Preparatory Material

Equit-I, The Finance Club of IIM Indore

Derivatives Basics

Introduction to
basics of
Derivatives

Understanding Derivatives
Types of Derivatives
Comparison between the Instruments
Short versus Long
ITM, OTM, ATM
Option Payoff Charts
 Understanding Derivatives

Derivative is a product whose value is to be derived from the value of one or more basic variables called bases
(underlying assets, index or reference rate).The underlying assets can be Equity, Forex, or Commodity.

The underlying has a marketable value which is subject to market risks. The importance of underlying in derivative
instruments is as follows:

 All derivative instruments are dependent on an underlying to have value.

 The change in value in a forward contract is broadly equal to the change in value in the underlying.
 In the absence of a valuable underlying asset the derivative instrument will have no value.
 On maturity, the position of profit/loss is determined by the price of underlying instruments. If the price of
the underlying is higher than the contract price the buyer makes a profit. If the price is lower, the buyer
suffers a loss.
 Understanding Derivatives

The main users of derivatives

Institutional Investor
Dealers
Individual Investors For hedging asset
Corporations For hedging position
For speculation, allocation, yield
To hedge currency risk taking, exploiting
hedging and yield enhancement and to
and inventory risk inefficiencies and
enhancement avail arbitrage
earning dealer spreads.
opportunities.

Basic Differences between cash and the derivatives market

In cash market tangible assets are traded whereas in derivative market contracts based on tangible or
intangibles assets like index or rates are traded.

In cash market, we can purchase even one share whereas in Futures and Options minimum lots are fixed.

Cash assets may be meant for consumption or investment. Derivative contracts are for hedging, arbitrage or
speculation.
 Types of Derivatives

FUTURES FORWARDS
Exchange traded derivative financial
Over-the-counter instruments which
contracts under which it is mandatory
obligates the buyer or seller to close
for the buyer or seller to complete the
the transaction on the set future date
transaction on the pre-determined
at the pre-determined price.
date at the pre-determined price.

Example: 500,000 bushels of oranges will be ready for sale in three months’ time. Price of oranges might change in
the commodities market between now and then. By entering into a forward contract with a buyer, the orange
grower can lock in a set price per bushel for when it’s time to sell the [Link] contract is fulfilled if the per bushel
price at the time of sale is the same as the specified contract price. If the contract reaches its end and the price has
increased, the seller would pay the buyer the difference between the forward price and the prevalent price. If the
price has fallen below the forward price, the buyer would pay the difference to the seller.
 Types of Derivatives

OPTIONS
It provides the choice to the buyer/seller to complete the transaction at the pre-determined price, called strike price,
before the set future date.

Types of Options
Example: Security - Reliance Stock -> current price = 2000, Strike Price = 2050
Call option If a party believes that Reliance stock price will increase in the future, it will buy a call
•An option which grants the
holder the right to buy an option with a strike price of say 2050. At the option maturity date, if the market price is
underlying security at a
predetermined price (called 2200, the party will have the right to exercise their option to buy the Reliance stock at
strike price) on expiry date
2050. The payoff for the party will be the difference in strike price and the market
Put option value of the stock -> 2200 - 2050 = 150. On the other hand, if the party believes that
•An option which grants the
holder the right to sell an the Reliance stock will decrease, they can buy a put option. If the market value in the
underlying security at a
predetermined price (strike future is 1900, the put option will allow the party to sell the Reliance stock at the strike
price) on expiry date
price of 2050. The payoff in this case is 2050 - 1900 = 150 (Strike Price - Market Value)
 Types of Derivatives

SWAPS

It is an over-the-counter derivative contract through Interest Rate Swaps Currency Swaps

•To exchange one set of •To hedge investment
which two parties swap the cash flows or liabilities from interest payments for other. positions against currency
rate fluctuations
•Generally involves exchange
between Fixed interest •Involves exchange of
two different financial instruments. payments and floating interest, and sometimes of
interest payment principal, in one currency
for the same in another
currency

Example: XYZ Inc. is willing to pay ABC an annual rate

of LIBOR​ plus 1.5% on a notional principal of $2 million
Commodity Swaps Credit Default Swaps
for five years. In exchange, ABC pays XYZ a fixed annual
•To exchange between •To insurance from default
floating cash flows that are of a debt instrument against
rate of 5% on a notional value of $2 million for five based on a commodity’s premium payments. In case
spot price and fixed cash the asset defaults, the seller
years. ABC benefits from the swap if rates rise flows determined by a pre-
agreed price of a
will reimburse the buyer the
face value of the defaulted
commodity asset.
significantly over the next five years. XYZ benefits if rates
fall, stay flat or rise only gradually.
 Comparison between the Instruments

Forwards Futures Options Swaps

Obligation to perform Obligation to perform Obligation for option Obligation to perform

writer, right for option
buyer
Over the counter Exchange traded Exchange traded Over the counter

Customised Standardised Standardised Customised

Less liquid More Liquid More liquid Less Liquid

No guarantor Guarantor-Clearing Guarantor-Clearing No guarantor

house house

No payment at the time No payment at the time Premium-Requires No payment at the time
of agreement of agreement payment to buy an of agreement
option
 Long versus Short

The party buying the derivative

assumes the long position or
that the party is long the The party selling a derivative assumes
derivative the short position or that the party is
short a derivative

Example: Derivative Type - Call Option giving right to buy 100 shares of RELIANCE IND.
A party that is long the call option gets a right to buy 100 shares of Reliance, where as the counter party that is
short the call option has an obligation for to sell 100 shares of Reliance in case the call option is exercised.
 In the Money, Out of the Money, At the Money

In the Money (ITM) Out of the Money (OTM)

If the option is exercised at the current If the option is exercised at the current
market price, the holder gains market price, the holder faces a loss
• Call option • Call option
• Strike price lower than the current • Strike price higher than the current
market price market price
• Put option • Put option
• Strike price higher than the current • Strike price lower than the current
market price market price

At the Money Current

Strike
Market
(ATM) price
price
 Option Payoff charts
Strike Price (SP) – A strike price is the set price at which a derivative contract can be bought or sold when it is exercised. For call options,
the strike price is where the security can be bought by the option holder; for put options, the strike price is the price at which the
security can be sold.
Option Premium (OP) - An option premium is the current market price of an option contract. It is thus the income received by the seller
of an option to another party (Expense foe the buyer of an option)
Payout Payout Long Put
Long Call When going long (Buying) on an option,
the loss is limited to the option premium.

Long Call – The trader is in gain if the SP

SP
Price Expiry price of the underlying security is Price
more than Strike Price. The difference OP
OP
between the expiry price and the strike
price will be earned by the trader.

Total profit of Long call trader = (Expiry

price – Strike Price) – Option Premium Put Option Premium – INR 10
Call Option Premium – INR 10
Strike Price – 100 Long Put – Trader is in gain if the Expiry Strike Price – 100
price of the underlying security is less than
Expiry Price Profit / (Loss) the Strike Price. The difference between Expiry Price Profit / (Loss)
the expiry price and the strike price will be 80 (100-80) – 10 = 10
80 (10) earned by the trader.
100 (10) 100 (10)
Profit of Long put trader = (Strike Price –
120 (120-100) – 10 = 10 Expiry price) – Option Premium 120 (10)
 Option Payoff charts

Payout Payout Short Put

Short Call

OP When going short (Selling) on an option, OP

the profit is limited to the option
Price premium. Price
SP SP
Short Call - Trader is in gain if the Expiry
price of the underlying security is less than
Strike price. The trader is in loss if the
expiry price is higher than the strike price.

Loss of Short call trader = (Strike price –

Expiry price) – Option premium Put Option Premium – INR 10
Call Option Premium – INR 10
Strike Price – 100
Strike Price – 100 Short Put – Trader is in gain if the Expiry
price of the underlying security is more Expiry Price Profit / (Loss)
Expiry Price Profit / (Loss) than Strike price
80 (80-100) + 10 = 10
80 10
Loss of Short put trader = (Expiry price –
Strike price) – Option premium 100 10
100 10
120 (10)
120 (100-120) + 10 = (10)