You are on page 1of 12




forex. was amended to include derivative contracts in securities. The forwards contracts (regulation) Acts. However when derivatives trading in securities was introduced in 2001. the term “security” in the securities contracts (Regulation) Act. share. The price of this derivative is driven by the spot price of wheat is the “underlying” in this case. 1956 defines “derivative” to include. As per this the forward Markets commission (FMC) continues to have jurisdiction over commodity futures contracts. 1952. The securities contracts (Regulation) Act. regulation of derivatives came under the purview of Securities Exchange Board of India (SEBI).DERIVATIVE A derivative is a product whose value is derived from the value of one or more underlying variables or assets in a contractual manner. In our earlier discussion. we saw that wheat farmers may wish to sell their harvest at a future date to eliminate the risk of change in price by that date. Consequently. TYPE OF DERIVATIVE Future Forward Derivative OPTION Swaps . or index of prices. risk instrument or contract differences or any form of security. loan whether secured or unsecured. regulates the forward/futures contracts in commodities all over India. We thus have separated regulatory authorities for securities and commodities derivative markets.A security derived from a debt instrument. Such a transaction is an example of a derivative. Derivatives are securities under the SCRA and hence the trading of derivative is governed by the regulatory framework under the SCRA. of underlying securities. Commodity or any other assets. A contract which derives its value from the price. The underlying asset can be equity. 1956 (SCRA).

traded on a futures exchange. its price constantly fluctuates. at a certain date in the future. normally. This can be the notional amount of bonds. effectively closing out the futures position and its contract obligations. which gives the buyer the right. and the option writer (seller) the obligation. at a pre-set price is price is called the futures price. The exchange acts as counterparty on all contracts. but not the right. The currency in which the futures contract is quoted. The delivery month. To minimize this risk. a futures contract is a standardized contract. to buy or sell a certain underlying instrument at a certain date in the future. converges towards the future price on the delivery date. Other details such as the tick. This renders the owners liable to adverse changes in value. BASIC FEATURES OF FUTURE CONTRACT 1. The last trading date. the exchange . this specifies which bonds can be delivered. In case of bond. To exit the commitment. and creates a credit risk to the exchange. a fixed number of barrels of oil. The type of settlement. either cash settlement or physical settlement. sets margin requirements. Futures contracts are exchange traded derivatives. The amount and units of the underlying assets per contract. the minimum permissible price fluctuation. but not the obligation. The settlement price. In case of physical commodities. usually by specifying:    The underlying: This can be anything from a barrel of sweet crude oil to a short term interest rate.     2. Margin: Although the value of a contract at time of trading should be zero. which differs from an options contract. units of foreign currency. A futures contract gives the holder the right and the obligation to buy or sell. who always acts as counterparty. the holder of a futures position has to sell his long position or buy back his short position. Standardization: Futures contracts ensure their liquidity by being highly standardized. this specifies not only the quality of the underlying goods but also the manner and location of delivery. the national amount of the deposit over which the short term interest rate is traded. The grade of the deliverable. etc. The price of the underlying asset on the delivery date is called the settlement price. etc.FUTURE CONTRACT In finance.

the contract is marked to its present market value. i. a further margin. the exchange will debit his account.  Physical delivery – the amount specified of the underlying asset of the contract is delivered by the seller of the contract to the exchange. and can be done in one of two ways. and by the exchange to the buyers of the contract. and the exchange pays this profit into account. called the “settlement” or mark-to-market price of the contract. usually called variation or maintenance margin. it occurs only on a minority of contracts. such as a short term interest rate index such as Euribor. If the trader is on the winning side of a deal. This is intended to protect the exchange against loss. In practices. his contract has increase in value that day. This is calculated by the futures contract. deposits money with the exchange. as determined by historical price change which is not likely to be exceeded on a usual day‟s trading.that is. is required by the exchange. buying a contract to cancel out an earlier sale (covering a short). A futures contract might also opt to settle against an index based on trade in a relation spot market. If he cannot pay. Settlement: Settlement is the act of consummating the contract. this happens on the last Thursday of certain trading month . as specified per type of future contract. It may be 5% or 10% of total contract price. if he is on the losing side. Initial Margin: is paid by buyer and seller. 3. commonly known as margin requirements are waived or reduces in some cases traders who have physical ownership of the covered commodity or spread traders who have offsetting contracts balancing the position. Cash settlement – a cash payment is made based on the underlying reference rate. Mark to markets Margin: because a series of adverse price changes may exhaust the initial margin.e agreeing on a price at the end of each day. To understand the original practices that a future traders.  Expiry is the time when the final prices of the future are determined.demands that‟s contract owners post a form of collateral. or the closing value of a stock market index. Most are cancelled out by purchasing a covering position. On the other hand.on this day the t+2 futures contract becomes the t forward contract. For many equity index and interest rate futures contracts. At the end of every trading day. called a “ margin ” . It represents the loss on that contract. then the margin is used as the collateral from which the loss is paid. or selling a contract to liquidate an earlier purchase (covering a long). . when taking a position.

he invests the proceeds. Exists. which has appreciated at the risk free rate. parties (not traded on the exchanges. The arbitrageur sells the futures contract and buys the underlying today (on the spot market) with borrowed money. for no arbitrage to be possible. In the case where the forward price is higher: 1. F(t). and receives the agreed forward price. On the delivery date.) Differ from trade to trade. 4.] 4. In other words. dividend yield. the value of the future/forward. non dividend paying assets.[if he was short the underlying. Exists. F(t) = S(t) * (1+r)(T-t) This relationship may be modified for storage cost. 2. the rational forward price represents the expected future value of the underlying discounted at the risk free rate. He then repays the lender the borrowed amount plus interest. 3. assumed by Counter. However. The difference between the two amounts is the arbitrage profit. The arbitrageur buys the futures contract and sells the underlying today (on the spot market). for a simple. DISTINCTION BETWEEN FUTURES AND FORWARDS CONTRACTS FEATURE Operational Mechanism Contract Specifications FORWARD CONTRACT FUTURE CONTRACT Traded directly between two Traded on the exchanges. and convenience yields. On the delivery date. return r. In the case where the forward price is lower: 1. He then receives the underlying and pays the agreed forward price using the matured investment. he cashes in the matured investment. 2. will be found by discounting the present value S(t) at t to maturity T by the rate of risk. 3. the price paid on delivery (the forward price) must be the same as the cost (including interest) of buying and storing the asset. Contracts are standardized contracts.PRICING OF FUTURE CONTRACT in a future contract. The difference between the two amounts is the arbitrage profit. Thus. the arbitrageur hands over the risk . Any deviation from this equality allow for arbitrage as follows. he returns it now.

Liquidation Profile Low. For calls. The value of a stock option contract is determined by five factors the strike price. the expiration date. as markets are scattered. OPTION Options are basically the financial instruments that give the buyers the right to buy or sell the underlying security within a point of time in the future for a the premium you pay today is likely to be higher or lower than the premium yesterday or tomorrow. the cumulative cost that is required to hold a position in the stock and the estimated future volatility of the stock price. future. What those changing price reflect is the give and take between what buyers are willing to pay and what seller are willing to accept for the option. AT PREMIUM When you buy an option.the clearing corp. Not efficient. index futures and individual stock futures in India. which is fixed at the time when the option is bought. which becomes the counter party to all the trades or unconditionally guarantees their settlement. the purchase price is called the premium. If you sell. High. as contracts are standardized exchange traded contracts. Price Discovery Examples Currency markets in India. as markets are centralized and all buyers and sellers come to a common platform to discover the price. The premium is not fixed and charges constantly. The „call‟ in option trading gives the owner of option a right but not an obligation to buy an underlying security within the specified time while the „put‟ gives the owner a right but not the obligation to sell the underlying assets within the specified time at a pre-fixed price. Efficient. . Commodities. The strike price is referred to the price for which an option stock can be bought or sold. as contracts are tailor made contracts catering to the needs of the needs of the parties. The point at which there‟s agreement becomes the price for that transaction. the stock price must go above the strike price while for puts the stock price should be below the strike price. and then the process begins again. price of the stock. The stock option buyers are called the holders and sellers are called writers in option trading terminology. the premium is the amount you receive.

The identity of the underlying investment. and what it is doing at the moment are more specific ones.the. The value of call option will go down . you keep the money. The value of call option will go up – If Price goes down…. you start out with what‟s known as a net debit. the option is assumed to be worthless. 1. or other instrument at a specified price within a specific time period. how it traditionally behaves. you still get to keep the premium. If the option is never exercised. as investors attempt to gauge how likely it is that an option will move in-the-money. in-the-money or out. OPTION PRICES Several factors. the greater the time value. What‟s happening in the overall investment markets and economy at large are two of the broad influences. X Purchases the 3000 Nifty Feb 09 Call Option at Rs. or is likely to be. but are obligation to buy or sell the underlying stock if you‟re at expiration. that‟s determined by whether or not the option is. As seller. including supply and demand in the market where the option is traded. The means you have spent money you might never recover if you don‟t sell your option at a profit or exercise it. commodity.If you buy option. The longer the amount of time for market condition to work to your benefit. Its volatility is also an important factor. A call option is in –the-money if the currency market value of the underlying stock is above the exercise price of the option. An option‟s premium has two parts an intrinsic value and a time value is and what the premium is. – If Price goes up…. If the option is exercised. CALL OPTION: An agreement that gives an investor the right (but not the obligation) to buy a stock. And if you do make money on a transaction. Example: • Mr. and out-of-the if the currency market value of the underlying stock is below the exercise price and out-of-the-money if it is above it if an option is not in-the-money at expiration. you begin with a net credit because you collect the premium. on the other hand. THE VALUE OF OPTIONS A particular options contract is worth to a buyer r seller is measured by how likely it is to meet their expectations. In the language of options. affect the price of an option.100. bond. as is the case with an individual stock. you must subtract the cost of the premium from any income you realize to find net profit.

an option is at-themoney. The value of Put option will go down – If Price remains constant……… the value of Put option will come down. LEVERAGE & RISK There is an important implicit assumption in that account. however. PUT OPTION: An agreement that gives an investor the right (but not the obligation) to Sell a stock. A put option is out-of-the money if the strike price is less than the market price of the underlying security . the additional diversification might more than offset the additional risk from leverage. If a company borrows money to modernize. So while adding leverage to a given asset always adds risk. A put option is in-the-money if the strike price is greater than the market price of the underlying security. or expand internationally. or add to its product line. IN THE MONEY. many highly-levered hedge funds have less return volatility than unlevered bond funds. and public utilities with lots of debt are usually less risky stocks than unlevered technology companies. Example: • Mr. – If Price goes down…. AT THE MONEY & OUT OF THE MONEY When the price of the underlying security is equal to the strike price. Or if an investor uses a fraction of his or her portfolio to margin stock index futures and puts the rest in a money market fund. bond. A call option is out-of-the-money if the strike price is greater than the market price of the underlying security. The value of Put option will go up – If Price goes up…. commodity. he or she might have the same volatility and expected return as an investor in an unlevered equity index fund. In fact.100. A call option is in-the-money if the strike price is less than the market price of the underlying security. which is that the underlying levered asset is the same as the unlevered one. or other instrument at a specified price within a specific time period. X Purchases the 3000 Nifty Feb 09 Put Option at Rs.– If Price remains constant……… the value of call option will come down. 2. with a limited downside. it is not the case that a levered company or investment is always riskier than an unlevered one.

Buy Lower Strike Put Option & Sell Higher Strike Put Option. Far Month Option  As per Right to Exercise 1. Next Month Option 3. called a strike price. the contract gives them the right but not the obligation to buy or sell an asset at a predetermined price. EXPIRATION DAY The last day that an options or futures contract is valid. time value decays more rapidly. which is on or before the expiration date. As such. American Option OPTION STRATEGIES: (a)    Bullish Strategies Buy Lower Strike Call Option & Sell Higher Strike Call Option. the holders of deep-in-the-money options nearing expiry discount the time value to attract buyers and in turn realize the intrinsic value. If the investor chooses not to exercise that right. Current Month Option 2. But in the case of options that are deep in the money. TYPE OF OPTION  As per Maturity 1. provided the option is not in the money. (b) Bearish Strategies .TIME DECAY Time decay of an option begins to accelerate in the last 60 to 30 days before expiry. within a given time period. the option expires and becomes worthless and the investor loses the money paid to buy the option. Buy one Future and One ATM Put and Sell one OTM Call. European Option 2. The market finds these options too expensive compared to other strike prices or futures. When an investor buys an option.

a forward or an option. For example. Buy Higher Strike Put Option & Sell Lower Strike Put Option. (d) Short Straddle    Sell same strike price call and put option. swaps can be in cash or collateral. the notional amount is usually not exchanged between counterparties. in the case of a swap involving two bonds. . (e) Long Strangle    Buy Different strike price call and put option. Long Straddle Buy same strike price call and put option. It is beneficial when market looks very volatile. These streams are called the legs of the swap. Trader has to pay time value. Trader will receive time value. (f) Short Strangle    Sell different strike price call and put option. Specifically. Trader has to pay time value. equity price or commodity price. foreign exchange rate. Contrary to a future. a swap is a derivative in which counterparties exchange cash flows of one party's financial instrument for those of the other party's financial instrument. The cash flows are calculated over a notional principal amount. SWAPS In finance. It is beneficial when market looks very volatile. Consequently. Short Strangle It is beneficial when market looks range bound Trader will receive time value. Usually at the time when the contract is initiated at least one of these series of cash flows is determined by a random or uncertain variable such as an interest rate. The benefits in question depend on the type of financial instruments involved.  (c)    Buy Higher Strike Call Option & Sell Lower Strike Call Option. the benefits in question can be the periodic interest (or coupon) payments associated with the bonds. The swap agreement defines the dates when the cash flows are to be paid and the way they are calculated. the two counterparties agree to exchange one stream of cash flows against another stream. It is beneficial when market looks range bound.

The payments are calculated over the notional amount. The reason for this exchange is to take benefit from comparative advantage. A swap has the effect of transforming a fixed rate loan into a floating rate loan or vice versa. such as LIBOR. currency swaps. The vast majority of commodity swaps involve crude oil. the actual rate received by A and B is slightly lower due to a bank taking a spread. commodity swaps and equity swaps. this may lead to a company borrowing fixed when it wants floating or borrowing floating when it wants fixed. This is where a swap comes in. Just like interest rate swaps. Some companies may have comparative advantage in fixed rate markets. credit swaps. The life of the swap can range from 2 years to over 15 years. from the market where they have comparative advantage. When companies want to borrow. It is also a very crucial uniform pattern in individuals and customers. INTEREST RATE SWAPS: The most common type of swap is a “plain Vanilla” interest rate swap. they look for cheap borrowing.65%. In reality. the currency swaps are also motivated by comparative advantage.e. with the cashflows in one direction being in a different currency than those in the opposite direction.TYPR OF SWAPS The five generic types of swaps. It is the exchange of a fixed rate loan to a floating rate loan. i. CURRENCY SWAPS A currency swap involves exchanging principal and fixed rate interest payments on a loan in one currency for principal and fixed rate interest payments on an equal loan in another currency. while other companies have a comparative advantage in floating rate markets. are: interest rate swaps. . There are also many other types of swaps. However. The first rate is called variable because it is reset at the beginning of each interest calculation period to the then current reference rate. COMMODITY SWAPS A commodity swap is an agreement whereby a floating (or market or spot) price is exchanged for a fixed price over a specified period. in order of their quantitative importance. For example. Currency swaps entail swapping both principal and interest between the parties. party B makes periodic interest payments to party A based on a variable interest rate of LIBOR +70 basis points. Party A in return makes periodic interest payments based on a fixed rate of 8.

FINANCIAL SWAPS Financial swaps constitutes a funding technique which permit a borrowers to access one market and then exchange the liability for another type of liability.CREDIT DEFAULT SWAPS A credit default swap (CDS) is a contract in which the buyer of the CDS makes a series of payments to the seller and. bankruptcy or even just having its credit rating downgraded.typically a bond or loan . It also allows the investors to exchange one type of assets for another type of asset with a preferred income stream. the credit event that triggers the payoff can be a company undergoing restructuring. Unlike an actual insurance contract the buyer is allowed to profit from the contract and may also cover an asset to which the buyer has no direct exposure. CDS contracts have been compared with insurance. . Less commonly. receives a sum of money if one of the events specified in the contract occur. receives a payoff if an instrument . because the buyer pays a premium and. in return.goes into default (fails to pay). in exchange.