What are Derivatives?

⚫ A derivative is a financial instrument whose value is derived

from the value of another asset, which is known as the
underlying.

⚫ When the price of the underlying changes, the value of the

derivative also changes.

⚫ A Derivative is not a product. It is a contract that derives

its value from changes in the price of the underlying.
Example :
The value of a gold futures contract is derived from the
value of the underlying asset i.e. Gold.
 Traders in Derivatives Market
There are 3 types of traders in the Derivatives Market :
⚫HEDGER
A hedger is someone who faces risk associated with price
movement of an asset and who uses derivatives as means of
reducing risk.
They provide economic balance to the market.

⚫SPECULATOR
A trader who enters the futures market for pursuit of profits,
accepting risk in the endeavor.
They provide liquidity and depth to the market.
⚫ ARBITRAGEUR
A person who simultaneously enters into transactions in two
or more markets to take advantage of the discrepancies
between prices in these markets.

⚫ Arbitrage involves making profits from relative mispricing.

⚫ Arbitrageurs also help to make markets liquid, ensure accurate

and uniform pricing, and enhance price stability

⚫ They help in bringing about price uniformity and discovery.

⚫ OTC and Exchange Traded Derivatives.

⚫1. OTC
Over-the-counter (OTC) or off-exchange trading is to trade
financial instruments such as stocks, bonds, commodities or
derivatives directly between two parties without going through
an exchange or other intermediary.
• The contract between the two parties are
privately negotiated.

• The contract can be tailor-made to the two parties’

liking.

• Over-the-counter markets are uncontrolled, unregulated

and have very few laws. Its more like a freefall.
2. Exchange-traded Derivatives
⚫Exchange traded derivatives contract (ETD) are those
derivatives instruments that are traded via specialized
Derivatives exchange or other exchanges. A derivatives
exchange is a market where individuals trade standardized
contracts that have been defined by the exchange.

⚫The world's largest derivatives exchanges (by number of

transactions) are the Korea Exchange.

⚫There is a very visible and transparent market price for the

derivatives.
 Economic benefits of derivatives
⚫ Reduces risk
⚫ Enhance liquidity of the underlying asset
⚫ Lower transaction costs
⚫ Enhances liquidity of the underlying asset
⚫ Enhances the price discovery process.
⚫ Portfolio Management
⚫ Provides signals of market movements
⚫ Facilitates financial markets integration
 What is a Forward?
⚫ A forward is a contract in which one party commits to buy
and the other party commits to sell a specified quantity
of an agreed upon asset for a pre-determined price at a
specific date in the future.

⚫ It is a customised contract, in the sense that the terms of

the contract are agreed upon by the individual parties.

⚫ Hence, it is traded OTC.

Forward Contract Example
I agree to sell Bread
Farmer 500kgs wheat at
Rs.40/kg after 3
months. Make
r
3 months Later

500kgs wheat Bread

Farmer
Rs.20,000 Make
r
 Risks in Forward Contracts
⚫ Credit Risk – Does the other party have the means to
pay?

⚫ Operational Risk – Will the other party make delivery?

Will the other party accept delivery?

⚫ Liquidity Risk – Incase either party wants to opt out of the

contract, how to find another counter party?
 Terminolog
y
⚫ Long position - Buyer

⚫ Short position - seller

⚫ Spot price – Price of the asset in the spot market.(market

price)

⚫ Delivery/forward price – Price of the asset at the delivery

date.
 What are Futures?
⚫ A future is a standardised forward contract.

⚫ It is traded on an organised exchange.

⚫ Standardisations-
- quantity of underlying
- quality of underlying(not required in financial futures)
- delivery dates and procedure
- price quotes
 Futures Contract Example
A
Market
Price/Spot Price
L $10 D1 $10
S $12 D2 $12
Profit $2 D3 $14

B C
S $10 L $12
L $14 S $14
Loss $4 Profit $2
 Types of Futures Contracts
⚫ Stock Futures Trading (dealing with shares)

⚫ Commodity Futures Trading (dealing with gold futures,

crude oil futures)

⚫ Index Futures Trading (dealing with stock market

indices)
 Closing a Futures Position
⚫ Most futures contracts are not held till expiry, but closed
before that.

⚫ If held till expiry, they are generally settled by delivery. (2-

3%)

⚫ By closing a futures contract before expiry, the net

difference is settled between traders, without physical
delivery of the underlying.
 Terminolog
y
⚫ Contract size – The amount of the asset that has to be
delivered under one contract. All futures are sold in
multiples of lots which is decided by the exchange board.
Eg. If the lot size of Tata steel is 500 shares, then one
futures contract is necessarily 500 shares.

⚫Contract cycle – The period for which a contract trades.

The futures on the NSE have one (near) month, two (next)
months, three (far) months expiry cycles.

⚫ Expiry date – usually last Thursday of every month or

previous day if Thursday is public holiday.
 Terminolog
⚫ Strike price – Theyagreed price of the deal is called the
strike price.

⚫ Cost of carry – Difference between strike price and

current price.
 Margins
⚫ A margin is an amount of a money that must be
deposited with the clearing house by both buyers and
sellers in a margin account in order to open a futures
contract.

⚫ It ensures performance of the terms of the contract.

⚫ Its aim is to minimise the risk of default by either

counterparty.
 Margins
⚫ Initial Margin - Deposit that a trader must make before trading
any futures. Usually, 10% of the contract size.

⚫ Maintenance Margin - When margin reaches a minimum

maintenance level, the trader is required to bring the margin
back to its initial level. The maintenance margin is generally
about 75% of the initial margin.

⚫ Variation Margin - Additional margin required to bring an

account up to the required level.

⚫ Margin call – If amt in the margin A/C falls below the

maintenance level, a margin call is made to fill the gap.
 Marking to Market
⚫ This is the practice of periodically adjusting the margin
account by adding or subtracting funds based on changes
in market value to reflect the investor’s gain or loss.

⚫ This leads to changes in margin amounts daily.

⚫ This ensures that there are o defaults by the parties.

 COMPARISON FORWARD FUTURES

• Trade on organized exchanges No Yes

• Use standardized contract terms No Yes

• Use associate clearinghouses to

guarantee contract fulfillment No Yes

• Require margin payments and daily

settlements No Yes

• Markets are transparent No Yes

• Marked to market daily No Yes

• Closed prior to delivery No Mostly

• Profits or losses realised daily No Yes

 What are Options?
⚫Contracts that give the holder the option to buy/sell
specified quantity of the underlying assets at a
particular price on or before a specified time period.
⚫The word “option” means that the holder has the
right but not the obligation to buy/sell underlying
assets.
 Types of Options
⚫Options are of two types – call and put.
⚫Call option 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 particular date
by paying a premium.
⚫ Puts give the buyer the right, but not obligation to
sell a given quantity of the underlying asset at a given
price on or before a particular date by paying a
premium.
 Types of Options (cont.)
⚫The other two types are – European style options and
American style options.
⚫European style options can be exercised only on the
maturity date of the option, also known as the expiry
date.
⚫American style options can be exercised at any time
before and on the expiry date.
 Call Option Example
CALL OPTION Current Price = Rs.250
Premium =
Right to buy 100
Rs.25/shar
e Reliance shares at Strike Price
Amt to buy Call a price of Rs.300
option = Rs.2500 per share after 3
months. Expiry
date
Suppose after a month,
Market price is Rs.400, then Suppose after a month, market
the option is exercised i.e. price is Rs.200, then the option
the shares are bought. is not exercised.
Net gain = 40,000-30,000- Net Loss = Premium amt
2500 = Rs.7500 = Rs.2500
 Put Option Example
PUT OPTION Current Price = Rs.250
Premium =
Right to sell 100
Rs.25/shar
e Reliance shares at Strike Price
Amt to buy Call a price of Rs.300
option = Rs.2500 per share after 3
months. Expiry
date
Suppose after a month,
Market price is Rs.200, then Suppose after a month, market
the option is exercised i.e. price is Rs.300, then the option
the shares are sold. is not exercised.
Net gain = 30,000-20,000- Net Loss = Premium amt
2500 = Rs.7500 = Rs.2500
 Features of Options
⚫ A fixed maturity date on which they expire. (Expiry date)
⚫ The price at which the option is exercised is called the exercise
price or strike price.
⚫ The person who writes the option and is the seller is referred
as the “option writer”, and who holds the option and is the
buyer is called “option holder”.
⚫ The premium is the price paid for the option by the buyer to
the seller.
⚫ A clearing house is interposed between the writer and the
buyer which guarantees performance of the contract.
 Options Terminology
⚫Underlying: Specific security or asset.
⚫Option premium: Price paid.
⚫Strike price: Pre-decided price.
⚫Expiration date: Date on which option expires.
⚫Exercise date: Option is exercised.
⚫Open interest: Total numbers of option contracts that
have not yet been expired.
⚫Option holder: One who buys option.
⚫Option writer: One who sells option.
 Options Terminology (cont.)
⚫Option class: All listed options of a type on a
particular instrument.
⚫Option series: A series that consists of all the options
of a given class with the same expiry date and strike
price.
⚫Put-call ratio: The ratio of puts to the calls traded in
the market.
 Options Terminology (cont.)
⚫Moneyness: Concept that refers to the potential
profit or loss from the exercise of the option. An
option maybe in the money, out of the money, or at
the money.
Call Option Put Option
In the money Spot price > strike Spot price < strike
price price

At the money Spot price = strike Spot price = strike

price price

Out of the Spot price < strike Spot price > strike
money price price
 What are SWAPS?
⚫ In a swap, two counter parties agree to enter into a
contractual agreement wherein they agree to exchange
cash flows at periodic intervals.

⚫ Most swaps are traded “Over The Counter”.

⚫ Some are also traded on futures exchange market.

 Types of Swaps
There are 2 main types of swaps:

⚫Plain vanilla fixed for floating swaps

or simply interest rate swaps.

⚫Fixed for fixed currency swaps

or simply currency swaps.
What is an Interest Rate Swap?
⚫ A company agrees to pay a pre-determined fixed interest
rate on a notional principal for a fixed number of years.

⚫ In return, it receives interest at a floating rate on the

same notional principal for the same period of time.

⚫ The principal is not exchanged. Hence, it is called a

notional amount.
 Floating Interest Rate
⚫ LIBOR – London Interbank Offered Rate
⚫ It is the average interest rate estimated by leading banks
in London.
⚫ It is the primary benchmark for short term interest rates
around the world.
⚫ Similarly, we have MIBOR i.e. Mumbai Interbank Offered
Rate.
⚫ It is calculated by the NSE as a weighted average of
lending rates of a group of banks.
 Interest Rate Swap Example
LIBOR LIBOR

Co.A
SWAP
S Co.B
Aim - VARIABLE 8% BANK 8.5% Aim - FIXED

5m 7% 5m LIBOR
+ 1%
Notional Amount =
£ 5 million

Bank A Bank B
Fixed 7% Fixed 10%
Variabl Variable LIBOR + 1%
e LIBOR
 Using a Swap to Transform a Liability
⚫Firm A has transformed a fixed rate liability into a
floater.
⚫ A is borrowing at LIBOR – 1%
⚫ A savings of 1%

⚫Firm B has transformed a floating rate liability into a

fixed rate liability.
⚫ B is borrowing at 9.5%
⚫ A savings of 0.5%.

⚫Swaps Bank Profits = 8.5%-8% = 0.5%

 What is a Currency Swap?
⚫ It is a swap that includes exchange of principal and
interest rates in one currency for the same in another
currency.

⚫ It is considered to be a foreign exchange transaction.

⚫ It is not required by law to be shown in the balance

sheets.

⚫ The principal may be exchanged either at the beginning

or at the end of the tenure.
⚫ However, if it is exchanged at the end of the life of the
swap, the principal value may be very different.

⚫ It is generally used to hedge against exchange rate

fluctuations.
Direct Currency Swap Example
⚫ Firm A is an American company and wants to borrow
€40,000 for 3 years.

⚫ Firm B is a French company and wants to borrow $60,000

for 3 years.

⚫ Suppose the current exchange rate is €1 = $1.50.

 Direct Currency Swap Example
7%
Firm A Firm B
Aim - EURO 5% Aim - DOLLAR

$60th 7% €40th 5%

Bank A Bank B

€ 6% € 5%
$ 7% $ 8%
 Comparative Advantage
⚫ Firm A has a comparative advantage in borrowing
Dollars.

⚫ Firm B has a comparative advantage in borrowing

Euros.

⚫ This comparative advantage helps in reducing borrowing

cost and hedging against exchange rate fluctuations.