Module IV

Derivatives

A financial contract, between two or more parties, of pre-determined duration, whose value is derived from the value of an underlying asset. Underlying asset can be:
Securities(shares and share warrants) commodities( includes grain, coffee bean) bullion precious metals(gold, silver) currency

livestock
index such as interest rates, exchange rates. OTC(over the counter) money market instruments.

Uses of derivatives:

Management of risk
Hedging

Efficiency in trading
Financial derivatives are more attractive than underlying

security

Speculation Price discovery

Revealing information about future market prices.

Price stabilization function

Participants of Derivatives MarketsThey are those who buy or sell in derivatives market Hedgers
in order to reduce their risk of their portfolio.
Eg: if the portfolio of hedger is long then he will protect or hedge this

position by buying put options in derivatives market.

Speculators Speculators are those who enter into the market

purely for making profit by buying or selling the derivatives, they do not have any intention of hedging their portfolio or such thing their only aim is to make profit based on their judgment about the stock or market.
Arbitrageurs Arbitrage refers to obtaining risk free profits by

simultaneously buying and selling similar instruments in different markets. Arbitrageurs enter into derivative market in order to take advantage of any such opportunity and profit from it.

Types of Derivatives

Based on the underlying assets derivatives are classified into.

Financial Derivatives (UA: Fin asset) Commodity Derivatives (UA: gold etc)

Index Derivative (BSE sensex)

(UA: Underlying Asset)

DERIVATIVE INSTRUMENTS
Forward contracts Futures

Commodity Financial (Stock index, interest rate & currency )

Options
Put Call

Swaps.
Interest Rate Currency

What is a Hedge
Hedge

means to be cautious or to protect against

loss. In financial parlance, hedging is the act of reducing uncertainty about future price movements in a commodity, financial security or foreign currency . Thus a hedge is a way of insuring an investment against risk.

FORWARD CONTRACTS.

A cash market transaction in which a seller agrees to deliver a specific cash commodity to a buyer at some point in the future. A one to one bipartite contract, which is to be performed in future at the terms decided today.

Product ,Price ,Quantity & Time have been determined in advance by both the parties.
Forward price= spot price + cost of carry(storage, insurance.
transport

Example of forward contract: Jay and Nithin enter into a contract to trade in one stock on Infosys 3 months from today the date of the contract @ a price of Rs4675/-

Features in a forward contract

Traded between two persons. Each contract is custom designed, hence is unique in terms of size, expiration date, asset type. Credit risk to both parties On expiration date, delivery of asset is done. Forward contracts are not normally negotiable No payment is involved, as the contract is simply an agreement to buy or sell at future date.

FUTURES.
Future contracts are organized/standardized contracts in terms of quantity, quality, delivery time and place for settlement on any date in future. These contracts are traded on exchanges. These markets are very liquid, In these markets, clearing corporation/house becomes the counter-party to all the trades or provides the unconditional guarantee for the settlement of trades i.e. assumes the financial integrity of the whole system. In other words, we may say that the credit risk of the transactions is eliminated by the exchange through the clearing corporation/house.

Example

Let us once again take the earlier example where Jay and Nithin entered into a contract to buy and sell Infosys shares. Now, assume that this contract is taking place through the exchange, traded on the exchange and clearing corporation/house is the counter-party to this, it would be called a futures contract.

Positions in a futures contract

Long - this is when a person buys a futures contract, and agrees to receive delivery at a future date. Eg: Nithins position Short - this is when a person sells a futures contract, and agrees to make delivery. Eg: Jays Position

How does one make money in a futures contract?

The long makes money when the underlying assets price rises above the futures price. The short makes money when the underlying assets price falls below the futures price. Concept of initial margin

Futures Vs Forwards
Futures are exchange-traded, while forwards are traded over-the-counter. Futures are standardized and face an exchange, while forwards are customized and face a non-exchange counterparty. Futures are margined, while forwards are not. Futures have significantly less credit risk, and have different funding.

Options
An option is a contract giving the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An option is a security, just like a stock or bond, and is a binding contract with strictly defined terms and properties.

Types of options:
Call

option: An option contract giving the owner the right to buy a specified amount of an underlying security at a specified price within a specified time. Put Option: An option contract giving the owner the right to sell a specified amount of an underlying security at a specified price within a specified time

Terms in Options
Underlying: This is the specific security / asset on which an options contract is based. Option Premium: Premium is the price paid by the buyer to the seller to acquire the right to buy or sell. Strike Price or Exercise Price :price of an option is the specified/ pre-determined price of the underlying asset at which the same can be bought or sold if the option buyer exercises his right to buy/ sell. Expiration date: The date on which the option expires is known as Expiration Date

European style of options: The European kind of option is the one which can be exercised by the buyer on the expiration day only & not anytime before that. American style of options: An American style option is the one which can be exercised by the buyer on or before the expiration date, i.e. anytime between the day of purchase of the option and the day of its expiry. Asian style of options: these are in-between European and American. An Asian option's payoff depends on the average price of the underlying asset over a certain period of time. Option Holder Option seller/ writer

Positions
Long Position: The term used when a person owns a security or commodity and wants to sell. If a person is long in a security then he wants it to go up in price. Short position: The term used to describe the selling of a security, commodity, or currency. The investor's sales exceed holdings because they believe the price will fall.

Profit/Loss Profile of a Long call Position

Profit

0 100 -3 103

Loss

Option Price = Rs3 Strike Price = Rs100

Price of Asset XYZ at expira tion

Time to expiration = 1month

Profit /Loss Profile for a Short Call Position

Profit
+3

0 100 103

Price of the Asset XYZ at expiration

Loss

Initial price of the asset = Rs100 Option price= Rs3 Strike price = Rs100 Time to expiration = 1 month

Profit/Loss Profile for a Long Put Position

Profit

0 98 100

Price of the Asset XYZ at expiration

-2

Initial price of the asset XYZ = Rs100

Option Price = Rs2 Strike price = Rs100

Loss

Time to expiration = 1 month

Profit/Loss Profile for a Short Put Position

Profit
+2

0 94 100

Price of the Asset XYZ at expiration Initial price of the asset XYZ = Rs100 Option Price = Rs2 Strike price = Rs100 Time to expiration = 1 month

Loss

Long Call
Short Put
Price rises

Price Falls

Long Put Short Call

Futures and options

Both are traded through exchanges as standardized contracts. Execution of contract is guaranteed by the concerned exchanges. Downside risk in futures are unlimited which is limited to option premium in options.

SWAPS.
An

agreement between two parties to exchange one set of cash flows for another. In essence it is a portfolio of forward contracts. While a forward contract involves one exchange at a specific future date, a swap contract entitles multiple exchanges over a period of time. The most popular are interest rate swaps and currency swaps.

Interest Rate Swap

Counter Party
LIBOR

Counter Party B

A
Fixed Rate of 12%

A is the fixed rate receiver and variable rate payer. B is the variable rate receiver and fixed rate payer.

Types of swaps
Interest rate swaps 2. Currency swaps 3. Commodity swaps 4. Equity swaps
1.

General risk associated with derivative instrument:

Credit risk Market risk Operational risk

Inadequate documentation Bankruptcy of counterparty

Strategic risk

Stock Index Option

Trading in options whose underlying instrument is the stock index. Here if the option is exercised, the exchange assigned option writer pays cash to the options buyer. There is no delivery of any stock.

Badla trading

Badla was an indigenous carry-forward system invented on the Bombay Stock Exchange as a solution to the perpetual lack of liquidity in the secondary market. Badla were banned by the Securities and Exchange Board of India or SEBI in 1993 (effective March 1994), amid complaints from foreign investors, with the expectation that it would be replaced by a futures-and-options exchange. Such an exchange was not established and badla were legalized again in 1996 (with a carry-forward limit of Rs 20 crore per broker) and banned again on July 2, 2001, following the introduction of futures contracts in 2000.

Options Trading in India

The Security Exchange Board of India (SEBI) has announced a list of 31 shares for the stock-based option trading from July 2002. SEBI selected these shares for option trading on the basis of the following criteria:
Shares must be among the top 200 in terms of market capitalisation and trading volume. Shares must be traded in at least 90 per cent of the trading days.

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Options Trading in India

The non-promoter holding should be at least 30 per cent. The six-month average trading volume in the share in the underlying cash market should be a minimum of Rs 5 crore. The ratio of daily volatility of the share vis--vis the daily volatility of the index should not be more than four times at any time during the previous six months.

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Lets sum up!!!!

Derivatives Participants Use of derivatives

Types of derivatives
Forwards Futures Options contract Swaps Risk associated with derivative instruments Bandla trading Derivatives markets in India