Introduction To Derivatives

Learning Objectives
• The students will be able to learn and
understand:
1.The meaning of derivatives
2.Different types of derivatives
3.Derivates as hedging instruments
 Current News
• The Reserve Bank on Friday allowed banks to participate in
offshore non-deliverable forward (NDF) rupee markets with
a view to contain volatility in the domestic currency.
It can be noted that the ongoing financial market volatilities
triggered by coronavirus outbreak dragged the rupee to
touch lifetime lows and also breach the 75-mark against
the US dollar before gaining some lost ground in the last
few days.
Read more at:
https://economictimes.indiatimes.com/markets/stocks/ne
ws/rbi-allows-banks-to-trade-in-offshore-rupee-derivative-
market/articleshow/74842557.cms?utm_source=contento
finterest&utm_medium=text&utm_campaign=cppst
 Derivatives
• https://www.youtube.com/watch?
v=FLGRPYAtReo
 Definition
• A derivative is a product whose value is
derived from the value of one or more
underlying variables or assets in a contractual
manner.

• The underlying asset can be equity, forex,

commodity or any other asset
 Products, Participants and Functions
• Derivative contracts are of different types. The most common ones are :

• forwards,
• futures,
• options and
• swaps.

• Participants who trade in the derivatives market can be classified under

the following three broad categories: hedgers, speculators, and
arbitragers
 Participants
• Hedgers face risk associated with the price of an
asset. They use the futures or options markets to
reduce or eliminate this risk.

• Speculators: Speculators are participants who wish

to bet on future movements in the price of an asset.

• Arbitragers: Arbitragers work at making profits by

taking advantage of discrepancy between prices of
the same product across different markets.
• https://www.youtube.com/watch?v=jQRjpjQ6Jdg
 Some Commonly Used Derivatives
• Forwards:
• A forward contract is an agreement between two entities to buy or sell the
underlying asset at a future date, at today's pre-agreed price.

• The main features of forward contracts are: * They are bilateral contracts and

hence exposed to counter-party risk. * Each contract is custom designed, and
hence is unique in terms of contract size, expiration date and the asset type and
quality. * The contract price is generally not available in public domain.

• https://www.myforexeye.com/forward-contract-important-features simple site

• https://www.youtube.com/watch?v=t5XWCy21lyo&t=77s

• https://www.youtube.com/watch?v=t5XWCy21lyo
• Futures: A futures contract is an agreement
between two parties to buy or sell the
underlying asset at a future date at today's
future price. Futures contracts differ from
forward contracts in the sense that they are
standardized and exchange traded
• Site Actual
• https://www.yourarticlelibrary.com/economics/foreign-exchange/features-of-
futures-contracts-foreign-exchange/98195.

• https://stocks4all.com/what-is-future-market-features-of-future-market-
advantages/
• Difference between Forward and Future Contract
• https://www.slideshare.net/MahithaKatragadda/forward-and-
future-contract
• Videos:
• https://www.youtube.com/watch?v=EmpaoJAwMSY
• https://www.youtube.com/watch?v=3bPRN_GhHiY

• MCQs on Forward and Future Contract

• http://14.139.185.6/website/SDE/sde474.pdf
• https://wps.prenhall.com/
ema_uk_he_levy_fundinvest_1/6/1721/440724.cw/index.html
•MCQs
 Some Commonly Used Derivates
• Options:
• There are two types of options – call and put.

• A Call option gives the buyer the right but not the
obligation to buy a given quantity of the underlying
asset, at a given price on or before a given future
date.
• How does a call option work?

• A call option gives you the right, but not the

requirement, to purchase a stock at a specific
price (known as the strike price) by a specific
date, at the option's expiration.

• For this right, the call buyer will pay an

amount of money called a premium, which
the call seller will receive
• A Put/Sell option : gives the buyer the right, but not the
obligation to sell a given quantity of the underlying asset at a
given price on or before a given date.

• A put option is a contract that gives an investor the right, but

not the obligation, to sell shares of an underlying security at a
set price at a certain time.
• Unlike a call option, a put option is typically a bearish bet on the
market, meaning that it profits when the price of an underlying
security goes down. 

• Options trading isn't limited to just stocks, however. You can

buy or sell put options on a variety of securities including ETFs,
indexes and even commodities.
• The advantages and disadvantages of options

• Options are a very unique investment vehicle so it is important to learn the unique
characteristics of options before you decide to trade them.

Advantages
• Leverage. Options allow you to employ considerable leverage. This is an advantage to
disciplined traders who know how to use leverage.

Risk/reward ratio. Some strategies, like buying options, allows you to have unlimited upside
with limited downside.

Unique Strategies. Options allow you to create unique strategies to take advantage of
different characteristics of the market - like volatility and time decay.

Low capital requirements. Options allow you to take a position with very low capital
requirements. Someone can do a lot in the options market with $1,000 but not so much with
$1,000 in the stock market.
• Disadvantages
• Lower liquidity. Many individual stock options don't have much volume at all.
The fact that each optionable stock will have options trading at different strike
prices and expirations means that the particular option you are trading will be
very low volume unless it is one of the most popular stocks or stock indexes.
This lower liquidity won't matter much to a small trader that is trading just 10
contracts though.

• Higher spreads. Options tend to have higher spreads because of the lack of
liquidity. This means it will cost you more in indirect costs when doing an
option trade because you will be giving up the spread when you trade.

• A spread option is a type of option that derives its value from the difference,
or spread, between the prices of two or more assets. ... The latter is a strategy
typically involving two or more options on the same, single underlying asset.
• Higher commissions. Options trades will cost you more in commission per
dollar invested. These commissions may be even higher for spreads where
you have to pay commissions for both sides of the spread.

• Complicated. Options are very complicated to beginners. Most beginners,

and even some advanced investors, think they understand them when they
don't.

Time Decay. When buying options you lose the time value of the options as
you hold them. There are no exceptions to this rule.

• Less information. Options can be a pain when it is harder to get quotes or

other standard analytical information like the implied volatility.

Options not available for all stocks. Although options are available on a good
number of stocks, this still limits the number of possibilities available to you.
• A short position refers to a trading technique in which
an investor sells a security with plans to buy it later.
• Shorting is a strategy used when an investor anticipates the
price of a security will fall in the short term.

• A long—or a long position—refers to the purchase

of an asset with the expectation it will increase in value—a
bullish attitude
• What is derivative by Rachna Ranaday
• What are futures ?
• https://www.youtube.com/watch?v=5hnyb78_sMc
• https://www.youtube.com/watch?v=nNX51v-Ve5g
• https://www.youtube.com/results?search_query=basic+on+F
%26O+by+Rachana+ranade
• https://www.youtube.com/watch?v=yHVjPbM_O0w

• Option Explained by Rachna Ranaday

• https://www.youtube.com/watch?v=M86YwBWxygI
• Very Good Case Study /Latest News – ET27Jan
2021

• https://economictimes.indiatimes.com/
markets/stocks/news/how-a-reddit-group-
brought-a-billion-dollar-hedge-fund-to-its-
knees/articleshow/80473091.cms
 Some Commonly Used Derivates
• Swaps: Swaps are private agreements between two parties
to exchange cash flows in the future according to a
prearranged formula.
• The two commonly used swaps are:

1. Interest rate swaps: These entail swapping only the interest

related cash flows between the parties in the same currency.

2. Currency swaps: These entail swapping both principal and

interest between the parties, with the cash flows in one
direction being in a different currency than those in the
opposite direction
 MCQ
• The markets in which the derivatives are
traded, are classified as
1.Assets backed market
2.Cash flow backed markets
3.Mortgage backed markets
4.Derivative securities markets
 MCQ
• The type of contract which involves the future
exchange of assets at a specified price is
classified as
1. future contracts
2. present contract
3.spot contract
4. forward contract
 MCQ
• Call option means:
1.The right to buy securities
2.The right to sell securities
3.The obligation to buy securities
4.The obligation to sell securities
 Interest Rate Derivatives
• An interest rate swap is a type of a derivative
contract through which two counterparties agree to
exchange one stream of future interest payments for
another, based on a specified principal amount.

• In most cases, interest rate swaps include the

exchange of a fixed interest rate for a floating rate.

• The interest rate derivatives market is the

largest derivatives market in the world.
 Interest Rate Derivatives
• Derivatives are valuable tool that provide an
excellent way to reduce financial risks.

• They are used to hedge against the volatility of

market conditions.

• Banks resort to derivatives to hedge their balance

sheet items and they also trade in derivatives.
 Risk Associated with Hedging Instrument
• Correlation Risk-
• it is the risk that the gain on the hedge instrument will not
offset the loss on the hedged item to the extent anticipated.

• In risk management, correlation risk refers to the risk of a

loss in a financial position occurring due to a difference
between anticipated correlation and realized correlation.

• In particular, this occurs when the estimate of correlation was

wrong or the correlation in the market changed.
• Basis Risk- the risk that the difference between the
spot price of the hedged item and the price of the
hedging instrument will increase or decrease over
time.

• Basis risk is the potential risk that arises from

mismatches in a hedged position. 
• Basis risk occurs when a hedge is imperfect, so that
losses in an investment are not exactly offset by the
hedge. Certain investments do not have good
hedging instruments, making basis risk more of a
concern than with others assets.
Risk Associated with Hedging Instrument

• Credit Risk- that the counterparty will not

honor its commitments.

• Proper hedging strategy can enable a

company to reduce risks associated with
exposures.
 Policies
and
Procedures
 Policies and Procedures
• Companies should have explicit policies, in writing,
defining objectives of hedging transactions.

• It should be approved by the board of directors.

• The policy should conform to applicable laws

including the company’s by laws.

• Limit should be established on the amount that may

be placed in any one financial instrument
 Policies and Procedures

• Counterparties must be evaluated initially and

monitored periodically thereafter.

• Appropriate procedures should be in place to

demarcate the duties among individuals and
ensures that they function within their well
defined and assigned areas of responsibility.
 Monitoring and Evaluating Results

• It is essential to monitor the results of hedging

activities to ensure that the initial hedging objectives
are being achieved by reducing the risks of
unfavorable movements in the hedged item.