LUDHIANA STOCK EXCHANGE

LECTURE
ON

DERIVATIVES
BY
Pooja M. Kohli
Executive Director (Offtg.)

LUDHIANA STOCK EXCHANGE 1

 CONTENTS OF TOPIC
1. MEANING OF DERIVATIVES.
2. DERIVATIVES PRODUCTS
3. PARTICIPANTS IN DERIVATIVES
4. FORWARD VS FUTURE CONTRACTS
5. VARIOUS TERMINOLOGIES
6. BENEFITS OF DERIVATIVES
7. DERIVATIVES IN INDIA

LUDHIANA STOCK EXCHANGE 2

 CONTENTS OF TOPIC
8. INDEX DERIVATIVES PAYOFFS.
9. CALL OPTIONS PAYOFFS.
10. PUT OPTIONS PAYOFFS.
11. CONCLUSION.

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 1.MEANING OF DERIVATIEVES
 The term derivatives indicates that the
value is derived from some underlying
assets.
 It is a product but does not have any
independent value.
 Underlying assets could be securities,
commodities, bullion, currency, live stocks
or any thing else.

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 1.MEANING OF DERIVATIEVES Contd.

 Future trading is an advancement over

Forward Trading and has grown out of
need for hedging the price risk involved.

 It represents a more efficient way of

hedging risk.

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 2.DERIVATIVE PRODUCTS

1. Forward Contracts
2. Futures Contracts
3. Options

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 2.DERIVATIVE PRODUCTS Contd.

1. Forward Contracts: It is a customized,

tailor made contracts between two
parties.
2. Future Contracts: It is an agreement
between two parties to buy & sell at
future date. These are Standardised and
exchange traded contracts.

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 2.DERIVATIVE PRODUCTS Contd.

3. Options: It is a contract which gives

holder the right to exercise the option
and not the obligation.
 Call Option: Holder has right to buy and not
the obligation
 Put Option: Holder has right to sell and not the
obligation

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 2.DERIVATIVE PRODUCTS Contd.
4. LEAPS: Long Term Equity Linked
Anticipation Securities. Have maturity up
to three years.
5. Swaps: Agreement to Exchange cash
flows in a future date

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 3.PARTICIPANTS IN DERIVATIVES

1. HEDGERS: They use the derivatives to

reduce or eliminate the risk.
2. SPECULATORS: They wish to bet on
future movements in the price of as
asset.
3. ARBITRAGERS: They aim at profits by
taking advantage of difference in prices
in same products among different
markets.

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 4.FORWARD VS. FUTURES

Features Forward Future

1. Operational Traded between Traded on
Mechanism two parties Exchange

2. Contract Differ from Standardised

Specifications traded to trade Contracts

3. Counter party Exists such No such

Risks risk risk

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 5.TERMINOLOGIES USED
 Spot Price :Price in Cash Market
 Future Price :Price of Contract in Future
Mkt.
 Contract Cycle:One, two, three months
 Expiry Date :Last date when contract is
traded

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 5.TERMINOLOGIES USED
Contd..
Contract Size :Fixed by SEBI
Basis :Future Price Minus Spot price
Cost of Carry :Storage cost + Interest
Initial Margin :Margin deposited initially
Marked to Market:Profit or Loss at end of each
day
Stock Options :Options on individual Stock

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 5.TERMINOLOGIES USED IN
OPTIONS

Buyer of Options :Pays the premium to buy the

rights.
Writer of Options : Receives the premium to write
his obligations.
Call Options :Holder has the right to buy
and not the obligation.
Put Options : Holder has the right to sell
and not the obligations.
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 5.TERMINOLOGIES USED IN OPTIONS
Contd..
 Option Price/ Premium : Price paid by the
buyer of options to the writer of the
options.
 Expiration Date: Date specified is the
expiry date.
 Strike Price/ Exercise Price: Price specified
in the option is strike or exercise price.
 American Options: Can be exercised any
time up to expiration date.
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 5.TERMINOLOGIES USED IN OPTIONS
Contd..
 European Options: Can be exercised only on the
expiration date.
 In the Money Option: Results in positive cash
flow i.e. Current Price> Strike Price.
 At the Money Option: Results in zero cash flow
I.e. Current Price = Strike Price.
 Out of Money: Results in negative cash flow I.e.
Current Price < Strike Price

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 6.BENEFITS OF DERIVATIVES
1. Price discovery at future and current date.
2. Transfer of risk (Hedging).
3. Increase in trading volumes at spot mkt.
4. Speculation at controlled market.
5. New entrepreneurial activates.
6. Helps in savings and investment in long run.

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 6.FACTORS DETERMINIG
PREMIUM
1. SPOT PRICE.
2. STRIKE PRICE.
3. VOLATILITY.
4. TIME TO MATURITY.
5. FUTURE TREND OF MARKET

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 7.DERIVATIVES IN INDIA
1. Promulgation of Securities Law
(Amendment) Ordinance 1995-
Withdrawal of prohibition on options in
Securities.

2. Formation of 24 member committee

under Chairmanship of Dr. L.C.Gupta- To
Develop regulatory framework for
derivatives Trading in India.

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 7.DERIVATIVES IN INDIA Contd.

3. Formation of Prof. J.R. Varma Committee-

To recommend risk containment measures.

4. Amendment of SCRA, 1956- To include

Derivatives in the ambit of Securities in
December, 1999.

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7.DERIVATIVES IN INDIA Contd.

Activity Date
1. Formation of Dr. L.C. Gupta Com. Nov. 1996
2. Formation of Prof.J.R. Varma Com. Dec. 1999
3. Granting of approval by SEBI May 2000
4. Trading in Index Futures Jun. 2000
5. Trading in Index Options Jul. 2000
6. Trading in Stock Options Jul. 2001
7. Trading in Stock Futures Nov. 2001

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 7.DERIVATIVES IN INDIA Contd.

DIFFERENT PRODUCTS IN INDIA

1. INDEX FUTURES.
2. STOCK FUTURES.
3. INDEX OPTIONS.
4. STOCK OPTIONS.
5. COMMODITIES FUTURES.

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8.TREND OF BULLISH MARKET

 15th
 Feels the market will rise
 Buys 200 nifty contracts with expiry date - 31th at
1220 costing Rs. 244000 (200*1220)
 31st
 Nifty July futures has risen to 1310
 Sells off his position at 1310
 Makes a profit of Rs. 18000 (200*90)

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8.Payoff Index Futures (Buyer)

TREND BULLISH
Profit

0
1220 Index Loss

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 8.TREND OF BEARISH MARKET

 15th
 feels the market will fall

 Sells 200 Nifties July Contract

 Nifty July contract is trading at 1220

 His position is worth Rs. 244000 (200*1220)

 31st
 Suppose Nifty July futures has fallen to 1150

 Squares off his position at 1150

 Makes a profit of Rs. 14000 (200*70)

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 8.Payoff Index Futures (Seller)

TREND BEARISH
Profit

0 1220
Index

Loss
LUDHIANA STOCK EXCHANGE 26
 9.Call Option (Buyer)
 Why Call Option: If you think market will rise.
 Example: Buy a call with a strike of Rs 1340
at a premium of Rs. 35.
 Maximum profit potential: Unlimited.
 Maximum risk potential: Limited to Rs. 35.
 Breakeven: Rs. 1375
 Desired Movement: Bullish

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 9.Call Option (Buyer)
STRIKE 1340/ PREMIUM 35
PRICE PREMIUM GAIN/LOSS TOTAL
1280 -35 0 -35
1320 -35 0 -35
1340 -35 0 -35
1360 -35 20 -15
1375 -35 35 0
1380 -35 40 5
1400 -35 60 25
1420 -35 80 45
1440 -35 100 65

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 9.Payoff Call Option (Buyer)
Profit

1340
0 Index 35

Loss

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 9.Payoff Call Option (Buyer)
AT VARIOUS STRIKES (SEPCULATION BULLISH)
Profit

0
1200 1250 1300
27.50 Index
49.45
80.10
Loss
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 9.Call Option (Seller)
 Why sell Option: Market will remain
neutral or moderate bearish.
 Example: Sell a call with a strike of Rs
1340 at a premium of Rs. 35.
 Maximum profit potential: Rs. 35
 Maximum risk potential: Unlimited.
 Breakeven: Rs. 1375
 Desired Movement: Market will not go
up.
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 9.Call Option (Seller)
STRIKE 1340/ PREMIUM 35
PRICE PREMIUM GAIN/LOSS TOTAL
1300 35 0 35
1320 35 0 35
1340 35 0 35
1360 35 -20 15
1375 -35 35 0
1380 35 -40 -5
1400 35 -60 - 25
1420 35 -80 - 45
1440 35 -100 -65

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 9.Payoff Call Option (Seller)
Profit

0
1250
Index

Loss

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 9.PAYOFF CALL OPTION (SELLER)
AT VARIOUS STRIKES (SPECULATION BEARISH)
Profit 64.80
37.00
18.15

1200 1250 1300 Index

Loss

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 10.Put Option (Buyer)

 Why buy an Option: If you think market

will fall.
 Example: Buy a put with a strike of Rs
1360 at a premium of Rs. 25.
 Maximum profit potential: Substantial
 Maximum risk potential: Rs.25
 Breakeven: Rs. 1335
 Desired Movement:Bearish.
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 10.Put Option (Buyer)

STRIKE 1360/ PREMIUM 25

PRICE PREMIUM GAIN/LOSS TOTAL
1280 -25 80 55
1320 -25 60 35
1340 -25 40 15
1360 -25 20 -5
1380 -25 0 - 25
1400 -25 0 - 25
1420 -25 0 - 25
1500 -25 0 - 25

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 10.Payoff Put Option (Buyer)
Profit

0
1360
Index

Loss

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 10. PAYOFF PUT OPTION (BUYER)
AT VARIOUS STRIKES(SPECULATION BEARISH)
Profit

Index
0 1200 1250 1300
18.15 37.00

64.80
Loss

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 10.Put Option (Writer)
 Why sell Option: If he thinks market will
remain neutral or moderately bullish.
 Example: Sell a call with a strike of Rs
1360 at a premium of Rs. 25.
 Maximum profit potential: Rs. 25
 Maximum risk potential: Substantial
 Breakeven: Rs. 1335
 Desired Movement:Market will not go
down.
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 10.Put Option (Writer)

STRIKE 1360/ PREMIUM 25

PRICE PREMIUM GAIN/LOSS TOTAL
1280 25 -80 -55
1320 25 -60 -35
1340 25 -40 -15
1360 25 -20 5
1380 25 0 25
1400 25 0 25
1420 25 0 25
1440 25 0 25

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 10.Payoff Put Option (Writer)

Profit

25
1360
Index

Loss

LUDHIANA STOCK EXCHANGE 41

 10.Payoff Put Option (Writer)
AT VARIOUS STRIKES(SPECULATION BULLISH)
Profit

64.80 37.00 18.15 1200

1250 1300 Index

Loss

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 CONTRACT CYCLE

Jan Feb Mar Apr May

Time
Jan 30 Contract
Feb 27 Contract
Mar 27 Contract
Apr 24 Contract
May 29 Contract
Jun 26 Contract

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 11. CONCLUSION
1. Derivatives are good tools for Hedging.
2. These provide arbitrage opportunities.
3. These help in predicting the Future Price
Movement.
4. Speculation is done in controlled environment.
5. These eliminate the price risk.
6. These aim at transfer of risk from those who
have but may not like to those who do not
have but have an appetite for it.

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THANK

YOU

LUDHIANA STOCK EXCHANGE 45