Players in Derivatives

* Hedgers: Hedgers face risk associated with the price of an asset they own. They use derivatives to
reduce or eliminate risk.
* Speculators: Speculators bet on future movements in the prices of an asset. Derivatives give them
an extra leverage, by which they can increase both the potential gains and losses.
* Arbitrageurs: Arbitrageurs take advantage of discrepancy between prices in two different markets.
* Jobbers: Jobbers take advantage from the spread between the Bid and Ask price.
1.4 Forwards: Meaning, Definition, Features, Players & Limitations
Meaning
A forward contract is a private contract between a buyer and a seller in which the buyer agrees to
buy and the seller agrees to sell a specific quantity of a certain security or commodity (known as the
underlying instrument) at the price specified in the contract. The difference between a forward
contract and most other sales contracts is that with the forward contract, the delivery and payment of
the underlying instrument occurs at a specified future date instead of immediately.
Definition
A forward contract is a customized contract between two parties, where settlement takes place on a
specific date in future at a price agreed today.
Features of Forwards
The salient features of forward contracts are:
* They are bilateral contracts and hence exposed to counter-party risk.
* Each contract is custom designed, and hence is unique in terms of contract size, expiration date
and the asset type and quality.
* The contract price is generally not available in public domain.
* On the expiration date, the contract has to be settled by delivery of the asset.
* If the party wishes to reverse the contract, it has to compulsorily go to the same counter-party,
which often results in high prices being charged.

Players in Forwards
* Hedgers: The one who intends to minimize this risk which respect to price fluctuations
* Speculators: The one who speculates / anticipates the price movement in order to make maximum
profits.
Limitations of Forwards
* Lack of centralization of trading
* Illiquidity
* Counter party risk
In the first two of these, the basic problem is that of too much flexibility and generality. The forward
market is like a real estate market in that any two consenting adults can form contracts against each
other. This often makes them design terms of the deal which are very convenient in that specific
situation, but makes the contracts non-tradable.
Counterparty risk arises from the possibility of default by any one party to the transaction. When one
of the two sides to the transaction declares bankruptcy, the other suffers. Even when forward
markets trade standardized contracts, and hence avoid the problem of illiquidity, still the counterparty
risk remains a very serious issue.
2.0 Futures
2.1 Meaning
Future contracts is an agreement made and traded on the exchange between two parties to buy or
sell a commodity at a particular time in the future for a pre-defined price. Since both the parties are
unaware of each other, the exchange provides a mechanism to give the party assurance of honored
contract. The exchange specifies standardized features of the contract. The risk to the holder is
unlimited, and because the pay off pattern is symmetrical, the risk to the seller is unlimited as well.
Money lost and gained by each party on a futures contract are equal and opposite. In other words,
futures trading are a zero-sum game. These are basically forward contracts, meaning they represent
a pledge to make a certain transaction at a future date. The exchange of assets occurs on the date
specified in the contract. These are regulated by overseeing agencies, and are guaranteed by
clearing houses. Hedgers often trade futures for the purpose of keeping price risk in check.

Future contracts are often used by commercial enterprises as hedging tools to reduce the risk of
expected future purchases or sales of the underlying asset. If used to speculate, risk increases. So
risk depends on the underlying instrument and the use of the future.
Advantages of Futures Contracts
* If price moves are favourable, the producer realizes the greatest return with this marketing
alternative.
* No premium charge is associated with futures market contracts.
Disadvantages of Future Contracts
* Subject to margin calls
* Unable to take advantage of favourable price moves
* Net price is subject to Basis change
Futures contracts are similar to Options. Both represent actions that occur in future. But Options are
contract on the underlying futures contract where as futures are either to accept or deliver the actual
physical commodity. To make a decision between using a futures contract or an options contract,
producers need to evaluate both alternatives.
2.2 Terminologies
* Spot price: The price at which an asset trades in the spot market.
* Futures price: The price at which the futures contract trades in the futures market.
* Contract cycle: The period over which a contract trades. The index futures contracts on the NSE
have one- month, two-months and three- months expiry cycles which expire on the last Thursday of
the month. Thus a January expiration contract expires on the last Thursday of January and a
February expiration contract ceases trading on the last Thursday of February. On the Friday
following the last Thursday, a new contract having a three- month expiry is introduced for trading.
* Expiry date: It is the date specified in the futures contract. This is the last day on which the contract
will be traded, at the end of which it will cease to exist.
* Contract size: The amount of asset that has to be delivered under one contract. Also called as lot
size.

* Basis: In the context of financial futures, basis can be defined as the futures price minus the spot
price. There will be a different basis for each delivery month for each contract. In a normal market,
basis will be positive. This reflects that futures prices normally exceed spot prices.
* Cost of carry: The relationship between futures prices and spot prices can be summarized in terms
of what is known as the cost of carry. This measures the storage cost plus the interest that is paid to
finance the asset less the income earned on the asset.
* Initial margin: The amount that must be deposited in the margin account at the time a futures
contract is first entered into is known as initial margin.
* Marking-to-market: In the futures market, at the end of each trading day, the margin account is
adjusted to reflect the investor's gain or loss depending upon the futures closing price. This is called
marking-to-market.
* Maintenance margin: This is somewhat lower than the initial margin. This is set to ensure that the
balance in the margin account never becomes negative. If the balance in the margin account falls
below the maintenance margin, the investor receives a margin call and is expected to top up the
margin account to the initial margin level before trading commences on the next day.
Propose of Futures
* Hedging: Hedging is a mechanism to reduce price risk. Price Risk can be reduced by taking an
opposite position in futures market. Hedging can be initiated by Selling Nifty Futures or a stock
.hedge can be for 20%, 50% or 100% based on view. Ideally 25 35% hedge is kept at all times,
then based on view, its increased or decreased.
* Arbitrageurs: Arbitrageurs take advantage of discrepancy between prices in two different markets.
Eg. Buy L&T in cash market @ Rs. 800/- sell in future market @ Rs .840/- thereby profit Rs. 40/* Jobbing: Jobbing is nothing but taking advantage from the spread between the Bid and Ask price.
Eg. Powergrid
2.3 Payoff Profile
* A payoff is the likely profit or loss that would accrue to a market participant with change in the price
of the underlying asset

* Futures have a linear payoff, i.e. the losses as well as profits for the trader of futures contract are
unlimited
Payoff for Futures Buyer
Payoff for Futures Seller
2.4Numericals
Q.1. Krishna Seth sold a January Nifty futures contract for Rs.240,000 on 15th January. Each Nifty
futures contract is for delivery of 100 Nifties. On 25th January, the index closed at 2350. How much
profit/loss did she make?
a. -7,000 b. -5,000 c. +5,000 d. +7,000
Solution: Krishna Seth sold one futures contract costing her Rs.240, 000. At a market lot of 100, this
works out to be Rs.2400 per Nifty future. On the futures expiration day, the futures price converges
to the spot price. If the index closed at 2350, this must be the futures close price as well. Hence she
will have made of profit of (2400 - 2350)*100. The correct answer is option (c ).
Q.2. Santosh is bullish about Company XYZ and buys ten one- month XYZ futures contracts at
Rs.2,96,000. On the last Thursday of the month, XYZ closes at Rs.271. He makes a ___
a. profit of Rs. 15000 b. profit of Rs.25000
c. loss of Rs.15000 d. loss of Rs.25000
Solution: At Rs.2,96,000 per futures contract, it costs him Rs.296 per unit of futures, i.e. 2,96,000/(10
* 100). On expiration day the spot and futures converge. Therefore he makes a loss of (296 - 271) *
1000 = 25000. The correct answer is option (d).
Q.3. Rajiv is bearish about Company ABC and sells twenty one- month ABC futures contracts at
Rs.3,04,000. On the last Thursday of the month, ABC closes at Rs.134. He makes a _____.
a. profit of Rs. 18000 b. profit of Rs.36000
c. loss of Rs. 18000 d. loss of Rs.36000
Solution: At Rs.3,04,000 per futures contract, it costs him Rs.152 per unit of futures, i.e. 3,04,000/(20
* 100). On expiration day the spot and futures converge. Therefore his profit is (152-134) * 2000 =
36000. The correct answer is option (b).

Q.4. Ms. Sweta is short on NTPC; the details of her position are as follows:
Lot size: 1625 Shares
Net Future Value: Rs. 2, 59,431.25/Initial Margin: 33.95%
Span Margin / Maintenance Margin: 23.95%
At what price will she get the margin call and what is the Margin Amount she has to bring in if she
gets a margin call from her broker?
a. Price Rs. 172.55/- and Amount Rs. 22350.50/b. Price Rs. 175.62/- and Amount Rs. 25,943.13/c. Price Rs. 181.13/- and Amount Rs. 30,056.25/d. Price Rs. 180.00/- and Amount Rs. 29,596.50/(Ans: Option b)
Q.5. Mr. Ankit is long on BHEL, the details of her position are as follows:
Lot size: 75 Shares
Price: Rs. 1355/- per share
Initial Margin: 34.26%
Span Margin / Maintenance Margin: 24.26%
At what price will she get the margin call and what is the Margin Amount she has to bring in if she
gets a margin call from her broker?
a. Price Rs. 1219.50/- and Amount Rs. 10,162.50/b. Price Rs. 1220.50/- and Amount Rs. 10,262.50/c. Price Rs. 1221.50/- and Amount Rs. 10,362.50/d. Price Rs. 1222.50/- and Amount Rs. 10,462.50/- (Ans: Option a)

Section 3: Options
3.1 Meaning
Options give the buyer the right not the obligation to buy or sell a specified underlying at a set price,
on or before a specified date
3.2 Terminologies
Index options: These options have the index as the underlying. Some options are European while
others are American. Like index futures contracts, index options contracts are also cash settled.
Stock options: Stock options are options on individual stocks. Options currently trade on over 500
stocks in the United States. A contract gives the holder the right to buy or sell shares at the specified
price.
Buyer of an option: The buyer of an option is the one who by paying the option premium buys the
right but not the obligation to exercise his option on the seller/writer.
Seller / Writer of an option: The writer of a call/put option is the one who receives the option premium
and is thereby obliged to sell/buy the asset if the buyer exercises on him.
There are two basic types of options, call options and put options.
Call option: A call option gives the holder the right but not the obligation to buy an asset by a certain
date for a certain price.
Put option: A put option gives the holder the right but not the obligation to sell an asset by a certain
date for a certain price.
Option price/premium: Option price is the price which the option buyer pays to the option seller. It is
also referred to as the option premium.
Expiration date: The date specified in the options contract is known as the expiration date, the
exercise date, the strike date or the maturity.
Strike price: The price specified in the options contract is known as the strike price or the exercise
price.
American options: American options are options that can be exercised at any time upto the
expiration date. Most exchange-traded options are American.

European options: European options are options that can be exercised only on the expiration date
itself. European options are easier to analyze than American options, and properties of an American
option are frequently deduced from those of its European counterpart.
In-the-money option: An in-the-money (ITM) option is an option that would lead to a positive cash
flow to the holder if it were exercised immediately. A call option on the index is said to be in-themoney when the current index stands at a level higher than the strike price (i.e. spot price > strike
price). If the index is much higher than the strike price, the call is said to be deep ITM. In the case of
a put, the put is ITM if the index is below the strike price.
At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cashflow if it
were exercised immediately. An option on the index is at-the-money when the current index equals
the strike price (i.e. spot price = strike price).
Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to a
negative cashflow if it were exercised immediately. A call option on the index is out-of-the-money
when the current index stands at a level which is less than the strike price (i.e. spot price < strike
price). If the index is much lower than the strike price, the call is said to be deep OTM. In the case of
a put, the put is OTM if the index is above the strike price.
Intrinsic value of an option: The option premium can be broken down into two components - intrinsic
value and time value. The intrinsic value of a call is the amount the option is ITM, if it is ITM. If the
call is OTM, its intrinsic value is zero.