Derivatives

Session : Derivatives Defined

 Derivative Defined
Derivative is a product whose value is derived from
the value of one or more basic variables, called bases
(underlying asset, index, or reference rate), in a
contractual manner. The underlying asset can be
equity, forex, commodity, or any other asset.
Basic ideas

A derivative is a
• Contract

• Two counter parties

• Underlying asset

• Set of payments

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The underlying may be…...

• Stocks and stock indexes

• bonds and interest rates

• foreign currency

• commodities

• specific events viz., earthquakes, weather

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Factors driving the growth of derivatives

1. Increased volatility in asset prices in financial

markets,
2. Increased integration of national financial
markets with the international markets.
3. Market improvement in communication facilities
and sharp decline in their cost.
4. Development of more sophisticated risk
management tools,

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Functioning of derivatives.

An Indian importer has imported goods worth

$ 1000 form an exporter in U.S. he has to pay $
1000 after a period of three months.
Present rate: $ 1 = Rs. 45
It is expected that rate of the $ would increase by
Rs. 5 per $ in the next three months.
Indian importer enters into a contract with an F.I in
India to purchase $ 1000 now @ $1= Rs.47,
transaction will take place after three month only.

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Types of derivatives

• Forwards
• Futures
• Options
• Swaps (?) and
• many more exotics!!!!!

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Forwards:

A Forward contract is a customized contract between two entities,

where settlement takes place on a specific date in the future at
today’s pre agreed price.
For Example, if you agree on January 1 to buy 100 liter of petrol on
July 1 at a price of Rs. 49 per liter from a petrol dealer, you have
bought forward petrol, whereas petrol dealer has sold forward
petrol. No money or petrol changes hand when the deal is signed.
The forward contract only specifies the terms of transaction that
will occur in the future.

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Futures

• A future contract is an agreement between two

parties to buy and sell an asset at a certain time in
the future at a certain price. Futures contracts
are special types of forward contracts in the
sense that the former are standardized exchange-
traded contracts.

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Futures contd…

The exchange standardizes the terms of contract:

• Asset grade
• Contract size
• Delivery location
• Delivery months
• Minimum price movements
• Daily price limits
• Positions limits

• Standardization enables a futures contract to

trade on an exchange like a security.

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Options

Options are of two types- calls and puts. Call give 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.

Puts give the buyer the right, but not the obligation
to sell a given quantity of the underlying assets at
a given price on or before a given date.

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An option contract is

•To buy/sell
•right but not obligation
•underlying asset
•stated date and price

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Options terminology

Call option : the owner has the right to buy stock

Put option : the owner has the right to sell stock

Strike price : the fixed price for trading the stock

Expiration : the end of the time period

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Derivatives Markets

• Exchange traded
– Traditionally exchanges have used the open-outcry
system, but increasingly they are switching to electronic
trading
– Contracts are standard there is virtually no credit risk
• Over-the-counter (OTC)
– A computer- and telephone-linked network of dealers at
financial institutions, corporations, and fund managers
– Contracts can be non-standard and there is some small
amount of credit risk

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Ways Derivatives are Used

• To hedge risks
• To speculate (take a view on the future direction
of the market)
• To lock in an arbitrage profit
• To change the nature of a liability
• To change the nature of an investment without
incurring the costs of selling one portfolio and
buying another

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NSE’ s Derivative Market

• June 12, 2000 S&P CNX Nifty Index Futures

• June 4, 2001 Trading in index options
• July 2, 2001 Options on Individual securities
• Nov 9, 2001 single Index futures

Currently, the derivatives contracts have a

maximum of 3 months expiration cycles. Three
contracts are available for trading with 1 month, 2
months, and 3 months expiry.

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Trading Mechanism

• The futures and options trading system of NSE,

Called NEAT- F&O trading system, provides a fully
automated screen based trading for Nifty futures
and options and Stock Futures and options on a
nationwide basis and an online monitoring
mechanism.

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Turnover: Business growth of futures and options
market: Turnover (Rs. Crores)

Month Index Index Stock Stock

futures options options futures
June 00 35 ----- ------ ------

June 01 590 195 ------ -------

June 02 2,123 389 4,642 16,178

June 03 9,348 1,942 15, 042 46,.505

June 04 64,017 8,473 7,424 78,392

June 05 77,218 16,133 14,799 1,63,096

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Exchange Traded Vs OTC Derivatives Markets:

• The OTC derivatives markets have the following features

compared to exchange traded derivatives:

1. The management of the counter party (credit) risk is

decentralized and located within individual institutions.

2. There are no formal centralized limits on individual positions,

leverage and margining.

3. There are no formal rules for risk and burden sharing.

4. There are no formal rules or mechanism for ensuring market

stability and integrity, and safeguarding the collective
interest of market participants.

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Economic Functions of Derivative Market

• Price in an organized derivative market reflect the

perception of market participants about the future and lead
the prices of underlying to the perceived future level. Thus
derivatives helps in discovery of future as well as current
prices.

• The Derivatives market helps to transfer risk from those

who have them but may not like them to those who have an
appetite for them.

• It increases trading volume: because of participation by

more players who would not otherwise participate for lack of
an arrangement to transfer risk.

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Economic functions cont….

• Speculative trades shift to a more controlled

environment of derivative market. In the absence
of an organized derivative market, speculators
trade in the underlying cash markets.
Managing, monitoring and surveillance of the
activities of various participants become
extremely difficult in these kind of mixed
markets.

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Forward Contracts

• A forward contract is an agreement to buy or sell

an asset at a certain time in the future for a
certain price (the delivery price)
• It can be contrasted with a spot contract which is
an agreement to buy or sell immediately
• It is traded in the OTC market

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Forward Price

• The forward price for a contract is the delivery

price that would be applicable to the contract if
were negotiated today (i.e., it is the delivery price
that would make the contract worth exactly zero)
• The forward price may be different for contracts
of different maturities

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Terminology

• The party that has agreed to buy has what is

termed a long position
• The party that has agreed to sell has what is
termed a short position

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Example

• On August 16, 2010 the treasurer of a corporation

enters into a long forward contract to buy £1
million in six months at an exchange rate of 1.4359
• This obligates the corporation to pay $1,435,900
for £1 million on February 16, 2011.
• What are the possible outcomes?

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If the rate on 16, Feb 2011 is £1=$1.5

• K=> £1=$1.4359.
• St=> £1=$1.5
• Size of Contract £1 million.
• Calculate the saving?

• IS this contract absolutely risk free for the

Corporation?? If no, then what is the risk?

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If the Spot price after six month is
£1=$1.4??
• Strike Price K=> £1=$1.4359
• Spot Price St => £1=$1.4.

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Futures Contracts

• Agreement to buy or sell an asset for a certain

price at a certain time.
• Similar to forward contract
• Whereas a forward contract is traded OTC, a
futures contract is traded on an exchange

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Examples of Futures Contracts

• Agreement to:
– buy 100 oz. of gold @ US$300/oz. in December
(COMEX)
– sell £62,500 @ 1.5000 US$/£ in March (CME)
– sell 1,000 bbl. of oil @ US$20/bbl. in April
(NYMEX)

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Options…

• Call options gives the holder the right to buy the

underlying asset by a certain date for a certain
price.
• Put options gives the holder the right to sell the
underlying asset by a certain date for a certain
price.
• The price of the contract is known as exercise
price or strike price.
• The date in the contract is known as maturity date
or expiration date.
• European Options Vs. American Options

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Options..Prices of options on Intel, may 2009.

Calls Puts
Strike June July October June July October
Price ($)

$20.00 1.25 1.60 2.40 0.45 0.85 1.50

$22.50 0.20 0.45 1.15 1.85 2.20 2.85

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Options..

• Suppose the investor instructs a broker to buy

one October call option contract on Intel with a
strike price of $22.50.
• The broker will relay these instructions to a
trader at the exchange.
• The trader will then find another trader who
wants to sell 1 October call contract on Intel with
strike price of $22.50, and the price will be
agreed.
• As per the table above the price is $1.15.
• This is the price for an option to buy one Intel
share.
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Options..
• In the U.S., one option contract is a contract to
buy or sell 100 shares.
• Therefore the investor must arrange for
$1.15*100 = $115 to be remitted to the exchange
through the broker.
• The exchange will then arrange this amount to be
passed on to the party on the other side of the
transaction.

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Options..

• In this example:
• The investor has obtained at a cost of $115 the
right to buy 100 Intel shares for $22.50 each.
• The other party has received $115 and has agreed
to sell 100 shares of Intel for $22.50 per share.
He is under obligation to sell the said shares.

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Options.. What if October spot price of Intel
is $ 30?
• Call Option payoff = (St-K,0)
• Put option payoff = (k-St,0)

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Options.. What if the October spot price of
Intel is $22.00
• Payoff to investor =???

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Put Options..

• An alternative trade for an investor would be to

purchase a July put option with a strike price of
$20.0.
• How much will it cost??
• $0.85*100 =$85 for 100 Intel stocks.
• Investor will get right to sell 100 shares of Intel
@$20 in July.

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Put Options.. What if July spot price of Intel
is $18??
• Payoff of the Put option = (K-St,0)

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Put option.. What if July Spot price of Intel
is $22.50??
• Payoff to the investor?

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