By:
Amit Mittal
Nitin Mittal
Introduction to Derivatives
Derivatives are the financial instruments which
derive their value from the value of the underlying
asset.
The underlying asset can be equity, fixed income
instruments, interest rates, foreign exchange or
commodities.
The price movements of derivative products are
related to that of the underlying securities.
Various types of Derivatives
History of Derivatives
Chicago Board of Trade (CBOT) for derivatives trading,
became functional in 1848 and by 1865 futures contract in
commodities started trading.
In 1972 currency futures were introduced, followed by
equity options in 1973.
Year 1975 saw introduction to Interest Rate futures.
Currency Swaps were introduced in 1981 and in 1982 Index
futures, Interest Rate swaps and Currency Options were
started.
In 1983, Index Options and Options on futures were
started.
Advantages of using Derivatives
Leveraged Positions
Lesser transaction costs
Ease of creating positions
Derivatives as Risk Management Products
Derivatives as Trading Products
Structured or Over The Counter
versus
Exchange traded Derivatives
Exchange traded derivatives are standardized contracts
which can only be traded on a recognized exchange.
The clearing house of the exchange provides the
counterparty guarantee
OTC derivatives on the other hand are customized
contracts and the terms of the contract are flexible.
There is no counterparty guarantee.
The liquidity of an OTC derivative can be limited as it is a
customized contract.
Derivatives to be discussed
Futures
Forwards
Options
In simple terms, a futures contract is a contract that allows
the counterparties to exchange the underlying assets in
future at a price agreed upon today. Following are the
features of a futures contract-
Contract through an exchange
To exchange obligations on a future date
At a price decided today
For a quantity / quality standardized by the exchange
Settlement guaranteed by the clearing corporation of the
exchange
Difference between forwards and futures
Forwards Futures Forwards Futures
Nature of the Customized Standardized
contract
Counterparty Any entity Clearing house of
exchange
Credit Risk Exists Assumed by the
exchange
Liquidity Poor Very High
Margins Not Required Received / Paid on
daily
basis
Valuation Not Done Done on daily
basis
Underlying
Contract Multiplier
Tick size
Contract months
Expiry date
Daily settlement price
Final settlement price
Pricing of Futures
Trading of futures
Margins required for futures contracts
Settlement of futures
Forward Contracts
Forward Contract is an OTC derivative product.
It is a contract between two parties, which enables
the buyer to lock a desired value of the underlying
that will become applicable at some future date, now.
There is no counterparty guarantee provided by any
third party.
Forward contracts unlike futures, are deliverable
contracts (Though there are non-deliverable forward
contracts also).
Different Types of Forward Contracts
Depending on the underlying asset, the
most common types of forward contracts
are:
Currency Forwards
Interest Rate Forwards, and
Commodity Forwards
Participants in Forward Contracts
Hedgers – They participate in the forward market with a
view to protect or cover an existing exposure in the spot
market.
Speculators – These dealers based on their opinion about
the market movements take an exposure in the forward
market with a view to make profits from the expected
movement in the underlying element.
Arbitrageurs – These players neither hedge nor
speculate. They try to take advantage of the price
differences in the spot and forward markets.
Options
Options or option contracts are instruments
Right, but not the obligation, is given
To buy or sell a specific asset
At a specific price
On or before a specified date
Options can be exchange traded derivatives or even
over the counter derivatives.
Differences in equity shares and equity options
Option Terminologies
Strike Price or Exercise Price
Expiration Date
Exercise Date
Option Buyer
Option Seller
American option
European option
Option Premium
Option Classifications
Call Option : an option which gives a right to buy the
underlying asset at a strike price.
Put Option : an option which gives a right to sell the
underlying asset at strike price.
Call Option Buying
A Call option buyer basically is bullish about the underlying stock.
Put Option buying
A buyer of put option is bearish on underlying stock.
Both the Call and Put option buyers are buying the
rights, that is they are transferring their risks to the
sellers of the option.
For this transfer of risk to the sellers, buyers have to
compensate by paying Option Premium.
Option premium is also known as Price of the option,
Cost or Value of the option.
Option Selling: Motives for selling options
The seller is ready to assume the risk in option
exercise. The incentives for the seller to assume that
risk are two :
Option Premium – This is the actual amount received by him for
selling an option to the buyer.
The possibility of non-exercise of option – In seller’s view the
possibility of option being exercised by the buyer may be low.
Factors influencing Option Pricing
Time to expiration – greater the time to expiration,
higher the value of the options.
Volatility –higher the volatility, higher the value of
the options.
Risk free Rate of Interest – If interest rate goes up,
calls gain in value while puts lose value.
ITM, ATM, OTM Options
In the money
At the money
Out of money
Intrinsic and Time value of the option
Intrinsic value is equal to the amount by which
option is in the money.
Time value is the difference between market price of
the option and intrinsic value.
Settlement of Options
Physical Delivery
Cash settlement
Exercise of calls
Exercise of Puts
Pay off from a Long Call
Payoff from Short Call
Summary of basic option strategies
Thank You!
