Derivatives

Derivative is a product which

does not have any value on its
own but it derives its value
from some underlying assets
Types of Derivatives

 Forward contracts
 Futures
 Options
 Swaps
Forward Contracts
 It is one to one bi-partite contract
 To be performed in the future
 At the terms decided today.
 Offer tremendous flexibility to design the
contract in terms of the price, quantity,
quality ( in case of commodities)
 Delivery time
 Place
Forward contracts - continue
For example, if you agree on March 1 buy 15 gms of Gold
on June 1 at a price of Rs.870 per gm from a goldsmith,
you have bought forward gold or you are long forward
gold.
Whereas the goldsmith has sold forward gold or is short
forward gold.
No money or gold changes hand when the deal is signed.
Short position – which commits the seller to deliver an
item at the contracted price on maturity
Long position – which commits the buyer to purchase an
item at the contracted price on maturity.
Futures
 Agreement Between two parties
 To Buy or sell an asset
 At a certain time in the future
 At a certain price
 Every futures contract is a forward
contract but it is a standardised
contract.
Futures Vs Forward contracts

The key difference between OPTION CONTRACT and

FORWARD & FUTURES contracts is:
The holder of a option enjoys the right to buy or sell.
A forward or futures contract imposes a firm obligation
to go through the transaction.
The forward or futures contract is not an
investment because no cash is paid to buy an
asset. It is just commitment to do a transaction in
future.
Features Forward Futures
contract
Operational Not traded on Traded on
mechanism exchange. No organised
secondary exchange
market.
Contract Differs from Contracts are
specifications trade to trade. standardized
Tailor-made contracts
Counterparty contract. Exists, but
risk assumed by
To continue
Features Forward Futures
Security No collateral is A margin is
required required.

settlement They are settled They are

on the maturity ‘marked to
date. market’ on a
daily basis. This
means that
profits and
losses on
Futures Terminology
 Spot Price :- The price at which an
asset trades in Spot Market
 Futures Price :- Price at which the
futures contract trades in the futures
market
 Contract Cycle : - Period over which a
contract trades in the futures market
 Expiry Date :- last day on which the
contract will be traded
Futures Terminology cont.
 Contract Size : - Amount of Asset that
has to be delivered under one contract
 Initial Margin :- Deposited at the time a
futures contract is first entered into. It
may about 10% of the value of contract
– it is fixed by the exchange. The
margin has to be posted by both the
parties to the futures contract are
exposed to losses.
Continue
 Mark to the Market :- This means that the profits and
losses on futures contracts are settled on a periodic
basis. Ex.
The marking-to-market feature implies that the value of
the futures contract is set to zero at the end of each
trading day.
 Open Interest :- Total number of outstanding
contracts (long/short) at any point of time. It is either
the number of long or short contracts outstanding.
At the beginning of trading cycle open interest is
zero. When maturity date nears open interest
declines sharply.
Settlement of Futures Contracts
The NSCCL ( the National Stock Exchange Clearing Corporation
Limited) clears and settles all the deals executed on the NSE’s
F & O segment. Currently F&O contracts in India are cash-
settled.

Daily Mark to Market Settlement

 Open Positions are marked to daily settlement price and settled on
T+1 basis
 Open positions are reset to the Daily Settlement price

Final Settlement
 On the expiry day, open positions are marked to the final settlement
price
 Settlement takes place on T+1 basis
Types of Futures
 Commodity Futures : is a a futures
contract in a commodity like
cocoa/aluminium/cotton/gold/crude oil/.
Futures have their origins in commodities.
 Financial Futures : is a futures contract in
a financial instrument like treasury bonds,
currency or stock index.
 Equity futures, interest rate futures and
currency futures dominate market today.
Equity Futures in India
 Equity futures are of two types :
Stock index futures
Futures on individual securities

STOCK INDEX FUTURES

The NSE and BSE have introduced the stock
index futures.
NSE stock index futures based – S&P CNX Nifty
index. BSE – Sensex.
Index futures - continue
Item BSE NSE
Date of start June 9, 2000 June 12, 2000
Underlying Sensex S&P CNX Nifty
Contract Size Sensex value x 200 or multiples
50 of 200
Expiration 3 near months 3 near months
months
Trading cycle The near
month(1), the Same
next month
Continue
Item BSE NSE
Settlement In cash T + 1 Same
basis
Final settlement Index closing same
price price on the last
trading day
Daily settlement Closing of Same
price futures contract
price
Futures on individual securities
 Introduced in India in 2001.
 Both NSE and BSE have introduced futures on
individual securities.
 Three months trading cycle
 Currently available for 31 securities.
 Daily mark-to-market settlement/final mark-to-
market settlement on expiry of a futures
contract.
 T+1 basis
 Lot size may be stipulated by the exchange from
time to time.
Pricing of Future contracts
Equity futures :
 F = S(1 + r – d)(power t)
S = stock index
r = risk free interest rate
d = dividend yield
t = no. of months
Commodity futures ( storable commodities)
Futures price
-------------- = Spot price + present value of
(1 + r)power t storage costs – present val
convenience yield.
Use of Futures contracts
 Participants in the Futures market are :
Either Hedgers or Speculators.
Hedgers are parties who are exposed to risk because they have a prior
position in the commodity or the financial instrument specified in the
futures contract. They buy or sell futures contract to protect
themselves against the risk of price changes.
Speculators do not have a prior position that they want to hedge
against price fluctuation. Rather they are willing to assume the risk
of price fluctuation in the hope of profiting from them. It attracts them
because
- Leverage
- Ease of transaction
- Lower transaction cost.
Option Contracts
 Deferred delivery contracts
 Gives the buyer the right
 not the obligation
 to buy or sell
 a specified underlying
 at a set price
 on or before a specified date
Types of Options
Call Option
 Right to BUY ( but not the obligation) a specified
underlying ( commodity or a financial instrument)
at a set price on or before an expiration date.
 If a investor feels that the price of gold will
increase in the future, the investor can hedge
the inherent risk by buying a gold call option.
Put Option
Put Option
 Right to SELL ( but not the obligation) a
specified underlying ( commodity or a financial
instrument) at a set price on or before an
expiration date.
 For example, if an investor expects a decline in
the price of silver in the near future, he can buy
a silver put option.
To continue

A ‘call’ is way to profit if

prices go up.
 A ‘put’ is way to profit if
prices go down.
Options Terminology
 Index Options : Index in the underlying security. The
first derivative product to be introduced in the Indian
securities market – ‘index futures’
 Stock Options : Options on individual stocks
 American Options : Options that can be exercised at
any time
 European Option : Option that can be exercised only
on the expiration date
 Asian options : option that can be exercised at the
best price prevalent during option duration.
Options Terminology cont.
 Option Buyer – holder of the option
 has the right to buy an asset but not the obligation
 Option Writer/Seller
 Has the right to sell a stock at a fixed price but not the obligation
 Option Premium
 Price paid by the buyer to acquire the right to the seller.
 Strike Price OR Exercise Price
 Price at which the underlying may be purchased or sold
 Expiration Date
 Last date for exercising the option. Or is the date of which option
expires.
 Exercise Date
 Date on which the option is actually exercised
Options Terminology cont.
 In-the-Money Option (ITM)
 Isan option that would lead to a positive cash flow to
the holder if it were exercised immediately
 At-the-Money Option (ATM)
 Isan option that would lead to a zero cash flow if it
were exercised immediately.
 Out-of-the-Money Option (OTM)
 Is an option that would lead to a negative cash flow if
it were exercised immediately
Market Call Put
Scenar option option
ios s
Market In-the- Out-of-
price > money the-
strike money
price
Market At-the- At-the-
price = money money
strike
price
Market Out-of- In-the-
price < the- money
Strike money
price
Settlement of Option Contracts

Daily premium settlement

 On T+1 basis
Option valuation

 Binomial Model for Option Valuation

 Black and Scholes Model

Binomial Model for Option Valuation

C=#S-B
Black and Scholes Model
 One of the complicated formulae in finance, it is one of
the most practical.
C = S N (d1) – E N ( d2)
---
e(power rt)
Steps : 1. calculate d1 and d2
2. Find N (d1) and N(d2)
3. Estimate the P.V. of the exercise price.
E / e(power rt)
4. Apply the formula.
Equity options in India
 Two popular types of equity options :
Index options
Options on individual stocks.
Index Options
They are options on stock market indices.
The S&P CNX Nifty is the most traded on NSE in
India. ( other rules are the same as futures)
Option on individual stocks
 introduced by NSE and BSE.
 Trade cycle – maximum of 3 months
 The exchange shall provide a minimum of five strike
price for every option type ( call and put) during the
trading month. ( 2 contracts ITM, 2 contracts OTM and
one contract ATM)
 Expire on the last Thursday
 The value of the option contract shall not be less than
Rs.2 lakhs at the time of introduction.
 The permitted lot size multiples of 100
 Settlement is on T+3 days.
Options Vs Futures
In options, there is no In futures both the
obligation to honor the parties are equally
contract. Only there is responsible to honor
right. their obligations.
In options, the buyer has Both the parties have to
to premium to the writer deposit the initial margin
of the option. with the clearing house
and then have to pay
variation margin.
AO & EO No such distinctions
exists and the parties
To continue
In options the buyer In futures, the buyer is
limits the downside risk exposed to the whole of
to the extent of premium the downside risk and
paid. he retains the has the potential for all
upside potential. the upside return.
Employed by both Trading in futures is
hedgers and largely done by
speculators. speculators.
Swaps
 Swap contract is a spot purchase and
simultaneous futures sale or a spot sale
with a simultaneous buy from the futures
market. It is the agreed exchange of future
cash flows with spot cash flows.
 Types of swaps :
Interest rate swaps
Currency swaps
Equity swaps.
How can you trade ?
 Open account with a Derivatives Member
 Sign a client-broker agreement
 Understand & sign the Risk Disclosure Document
 Decide on the exposure you want to have in derivatives
 Pay Initial Margin on up front basis
 Take Positions
 Get Contract Notes for the trades executed
 Receive / Pay daily Mark to Market
 Periodic Billing.