DERIVATIVES
• A derivative is an instrument whose value depends on the
values of other more basic underlying variables or assets.
• The underlying variables could be :
• Stock prices
• Exchange rates
• Interest rates
• CHARACTERISTICS OF DERIVATIVES
• Derivatives have the characteristic of leverage or gearing.
• With a small initial outlay of funds (small percentage of the
entire contract value) one can deal big volumes.
• Pricing and trading in derivatives are complex and a thorough
understanding of the price behavior an product structure of the
underlying is an essential pre-requisite before one can venture
into dealing in these products.
DERIVATIVES
• Derivatives, by themselves, have no independent value.
• Their value is derived out of the underlying instruments.
• FUNCTIONS OF DERIVATIVES
• Derivatives shift the risk from the buyer of the derivative
product to the seller and as such are very effective risk
management tool.
• Derivatives improve the li9quidity of the underlying instrument.
• Derivatives perform an important economic function i.e. price
discovery.
• They contribute substantially to increasing the depth of the
markets.
• USERS OF DERIVATIVES
• Hedgers, Traders and Speculators use derivatives for different
purposes.
• Hedgers use derivatives to protect their assets/positions from
erosion in value due to market volatility.
DERIVATIVES
• Traders look for enhancing their income by making a two-way
price for other market participants
• Speculators set their eyes on making quick money by taking
advantage of the volatile price movements.
• Hedging is a mechanism by which an investor seeks to protect
his asset from erosion in value due to adverse market price
movements.
• A Hedger is usually interested in streamlining his future cash
flows.
• He is most concerned when the market prices are very volatile.
• He is not concerned with future positive potential of the value
of underlying asset.
• A SPECULATOR has, normally, no asset in his possession to
protect.
DERIVATIVES
• He is not concerned with stabilizing his future cash flows. He is
interested only in making quick money by taking advantage of
the price movements in the market.
• Arbitrageurs also form a segment of the financial markets.
They make riskless profit by exploiting the price differentials in
different markets.
• Ex: A company’s share were trading at Rs 3500 in Mumbai
market and Rs 3498 in Delhi market, an arbitrageur will buy it in
Delhi and sell it in Mumbai to make a riskless profit of Rs 2
(transaction cost is ignored for the purpose of this example).
• Successive such transactions will iron out the differences in
prices and bring equilibrium in the market. But it is not safe.
• Barings Bank where unscrupulous arbitraging between Osaka
and Tokyo exchanges in Nikkei Stock index futures drove the
Bank to bankruptcy.
TYPE OF DERIVATIVES
• There are number of derivative contracts.
• Basically they are forwards, futures and options.
• Forwards are definitive purchases and / or sales of a currency
or commodity for a future date.
• Forward contracts are contracted for a particular value and
should be transacted on a given date.
• Forwards are useful in avoiding liquidity risk, price variations
and locking in avoiding a downside.
• Forward however has the limitation that the contract has to be
performed in full and has attendant credit risk and market risk.
• Forwards are most useful in forex transactions where a spot
transaction can be covered by a contrary move I the forward
market.
FORWARD CONTRACTS
1. Essentially, OTC contracts involve
only buyer and seller.
• A forward contract is 2. Both parties have necessarily to
an over-the-counter perform the contract
contract under which 3. No payment of any initial margins
a purchaser agrees to 4. Maturity and size of contract may be
buy from the seller, customized
and the seller agrees 5. Settlement takes place only on the
date of maturity.
to sell to the purchaser,
6. Credit or counter-party risk is high.
a specified amount of
7. Markets for forward contracts are
a specified commodity
not very liquid.
in the future, at a known
8. Physical delivery takes place on the
price . maturity date.
FUTURE CONTRACTS
• Is an agreement to buy or sell an asset for a certain price at a
certain time.
• It is similar to forward contract. While a forward contract is
traded over the counter, a futures contract is traded on an
exchange.
• It has standardized contract parameters.
• A future contract is traded through an exchange. Buyer, Seller
and Exchange are involved.
• The contract need not necessarily culminate in deliver of the
underlying.
• To trade in futures contract, one has to become a member of
the exchange by paying the initial margin and maintain a
variable margin account too with the Futures Exchange.
FUTURE CONTRACTS
• The maturity and size of contracts are standardized.
• Settlement is on a daily basis on all the outstanding contracts
(marking to market on a daily basis)
• The Futures Exchange takes care of credit or counter-party
risk.
• The future contracts are highly liquid an cn be closed out
easily.
• In India, futures contracts are available an traded on the NSE
and BSE. These are either the indexes or specific stock.
• Commodity futures are traded on the commodity exchanges
viz. NSDEX, MCX.
FORWARD CONTRACT
• A forward foreign exchange transaction is one which is executed
today at rate agreed today but settlement takes place at an
agreed future time.
• The outright Forward Rate is calculated as a combination of spot
exchange rate and interest rates over a period of time in future.
• As an example consider an importer who has to make a USD
payment 6 months from now.
• Thus, he would have to buy USD exactly 6 months from now.
• However, he is not sure what the USD/INR rate would be.
• Hence, he enters into a contract to buy USD 6 months at a pre-
determined rate.
• Thus a forward contract is an agreement where 2 parties agree to
specified trade at a specified point in future.
OPTIONS
• An option is a contract, which gives the buyer (holder) the
right, but not the obligation, to buy or sell specified quantity of
the underlying assets, at a specific (strike) price on or before a
specified time (expiration date).
• The underlying may be physical commodities like
wheat/rice/cotton/gold/oil or financial instruments like equity
stock/stock index/bonds etc.
• IMPORTANT TERMINOLOGY
• Underlying: the specific security / asset on which an option
contract is based.
• Option Premium: Premium is the price paid by the buyer to the
seller to acquire the right to buy or sell.
OPTIONS
• Strike Price or Exercise Price: The strike or exercise price of an
option is the specified / pre-determined price of the underlying
asset at which the same can be bought or sold if the option
buyer exercises his right to buy/sell on or before the expiration
date.
• Expiration date: The date on which the option expires is known
as Expiration Date. On Expiration date, either the option is
exercised or it expires worthless.
• Exercise Date: is the date on which the option is actually
exercised. In case of European Options the exercise date is
same as the expiration date while in case of American Options,
the options contract may be exercised any day between the
purchase of the contract & its expiration date
OPTIONS
• Open Interest: the total number of options contracts
outstanding in the market at any given point of time.
• Option Holder: is the one who buys an option which can be a
call or a put option.
• He enjoys the right to buy or sell the underlying asset a
specified price on or before specified time.
• His upside potential is unlimited while losses are limited to the
premium paid by him to the option writer.
• Option seller/writer: is the one who is obligated to buy (in case
of put option) or sell (in case of call option), the underlying
asset in case of the buyer of the option decides to exercise his
option. His profits are limited to the premium received from the
buyer while his downside is unlimited.
OPTIONS
• EUROPEAN OPTION; The European option is the one, which
can be exercised by the buyer on the expiration date only and
not any time before that.
• AMERICAN OPTION: is one which can be exercised by the buyer
on or before the expiration date, i.e. any time between the day of
purchase of the option and the day of its expiry.
• CALL OPTIONS: All call options gives the holder (buyer/ one
who is long call) the right to buy specified quantity of the
underlying asset at the strike price on or before expiration date.
• The seller (one who is short call) however, has the obligation to
sell the underlying asset if the buyer of the call option decides to
exercise his option to buy.
OPTIONS
• Example: An investor buys one European call option on Infosys
at the strike price of Rs 3500 at a premium of Rs 100. If the
market price of Infosys on the day of expiry is more than Rs 3500,
the option will been exercised. The investor will earn profits once
the share price crosses Rs 3600 (strike price + Premium).
• Suppose the stock price is Rs 3800, the option will be exercised
and the investor will buy 1 share of Infosys from the seller of the
option at Rs 3500 and sell it in the market at Rs 3800 making a
profit of Rs 200 (spot price –strike price)-premium.
• In another scenario, if at the time of expiry stock price falls below
Rs 3500, suppose it touches Rs 3000, the buyer of the call option
will choose not to exercise his option.
• In this case the investor loses the premium (Rs100), paid which
shall be the profit earned by the seller of the call option.
PUT OPTION
• A put option given the holder (buyer/one who is long Put), the
right to sell specified quantity of the underlying asset at the
strike price on or before expiry date.
• The seller of the put option (one who is short Put) however, has
the obligation to buy the underlying asset at the strike price if
the buyer decides to exercise his option to sell.
• DIFFERENCE BETWEEN FUTURES AND OPTIONS
• Futures are agreements/contracts to buy or sell specified
quantity of the underlying assets at a price agreed upon by the
buyer & seller, on or before a specified time. Both the buyer
and seller are obligated to buy/sell the underlying asset. In
case of options the buyer enjoys the right & not the obligation,
to buiy or sell the underlying assets.
PUT OPTION
• In case of Options, for a buyer (or holder of the option), the
downside is limited to the premium (option price), he has paid
while the profits may be unlimited.
• For a seller or writer of an option, however, the downside is
unlimited while profits are limited to the premium he has
received from the buyer.
• The futures contracts prices are affected mainly by the prices
of the underlying asset.
• The prices of options are however, affected by the prices of the
underlying assets, time remaining for expiry of the contract &
volatility of the underlying asset.
• It costs nothing to enter into a futures contract whereas there
is a cost for entering into an options contract, termed as
Premium.
PUT OPTION
• IN MONEY: an option said to be ‘at-the-money’, when the
option’s strike price is equal to the underlying asset price.
• This is true for both puts and calls .
• A call option is said to be in-the-money when the strike price of
the option is less than the underlying asset price.
• For example, a Sensex call option with strike price of 3900 is
‘in-the-money’ when the spot Sensex is at 4100 as the call
option has value.
• The call holder has the right to buy a Sensex at 3900, no matter
how much the spot market price has risen
• And with the current price at 4100, a profit can be made by
selling Sensex at this higher price
