Introduction To Derivatives

Der i vat i ves

Some say the world will end in fire, Some say in ice
Fire and Ice Poem by Robert Frost (1874
1963)



This is what the Derivative world is.
Contents
Introduction to Derivatives
Derivatives in India
Basic purpose of derivatives
Application of Derivatives
for Risk Management & Speculation (Leveraging)
Basic Terms
Properties of
Forwards
Futures
Options

What is Derivatives?
A derivative can be defined as a financial instrument whose value
depends on (or derives from) the values of other, more basic underlying
variables. -John C. Hull
A derivative is simply a financial instrument (or even more simply an
agreement between two people) which has a value determined by the
price of something else. -Robert L. McDonald

The Securities Contracts (Regulation) Act, 1956 defines "derivatives" to
include:
1. A security derived from a debt instrument, share, loan whether secured
or unsecured, risk instrument, or contract for differences or any other
form of security.
2. A contract which derives its value from the prices, or index of prices,
of underlying securities.
Cont
In simple words, Derivative is Financial instrument whose price is dependent
upon or derived from the value of underlying assets.
The underlying not necessarily has to be an asset. It could be any other
random/uncertain event like temperature/weather etc.
The most common underlying assets includes:
Stock, Bonds, Commodities
Currencies, Interest rates
Derivatives cannot exist without the underlying
Derivatives do not convey any ownership in the underlying
Settlement : Cash settled or delivery of underlying
Physical Delivery : Exchange money and goods on final settlement
Cash : Settle profit / loss on final settlement

Origin of derivatives - Protection of Farmers Interest


Derivatives in India
In India, derivatives markets have been functioning since the
nineteenth century with organized trading in cotton through
the establishment of the Cotton Trade Association in 1875.
Derivatives, as exchange traded financial instruments were
introduced in India in June 2000. (Nifty 50 index futures
contract)
First to be traded were futures contract on Index.
After this came, options on individual securities and index
Futures contract on individual stocks were launched in
November,2001
In 1999, the Securities Contracts (Regulation) Act of 1956, or
SC(R)A, was amended so that derivatives could be declared
as securities.
The Act considers derivatives on equities to be legal and
valid, but only if they are traded on exchanges.
Milestones in the development of
Indian derivative market
November 18, 1996 L.C. Gupta Committee set up to draft a policy
framework for introducing derivatives
May 11, 1998 L.C. Gupta committee submits its report
on the policy framework
May 25, 2000 SEBI allows exchanges to trade in index
futures
June 12, 2000 Trading on Nifty futures commences on
the NSE
June 4, 2001 Trading for Nifty options commences on the
NSE
July 2, 2001 Trading on Stock options commences on the
NSE
November 9, 2001 Trading on Stock futures commences on the
NSE
August 29, 2008 Currency derivatives trading commences on the
NSE
August 31, 2009 Interest rate derivatives trading commences on
the NSE
February 2010 Launch of Currency Futures on
additional currency pairs
October 28, 2010 Introduction of European style Stock Options
October 29, 2010 Introduction of Currency Options
Derivatives Markets


Exchange Traded Contracts


Over The Counter Market
Market Participants

Hedger
Hedgers face risk associated with the price of an asset. They
use futures or options markets to reduce or eliminate this risk
Speculators
Speculators wish to bet on future movements in the price of an
asset. Derivatives can give them an extra leverage to enhance
their returns
Arbitrageurs
Arbitragers work at making profits by taking advantage of
discrepancy between prices of the same product across
different markets

Basic purpose of derivatives
In derivatives transactions, one partys loss is always
another partys gain.
The main purpose of derivatives is to transfer risk
from one person or firm to another, that is, to provide
insurance.
If a farmer before planting can guarantee a certain
price he will receive, he is more likely to plant
Derivatives improve overall performance of the
economy
Thus, the basic purpose of derivatives is to transfer
the price risk (inherent in fluctuations of the asset
prices) from one party to another; they facilitate the
allocation of risk to those who are willing to take it.

Example of Derivatives
a reimbursement program for college credit.
Consider that if your firm reimburses 100% of
costs for an A, 75% of costs for a B, 50% for a
C and 0% for anything less.
Your right to claim this reimbursement, then is
tied to the grade you earn. The value of that
reimbursement plan, therefore, is derived from
the grade you earn.
Applications of Derivatives
Derivatives are used by investors for the following:

1. Provide leverage (or gearing), such that a small movement
in the underlying value can cause a large difference in the
value of the derivative
2. Speculate and make a profit if the value of the underlying asset moves the
way they expect (e.g., moves in a given direction, stays in or out of a
specified range, reaches a certain level)
3. Hedge risk in the underlying, by entering into a derivative contract whose
value moves in the opposite direction to their underlying position and
cancels part or all of it out
4. Obtain exposure to the underlying where it is not possible to trade in the
underlying (e.g., weather derivatives)
5. Create option ability where the value of the derivative is linked to a specific
condition or event (e.g. the underlying reaching a specific price level)
Types of Financial Derivative
There is no definitive list of derivative products
and the types of derivative products that can be
developed are limited by human imagination only.
However the most common financial derivatives
can be classified as
1. Forwards
2. Futures
3. Options
Forwards
A forward contract is an agreement between two
parties to buy or sell an asset at a certain future time
for a certain future price.
Features:
These are bilateral contract
These contracts are customized
There is a counter party risk
Forward contracts are normally not exchange traded.
The party that agrees to buy the asset in the future is
said to have the long position.
The party that agrees to sell the asset in the future is said
to have the short position.
The specified future date for the exchange is known as
the delivery (maturity) date.

Forwards An example
11
th
August 2013

Mr. Tushar wants to buy 20 grm Gold, but his wife says
he should buy Gold only on the occasion of Diwali (on
11
th
November, 2013-Dhantreys)
Worried about price fluctuations
Jeweler thinks Prices of gold are very high currently
and may not go up during this Diwali
Worried about price fluctuations
Current gold price is Rs. 29000 per 10 grm

Both face a Price Risk

Transaction
Mr. Tushar and Jeweler enter into a contract on
11
th
August 2013
Mr. Tushar Jeweler
Will buy 20 grm. Gold Will sell 20 grm.
gold
Will Pay Rs. 30,000 per 10grm Will receive Rs.
30,000 per 10grm

Date of settlement : 11
th
Nov, 2013

This is a Forward contract,
trade happens today, settlement in future

Jewelers OBLIGATION is to give Gold and Mr.
Tushars OBLIGATION is to pay
Contract
Terms :
Underlying : Gold
Contract Date : August 11, 2013
Contract Price : Rs. 30,000 per 10 grm
Quantity : 20 grm.
Settlement date : November 11, 2013

By entering into the contract on August 11, 2013
what have the two parties done?
Locked in a future price of Rs. 30,000/- per
10grm.
Settlement
On November 11, 2013 :
Mr. Tushar buys 20 grm Gold from Jeweler
Jeweler Recieves Rs. 60,000
The contract entered on Aug 11, 2013 is settled.
Price of Gold quoting in the spot market
(underlying price) is Rs. 28000/- per 10 grm.
Cash Settlement
On Nov11, 2013 :
Price of Gold quoting in the spot market (underlying price)
is Rs. 28000/- per 10 grm.
Who gains? By how much?
Jeweler Rs. 2000 per 10 grm.
Settlement :
Loser pays to the Gainer the profit / loss
Jeweler receives Rs. 4000 from Mr. Tushar

Pay Off

Pay Off = S
T
K (for the long forward) - Buyer

Pay Off = K S
T
(for the short forward) Seller

Where,
T = Time to expiry of the contract
S
T
= Spot Price of the underlying asset at time T
K = Strike Price or the price at which the asset will be
bought/sold

Forward Contract Payoff

K

Futures
Futures were designed to solve the problems that existed in the
forward markets
Counter Party risk
Liquidity

A future is a forward contract that has been standardized and
sold through an organized exchange
Structure of a futures contract:
Seller (has short position) is obligated to deliver the commodity or a
financial instrument to the buyer (has long position) on a specific
date, this date is called settlement, or delivery date

The long and short party usually do not deal with each other
directly or even know each other for that matter. The
exchange acts as a clearinghouse. As far as the two sides
are concerned they are entering into contracts with the
exchange. In fact, the exchange guarantees performance of
the contract regardless of whether the other party fails.

Futures .exchange traded forwards
1. Exchange Traded (transperancy)

2. Standardised contracts (reduce complexity)

3. Counter - Party Risk is absent (settlement is guaranteed
by a Clearing Corporation)

Futures terminology
Spot price : Price at which asset trades in the spot market
Futures : Price at which Futures contracts trade in the
futures market
Contract cycle : The period over which a contract trades
Expiry Date : Last date of the contract
Contract size : Amount or value of each contract
Initial margin : Amount deposited initially to trade futures
(by both buyer & seller)
Cost of Carry : Relationship between futures and spot price is
determined by cost of carry. For
financial assets it is interest cost.

Contract Life Cycle - example
Futures contracts in NIFTY on Feb 2012: Any given time upto 3
months duration contracts.

Contract Month Expiry/settlement date
Feb 2012 25
th
Feb
March 2012 25
th
March
April 2012 29
th
April

*Expiry last Thursday of the month

You are on Feb 10.
You have a Near Month, Middle Month and Far Month contracts
to choose from.

Steps in trading Futures
Pay Initial Margin
Buy or Sell Futures
Daily Mark to Market Settlement
Initial Margin (IM)
Stock (ABC Ltd.) Futures (ABC Ltd. Futures)
Rs. 500 Rs. 510
Buy 1000 shares Buy 1000 Futures
Value = Rs. 5,00,000 Value = Rs. 5,10,000

Pay Rs. 5,00,000 Pay IM = Rs. 51,000

After 10 days :
Rs. 600 Rs. 610

RETURN = 20% RETURN = 196%
Pricing of Futures
Futures price = Spot Price + Cost of carry

Cost of carry = interest rate*

At expiry : Futures price = Spot price


*for financial futures
Pricing - Futures
Feb 10, you have Rs. 100.
How much will it become on March 10.

Depends on how much interest you can earn

If it is 12% p.a., then after 1 month Rs. 100 will become =

Rs. 101

F = S + Int.
Rs. 101 = Rs. 100 + Re. 1
Points to remember.
Long Buy (going long) [Bullish view]
Short Sell (going short) [Bearish view]
Squaring off (turn around trades) opposite
transaction to the previous one
Buy low, sell high - gives a profit
Sell high, buy low - also gives a profit
Sell low, buy high gives a loss
Buy high, sell low also gives a loss
Daily Mark to Market Settlement Futures contracts
Date


Oct 1, 2008
11:00 am
Spot Price of
ABC Ltd. :


Rs. 490
Mr. Raju Buys
ABC Ltd.
Futures @

Rs. 510
MTM Gain
/ Loss
Mr. Ajay Sells
ABC Ltd.
Futures @

Rs. 510
MTM Gain
/ Loss
Remarks :
Gainer receives
MTM amount from
the loser on a daily
basis
Oct 1, 2008
3:30 pm

Rs. 500

Rs. 512 + Rs. 2 Rs. 512 - Rs. 2
Ajay Pays Rs. 2 to
Raju
Oct 2, 2008
3:30 pm
Rs. 510 Rs. 520 + Rs. 8 Rs. 520 - Rs. 8
Ajay Pays Rs. 8 to
Raju

Oct 3, 2008
3:30 pm
Rs. 495 Rs. 510 - Rs. 10 Rs. 510 + Rs. 10
Raju Pays Rs. 10 to
Ajay

Oct 4, 2008
3:30 pm

Rs. 505 Rs. 515 + Rs. 5 Rs. 515 - Rs. 5
Ajay Pays Rs. 5 to
Raju

Oct 5, 2008
3:30 pm
Rs. 515 Rs. 525 +Rs. 10 Rs. 525 - Rs. 10
Ajay Pays Rs. 10 to
Raju

Futures Payoff
A payoff is the likely profit or loss that would
accrue to a market participant with change in the
price of the underlying asset

Futures have a linear payoff, i.e. the losses as
well as profits for the trader of futures contract are
unlimited
Payoff diagram for futures
P
R
O
F
I
T
S
L
O
S
S
E
S
Rs. 250 0 Rs. 500
Buy RELIANCE
FUTURES @ Rs. 250
Rs. 300
Sell @ Rs. 300
Linear Pay Off
Rs. 50
P
R
O
F
I
T
S
L
O
S
S
E
S
Payoff diagram for futures
Sell RELIANCE
FUTURES @ Rs. 250
Buy @ Rs. 200
Linear Pay Off
Rs. 250 Rs. 200
Final Settlement convergence of Futures to Spot

Time
(a)
Futures
Price
Spot Price
No Arbitrage Principle

On the final settlement day/
expiry day, the Futures
contract is settled at the
underlying closing price
(spot price)

Cash Settlement

DISTINCTIONS BETWEEN FUTURES
& FORWARDS
Forwards
Traded in dispersed
interbank market 24 hr a day.
Lacks price transparency

Transactions are customized
and flexible to meet
customers preferences.
Futures
Traded in centralized
exchanges during specified
trading hours. Exhibits price
transparency.

Transactions are highly
standardized to promote
trading and liquidity.
DISTINCTIONS BETWEEN FUTURES
& FORWARDS
Forwards
Counter party risk is variable




No cash flows take place
until the final maturity of the
contract.
Futures
Being one of the two parties,
the clearing house
standardizes the counterparty
risk of all contracts.


On a daily basis, cash may
flow in or out of the margin
account, which is marked to
market.

Options
Example :-
TATA is launching a car Nano
Price is Rs. 1Lakh. [Purchase price]
You can book the car by paying Rs. 20,000 [deposit]
By booking the car, what have you bought?
o A RIGHT to buy the car
When booking matures, can TATA force you to buy
Nano?
o TATA has only OBLIGATION
Can you force TATA to sell Nano?


Introduction to Options
An options contract gives the buyer the
right, but not the obligation to Buy or Sell a
specified underlying at a set price on or
before a specified date


: eg. Car Purchase, Insurance
Options Terminology
Index options
Stock Options
Option buyer
Option seller
Option premium
Strike / Exercise price

Expiry date: Its last Thursday of the month for
options to be exercised/ traded. Options cease to
exist after expiry

Options
Calls give the buyer the right but not the obligation
to buy.

Puts give the buyer the right, but not the obligation
to sell.

CALL OPTIONS : Gives the buyer of the Call Option
the RIGHT to buy at the STRIKE PRICE
CALL OPTIONS : The Seller of the Call Option has to
meet his OBLIGATION of selling when the buyer
EXERCISES his right
The Buyer retains the RIGHT to Exercise or not
Exercise

Call Option
Exercise Point : U > SP

Break Even point : U = SP + Premium

Net profit : U > SP + Premium
Call Option
December 15,
Underlying Price Strike Price Premium
Rs. 100 Rs. 80
Rs. 30

December 28,
Underlying Price can be above, at or below Strike Price
Rs. 112
Rs. 80
Rs. 75

At which underlying price Buyer will exercise the Option ?




Certain Concepts - Options
In the money- positive cash flow if
exercised
immediately
At the money - zero cash flow if
exercised immediately
Out of the money - negative cash flow if
exercised
immediately
Call Option
The Buyer of an Options needs to pay to the
Seller the PRICE of the Option.
This is called as the PREMIUM.
It is paid immediately on buying the Option.
The Seller receives the Premium on T+1 day.

Call Option
Buyer : Unlimited Profits, Limited Losses
Seller : Unlimited Losses, Limited Profits

Buyer : Losses Limited to the premium (max. loss)
Seller : Profits Limited to the premium
(max. gain)
Classification of Options
Type
Call or Put

Exercise style
EUROPEAN is an option that can be exercised only
on its expiration date
AMERICAN is an option that can be exercised any
time up until and including its expiration date

Settlement
Cash or physical

RIGHT
CALLS Buyer Buy at the strike price at expiry


OBLIGATION
Seller Sell at the strike price at expiry




RIGHT
PUTS Buyer Sell at the strike price at expiry


OBLIGATION
Seller Buy at the strike price at expiry

CALLS & PUTS RIGHTS AND OBLIGATION
BUYER OF AN OPTION

PAYS PREMIUM

PREMIUM IS THE MAXIMUM LOSS THE BUYER CAN SUFFER



SELLER OF AN OPTION

RECEIVES PREMIUM

PREMIUM IS THE MAXIMUM PROFIT THE SELLER CAN MAKE

APPLICABLE FOR BOTH CALLS AND PUTS



Intrinsic value
Price of an option is called Premium

Premium = Intrinsic value + time value

Intrinsic value is the amount the contract is in
the money
e.g. Spot = 1000, Strike Price = 990 March Call
Premium = Rs 15 (Intrinsic value = Rs. 10, time
value = 5)


Options Pricing
Intrinsic Value (IV )
Difference between spot and strike
ITM has IV, ATM and OTM have zero IV

Time Value ( TV )
Difference between the premium and intrinsic value
ITM have both IV and TV, ATM and OTM have only
TV
Longer the expiry more the TV, on expiry TV is 0
Options Payoff
Optional characteristics of options results in a non
linear payoff for options. Non linear payoffs provide
flexibility to create combinations

Losses of the buyer is limited to the premium paid and
profits are unlimited

For writers/sellers losses are unlimited and profits
limited to the premium received
Options Payoffs
Payoff profile of buyer of asset: Long asset
Payoff for investor who went Long Nifty at 2220
Payoff profile for seller of asset:
Short asset
Payoff for investor who went Short Nifty at
2220
Payoff profile for buyer of call
options: Long call
Payoff for the buyer of a three month call
option with a strike of 2250 bought at a
premium of 86.60
Payoff profile for writer of call
options: Short call
Payoff for the writer of a three month call
option with a strike of 2250 sold at a premium
of 86.60.
Payoff profile for buyer of put options:
Long put
Payoff for the buyer of a three month put
option with a strike of 2250 bought at a
premium of 61.70.
Payoff profile for writer of put options:
Short put
Payoff for the writer of a three month put
option with a strike of 2250 sold at a premium
of 61.70
THE PAY OFF DIAG. - OPTIONS
PROFITS AND LOSSES ON CALLS AND PUTS
Security ACC

100
PROFITS
CALLS
LOSSES
100
LOSSES
PROFITS
PUTS
20
120
20
80
Any Questions?



Now we have some Questions.
Spot value of NIFTY is 2240. An investor buys a one
Month NIFTY 2227 put option for a premium of Rs.17.
The option is
________.

Out of the money

In the money

At the money

Above the money
A call option that is out-of-the-money or at-the-money
has ________.



only time value only intrinsic
value
face value no value
A put option is in-the-money if the price of
the underlying asset is __________ the
strike price.

Above
Below
Equal to
Between the premium and strike price
Spot value of NIFTY is 2230. An investor buys a one
Month NIFTY 2245 call option for a premium of Rs.5.
After One month the spot value of NIFTY is 2250. The
Option is _________.

In the money
At the money
Above the money
Out of the money
An index put option at a strike of Rs.
2176 is selling at a premium of Rs. 28.
At what index level will it break even for
the buyer of the option?


Rs. 2148
Rs. 2196
Rs. 2204
Rs. 2194
Thank You !!