Introduction to Derivatives

Prasanna V
Derivatives
 Instrument whose value is derived from an underlying

 Underlying - commodity, equity, Index, interest rate, etc.

 Cash settled or delivery of underlying

 Exchange Traded or OTC

 Used for risk management

Prasanna V
Derivatives (Contd)
 Exchange traded
 Screen based, automated 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 an element of credit
risk

Prasanna V
Financial Derivative

 Its value must be linked to the price of specified underlying asset

 Settles on a future date

 Requires no or minimal initial investment

Prasanna V
Financial Derivatives-Types
Generic Types
 Forward : Forward Contract Consist of buying or selling a specified underlying
asset for delivery on a specified future date at price fixed on trade date
 Futures: It is same as forward contract except in the operating environment and
framework.
 Swap: Consists of exchanging a series of predefined cash flows during a
specified future period
 Option: is buying certain rights on underlying asset not buying the underlying
asset.

 Exotic Derivatives : Customised pay offs, often consists of two or more generic
types
 Embedded Derivatives : Underlying assets are attached with a derivative. For
Example Callable bonds, puttable bonds

Forward and swaps are traded only in OTC Market, Future is traded in
exchange and option is trades in both

Prasanna V
Financial Derivative-Market

Market Segment Asset Market Derivative Product

Exchange
All Markets Futures & Options

Forex Forward

OTC
Interest Rate Swap

Equity & Commodity Option

Prasanna V
 Forward Contract
 SPOT MARKET
 Goods and funds change hands the moment a trade takes
place.

 FORWARD CONTRACT
 Two parties agree upon everything, but settlement takes place
x days later.

Prasanna V
 Forwards are Futures when…
 Exchange Traded

 Standardised

 Counter - Party Risk is absent (settlement of trade is guaranteed)

 Marked to Market everyday

Prasanna V
Use of Futures

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

Prasanna V
Futures Contracts
 ASSETS INVOLVED IN FUTURES TRADING
 Agricultural goods (wheat, corn, etc.)
 Natural resources (oil, natural gas, etc.)
 Foreign currencies (pounds, marks, etc.)
 Fixed-income securities (T-bonds, etc.)
 Market indices (Nifty, S&P 500)
 Stocks (RELIANCE, SBI, INFOSYSTECH)

Prasanna V
 Pricing of Futures
 Futures price = Spot Price + Cost of carry

 Cost of carry = interest rate*

 At expiry : Futures price = Spot price

*for financial futures

Prasanna V
Payoff diagram for futures
P
R
O
F
I
T
S

0 Rs. 250 Rs. 300 Rs. 500

L
O
S
Buy RELIANCE
S FUTURES @ Rs. 250
E
S
Sell @ Rs. 300

Prasanna V
Options

Prasanna V
What is an Option ?

Option is
 Right to buy or sell
 but not an
obligation
 Stated quantity
 Stated date
 Stated price

Prasanna V
Classification of Options
Call Option : An agreement that gives an investor the right (but not the
obligation) to buy a stock, bond, commodity, or other instrument at a
specified price within a specific time period. It may help you to
remember that a call option gives you the right to "call in" (buy) an
asset. You profit on a call when the underlying asset increases in price.

Put Option :An option contract giving the owner the right, but not the
obligation, to sell a specified amount of an underlying security at a
specified price within a specified time. This is the opposite of a call
option, which gives the holder the right to buy shares.

Exercise Style:
 American style — which allows exercise up to the expiration date
 European style — where exercise is only allowed on the expiration date
 Bermudan style — where exercise is allowed on several, specific dates
up to the expiration date

Prasanna V
Basic Option Terminology

 Strike price: Also called the exercise price. The price at which the
underlying asset can be bought or sold.

 Expiration date: The maturity date of the option

 Option premium: The price paid for the option

Prasanna V
 Option Status
 In-the-Money (ITM) : Option Exercise will result in benefit to buyer

 At-the-Money (ATM): Exercise has neither benefit nor loss to buyer

 Out-of-the-Money (OTM) : Exercise will result in loss to buyer

Prasanna V
 Longs & Shorts
 The buyer of a forward, futures, or options contract is known as the Long.
 He is said to have taken a Long Position.
 The seller of a forward, futures, or options contract, is known as the Short.
 He is said to have taken a Short Position.
 In the case of options, a Short is also known as the option Writer.

Prasanna V
 Benefit if the
Long Call underlying rises.
Right to buy the Profits substantial
underlying at
strike price
Buy
Lose if the underlying
is steady/ falling.
Loss limited to
Call Options Premium
Benefit if the
underlying is steady/
Short Call falling. Profit limited
Sell to Premium
Obligation to
sell the
underlying at Lose if the underlying
strike price rises. Loss substantial
 Long Put Benefit if the
Right to sell the underlying falls.
underlying at Profits substantial
Buy strike price
Lose if the underlying
is steady/ rising.
Loss limited to
Put Options Premium
Benefit if the
underlying is steady/
Short Put rising. Profit limited
Sell to Premium
Obligation to
Buy the
underlying at Lose if the underlying
strike price falls. Loss substantial
OTC Derivatives

Prasanna V
Over-the-Counter Derivatives
(OTC Derivatives)
 Over-the-counter (OTC) derivatives are contracts that are traded
(and privately negotiated) directly between two parties, without going
through an exchange or other intermediary. Products such as swaps,
forward rate agreements, and exotic options are almost always traded
in this way.

Some of the OTC Derivative products are described in the following

slides.

Prasanna V
Rates Products

Prasanna V
Forward Rate Agreement (FRA)
 Forward Rate Agreement is an agreement between two parties to settle the
difference between an agreed level of interest and an actual future level of
interest. The contract is agreed at the start of the period for which the interest is
fixed.

 The lead-in period to this settlement date is in practice not longer than 21 months.
The maximum period over which the interest may be settled is 12 months. The
most popular period is three to six months

 For FRAs in foreign currency Libor (London Interbank Offered Rate) is normally
used.
For FRAs the reference interest rate must be set two days before settlement
takes place.

Advantages of FRA
 When you buy a Forward Rate Agreement, you can protect future withdrawals or
investments against unfavourable interest rate changes. A FRA is attractive when
you must set the interest paid on a future financing (FRA purchase) or
want to safeguard the interest yield on future investments (FRA sale).

Prasanna V
Forward Rate Agreement (FRA)
Example
Pays 1.25 % Fixed
Party A Party B
Receives 3m USD LIBOR
Party A Pays Party A Receives
Notional Amount USD 1,000,000,000 Notional Amount USD 1,000,000,000
Tenor 3 Months Tenor 3 Months
Rate 1.25% Rate 3M USD-LIBOR-BBA
Day Count A/360 Reset Frequency Quarterly
Payment Frequency Quarterly Payment Frequency Quarterly
Day Count A/360

Prasanna V
Plain-Vanilla Interest Rate Swap
 Plain-vanilla interest rate swap is an exchange of a series of fixed
interest payments for a series of floating interest payments, fluctuating
with LIBOR (London interbank offer rate). The fixed rate of interest is
often quoted as a spread over the current US Treasury security of the
desired maturity and is called the swap rate. Normally, the floating rate
paid at the end of each period is based on LIBOR at the beginning of
the period. The times at which the floating rates are established are
called the “reset dates.” The two sides of the swap are called the “fixed
leg” and “floating leg”; and the life of a swap is called its tenor. In this
case, only the cash flows, not the principals, of the two types of debt
are exchanged. So the size of the swap is measured by its notional
principal.

Prasanna V
Plain Vanilla Swap-Example
Fixed 5%
Party A Party B
Floating USD 3M Libor
Fixed Payer Floating Payer
Notional Amount USD 10,000,000 Notional Amount USD 10,000,000
Tenor 5 Years Tenor 5 Years
Rate 5% Rate USD 3M Libor
Day Count 30/360 Day Count A/360
Payment Frequency Semi-Annual Payment Frequency Quarterly
Reset Frequency Quarterly

Prasanna V
Overnight Index Swap (OIS)
 An OIS is a fixed/floating interest rate swap with the floating leg tied to
published index of daily overnight rate reference . The term ranges from
one week to two years (sometimes more). The two parties agrees to
exchange at maturity,on the agreed notional amount, the difference
between interest accrued at the agreed fixed rate and interest accrued
through geometric averaging of the floating index rate.

Prasanna V
Overnight Index Swap- Example

Fixed rate 2.50%

Part A Party B
Floating EUR-EONIAOIS-Comp

Fixed Payer Floating Payer

Notional Amount EUR 10,000,000 Notional Amount EUR 10,000,000
Tenor 1 Year Tenor 1 Year
Rate 2.50% Rate EUR-EONIA-OIS-Compound
Day Count A/360 Day Count A/360
Payment Date Termination Date Fixing Source Telerate Page 247

Prasanna V
Cross-Currency Swaps
 A cross-currency swap is an interest rate swap in which the cash flows
are in different currencies. Upon initiation of a cross-currency swap, the
counterparties make an initial exchange of notional principals in the two
currencies. During the life of the swap, each party pays interest (in the
currency of the principal received) to the other. And at the maturity of
the swap, of the initial principal amounts, reversing the initial exchange
at the same the parties make a final exchange spot rate. A cross-
currency swap is sometimes confused with a traditional FX swap, which
is simply a spot currency transaction that will be reversed at a
predetermined date with an offsetting forward transaction; the two are
arranged as a single transaction.

Prasanna V
MTM on Cross-Currency Swaps

Exchange periodic payments in order to compensate for foreign exchange

fluctuations Mark to Market valuation of the variable currency

Compensating Amount = (Prior period amount)-(Current Period Amount)

MTM valuation dates usually coincides with floating rate option fixing
dates.

Prasanna V
Cross-Currency Swaps-Example
3M USD LIBOR
Party A Party B
3M GBP LIBOR

Party A Pays Party B Pays

Nominal Amount USD 16,000,000 Nominal Amount GBP 10,000,000
Tenor 5 Years Tenor 5 Years
Rate 3M USD LIBOR Rate 3M GBP LIBOR
Reset Frequency Quarterly Reset Frequency Quarterly
Payment Frequency Quarterly Payment Frequency Quarterly
Day Count A/360 Day Count A/365

Prasanna V
 Novation

A situation where a client transacts a swap with one party and the
assigns the swap to another counterparty, thus stepping aside from the
deal, receiving or paying a net sum from the difference in the value of the
deal.

Prasanna V
Swaption
 A Swaption is an option on a swap, An option giving the buyer the right to
enter into a swap agreement by a specified date.
Payer swaption : A Payer swaption gives its purchaser the right, but not the
obligation, to enter into an interest-rate swap at a preset rate within a specific
period of time. The swaption buyer pays a premium to the seller for this right.
Receiver Swaption :A receiver swaption gives the purchaser the right to receive
fixed payments. The seller agrees to provide the specified swap if called
upon, though it is possible for him to hedge that risk with other offsetting
transactions.
The buyer and seller of the swaption agree on:
 the strike rate,
 length of the option period (which usually ends on the starting date of the
swap if swaption is exercised),
 the term of the swap,
 notional amount,
 amortization,
 frequency of settlement

Prasanna V
SWAP

Swap Payer Swap Receiver

Pays fixed interest amount Receives fixed interest amount

Seller of the swap (or Short on swap) Buyer of the Swap ( or long on it)

Issuer of notional fixed-rate bond Investor in notional fixed-rate bond

Receives floating interest amount Pays floating interest amount

Investor in notional floating rate note Issuer in notional floating rate note

Lender at floating interest rate Borrower at floating interest rate

Borrower at fixed interest rate Lender at fixed interest rate

Prasanna V
Fixed Income Security

Prasanna V
Fixed-Income Security
An investment that provides a return in the form of fixed periodic payment
and eventual return of principal at maturity. Unlike a variable-income
security, where payments change based on some underlying measure
such as short-term interest rates, the payments of a fixed-income security
are known in advance. 

Prasanna V
Front Office vs ISDA Terminology

Front Office Terminology ISDA Terminology

Start Date Effective Date

End Date Termination Date

Payer Fixed rate (or Fixed Amount) Payer

Receiver Floating rate (or Floating Amount) Payer

Day count basis Day count fraction

Business day adjustment Business day convention

Holiday Calendar Business Days

Benchmark Floating Rate Option

Tenor of Benchmark Designated Maturity

Prasanna V
Thank You

Prasanna V