UNIT III

DERIVATIVES

BY,
NIDHINA ELIZABATH TOM
Derivatives
• Apart from money market and capital market securities, a variety of
other securities known as derivatives have now become available for
investment and trading.
• “ derivatives or derivative securities are contracts which are written
between two parties and whose value is derived from the value of
underlying widely held and easily marketable asset such as agricultural
and other physical commodities or currencies or short term and long
term financial instruments or intangible things like commodities price
index, equity price index or bond price index”
• A derivative contract simply represents a promise or an agreement to
transfer the ownership of the underlying asset at a specific place, price
and time specified in the contract.
• Commodity derivative and financial derivative
• Derivatives are traded either in organised exchanges or in an Over the Counter
market.
• Derivative contracts can be standardized and traded on the stock exchange. Such
derivatives are called exchange-traded derivatives. Or they can be customized a
per the needs of the user by negotiating with the other party involved. Such
derivatives are called over-the-counter (OTC) derivatives.
• The term derivative indicates that it has no independent value which means its
value is derived from the value of an underlying asset.
• The derivative contract also has a fixed expiry period mostly in the range of 3 to
12 months, from the a date of commencement of the contract. The value of the
contract depends on the expiry period and also on the price of the underlying
asset
Economic functions of derivatives market
• They help in transferring the risk from risk averse people to risk
oriented people
• Help in the discovery of future as well as current price
• They catalyse the entrepreneurial activity.
• They increase the volume of traded in markets because of
participation of risk averse people in greater numbers.
• They increase the savings and investments in the long run.
Major participants
• Hedgers: those who reduce the risk. Hedging is when a person invests
in financial markets to reduce the risk of price volatility in exchange
markets, i.e., eliminate the risk of future price movements.
• Speculators: engaging in risk. It is a risky activity that investors
engage in. It involves the purchase of any financial instrument or an
asset that an investor speculates to become significantly valuable in
the future.
• Arbitrageurs: Some traders participate in the market for obtaining
risk-free profits. They do so by simultaneously buying and selling
financial instruments like stocks futures in different markets
Purpose of derivatives
• Price discovery
• Risk management
• Market efficiency
• Speculation
• Trading efficiency
• Accessible to unavailable assets or markets
• Operational advantages
Derivatives markets in India
• The Indian financial markets indeed waited for too long for derivatives trading to emerge.
• Since 1991, due to liberalization of economic policy, the Indian economy has entered an era in
which Indian companies cannot ignore global markets
• Commodities futures' trading in India was initiated long back in 1950s; however, the 1960s
marked a period of great decline in futures trading
• the Central Government imposed the ban on trading in derivatives in 1969 under a notification
issue.
• The late 1990s shows this signs of opposite trends—a large scale revival of futures markets in
India, and hence, the Central Government revoked the ban on futures trading in October, 1995,
• The Board of SEBI, on May 11, 1998, accepted the recommendations of the Dr.
L.C. Gupta Committee and approved introduction of derivatives trading in India
in the phased manner.
• The recommendation sequence is stock index futures, index options and options
on stocks
• The Board also approved the 'Suggestive Bye-Laws’ recommended by the
Committee for regulation and control of trading and settlement of derivatives
contracts in India
• The volumes, however, are gradually picking up due to active interest of the
institutional investors
Categories of derivatives traded in India
• Commodities futures for coffee, oil seeds, and oil, gold, silver, pepper, cotton, jute and jute goods are traded in the
commodities futures
• Index futures based on Sensex and NIFTY index are also traded under the supervision of Securities and Exchange
Board of India (SEBI).
• The RBI has permitted banks, Financial Institutions (Fl's) and Primary Dealers (PD's) to enter into forward rate
agreement (FRAs)/interest rate swaps in order to facilitate hedging of interest rate risk and ensuring orderly
development of the derivatives market.
• The National Stock Exchange (NSE) became the first exchange to launch trading in options on individual securities
• Options contracts are American style and cash settled and are available in about 40 securities Stipulated by the
Securities and Exchange Board of India.
• The NSE commenced trading in futures on individual securities on November 9 2001. The futures contracts are
available in about 31 securities stipulated by SEBl’ The BSE also started trading in stock options and futures (both
Index and Stocks) around at the same time as the NSE.
• The National Stock Exchange commenced trading in interest rate future on June 2003. Interest rate futures contracts
are available on 91-day 1-bills, 10-year bonds and 10-year zero coupon bonds as specified by the SEBI
Structure of Indian derivatives market
Types of derivatives
• In the financial markets, various derivatives are traded. They are
classified as:
1. Forwards
2. Futures
3. Options
4. Swaps
Forwards
• It is the simplest of all derivatives.
• “A forward contract is a customized contract between two entities, where
settlement takes place on a specific date in the future at today’s agreed price”.
• It is a one to one bipartite contract, which is to be performed in the future at
the terms decided today.
• One party in contract assumes long position and agrees to buy the underlying
asset. And the other party assumes short position and agrees to sell the
underlying asset
• Forward contracts being negotiated by the parties on one to one basis, offer
them tremendous flexibility to articulate the contract in terms of price,
quantity, quality, delivery time & place. But because they are customized they
are plagued with poor liquidity and default risk (credit risk)
Example
• Two parties ( A and B) entering into a contract to buy and sell 100
shares of reliance at Rs. 850 per share, two months down the line
from date contract.
• A is the buyer and B is the seller
Features
• It is an agreement between the two counter parties in which one is buyer and other is
seller. All the terms are mutually agreed upon by the counterparties at the time of the
formation of the forward contract
• It specifies a quantity and type of the asset (commodity or security) to be sold and
purchased
• It specifies the future date at which the delivery and payment are to be made
• It specifies a price at which the payment is to be made by the seller to the buyer. The
price is determined presently to be paid in future
• It obligates the seller to deliver the asset and also obligates the buyer to buy the asset.
• No money changes hands until the delivery date reaches, except for a small service
fee, if there is.
• The party who receives the underlier is said to be long the forward. The other party is
short.
Calculation of payoff from a forward
• two parties might agree today to exchange 500,000 barrels of crude oil for US $ 42.08 a
barrel three months from today.
• In our example, oil is the underlier. The notional amount is 500,000 barrels. The delivery
price is US $ 42.08 per barrel. The settlement date is the actual date three months from
now when the oil will be delivered in exchange for a total payment of US $ 21.04 MM.
• At settlement, the forward has a market value given by n(s – k)
• 500,000(47.36- 42.08)= US $ 2.64 MM
• The variables included in the contract are
1. Underlier: Crude oil
2. Notional amount (n)= 500000 barrels
3. Delivery price(k)= US $ 42.08 per barrel
4. Settlement date = 3 months from today
• A forward may be cash settled, in which case the underlier and payment never
exchange hands. Instead, the contract settles with a single payment for the
market value of the forward at settlement. If the market value is positive, the
short party pays the long party. If it is negative, the long party pays the short
party.
• Long position: the party agrees to buy the asset is assuming long
position
• Short position: the party agrees to sell the asset
• Underlying asset: the asset in the form of commodity, security or
currency which would be bought or sold
• Spot price: Price of the underlier at the time of settlement
• Delivery price: the specified price in the contract
Classification of forward contract
• Hedge contracts
• Transferable specific delivery contract
• Non transferable specific delivery contract
Futures
• Futures or future contracts are transferable specific delivery forward
contracts
• They are agreements between two counterparties that fix the terms of an
exchange, or that lock in the price today of an exchange which will take
place between them at some fixed future date.
• They are highly standardized contracts between the sellers or ‘writers’
or ‘shorts’ and the buyers or ‘longs’ which obligate the former to deliver
and the latter to receive, the given assets in specified quantities, of
specific grades, at fixed times in future at contracted price.
• Depending on the underlying asset, the future contacts can be
commodity futures as well as financial futures.
• Future contracts are transferable legal agreements and their terms
cannot be changed during the life of the contract.
• Future contracts means a legally binding agreement to buy or sell
the underlying security on a future date.
• Future contracts are the organized/standardized contracts in terms of
quantity, quality, delivery time and place for settlement on any date in
the future.
• These markets being organized/standardized, are very liquid by their
own nature.
Example
• Referring to the earlier example of A & B entered into a contract to
buy and sell Reliance shares. Now, assume that this contract is taking
place through the exchange, traded on the exchange and clearing
corporation/ house provides the unconditional guarantee for its
settlement, it would be called a future contract
Settlement of future contract
• Physical delivery: A physical settlement means on the expiry of futures contract,
actual physical delivery of stocks or commodities should be made. The physical
delivery method of settling commodities involves the literal physical delivery of
the underlying asset(s) on the settlement date of the contract.
• Cash settlement:The cash settlement method of settling commodities does not
involve the physical delivery of the asset(s) under consideration. It instead
involves the settlement of net cash on the settlement date. The net cash amount
is the difference between the spot price and the futures price (FP) of the
underlying(s).
• Off setting position: reversing their actual position. Both the parties to the
futures have a right to transfer the contract by entering into an offsetting futures
contract
Basic mechanism of future contract
• The profit or payoff position of future contract depends on the differences between the specified
price and the actual price prevailing in the market.,
• An investor purchased a future contract at the rate of Rs.300 and one contract in for five hundred
shares
Value of the contract=300*500=150000
Suppose On the date of maturity the rate is 310, then the value of the contract will be
310*500=155000
Profit=5000
Suppose on the maturity date the spot price is 296 per share
Then value of the contract will be equal to 296*500=148000
For the long investor: profit= spot price on maturity date- futures price
loss= future price – spot price
For the short investor: profit= Future price- spot price
loss= spot price – futures price
Types financial futures traded
• Interest rate futures: futures trading on interest bearing securities
• Foreign currencies futures/exchange rate futures: trade in the foreign
currencies
• Stock index future: these are based on stock market indices.
• Bond index futures: future contracts are based on particular bond
price indicees
• Cost of living index futures/ inflation futures: the futures contracts are
based on a specified cost of living index such as CPI, WPI etc.
Features of future market
• Organised Exchanges:
• Standardisation:
• Clearing House:
• Margins:
• Marking to Market:
• Actual Delivery is Rare
Operation of margins
• An investor who enters into a future contract is required to deposit funds with his
broker. That deposit is known as margin.
• In futures contract, the clearing house undertakes the default risk. To protect itself
from this risk, the clearing house requires the participants to keep margin money
• Basically there are three types of margins
1. Initial margin: it is the original amount that must be deposited into account to
establish future position
2. Maintenance margin: it is the minimum amount which must be remained in a
margin account. “Margin Call”-In case the margin drops below the limit, your
broker will make a margin call and can also liquidate the position if you do not
make up for the requirement amount.
3. Variation margins : the additional amount which has to be deposited by the trader
with the broker to bring the balance of the margin account to the initial margin
Daily settlement/ marking to market
• The daily settlement of future contract is known as marking market
• Marking to market refers to the daily settling of gains and losses due
to changes in the market value of the security.
• If the value of the security goes up on a given trading day, the trader
who bought the security (the long position) collects money – equal to
the security’s change in value – from the trader who sold the security
(the short position). Conversely, if the value of the security goes down
on a given trading day, the trader who sold the security collects
money from the trader who bought the security. The money is equal
to the security’s change in value
Differences between forwards and futures
• Forwards are customized and futures are standardized
• Futures are traded in the organized and recognized exchanges and
forwards can be traded on the OTC markets and off exchanges
• Forward contracts tend to be much larger in size than the future contracts
• Forward are mostly for the actual delivery and futures are not normally so
• Forward contract settlement occurs on the maturity date or the date
agreed upon by the counterparties and in case of futures it occurs daily
via exchange clearing house
• Transaction cost of forwards are based on bid ask spread, where as
futures entail brokerage fees for buy and sell of orders
• Margin or collateral is not required in forwards, but they are required
from both counterparties in future contracts.
Definition Forward contract is a customized Future contract is a standardized
contract to buy or sell an contract to buy or sell an
underlying assets at a preagreed underlying assets at a preagreed
price on a future date price on a future date

Structure and purpose Customized to customer needs and Standardized. Initial margin
no initial payment required. Usually payment is required . Usually used
used for hedging purposes for speculative purposes

Transaction method Negotiated directly by the buyer
and seller
Market regulation Not regulated
Institutional guarantee The contracting parties
Risk High counterparty risk
Guarantee No guarantee of settlement until
the maturity date and only the
forward price will be paid
Quoted and traded on the
organized exchanges
Government regulated market
Clearing house
Low counterparty risk
Both parties must deposit some
initial margin

Contract maturity Forward contracts generally mature It may not be so

by delivery of the commodity
Expiry date Depending upon the transaction Standardized
Contract size Depending on the transaction and Standardized
Options
• Options contract is a type of derivative contract which gives the buyer/holder of
the contract the right but not the obligation to buy or sell the underlying asset
at a predetermined price within or at the end of the specified period.
• An option is a unique instrument that confers a right without an obligation to
buy or sell another asset, called the underlying asset
• The buyer/ holder of the option purchases the right from the seller/writer for a
consideration which is called premium.
• The seller/writer of an option is obligated to settle the option as per the terms
and conditions of the contract when the buyer/holder exercises his right.
• Options are contracts between option writers(sellers) and buyers which
obligates the former to deliver and entitle the latter without obligation to buy
stated quantities of assets with stated quality at some future dates at today’s
contracted price(strike price or exercise price).
Example
• Consider an option on the share of a firm, say ABC ltd. And it would
confer the a right to the holder to either buy or sell the shares of ABC
ltd
Options can be defined as the contract that gives the owner the right
but no obligation to buy or sell an underlying asset at a predetermined
price with in a given time frame
Features
• It confers the right but no obligation to the holder of the contract.
• There is fixed maturity date on which the contract expires
• There is a predetermined price for the options contract( exercise price or
strike)
• The person who writes the option and seller is known as the option writer
and the other party who holds the option and is the buyer known as the
option holder
• The premium is the price paid for the option by the buyer to seller.
• There is a clearing house as an intermediary between the buyer and seller
of option contract which guarantees the performance of the contract
Terminology of options
• Call option: it gives right to buy the underlying asset
• Put option: it gives the right to sell the underlying asset
• Buyer/holder: is the person who obtains the right to buy or sell but not
obligation to perform.
• Writer/ seller: is the person who confers the right and undertakes the
obligation to the holder
• Premium: while conferring a right to the holder, the writer is entitled to charge
a fee upfront. This upfront amount is known as premium. This is paid by the
holder to the writer and is also called the price of the option
• Strike price: the predetermined price at the time of buying/writing of an
option at which the contract will be exercised
• Strike date/maturity date: the latest time when the options can be exercised
Types of options
• Call option: When the buyers have the right to receive the delivery of
asset, they are known as call option.

• Put option: when they have the right to receive the payment by
handing over the assets, they are known as put option.
Categories of options
• Based on several considerations the options can be categorized in a
number of ways, such as
1. Based on nature of exercise of options
2. Based on how are they generated, traded, and settled
3. Based on the underlying asset on which options are created
Based on nature of exercise of options

• Based on the timing of exercise the options can be either American or European or
Bermudan
1. American option: American options can be exercised at any point of time before
the expiry date of the option
2. European option: European options are exercisable only upon maturity
3. Bermudan option: these are used with OTC options. It can be excercised on a
few specific dates before maturity
Based on how/where are they generated, traded, and settled

• Options can also be categorized as OTC or exchange traded

depending upon where and how they are created, traded, and settled.
• In the exchange-traded options the contracts need to be standardized,
while an OTC product is tailor-made to the requirements of the parties
concerned.
Based on the underlying asset on which options are created

• Options on stocks, indices, commodities, curreneies, and

interest rates are available either OTC or on exchanges
• Stock option
• Foreign currency options
• Index options
• Futures option:
• Interest rate options
• Commodities options
Others
• Naked (uncovered) and covered options: Naked or uncovered options are those which
do not have offsetting positions, and therefore, are more risky. On the other hand, where the writer has
corresponding offsetting position in the asset underlying (he option is called covered option

• Leaps options: These options contracts are created for a longer period. The longest time before
expiration for a standard exchange traded option is six-months. However, Long Term Equity Anticipated
Securities (LEAPS) are option contracts designed to offer with longer period maturities even up to 39
months. These LEAPS options are available on individual stocks and some indexes.

• Flex options: It is a specific type of option contract where some terms of the option have been
customized.

• Exotic options : more complex created s per the needs of the customers are called exotic options
which may be with different expiration dates, exercise prices, underlying assets, expiration date and so on.
Ways of settlement
• Physical delivery
• Cash settlement
• Offsetting position: It can also be settled by the cancellation of the
contract by entering into an equal and opposite contract to the
original one.
Participants
• Buyers/holders of call option: right to purchase/buy
• Sellers/writers of call option: obligation to sell
• Buyers of put option: right to sell the underlying asset
• Sellers of put option : obligated to buy the underlying
• There are simple options such as commodity options, stock options,
bond options, currency options, stock index options, and options on
futures: compound options such as swaptions, flortions and captions:
and synthetic options which combine options and futures.

• In the money: If the current price of the underlying asset exceeds the exercise
price of a call option, the call is said to be in the money.
• Out of the money: Similarly if the current price of the underlying asset is less
than the exercise price of a call option, it is said to be out of the money
• Near the money: The near the money call options are those whose exercise price
is slightly greater than current market price of the asset
Futures vs options
• The maturity of the contract is longer in futures than in options
• In futures, risk exposure and profit potential are unlimited for both
the parties, in options, risk exposure is unlimited and profit potential
is limited for the sellers.
• In futures, there is no premium paid or received by any party,
whereas in options, the buyers have to pay a premium to the sellers.
• Futures impose obligations on both the parties, options do so only on
the sellers.
• Both the parties have to put in margins in future trading, but only the
sellers have to do so in options trading.
SWAPS
• Swaps are agreements between two parties to exchange assets or sets of
financial obligations or a series of cash flows for a specified period of time at
predetermined intervals.
• They made both spot and forward transactions in one agreement, and are
generally customised transactions and it is traded in the OTC markets.
• Exchange one with another.
• A swap is any agreement to a future exchange of one asset for another, one
liability for another or one stream of cash flows for another.
• Swaps are divided based on the time period
1. Short term: < 3 years
2. Medium term: 3 to 5 years
3. Long term: > 5 years
• Most existing maturity of swaps are 2 to 10 years.
• A party can reverse or unwind a swap position before the end of the
term by cancelling the agreement and delivering a final difference
payment to the counterparty.
• The corporates, banks, individual investors and so on, are now using
swaps to organize complex and innovative financing that reduces
borrowing cost and increase control over interest rate risk and foreign
currency exposure.
• While swaps are used for various purposes- from hedging to
speculation- their fundamental purpose is to change the character of an
asset or liability without liquidating that asset or liability.
• For example, an investor realizing returns from an equity investment can swap
those returns into less risky fixed income cash flows— without having to liquidate
the equities
Types of swaps
• Currency swaps: a currency swap involves two parties that exchange a notional principal with one another in
order to gain exposure to a desired currency. Put differently, in a currency swap, both the principal and
interest in one currency are swapped for principal and interest in another currency. On maturity the principal
amount are swapped back
• Interest rate swap: is a contractual agreement to exchange a series of cash flows. Or An interest rate swap is
a transaction between two parties involving an exchange of one steam of interest obligations (payments) for
another.
• Plain vanilla interest rate swap: fixed rate is exchanged for a floating rate. In this, a company agrees to pay
cash flows equal to interest at a predetermined fixed rate on a notional principal for a number of years. In
return, it receives interest at a floating rate on the same notional principal for the same period of time.
1. Basis swap: floating to floating rate
2. Amortising swap: An amortizing swap, or an amortizing interest rate swap, is a derivative instrument in
which one party pays a fixed rate of interest while the other party pays a floating rate of interest on a
notional principal amount that decreases over time.
3. Step-up swap: An interest rate swap on which the notional principal increases according to a
predetermined schedule.
1. Extendable swap: An extendable swap has an embedded option that
allows either party to extend the maturity of that swap , on specified
dates, past its original expiration date
2. Delayed start swap/forward swaps: A forward swap, also called a
deferred or delayed-start swap, is an agreement between two
parties to exchange cash flows or assets on a fixed date in the future,
and which also commences at some future date (specified in the
swap agreement).
• Debt equity swap : A debt/equity swap is a transaction in which the obligations or debts of a company or individual are exchanged for
something of value, namely, equity

• Bond swap: it’s a simultaneous purchase and sale of two or more bonds with similar characteristics
in order to earn a yield differential
• Commodity swap: contract between two parties(End users or hedgers
and investors or speculator) where they agreed to swap a physical
commodity in return for a cash flows
History of derivatives in India
• However, the advent of modern day derivative contracts is attributed to the
need for farmers to protect themselves from any decline in the price of their
crops due to delayed monsoon, or overproduction.
• The commodity derivative market has been functioning in India since the
nineteenth century with organized trading in cotton, through the
establishment of Cotton Trade Association in 1875.
• Exchange traded financial derivatives were introduced in India in June 2000
at the two major stock exchanges, NSE and BSE.
• National Commodity & Derivatives Exchange Limited (NCDEX) started its
operations in December 2003, to provide a platform for commodities trading.
• Stock Futures are the most highly traded contracts on NSE accounting for
around 55% of the total turnover of derivatives at NSE, as on April 13, 2005.
• Derivative trading in India takes can place either on a separate and
independent Derivative Exchange or on a separate segment of an
existing Stock Exchange.
• Derivative Exchange/Segment function as a Self-Regulatory
Organisation (SRO) and SEBI acts as the oversight regulator
• The clearing & settlement of all trades on the Derivative
Exchange/Segment would have to be through a Clearing Corporation/
House, which is independent in governance and membership from
the Derivative Exchange/Segment.
Policy developments
• Prior 1997, forward contracts were allowed only in 6 commodities.
During only commodity derivatives trading were allowed.
• In the year of 1995 January, prohibition of options were deleted from
the securities contract regulation act
• 1996 august, NSE planned to introduce stock index futures and
options
• NIFTY, NSE-50 index based futures were introduced in india
• By the end of 1996, NSE introduced futures and option exchange
• Rbi regulations in 1997
• In October 1996, RBI liberalised the policy on derivatives and given
certain guidelines.
• Since April 1997, RBI has allowed banks and corporates to deal with
swaps without its permission, for the tenors over 6 months.
• SEBI set up a committee under chairmanship of L.C Gupta to
recommend an appropriate regulatory framework for derivatives
trading in India. and the report submitted in December 1997. and
suggested two level regulation.
• In June 1998, SEBI set up a committee under Prof. J. R Varma, to
recommend measures of risk containment in derivatives market in
India.
• In December 1999, amendment in Securities contract(regulation ) act
was notified, making a way for derivatives trading in India.
• Interest rate futures were launched in june 2003, to expand the
universe of risk hedging products available to the market.
• V. K Sharma committee set up in August 2007 to study the issues and
to suggest measures to facilitate developments in interest rate futures
market.
• SEBI set up a derivatives markets review committee in March 2007 to
look into the developments in derivatives markets in India and to
suggest future possibilities.
• Interest rate futures contract on 10 year notional coupon bearing GoI
security was introduced in 31 august 2009.
• TAC proposed to introduce interest rate futures on 5 year and 2 year
notional coupon bearing.
• In 2007, RBI introduced the guidelines for credit default swaps.
• Centralised reporting of OTC trades in interest rate derivatives
commenced in August 2007 on the reporting platform of CCIL.
• Currency futures are operational in different currency pairs. 2008
• Interest rate futures on 91 day treasury bills were permitted since 2011.
• In May 2011, CDS on corporate bond was operationalised
• Comprehensive guidelines on OTC foreign exchange derivatives and
overseas hedging of commodity price and freight risk were issued in
December 2010.
• Guidelines on T-bill IRFs were issued.
• In Dec 2011, CCIL online reporting engine (CORE) has been set up for
reporting CDS trade.
• IRS contracts have been standardised to improve tradability and facilitate
centralised clearing and settlement of IRS contracts.