Gyaan@ Finstreet Derivatives:Anoverview

A derivative is a financial instrument that offers a return based on the return of some other underlying asset i.e. its return is derived from another instrument. The underlying asset can be equity,commodity,forex,bonds,interestratesoranyotherasset.Forexample,paddyfarmersmay wantoselltheircropatafuturedatetoeliminatetheriskofachangeinpricesbythatdate.Sucha transactionmaybecalledaderivative,forwardcontractinparticular.Thepriceofthederivativeis drivenbythespotpriceofpaddywhichistheunderlying. Whyderivatives? Derivatives initially emerged as hedging devices against fluctuations in commodity prices and commoditylinked derivatives remained the sole form for almost three hundred years. Financial derivativescameintothelimelightinthemid1970'sduetothegrowinginstabilityinthefinancial markets. Sincethenfinancialderivatives havebecome veryimportantandaccountforabout two thirdsofthetotaltransactionsinthederivativesmarket.Inrecentyearsthederivativesmarkethas grown tremendously in terms of variety of instruments available, their complexity and also their turnover. MajorFactorsResponsiblefortheGrowthofFinancialDerivatives

Integrationofinternationalmarketswithnationalfinancialmarkets Increasedvolatilityinassetpricesinfinancialmarkets Development of more sophisticated risk management tools, providing economic agents a widerchoiceofriskmanagementstrategies Innovations in the derivatives markets have led to the diversification of risk over a large numberoffinancialassets,leadingtohigher Improvementintechnologyandcommunicationfacilitiesandsharpdeclineincosts Themodernizationofcommercialandinvestmentbanking

TypesofDerivatives: Basicallyderivativecontractscanbeclassifiedintotwogeneralcategories: ForwardCommitments:Aforwardcommitmentisalegallybindingpromisetoperformsomeaction inthefuture.ForwardCommitmentsincludesForwardContracts,Futures,Swaps Contingentclaims:Acontingentclaimisaclaimwhosepayoffdependsonoccurrenceofaspecific event.Optionsarecontingentclaimsthatdependonastockpriceatsomefuturedate,ratherthan forwardcommitments.TheyincludeOptions,Warrants,LEAPS. ForwardContracts: Aforwardcontractisanagreementtobuyorsellanassetonaspecifieddateforaspecifiedprice. Oneofthepartiestothecontractassumesalongpositionandagreestobuytheunderlyingasseton acertainspecifiedfuturedateforacertainspecifiedprice.Theotherpartyassumesashortposition andagreestoselltheassetonthesamedateforthesameprice.Othercontractdetailslikedelivery date, price and quantity are negotiated bilaterally by the parties to the contract. The forward contractsarenormallytradedoutsidetheexchanges. 2|P a g e

Thesalientfeaturesofforwardcontractsare: Theyarebilateralcontractsandhenceexposedtocounterpartyrisk. Eachcontractiscustomdesigned,andhenceisuniqueintermsofcontractsize,expirationdate andtheassettypeandquality. Thecontractpriceisgenerallynotavailableinpublicdomain. Ontheexpirationdate,thecontracthastobesettledbydeliveryoftheasset. If the party wishes to reverse the contract, it has to compulsorily go to the same counterparty, whichoftenresultsinhighpricesbeingcharged. However forward contracts in certain markets have become very standardized, as in the case of foreign exchange, thereby reducing transaction costs and increasing transactions volume. This processofstandardizationreachesitslimitintheorganizedfuturesmarket. Forwardcontractsareveryusefulinhedgingandspeculation.Theclassichedgingapplicationwould bethatofanexporterwhoexpectstoreceivepaymentindollarsthreemonthslater.Heisexposed to the risk of exchange rate fluctuations. By using the currency forward market to sell dollars forward,hecanlockontoaratetodayandreducehisuncertainty. Similarlyanimporterwhoisrequiredtomakeapaymentindollarstwomonthshencecanreduce hisexposuretoexchangeratefluctuationsbybuyingdollarsforward. Forwardmarketsworldwideareafflictedbyseveralproblems: Lackofcentralizationoftrading, Illiquidity,and In the above issues, the basic problem is that of too much flexibility and generality. The forward market is like a real estate market in which 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 specification,butmakesthecontractsnontradable. Counterpartyrisk Counterparty risk arises from the possibility of default by any one party to the transaction. When oneofthetwosidestothetransactiondeclaresbankruptcy,theothersuffers.Evenwhenforward markets trade standardized contracts, and hence avoid the problem of illiquidity, still the counterpartyriskremainsaveryseriousissue. FuturesContract: Afuturescontractisanagreementbetweentwopartiestobuyorsellanassetatacertaintimein the future at a certain price. But unlike forward contracts, the futures contracts are standardized and exchange traded.Tofacilitate liquidityin thefuturescontracts, the exchangespecifies certain standardfeaturesofthecontract.Itisastandardizedcontractwithstandardunderlyinginstrument, astandardquantityandqualityoftheunderlyinginstrumentthatcanbedelivered,(orwhichcanbe used for reference purposes in settlement) and a standard timing of such settlement. A futures 3|P a g e

contractmaybeoffsetpriortomaturitybyenteringintoanequalandoppositetransaction.More than99%offuturestransactionsareoffsetthisway. Futuresterminology Spotprice:Thepriceatwhichanassettradesinthespotmarket. Futuresprice:Thepriceatwhichthefuturescontracttradesinthefuturesmarket. Contract cycle: The period over which a contract trades. The index futures contracts on the NSE haveonemonth,twomonths and threemonth expirycycleswhich expire onthelastThursdayof the month. Thus a January expiration contract expires on the last Thursday of January and a FebruaryexpirationcontractceasestradingonthelastThursdayofFebruary.OntheFridayfollowing thelastThursday,anewcontracthavingathreemonthexpiryisintroducedfortrading. Expiry date: It is the date specified in the futures contract. This is the last day on which the contractwillbetraded,attheendofwhichitwillceasetoexist. Contractsize:Theamountofassetthathastobedeliveredunderonecontract.Forinstance,the contractsizeonNSEsfuturesmarketis50Nifties. Basis:Inthecontextoffinancialfutures,basiscanbedefinedasthefuturespriceminusthespot price.Therewillbeadifferentbasisforeachdeliverymonthforeachcontract.Inanormalmarket, basiswillbepositive.Thisreflectsthatfuturespricesnormallyexceedspotprices. Costofcarry:Therelationshipbetweenfuturespricesandspotpricescanbesummarizedinterms ofwhatisknownasthecostofcarry.Thismeasuresthestoragecostplustheinterestthatispaidto financetheassetlesstheincomeearnedontheasset. Initial margin: The amount that must be deposited in the margin account at the time a futures contractisfirstenteredintoisknownasinitialmargin. Markingtomarket:In thefuturesmarket,attheendofeachtradingday,themarginaccountis adjustedtoreflecttheinvestorsgainorlossdependinguponthefuturesclosingprice.Thisiscalled markingtomarket. Maintenancemargin:Thisissomewhatlowerthantheinitialmargin.Thisissettoensurethatthe 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 marginaccounttotheinitialmarginlevelbeforetradingcommencesonthenextday. PayOffforafuturescontract(Shortposition): Fortheexampleshownaboveweanalysethepayoffgraph. Thefigureshowstheprofits/lossesforashortfuturesposition.Theinvestorsoldfutureswhenthe indexwasat4000. If the index goes down, his futures position starts making profit. If the index rises, his futures positionstartsshowingprofits.

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PayoffforShortFutures
4000 2000 0 2000 0 4000

2000

4000

6000

8000

PayOffforafuturescontract(Longposition): Fortheexampleshownaboveweanalysethepayoffgraph. Thefigure shows theprofits/lossesforashort futuresposition.Theinvestorbought futures when theindexwasat4000. Iftheindexgoesrises,hisfuturespositionstartsmakingprofit.Iftheindexgoesdown,hisfutures positionstartsshowinglosses.

PayOffforLONGFutures
3000 2000 1000 0 1000 0 2000 3000 4000

2000

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Therearefourwaystoterminateafuturescontract: 1. A short can terminate the contract by delivering the goods, a long by accepting delivery and payingthecontractpricetotheshort.Thisiscalleddelivery.Thelocationfordelivery(forphysical

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assets), terms of delivery, and details of exactly what is to be delivered are all specified in the contract.Deliveriesrepresentlessthan1%ofallcontractterminations. 2.Inacashsettlementcontract,deliveryisnotanoption.Thefuturesaccountismarkedtomarket basedonthesettlementpriceonthelastdayoftrading. 3.Youmaymakeareverse,oroffsetting,tradeinthefuturesmarket.Thisissimilartothewaywe described exiting a forward contract prior to expiration. With futures, however, the other side of yourpositionisheldbytheclearinghouseifyoumakeanexactoppositetrade(maturity,quantity, andgood)toyourcurrentposition,theclearinghousewillnetyourpositionsout,leavingyouwitha zerobalance.Thisishowmostfuturespositionsaresettled.Thecontractpricecandifferbetween thetwocontracts.Ifyouinitiallyarelongonecontractat$370perounceofgoldandsubsequently sell(taketheshortpositionin)anidenticalgoldcontractwhenthepriceis$350/oz.,$20timesthe numberofouncesofgoldspecifiedinthecontractwillbedeductedfromthemargindeposit(s)in youraccount.Thesaleofthefuturescontractendstheexposuretofuturepricefluctuationsonthe firstcontract.Yourpositionhasbeenreversed,orclosedout,byaclosingtrade. 4.Apositionmayalsobesettledthroughanexchangeforphysicals.Hereyoufindatraderwithan oppositepositiontoyourownanddeliverthegoodsandsettleupbetweenyourselves,offthefloor of the exchange (called an expit transaction). This is the sole exception to the federal law that requires that all trades take place on the floor of the exchange. You must then contact the clearinghouseandtellthemwhathappened.Anexchangeforphysicalsdiffersfromadeliveryinthat thetradersactuallyexchangethegoods,thecontractisnotclosedontheflooroftheexchange,and thetwotradersprivatelynegotiatethetermsofthetransaction.Regulardeliveryinvolvesonlyone traderandtheclearinghouse. OPTIONS: An option gives the holder of the option the right to do something. An option contract gives its ownertheright,butnotthelegalobligation,toconductatransactioninvolvinganunderlyingasset at a predetermined future date (the exercise date) and at a predetermined price (the exercise or strike price). Options give the option buyer the right to decide whether or not the trade will eventuallytakeplace.Theselleroftheoptionhastheobligationtoperformifthebuyerexercises the option. The owner of a call optionhas the right to purchase the underlying asset at a specific priceforaspecifiedtimeperiod. Buyerofanoption:Thebuyerofanoptionistheonewhobypayingtheoptionpremiumbuysthe rightbutnottheobligationtoexercisehisoptionontheseller/writer. Writerofanoption:Thewriterofacall/putoptionistheonewhoreceivestheoptionpremium andistherebyobligedtosell/buytheassetifthebuyerexercisesonhim. Therearetwobasictypesofoptions,calloptionsandputoptions. Call option: A call option gives the holder the right but not the obligation to buy an asset by a certaindateforacertainprice. Put option: A put option gives the holder the right but not the obligation to sell an asset by a certaindateforacertainprice. 6|P a g e

Optionprice/premium:Optionpriceisthepricewhichtheoptionbuyerpaystotheoptionseller.It isalsoreferredtoastheoptionpremium. Expiration date: The date specified in the options contract is known as the expiration date, the exercisedate,thestrikedateorthematurity. Strikeprice:Thepricespecifiedintheoptionscontractisknownasthestrikepriceortheexercise price. Inthemoneyoption:Aninthemoney(ITM)optionisanoptionthatwouldleadtoapositivecash flowtotheholderifitwereexercisedimmediately.Acalloptionontheindexissaidtobeinthe moneywhenthecurrentindexstandsatalevelhigherthanthestrikeprice(i.e.spotprice>strike price).Iftheindexismuchhigherthanthestrikeprice,thecallissaidtobedeepITM.Inthecaseof aput,theputisITMiftheindexisbelowthestrikeprice. Atthemoney option: An atthemoney (ATM) option is an option that would lead to zero cash flow if it were exercised immediately. An option on the index is atthemoney when the current indexequalsthestrikeprice(i.e.spotprice=strikeprice). Outofthemoney option: An outofthemoney (OTM) option is an option that would lead to a negativecashflowifitwereexercisedimmediately.Acalloptionontheindexisoutofthemoney whenthe current indexstands ata levelwhich islessthan the strike price(i.e. spotprice < strike price).Iftheindexismuchlowerthanthestrikeprice,thecallissaidtobedeepOTM.Inthecaseof aput,theputisOTMiftheindexisabovethestrikeprice. PayoffprofileforbuyerofCALLoptions:LongCALL Long call a call option gives the buyer the right to buy the underlying asset at the strike price specifiedintheoption.Theprofit/lossthatthebuyermakesontheoptiondependsonthespotprice of the underlying. If upon expiration, the spot price exceeds the strike price, he makes a profit. Higherthespotpricemoreistheprofithemakes.Ifthespotpriceoftheunderlyingislessthanthe strikeprice,heletshisoptionexpireunexercised.Hislossinthiscaseisthepremiumhepaid. Thefigureshowstheprofits/lossesfromalongpositionontheindex.Theinvestorboughttheindex at4000.Sotheinvestorwillbreakevenat4100(hepaidINR100aspremium).Iftheindexgoesup, heprofitsi.e.above4100heprofits.Iftheindexfallshehastobornelossesi.e.below4100heloses. At4100heneithergainsnorloses.ThegainforwriteroftheoptionisonlyINR100(premiumpaidby thebuyer).SimilarlywecananalyseforPUToptions.

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 PayoffprofileforwriterofPUToptions:ShortPUT Payoffprofileforwriterofputoptions:ShortputAputoptiongivesthebuyertherighttosellthe underlyingassetatthestrikepricespecifiedintheoption.Forsellingtheoption,thewriterofthe optionchargesapremium.Theprofit/lossthatthebuyermakesontheoptiondependsonthespot priceoftheunderlying.Whateveristhebuyersprofitisthesellersloss.Ifuponexpiration,thespot pricehappenstobebelowthestrikeprice,thebuyerwillexercisetheoptiononthewriter.Ifupon expirationthespotpriceoftheunderlyingismorethanthestrikeprice,thebuyerletshisoptionun exercisedandthewritergetstokeepthepremium. Figuregivesthepayoffforthewriterofathreemonthputoption(oftenreferredtoasshortput) withastrikeof4100soldatapremiumof100.Weobservethatat4000thewriterbreaksevenand whenNiftygoesbelowthisheloses.WritersprofitsremainconstantatINR100(premiumprice)for theindexvalue(Nifty)>=4100. Warrants:Optionsgenerallyhavelivesofuptooneyear,themajorityofoptionstradedonoptions exchanges having a maximum maturity of nine months. Longerdated options are called warrants andaregenerallytradedoverthecounter. LEAPS: The acronym LEAPS means LongTerm Equity Anticipation Securities. These are options havingamaturityofuptothreeyears.Thesearegenerallytradedoverthecounter.

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 SWAP: Swapsareagreementstoexchangeaseriesofcashflowson,periodicsettlementdatesovercertain timeperiod(e.g.quarterlypaymentsovertwoyears).Inthesimplesttypeofswap,onepartymakes fixedrateinterestpaymentsonthenotionalprincipalspecifiedintheswapinreturnforfloatingrate paymentsfromtheotherparty.Ateachsettlementdate,thetwopaymentsarenettedsothatonly one(net)paymentismade.Thepartywiththegreaterliabilitymakesapaymenttotheotherparty. Thelengthoftheswapistermedthetenoroftheswapandthecontractendsonthetermination date. A swap can be decomposed into a series of forward contracts (FRAs) that expire on the settlementdates. ForExample,Ifyoulendme$5,000atafloatingrateandIlendyou$5,000atafixedrate,wehave createdaswap.Thereisnoreasonforthe$5,000toactuallychangehands,thetwoloansmakethis pointless.AteachpaymentdateIwillmakeapaymenttoyoubasedonthefloatingrateandyouwill makeonetomebasedonthefixedrate.Again,itmakesnosensetoexchangethefullamounts;the one with the larger payment liability will make a payment of the difference to the other. This describesthepaymentsofafixedfarfloatingor"plainvanilla"swap. Currency swap: A currency swap can be viewed the same way. If I lend you INR 1,000,000 at the Rupeesrateofinterestandyoulendmetheequivalentamountofdollarsattoday'sexchangerate at the dollars rate of interest, we have done a currency swap. We will "swap" back these same amountsofcurrencyatthematuritydateofthetwoloans.Intheinterim,Iborroweddollars,soI makedollarinterestpayments,andyouborrowedRupeesandmustmakeinterestpaymentsinINR. 1.PartyApaysafixedrateonINRreceived,andPartyBpaysafixedrateonUSDreceived(Fixedfor FixedCurrencySwap)

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2. Party A pays a floating rate on INR received, and Party B pays a floating rate on USD received (FloatingforFloatingCurrencySwap) Interest Rate Swaps: The plain vanilla interest rate swap involves trading fixed interest rate paymentsforfloatingratepayments.Thepartywhowantsfloatingrateinterestpaymentsagreesto payfixedrateinterestandhasthepayfixedsideoftheswap.Thecounterparty,whoreceivesthe fixedpaymentsandagreestopayvariablerateinterest,hasthepayfloatingsideoftheswapandis calledthefloatingratepayer. Eg:Considera3yearswapdeal,betweenInfosysandMicrosoft.MicrosoftagreestopaytoInfosys aninterestrateof5%perannumonanotionalprincipalof$100million,andinreturnInfosysagrees to pay Microsoft the 6 month LIBOR rate on the same principal. Microsoft is the fixedrate payer, Infosysisthefloatingratepayer. The floating rate quoted is generally the London Interbank Offered Rate (LIBOR), flat or plus a spread.Let'slookatthecashflowsthatoccurinaplainvanillainterestrateswap. Since the notional principal swapped is the same for both counterparties and is in the same currency units, there is no need to actually exchange the cash. Notional principal is generally not swappedinsinglecurrencyswaps. Thedeterminationofthevariablerateisatthebeginningofthesettlementperiod,andthecash interestpaymentismadeattheendofthesettlementperiod.Sincetheinterestpaymentsareinthe samecurrency,thereisnoneedforbothcounterpartiestoactuallytransferthecash.Thedifference between the fixedrate payment and the variablerate payment is calculated and paid to the appropriatecounterparty.Netinterestispaidbytheonewhoowesit. Attheconclusionoftheswap,sincethenotionalprincipalwasnotswapped,thereisnotransferof funds. You should note that swaps are a zerosum game. What one party gains, the other party loses. CrossCurrencySwap: Herewehavefloatingrate(usuallyLIBOR)inonecurrencyisexchangedforafixedrateinanother currency.Thisisacombinationoffixedforfloatinginterestrateswapandafixedforfixedcurrency swapandisknownascrosscurrencyswap. 1. Party A pays a floating rate on INR received, and Party B pays a fixed rate on USD received (FloatingforFixedCurrencySwap) 2.PartyApaysafixedrateonINRreceived,andPartyBpaysafloatingrateonUSDreceived(Fixed forFloatingCurrencySwap) Swaption:ASwaptionisanoptiontoenterintoaswap.Theoptiontoenterintoanoffsettingswap providesanoptiontoterminateanexistingswap.Considerthat,inthecaseoftheprevious5year pay floating swap,we purchaseda3year call optionona2year payfixedswap at3%. Exercising thisswapwouldgiveustheoffsettingswaptoexitouroriginalswap.

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