Derivatives

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A derivative is a financial instrument, whose
value depends on the value of one or more
basic underlying variables.
Examples:
Underlyings: stocks or market indices
Derivatives: options, futures, forward
contracts

Not all trading is done on exchanges. The over-

the-counter market is an important
alternative to exchanges.
Whereas futures are traded on stock exchanges,
forward contracts are traded over-the-counter.
Options are traded both, on stock exchanges
and over-the-counter.
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Time to expiry
Time to expiry is the another factor of
consideration in case of derivative trading. In
India, the derivatives are traded for three
months trading cycle i.e. current, near and far
months. In practice, the most active instruments
are of current months and the trades for the far
month are very rare. In fact, the majority of the
volumes are concentrated on the current and
near month contracts.

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Derivative products
Forwards
Futures
Options
Warrants
LEAPS
Basket
Swaps
Swaptions

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Participants in derivatives
market
Hedgers face risk associated with the price
of an asset

Speculators wish to bet on future

movements in the price of an asset

Arbitrageurs like to take advantage of a

discrepancy between prices in two
different markets

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Forward Contracts
A forward contract is an agreement between two
parties to buy or sell an asset at a certain
future time for a certain future price.
 Forward contracts are normally not exchange
traded.
 The party that agrees to buy the asset in the
future is said to have the long position.
 The party that agrees to sell the asset in the
future is said to have the short position.
 The specified future date for the exchange is
known as the delivery (maturity) date.

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Forward Contracts
The specified price for the sale is known as the
delivery price

As time progresses the delivery price doesn’t

change, but the current spot (market) rate
does. Thus, the contract gains (or loses)
value over time.

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Forward Contracts
Long and Short Positions in a Forward Contract
For Wheat at Rs. 4/Bushel

4
3
2
1 Short Position
0
-1 0 1 2 3 4 5 6 7 8
fP
o
y
a

Long Position
-2
-3
-4
Net Wheat Price

Position

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Problems with Forwards
Counter-party risk:
A party to the contract may not fulfill the obligation

Low degree of liquidity

 Both the parties have to wait till maturity. No one can come out
from the contract

Lack of centralized trading

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Distinction between
forwards and futures
‘Futures’ was designed to solve the problems of forward
markets

Futures Forward
Organized stock exchange OTC
Standardized contractCustomized
liquid less liquid
Requires margin payment No margin required
Daily settlement End of the period

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 Futures Contracts
 A futures contract is similar to a forward contract in that it
is an agreement between two parties to buy or sell an asset
at a certain time for a certain price. Futures, however, are
usually exchange traded and, to facilitate trading, are
usually standardized contracts. This results in more
institutional detail than is the case with forwards.

 The long and short party usually do not deal with each
other directly or even know each other for that matter. The
exchange acts as a clearinghouse. As far as the two sides
are concerned they are entering into contracts with the
exchange. In fact, the exchange guarantees performance
of the contract regardless of whether the other party fails.

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Futures Contracts
 The exchange will usually place restrictions and
conditions on futures. These include:
 Daily price (change) limits.
 For commodities, grade requirements.
 Delivery method and place.
 How the contract is quoted.

 Note however, that the basic payoffs are the

same as for a forward contract.
 Basis = Futures price – spot price

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Futures payoff
 Buy futures (Long asset)
If index goes up futures position starts making profit and
vice versa

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Futures payoff
 Sell futures (Short asset)
If index goes down futures position starts making profit
and vice versa

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Pricing futures
Fair value = (S) e^ (r * T)
r = cost of financing (continuously compound interest
rate)
T = Time till expiration in years
e = 2.71828

Reliance industries is trading in spot market at Rs. 1150.

Money can be invested at 11% p.a. Calculate the fair value
of one month futures contract
Fair value = (S) e^ (r * T)
= 1150*(2.71828)^(0.11*(1/12))
= 1160

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Margin Money
Collected from the client/broker
Minimize the risk of settlement default by either
counterparty
Like a security deposit or insurance against a
possible future loss of value
Once the transaction is successfully settled, the
margin money held by the exchange is
released / adjusted against the settlement
liability.

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Types of Margins
Initial Margin
Variation/Maintenance/Mark to market margin
Additional Margin (if any)

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Initial Margin
To cover the largest potential loss in one day
Both buyer and seller have to deposit the
margins
Has to be deposited before opening a position

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Mark to Market Margin
Daily profit or loss obtained by marking the
member’s outstanding position to the market
Receive or pay the difference in cash on the
next working day

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Daily Settlement
In case the position is not closed the same
day
Net total of all the flows everyday would be
equal to the profit/loss calculated earlier

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Example
Let us take the illustration where a long position
is opened at 15550 and closed at 15650
resulting in a profit of 100 points.
Let us assume the daily closing settlement
prices
DAYto be CLOSING PRICE
1 15550
2 15580
3 15560
4 15600
Position closed 15650

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 Calculate settlement
prices
DAY CLOSING PRICE Difference Profit/Loss

Position opened –
Long @ 15550

Day 1 15500 15500-15550 -50

2 15580 15580-15500 +80

3 15560 15560-15580 -20

4 15600 15600-15560 +40

Position closed 15650 15650-15600 +50

Profit +100

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Application of futures
Hedging – Long security, sell futures

Reliance capital is trading at Rs 390.Two month

futures cost Rs. 402. Position can be hedged by
shorting futures position

If spot price falls to Rs. 350 loss of Rs.40 incurred

on the security will be made up by the profits
made on the short futures position

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Application of futures
Speculation – Bullish – buy futures
Bearish – sell futures
Spot price = Rs.1000
Future price = Rs.1006
Contract value = 100 lots consisting 100 securities each
Margin = Rs.20000
Two months later security closes at Rs.1010
Profit = 1010 – 1006 = 4*100 = 400
Rs.400 profit on an investment of Rs.20000 ( 12 percent)

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Application of futures
 Arbitrage – Overpriced – Buy spot sell future
Underpriced – Buy futures sell spot

Tata steel trading at Rs.1000

Future price = Rs.1025
Security closes at Rs.1015
Profit of Rs.15 on spot and Rs.10 on futures position

Relinfra trading at Rs.1000

Futures price = Rs.965
Security closes at Rs.975
Profit of Rs.10 on futures, Rs.25 on spot

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