Derivatives

•A financial product that has been derived from

another financial product or commodity.

•Theterm "derivative" indicates that it has no

independent value.

• Main objective is to transfer risk.

Examples of Derivatives
Forward Contracts
Futures Contracts
Swaps
Options
FORWARD CONTRACTS

 Forward contract is an agreement entered

between two parties to buy or sell an asset at
a future date for an agreed price.
Features of forward contracts
 Each contract is custom designed.

 The contract price is generally not available

in public domain

 It is settled by delivery of the asset on the

expiration date.

 They are bilateral contracts and hence

exposed to counter-party risk.
Futures
 Type of a forward contract

 They are highly standardized

 A futures contract is an agreement between

two parties to buy or sell a specified
quantity and quality of asset at a certain
time in future at a certain price agreed at
the time of entering into the contract on the
futures exchange.
Difference between Forward and Futures
Contract

Forward Futures
Type Customized Standardized

Counter party The actual party Exchange

Squaring off Can be reversed only Can be reversed with

with the same any member of the
counter party exchange.
More about Futures

 Maturity
 1 month / 2 months/ 3 month

 Tick Size is 0.1 and contract multiplier is 50

 Margin Money
 To minimize the risk of default by either party
 Types:
 Initial Margin
 Variation Margin
Pricing of Futures
 Generally,
Future Price = Spot Price + Cost of Carry

 Contango Market:
Future price > Spot Price

 Backwardation :
Future price < Spot Price
OPTIONS

 An Option is the right, but not the obligation

of the holder, to buy or sell underlying asset
by a certain date at a certain price.

 2 types:
◦ Call option
◦ Put Option
Call Option

A call option is a contract that gives

the owner the right, but not obligation
to buy the underlying asset by a
specified date at a specified price.
Put Option

 A put option is a contract that gives the

owner the right, but not obligation to sell
the underlying asset by a specified date at a
specified price.
Important Terminology
 Option Premium

 Strike Price / Exercise Price

 Expiration Date

 Exercise Date
◦ American Style
◦ European Style
…Important Terminology
 Option Holder

 Option Seller / Writer

 Open Interest
Why Options?
 Pre known Maximum Risk for the buyer : Your
risk is never more than the premium paid

 Large profit potential

 Limited risk potential

 Flexibility to the buyer of the Option to buy /

sell.
Products on NSE
 Index futures and options on 6 indices:
◦ S&P CNX Nifty
◦ S&P Nifty Junior
◦ CNX IT
◦ CNX 100
◦ Bank Nifty
◦ Nifty Midcap 50

 Futures and Options on individual

securities (189 securities)
 Interest Rate Derivatives
SWAPS

 Swaps are private agreements between two

parties to exchange cash flows in the future
according to a prearranged formula.

 2 main types
◦ Interest rate swaps
◦ Currency swaps
Worldwide derivatives market

 The derivatives market is mostly made up of

derivatives based on:
 Interest rates: ( ~65% of the market).
 Currencies: (~25%). Options and swaps on
foreign exchange.
 Equity: (~5-10%) -- Index futures, Index
swaps, etc.
 Commodities: (~0-5%).
Derivative Markets
 2 types
◦ OTC - Over The Counter
◦ Exchange Traded
 OTC vs Exchange traded
Key Differences—OTC vs. Exchange-Traded
Derivatives
Over-the-Counter Exchange-Traded
Private transaction Public price quote
 Customized
Credit risk  Standardized
Limited credit risk due to
 No risk
 Very little credit risk clearing house
Wide range of structures Standard contracts and size
and contract size
Many currencies Major currencies
Any maturity Standard expiration dates
Participants
 Hedgers

 Speculators

 Arbitrageurs
Derivatives in India
 Started in 2000

 Carried out by 2 stock exchanges – NSE & BSE

 Exchange traded derivatives

◦ June 2000 – Equity Index futures
◦ June 2001 – Equity Index options
◦ July 2001 – Stock Options
◦ November 2001 – Stock futures
◦ June 2003 – Interest rate futures