Derivatives &

Derivatives Market

Derivative comes from the word to

derive

A derivative is a contract whose value

is derived from the value of another
asset called underlying asset

If
the
price
of
underlying
asset/security changes the price of
derivative security also changes.

Financial derivatives
Underlying is stocks, bonds, indexes, foreign

exchange, Eurodollar etc.

Commodity derivative
Underlying is wheat, cotton, pepper, corn, oats,

soyabean, crude oil, natural gas, gold, silver,

turmeric etc.

Derivative minimizes the risk of owning things

that are subject to unexpected price fluctuations
like stocks & bonds, foreign currencies,
commodities like wheat, minerals, etc.

Under
lying Price
Change

Derivative
Price
Change

Change in
Spot or
Cash Market
Price of
Underlying

Change in
Prices in
Derivatives
market

Three
Purposes
HEDGING

SPECULATI
ON

PROFIT
THROUGH
ARBITRAGE

Forwards
Futures
Options
Swaps

1.
2.

Over the counter derivatives

Exchange traded derivatives

Over the counter derivatives are the ones

that are traded directly between 2
parties, without the intermediation of
stock exchanges
Exchange-traded derivatives are those that
are traded via derivative exchanges.

 In

case of OTC derivatives, the

management of counterparty risk is
decentralised and rests with the
individual parties
But in case of exchange traded
derivatives the counter party risk lies
with the exchange concerned

 There

are no formal centralised

limits on individual positions,
leverage or margining
In the case of exchange traded
derivative, such regulations would be
there

 In

case of OTC derivatives, the

contracts are custom designed
In the case of exchange traded
derivatives, they are highly
standardised regarding the size,
price and time duration

 In

case of OTC derivatives, there are

not formal rules for risk and burden
sharing
But in case of exchange traded
derivatives such rules exist. Hence
the element of risk is relatively less
here.

 In

case of OTC derivatives, there are

no rules or mechanisms to ensure
market stability and integrity and for
safeguarding the interests of market
participants
But in case of exchange traded
derivatives there are elaborate rules
and institutional mechanisms in
these matters

In India, two exchanges offer derivatives trading:

the Bombay Stock Exchange (BSE) and the
National Stock Exchange (NSE).
OTC derivative trading are considered as illegal in
Indian Law.
OTC Contract
Exchange Traded
Contract
Customized Terms

Standardized Terms

Substantial Credit Risk No risk

Unregulated

Regulated

Transparency

Information
Asymmetry

Overleveraged
positions

Less leveraged

FORWARDS
It is a contract between two parties to buy or sell an
underlying asset at todays pre-agreed price (known as
Forward Price) on a specified date in the future.
This forward price is set at the inception of contract
It is the most basic form of derivative contract.
These contracts are not standardized, the end users can
tailor make the contracts to fit their very specific needs.
Traded at Over The Counter exchange.

1.
2.
3.
4.
5.

It is a bilateral contract
It is exposed to counterparty risk
Each contract is customer
designed and hence is unique
Contract price is not generally
available in public domain
On the expiration date the
contract has to be settled
through delivery of the asset

 Forward

contracts are very

useful in hedging, speculation
and arbitrage

Suppose the present value of share is 45 and Mr X

expects it to go up to 75 in 3 months. Mr X can
make a good profit by buying 10,000 shares at, say,
50 per share through a forward contract today.

After 3 months, the investor can take a reversing

transaction to book profits. If the actual price in 3
months is 75, Mr X will be making a profit of 25
per share and a total profit of 2,50,000.

But the risk is that price can decrease also. If price

drops to 25, then Mr X will incur a loss of 2,50,000

An Indian Company has ordered machinery from

USA. The price of $ 5,00,000 is payable after six
months. The current exchange rate is 49.08 as on
28th Feb 2012. At the current rate the company
needs 49.08*5,00,000 = 2,45,40,000
If the company anticipates depreciation of Indian
rupee over time. The company can enter into a
forward contract & forget about any exchange
rate fluctuations. Suppose the exchange rate
becomes 50, then also the company has to pay
Rs. 2,45,40,000 for buying $ 5,00,000 though the
value is 2,50,00,000.

1.
2.
3.

Lack of centralisation of trading

Inadequate liquidity
Presence of huge counterparty
risk

FUTURES
Futures are financial contracts that help to lock-in
the price at which one wishes to buy or sell an
asset in the future.
Futures are highly standardized, exchange
traded contracts to buy or sell specified
quantity of financial instruments/commodity in a
designated future month at a future price.
Futures Price: The price agreed by the two
traders on the floor of exchange.

 Futures

are standardised contracts.

For e.g. an exchange may offer 4
different types of future contracts on a
given security like
March 31/110, June 30/115, September
30/120, December 31/125
That means, the buyer/seller of a March
31/110 futures contract in effect
undertakes to buy/sell the security at Rs
110 on March 31, and so forth

A farmer supplies Barley to a Breakfast

cereal manufacturer. He fears fall in
future prices of Barley. so he thinks of
entering into a futures contract for selling
20 metric ton of barley.
If he wants to sell less than 20 metric ton
he has to enter into a forward agreement
& not futures.
This is bcoz standard contract size
for
barley
in
barley
international
exchange is 20 metric ton or its multiples.

Futures vs Forwards

 It is the initial deposit required to open a

trading account in a futures trading
exchange.
The initial margin is fixed by the broker,
but has to satisfy an exchange minimum.
The variation margin i.e. the change in the
amount of an account on a given day in
response to a marked to - market
process, is settled on daily basis.

The exchange requires both parties to put up an

initial amount of cash, the margin. Additionally,
since the futures price will generally change daily,
the difference in the prior agreed-upon price and
the daily futures price is settled daily
The exchange will draw money out of one party's
margin account and put it into the other's so that
each party has the appropriate daily loss or profit.
If the margin account goes below a certain value,
then a margin call is made and the account owner
must replenish the margin account. This process
is known as marking to market.

 Initial Margin The amount that must be

deposited in the margin account when
establishing a position. The margin requirement is
about 12% futures & 8% for options.
Marking to Market In the futures market at the
end of each trading day, the margin account is
adjusted to reflect the investors gain or loss
depending upon the futures closing account.
Maintenance 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 is expected to top up the initial level
before trading commences on the next day.

For example, say, you have bought 100 shares of XYZ at Rs.100 and
Threshold MTM Loss is 20% and the applicable margin % is 35%. You
would be having a margin of Rs.3500 blocked on this position. The
current market price is now say Rs.75. This means the MTM loss is 25%
which is more than the threshold MTM loss % of 20% and hence
additional margin to be called in for. Additional margin to be calculated as
follows:

(a) Margin available

100*100*35%

Rs.3500

(b) Less : MTM Loss

(100-75)*100

Rs.2500

(c) Effective available

margin

(a-b)

Rs.1000

(d) Required Margin

75*100*35%

Rs.2625

(e) Additional Margin (d-c)

required

Rs.1625

Types of Futures
Commodity futures (Wheat, corn, etc.) and
Financial futures
Financial futures include:

Foreign currencies
Interest rate
Market index futures (Market index futures are
directly related with the stock market)
Individual stock.

OPTIONS
An option is a contract between two parties in
which one party has the right but not the
obligation to buy or sell some underlying asset
on a specified date at a specified price.
The option buyer has the right not an obligation
to buy or sell.
If the buyer decides to exercise his right the
seller of the option has an obligation to deliver or
take delivery of the underlying asset at the price
agreed upon.

Types of Options
On the basis of the nature of the rights
and obligations in the option contract,
options are classified in to two categories.
They are:
Call Options and
Put Options.

CALL OPTIONS
A call option is a contract that gives the option
holder the right to buy some underlying asset from
the option seller at a specified price on or before a
specified date.
Eg. The current market price of Ashok Leyland is
Rs.69. An option contract is created and traded on
this share. A call option on the share would give
the right to buy the share at a specified price
(Rs.70) during June 2014. This call option would
be traded between two parties P (the purchaser
and S ( the seller). The purchaser P would be
prepared to pay a small price known as option
premium (Rs.2) to S, the seller of the option.

PUT OPTIONS
A put option is a contract which gives
its owner the right to sell some underlying
asset at a specified price on or before a
specified date.
The seller of the put option has the
obligation to take delivery of the
underlying asset, if the owner of the option
decides to exercise the option.

A Call Option
If an investor buys one option to buy one
Infosys share at Rs 730 by paying a
premium of Rs 10, his total cost is Rs 740
At any time before or on the expiration
date, the investor can exercise the right to
buy the option, if the price goes above Rs
740 in the cash market.
If it does not, then he will not do anything
and will allow the option to expire.

A Put Option
If an investor buys one option to sell one
Infosys share at Rs 730 by paying a
premium of Rs 10, again his total cost is Rs
740
At any time before or on the expiration
date, the investor can exercise the right to
sell the option, if the price goes below Rs
740 in the cash market.
If it does not, then he will not do anything
and will allow the option to expire.

 Option Writer or Option Grantor: The

seller of option.
Strike price or Exercise price : The price
at which the option holder may purchase
the underlying asset from the option seller.
Time to Expiration or Time to Expiry :
The period of time specified for exercising
the option.
Expiration Date : The precise date on
which the option right expires.

Types of Options
On the basis of maturity pattern of
options, option contracts are categorized
in to two. They are:
European Style Options
American Style Options

 European Style Options

Options which can be exercised only
on the maturity date of the option or on the
expiry date.
American Style Options
Options which can be exercised at any
time up to and including the expiry date.
Most of the exchange traded options
are American style. In India stock options
are American style while index options are
European style.

Types of Options
Based on the mode of trading options
are classified in to two:
Over-the-counter Options
Exchange Traded Options

Moneyness of Options
Moneyness of an option describes the
relationship between the strike price of the
option and the current stock price. This
takes three forms:
1. In the Money (advantageous to option
holder)
2.
At the Money (neutral)
3.
Out of the Money (not advantageous
to option holder)

1. In the Money Options

When the strike price of a call option is lower
than the current stock price, the option is said to
be in the money. This is because the owner of
the option has the right to buy the stock at a price
which is lower than the price which he has to pay
if he had to buy it from the open market.
Similarly in the case of put option, when the
strike price is greater than the stock price, the
option is said to be in the money.
If an in the money option is exercised, there will
be an immediate cash inflow.

When the strike price of a call option

is equal to the current stock price, the
option is said to be at the money option.
In the case of a put option if the strike
price of the option is equal to the stock
price, the put option is said to be at the
money.

When the strike price of a call option is

more than the stock price, the option is
termed as out of the money option.
In the case of put option, if the strike
price is less than the stock price, the
option is said to be out of the money
option.

When the Shares of A Ltd. is

Trading at Rs.450
Strike Price (Rs.)

Call Option

Put Option

In the Money

Out of the Money

At the Money

At the Money

Out of the Money

In the Money

420
430
440
450
460
470
480

Difference between Futures & Options

An Option
gives the buyer the right but not the obligation while the seller has
an obligation to comply with the contract. In the case of a futures contract,
there is an obligation on the part of both the buyer and the seller. When you
purchase call or put Options you have the right to let your Option lapse but if
you choose to exercise it, the counter-party (seller) must comply. A futures
contract, on the other hand, is binding on both counter-parties as both parties
have to settle on or before the expiry date.

Purchasing a futures contract requires an up front margin and normally

involves a larger outflow of cash than in the case of Options, which require
only the payment of premium.
A futures contract carries unlimited profit and loss potential whereas the buyer
of a Call or Put Option's loss is limited but the profit potential is unlimited.
Futures are a favourite with speculators and arbitrageurs whereas Options are
widely used by hedgers.

When you buy an option, you pay the seller a nonrefundable amount, known as the option premium,
for the right to exercise that option before it
expires.
If you sell an option, you receive a premium from
the buyer. In fact, collecting the premium is often
one motive for selling options, including those you
anticipate will expire without being exercised.
Factors such as the price and volatility of the
underlying instrument, current interest rates, and
so on affect the premium price.

1.

No big investment

2.

No margin as in futures

3.

No obligation (for buyer)

4.

No mark to market

5.

More gain than risk

1.

Involves premium payment

2.

Less liquidity

On December 1999, the Securities Contract

Regulation Act was amended to include
derivatives within the sphere of securities.
Derivatives trading commenced in India in June
2000 after SEBI granted the final approval to this
effect in May 2000 on the recommendation of L.
C Gupta committee.
Securities and Exchange Board of India (SEBI)
permitted the derivative segments of two stock
exchanges, NSE and BSE, and their clearing
house/corporation to commence trading and
settlement in approved derivatives contracts.