a market lot
of 200, this works out to be Rs 2,690
per Nifty future. On the futures
expiration day, the futures price
converges to the spot price. If the index
closed at 2,520 this must be the futures
close price as well. Hence, he would
have made profit of (Rs 2,690 – Rs
2,520) × 200 = RsDerivatives
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34,000. Market 21
Practical Question:

• Example 3 On January 15, X bought

one January Nifty futures contract that
cost him Rs 2,69,000. For this he had to
pay an initial margin of Rs 21,520 to his
broker. Each Nifty contract is for the
delivery of 200 Nifties. On January 25,
the index closed at 1,280. How much
profit/loss did he make?

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Practical Question

• Solution 3 X bought one futures

contract for Rs 2,69,000. At a market lot
of 200, this means he paid Rs 1,345 per
Nifty future. On the futures expiration
day, the futures price converges to the
spot price. If the index closed at 1,280,
this must be the futures close price as
well. Hence, he made of loss of (Rs
1,345 – Rs 1,280) × 200 = Rs 13,000.
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Practical Question

• Example 4 X sold one January Nifty

futures contract for Rs 2,69,000, on
January 15. For this he had to pay an
initial margin of Rs 21,520 to his broker.
Each Nifty futures contract is for the
delivery of 200 Nifties. On January 25,
the index closed at 1,390. How much
profit/loss did he make?

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Practical Question

• Solution 4 X sold one futures contract

for Rs 2,69,000. In a market lot of 200,
this works out to be Rs 1,345 per Nifty
future. On the futures expiration day,
the futures price converges to the spot
price. If the index closed at 1,390, this
must be the futures close price as well.
Hence, he made of loss of (Rs 1,390 –
Rs 1,345) × 200 = Rs 9,000
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Distinction Between Futures and Forwards

• Traded on an organised stock

exchange
• Over the Counter (OTC) in nature
• Standardised contract terms, hence,
more liquid
• Customised contract terms, hence,
less liquid
• Risk is high
• Risk
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is less compare to forwards.
Derivatives Market 26
Distinction Between Futures and Forwards

• Requires margin payments

• No margin payment
• daily settlement
• Settlement happens at the end of the
period.
• Based on hedging
• Based on Speculation.
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OPTIONS CONTRACT:
An options contract is an agreement
between a buyer and seller that gives the
purchaser of the option the right to buy or
sell a particular asset at a later date at an
agreed upon price. Options contracts are
often used in securities, commodities, and
real estate transactions..

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Options Contract
A call option is the right to buy a stock at
the strike price before or at expiry American
option). For instance, assume there is a call
option to buy stock XYZ at $50 (strike), and
the option expires in three months. The
stock is currently trading at $49. If before,
or at, expiry the stock is trading above $50,
say at $60, the call buyer can exercise their
right to buy the stock at $50.
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 Options Contract
• They buy the stock at $50 from the call
writer and are able to sell the stock at $60
for a $10 profit per share. Alternatively, the
option buyer can simply sell the call to reap
the profit, since the call option is worth $10
per share, plus any time value that remains.
If the option is trading below $50 (strike) at
expiry, the option is worthless and the call
buyer loses what they paid for the option,
called the premium. 30
CALL OPTION:

• A call option is a contract that gives the

owner of the call option the right, but
not the obligation, to buy an
underlying asset, at a fixed price ($K), on
(or sometimes before) a pre-specified day,
which is known as the expiration day.

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PUT OPTION:

• A put option is a contract that gives the

owner of the put option the right, but
not the obligation, to sell an underlying
asset, at a fixed price, on (or sometimes
before) a pre-specified day, which is
known as the expiration day (T).

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Option Terminology

• Index Options These options have the index as the

underlying. Some options are European while others
are American. American options can be exercised at
any time upto the expiration date. Most exchange
traded options are American. European options can
be exercised only on the expiration date itself.
European options are easier to analyse than
American options, and properties of an American
option are frequently deduced from those of its
European counterpart. Like index futures contracts,
index options contracts are also cash settled

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 Option Terminology
• Stock Options Stock options are
options on individual stocks. A
contract gives the holder the right to
buy or sell shares at the specified
price.
• Buyer of an Option The buyer of an
option is the one who by paying the
option premium buys the right but
not the obligation to exercise his
option on the seller/writer.
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Option Terminology

• Writer of an Option The writer of a

call/put option is the one who receives
the option premium and is thereby
obliged to sell/buy the asset if the
buyer exercises the option on him

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Option Terminology

• Call Option A call option gives the holder the

right but not the obligation to buy an asset by a
certain date for a certain price.

• Put Option A put option gives the holder the

right but not the obligation to sell an asset by a
certain date for a certain price.

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Option Terminology

• Option Price/Premium Option price

is the price that the option buyer
pays to the option seller. It is also
referred to as the option premium.
• Expiration Date The date specified in
the options contract is known as the
expiration date, the exercise date,
the strike date or the maturity.
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Option Terminology

• Strike Price The price specified in

the options contract is known as the
strike price or the exercise price

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Option Terminology

• In-the-Money Option An in-the-money (ITM)

option is an option that would lead to a
positive cashflow to the holder if it were
exercised immediately. A call option on the
index is said to be in-the-money when the
current index stands at a level higher than
the strike price (that is, spot price > strike
price). If the index is much higher than the
strike price, the call is said to be deep ITM. In
the case of a put, the put is ITM if the index is
below the strike price.
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Option Terminology

• At-the-Money Option An at-the-money

(ATM) option is an option that would
lead to zero cashflow if it were
exercised immediately. An option on
the index is at-the-money when the
current index equals the strike price
(that is, spot price = strike price).

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 Option Terminology
• Out-of-the-Money Option An out-of-the-
money (OTM) option is an option that would
lead to a negative cashflow if it were
exercised immediately. A call option on the
index is out-of-the-money when the current
index stands at a level that is less than the
strike price (that is, spot price < strike price).
If the index is much lower than the strike
price, the call is said to be deep OTM. In the
case of a put, the put is OTM if the index is
above the strike price.
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Option Terminology

Intrinsic Value of an Option The option premium can

be broken down into two components (i) intrinsic value
and (ii) time value. The intrinsic value of a call is the
amount the option is ITM, if it is ITM. If the call is OTM,
its intrinsic value is zero. Putting it another way, the
intrinsic value of a call is Max[0,(St – K)] which means
the intrinsic value of a call is the greater of 0 or
(St – K). Similarly, the intrinsic value of a put is Max[0,
K – St], that is, the greater of 0 or (K – St). K is the strike
price and St is the spot price.

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 Option Terminology

• Time Value of an Option The time value of an

option is the difference between its premium
and its intrinsic value. Both calls and puts have
time value. An option that is OTM or ATM only
has time value. Usually, the maximum
time value exists when the option is ATM. The
longer the time to expiration, the greater is an
option’s time value, other things being equal.
At expiration, an option would have no time
value.

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Distinction Between Futures and
Options

Fundamental difference between options

and futures lies in the obligations they put
on their buyers and sellers. An option gives
the buyer the right, but not the obligation,
to buy (or sell) a certain asset at a specific
price at any time during the life of the
contract.

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• There are call options and put options. A
trader can buy a put or a call, or a trader
can write a put or a call.
• A futures contract is the obligation to
sell/buy a commodity (or other asset) at a
later date, at an agreed price.

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Distinction Between Futures
and Options

• FuturesExchange traded.
• Same as futures
• Exchange defines the product
• Same as futures
• Price is zero, strike price moves
• Strike price is fixed, price moves

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Distinction Between Futures
and Options

• Price is zero
• Price is always positive
• Linear payoff
• Non linear payoff
• Both long and short at risk
• Only short at risk
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Linear Derivative

• A linear derivative is one whose payoff

is a linear function. For example, a futures
contract has a linear payoff where a price-
movement in the underlying asset of the
futures contract translates directly into a
specific dollar value per contract.
• A non-linear derivative is one whose
payoff changes with time and space.
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 SWAPS:
• swap contract obligates two parties to
exchange, or swap, cash flows at specified
future dates.
• A swap is like a portfolio of forwards. Each
forward in a swap has a different delivery
date and the same forward price.
• A swap is an agreement between two
parties to exchange a series of
future cash flows.
Derivatives Market 49
SWAP

• A swap is a derivative contract where

two parties exchange financial
instruments. Most swaps are derivatives
in which two counterparties exchange
cash flows of one party's financial
instrument for those of the other party's
financial instrument.

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Examples for SWAP

Swaps are financial agreements to

exchange cash flows. Swaps can be based
on interest rates, stock indices,
foreign currency exchange rates and even
commodities prices.

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Swap - Examples

• The party paying the floating rate of the

swap believes that interest rates will go
down. If they do, the party's interest
payments will go down as well.
• The party paying the fixed rate "leg" of
the swap doesn't want to take the chance
that rates will increase, so they lock in
their interest payments with a fixed rate.
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 CONCLUSION

The volume of over-the-counter derivatives

traded rose by a quarter in the first half of
this year to $370 trillion. Derivatives are
contracts that originated from the need to
minimise risk.

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 THANK YOU

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