CHAPTER FIVE: INTRODUCTION TO DERIVATIVE MARKET 5.

0 INTRODUCTION TO DERIVATIVES Derivative is a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index, or reference rate), in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the “underlying”. 5.1. Hedging against risk Investments based on some underlying assets are known as derivatives. The capital invested is less than the price of the underlying asset. This creates financial leverage and allows investors to multiply the rate of return on the underlying asset. Because of this leverage, derivatives have several uses,  Speculative or taking an advantage over specific profit opportunity,  Hedging a portfolio against a specific risk. Participants in derivative markets own portfolios of financial securities, which must be taken into consideration when understanding impact of any particular derivatives transaction. Any derivatives transaction involves cash flows, which are more or less opposite to the cash flows generated by the other securities in the portfolio. When the two sets of cash flows moves in the opposite direction, it is a hedge. When the two sets of cash flows moves in the same direction, it is a speculative position. This is why speculative trades increase risk exposure, while hedging reduces risk exposure. Hedging ensures counterbalancing cash flows, which reduce dispersion of possible outcomes and therefore reduces the risk. Conversely, by adding more cash flows, which move in the same direction, speculating increases profit when outcomes are favourable, but increases losses when outcomes are un favourable. Thus the risk is increased. The underlying cash position is the twin transaction that is undertaken simultaneously with the derivatives trade. The underlying cash position motivates the hedge transaction. If the underlying

cash position consists of only one financial security, then it is called micro hedge. If the underlying cash position consists of a portfolio of financial securities, then it is called macro hedge. Macro hedging is prevalent in financial institutions than in non-financial companies, which may be hedging only a single financial security on their balance sheets. The hedge is always tailored to the hedger’s underlying cash position. The hedger’s cash flows as well as his goals will determine the configuration of the derivatives transaction. 6.2. Description of derivatives markets The establishment and growth of financial derivatives markets has been major development trend in financial markets over the past thirty-five years. Financial innovation and increased market demand led to a rapid growth of derivatives trading. Development of financial derivatives was speeded up by the globalization of business, the increased volatility of foreign exchange rates, and increasing and fluctuating rates of inflation. Concept Derivatives - securities .bearing a contractual relation to some underlying asset or rate. In general derivatives contracts promise to deliver underlying products at some time in the future or give the right to buy or sell them in the future. They can be based on different types of assets (such as equities or commodities), prices (such as interest rates or exchange rates), or indexes (such as a stock-market index). The derivative contract can then be traded in a different market from that in which the underlying product (equity, bonds, currency) is itself traded. Markets in which underlying products are traded (such as the forex market) are often referred to as cash markets to distinguish them from derivatives markets. Although cash and derivatives markets are separate, the derivatives markets are linked to cash markets through the possibility that a delivery of the underlying product might be required. There is a close relationship between the prices of derivatives contracts and the prices of the underlying assets they represent, and that the value of a derivative, and hence its price, varies as the price in the cash market fluctuates. However, in practice, derivatives seldom lead to the

 Swap contracts  Various forms of bonds. quantity. an interest-rate swap is a derivative in which one party exchanges a stream of interest payments for another party’s stream of cash flows. Instead. at a specified price (i.. location.e. are negotiable in . A forward contract gives the holder the obligation to buy or sell a certain underlying instrument (like a bond) at a certain date in the future (i. For example. date. the delivery or final settlement date). generally interest-rate linked derivatives.. Swaps are forward contracts in which counterparties agree to exchange streams of cash flows according to predetermined rules. including the costly transfer of securities.e. Without derivatives.e. such as delivery quality. bond. contracts are closed out or allowed to lapse before the delivery date arrives. The most important difference with options is that options give the holder the right (but not the obligation) to buy or sell a certain underlying instrument at a certain date in the future at a specified price. Thus the dynamic growth of hedge funds can be explained by the rise of low-cost derivatives markets.  Futures. Hedge funds typically exploit small price differences of similar financial products. Only when the transaction cost is smaller than the price differential. money. Derivatives are traded on organized exchanges or over-the-counter (OTC) market.  Forwards. Derivatives contracts traded and privately negotiated directly between two parties belong to the OTC market.. the settlement price). then hedge fund takes a position. The types of derivatives include:  Options. portfolio managers have to conduct transactions in the underlying cash markets (i.exchange of the underlying product. and price. or equity markets) at a higher cost. For portfolio managers change of the risk profile through derivative transactions takes a very low cost. like swaps and forward-rate agreements. All contract terms. Futures contracts are forward contracts traded on organised exchanges. Forward contracts consist of futures and swaps.

The contract is traded on an organized exchange.a customized contract to buy (sell) and asset at a specified date and a specified price (forward price. Derivative contracts like futures and options.3. Concept Futures contracts . Principles of forward and futures contracts A futures contract is a legally binding commitment to buy or sell a standard quantity of a something at a price determined in the present (the futures price) on a specified future date. Forwards and futures contracts markets include diverse instruments on:  Currencies.3. Futures contracts are “zero sum games”. OTC trades are increasingly being cleared through clearinghouses in much the same way as exchange-based contracts. which are traded in organized exchanges are generally standardized.1.it. which makes it easier for more participants to access the OTC markets. and the seller is called the short. .a customized contract to buy (sell) an asset at a specified date and a specified price (futures price). The total value of derivative contracts outstanding in global OTC markets is substantially higher than the exchanges-traded amount. Forward and futures contracts 6. Besides. The traditional distinction between exchange-based and OTC derivatives is becoming less clear. Concept Forward contract . The forward contract is a private agreement between the two parties and nothing happens between the contracting date and the date of delivery. The buyer is called the long. A trend is a provision of standard contracts. 6. No payment takes place until maturity. based on electronic trading. and the potential gain/ loss is realized each day (marking to market).

. Most future contracts are closed out by an offsetting position before the delivery occurs. Commodities. Thus financial futures markets are independent of the underlying cash markets. In effect future contracts are canceled every day and replaced by new contracts with a delivery price equal to the new futures price. Margin is determined depending upon the risk of the individual contract Futures prices fluctuate every day. If this is not done immediately. Offsetting does not involve incremental brokerage fees because the fee to establish initial short position includes the commission to take the offsetting long position.  Bonds. a margin deposit is required. and are operating in parallel to those markets. As soon as a customer’s account falls below the maintenance margin.e. if there is a loss.  Stock futures. If net price movements result in gain on a position of the previous day. Therefore all contract positions are marked to market at the end of every day. It is rare for a futures contract to be used for the exchange or physical delivery of the underlying instruments.  Interest rate futures. And vise versa. A long offsets by going short and the short offsets by going long at any time before the delivery date. the customer must cover the loss. the customer receives a margin call to fill up the initial margin. then the broker closes down the position on the market. i.  Single stock futures (contract for difference).  Short-term deposits. The exchanges set a minimum margin for each contract and revise it periodically.  Stock index futures.e. To ensure that each party fulfills its commitments. i. the customer immediately receives cash in the amount of the gain. There is no money exchanged when the contract is signed. Many contracts have no facility for the exchange of the financial instrument. the settlement price at the end of the day. the round trip commission.

which implies that all potential profits and losses are immediately realized. To increase their tradability. They specify the quantity and quality of the underlying product. they can be bought and sold in futures markets. Concept Open interest or a financial instrument at some specified future date. the open interest remains unchanged. For every outstanding contract one person is short (has taken a short position) and one is long (has taken a long position. If a transaction involves offsetting by an existing long and offsetting by an existing short. futures contracts are standardized in terms of both time period and amount. The procedure of marking to market of futures contract. A hedger seeks to reduce an already existing risk. the agreed price and the date of delivery. This risk reduction could be achieved by taking a futures position that would provide profit in the event of a loss on the underlying position (and a loss in the case of a profit on the underlying position). the open interest decreases by one contract. . is the basis for the key difference between the forward and future contracts. interest rates on notional amounts of capital. If a particular transaction involves a new long and a new short. Concept Short hedge – a short hedge involves selling futures contracts to cover the risk on a position in the spot market.The total number of outstanding contracts is called open interest. the open interest increases by one contract. Concept Long hedge – a long anticipatory hedge generally involving buying futures contracts in anticipation of spot purchase. The main economic function of futures is to provide a means of hedging. and if the other side of transaction is a new investor. This is the most common use of hedging in investment management. Each futures exchange has a clearing house to keep track of the short and long positions. The futures contracts are themselves tradable – that is. However. The most common products underlying futures contracts are foreign currencies (exchange rates). if a transaction is made by offsetting an existing short or long. and stock exchange indices.

000.The futures mature in one year. which will dictate the use of some specific stock market index. Because there is no clearinghouse that guarantees the performance of a counterparty in a forward contract. Hedge ratio = (Number of contracts x Size x Spot price) / V.000/ (5000 x 10) = 20 contracts . The hedge ratio is the ratio of the size of the (short) position to be taken in futures contract to the size of the exposure (the value of the portfolio to be hedged). The fund manager buys FTSE 100 futures relating to 1000000 of shares when the FTSE 100 stands at 5000. However. is known can be derived from this equation: N = Hedge ratio x V / (Size x Spot price) Example Assume the manager of a futures fund has 1000000 Euro. interest rate or currency contract. The answer to the second question depends upon optimal hedge ratio to be used. that is to be implemented. then there are no interim cash flows. When hedging the specified source of risk two questions have to be answered:  Which contract should be used?  What amount should be hedged? The answer to the first question depends upon the source of risk. where V – is the market value of the underlying asset position. if one or both of the parties are concerned with the counterparty risk of the other. the parties to a forward contract are exposed to counterparty risk.A forward contract may or may not be marked to market. the risk that the other party to the transaction will fail to perform. the two parties may agree not to mark positions to market. The number of contracts to be sold if hedge ratio. When a forward contract is not marked to market. Let’s determine the key characteristic of the contract The number of futures contracts bought will be equal: 1. then positions may be marked to market. Where the counterparties are two highcredit-quality entities.

the underlying asset or instrument for the derivative contract) and borrowing or lending so as to generate the same cash flow as the derivative. the initial margin must be provided The approximate capital gain on the fund over a year. 6.Does any of the 1000000Euro need to be used in the purchase of the futures? Yes. interest on the money on deposit plus interest on maintenance margin (i. The pricing of futures and forward contracts is similar. If the market price of the derivative deviates from the theoretical price. The value of the package is then equal to the theoretical price of the derivative. interest on approximately 1.2.000) should be added to the capital gain. If the underlying asset for both contracts is the same. A futures price equals the spot (cash market) price at delivery. will be equal to 7% (minus the net Cost of carry). the difference in pricing is due to differences in features of the contract that must be dealt with by the pricing model. though not during the life of the contract.000.e. . This value is constraint by the existence of profitable riskless arbitrage between the futures and spot markets for the asset. In order to find the total return on the fund. Forward and futures valuation Valuations of all derivative models are based on arbitrage arguments. The difference between the two prices is called the basis: Basis = Futures price – Spot price = F – S The basis is often expressed as a percentage of the spot price (discount or premium) = Percentage basis = ( F – S ) / S Futures valuation models determine the theoretical value of the basis. if the FTSE 100 rises by 7%. This involves developing a strategy or a trade wherein a package consisting of a position in the underlying (that is. then the actions of arbitrageurs will drive the market price of the derivative toward its theoretical price until the arbitrage opportunity is eliminated.3.

Example Assume that the underlying asset price is 100 Euro. when the delivery date approaches. and finally the cost of carry.Cash yield) where financing cost . this would force the futures price down so that at some price for the futures contract. approaches zero. Zero futures happen when the futures price is equal to the spot (cash) price. At the settlement date of the futures contract. as the delivery date approaches. the futures price must equal the spot (cash market) price. the formula for determining the theoretical price of the contract. The reason for this name is that implementation of the strategy involves borrowing cash to purchase the underlying asset and “carrying” that underlying asset to the settlement date of the futures contract. the arbitrage profit is eliminated. Negative carry means that the financing cost exceeds the cash yield. financing cost is 1% and cash yield is 2%. dividend) as a percentage of the cash price.In a well-functioning market.g. This happens as financing cost and the yield that can be earned by holding the underlying asset. and that there is no margin. the futures price is converging to the spot (cash market) price.is the interest rate to borrow funds. The difference between these rates is called the cost of carry and determines the net financing cost. In general. This strategy that results in the capturing of the arbitrage profit is referred to as a cash-and-carry trade. Then the theoretical futures price is: 100 Euro + [100 Euro × (1% − 2%)] = 99 Euro The future price can be above or below the spot (cash) price depending on the difference between the financing cost and cash yield. cash yield . .is the payment received from investing in the asset (e. The reason is that a futures contract with no time left until delivery is equivalent to a spot (cash market) transaction. Positive carry means that the cash yield exceeds the financing cost. Therefore. when arbitrageurs implement their strategy by selling the futures and buying underlying asset. becomes: Theoretical futures price = Spot price + (Spot price) x (Financing cost . assuming that lending and borrowing rates are both the same and equal to financing cost. while the difference between the financing cost and the cash yield is a negative value.

the underlying may be borrowed. The reverse cash-and-strategy trade requires the short selling of the underlying. the theoretical futures price based on borrowing rate becomes Theoretical futures price = Spot price + (Spot price) × (Borrowing rate -Cash yield) In the reverse cash-and-carry trade.y)/100} x{d/365}] where FP is the fair value premium. y is the expected percentage dividend yield on the index portfolio. It is assumed in this strategy that the proceeds from the short sale are received and reinvested. Short cash and carry involves selling the borrowed stock and buying futures.e. For valuation of stock index futures the fair value premium is used. a short sale of the components stocks in the index means that all stocks in the index must be sold simultaneously. The first equation establishes the upper value for the band while the second equation provides the lower value for the band. actual) stock index is called the fair value premium. and d is the number of days to maturity of the futures contract. In this case the excess of interest over dividends is a net inflow and this gain should be matched by having a guaranteed future purchase price that exceeds the spot sale price by the amount of this net .Cash yield) Both equations together provide a band between which the actual futures price can exist without allowing for an arbitrage profit. This may be difficult to do and therefore would widen the band for the theoretical future price. and. The formula for the fair value premium is: FP = I x [{(r . but there is a cost to borrowing. This cost of borrowing can be incorporated into the model by reducing the cash yield on the underlying.However. the individual investor is required to deposit margin (securities margin and not futures margin) to short sell. For strategies applied to stock index futures. The excess of the fair futures price over the spot (i. for individual investors. In practice. I is the spot FTSE 100 Index. In the cash-and-carry trade. The impact of this difference is important when defining theoretical futures price. the borrowing rate is usually higher than the lending rate. the theoretical futures price based on lending rate becomes: Theoretical futures price = Spot price + (Spot price) ×(Lending rate . For institutional investors. the proceeds are not received. in fact. r is the interest rate.

As the spot price increases (decreases) the investor gains (losses) exactly the same amount. Speculative position. In a short hedge the investor takes a short position in futures. The hedged position has lower expected return than an un hedged position. Assume. In the case of short selling. In a long hedge the investor takes a long position in futures.1. The objective is to reduce the overall risk position. Use of forwards and futures Going long or short in futures market without any offsetting position is described as taking A. A very important type of hedge occurs when an investor with the long position in the spot market simultaneously take a short position in the futures contracts. This offset is shown in the figure bellow.1.3. In a futures hedge an investor offsets a position in the cash (spot) market with a nearly opposite position in the futures market. In short hedging the hedger may be able to find a futures contract for a virtually identical item as hedger’s cash (spot) position. The excess of interest over dividends is a net inflow that should be matched by a capital loss guaranteed by the futures price. Figure5. Profit profile .inflow. 6.3. Then the gains (losses) in the spot market are offset by the gains (losses) in the futures market. Profit profile for perfect hedge Short future profit 0 loss Long spot -----------------------------------------------------------------------------Hedge p Figure5.1 provides profit profiles. The money from the stock sale is put on deposit. the investor goes long in the spot market at 50 Euro. the borrower of the stock must pay sums equivalent to the dividends to the lender of the stock. The profit profile for a spot position is offset exactly by the short futures position. Profit profile for perfect hedge The Figure5.

2 shows profit profile for long spot grade A investment assets. . The optimal hedge ratio is not a perfect hedge. In this situation. Grade B asset prices are assumed to move half as fast as grade A asset prices. The relationship between a spot position and a futures contract in a cross hedge is not a perfect straight line. The optimal hedge ratio is the best in the sense that the expected change in the hedged position is zero. but different asset. Profit profile for a cross hedge The hedger can estimate the slope of the line (β) by using regression analysis in order to find the best-fitting relationship.for the net position is a horizontal line. and offsets by taking short position in the futures market in grade B investment assets. the hedger shorts β units of the futures. Here it is assumed that the investor takes a long position in the spot market in grade A investment assets. the hedger must utilize a short position in a similar. because the link between the spot and futures is not perfect. short futures grade B investment assets and the net position. For every unit of the spot asset (cash market). indicating no change in the value of the net position as the spot price changes. The gains and losses on the spot position are cut in half for grade an investment asset by the short hedge. It is shown as a dotted line in the figure below. However most often identical or similar future contracts do not exist. The Figure 5. Flat profile represents a perfect hedge. β is called the optimal hedge ratio. This is called a cross hedge.2. Long Grade Short future Grade B Profit 0 Loss Hedge p Figure 5.

5. Options definition Stock markets by their very nature are fickle. or if he chooses not to. Options 6. that is to curtail the risk exposure of an investor. walk away from the contract. When you buy a Call option. an option is a contract. In this way. If for example. is a choice given to the investor to either honor the contract. Options contracts allow you to run your profits while restricting your downside risk. While fortunes can be made in a jiffy. but you would have no other liability. To begin with there are two kinds of options. A "Call Option". or A downside which could make you a pauper. "Option". as the word suggests. which gives the buyer the right. as options are built into everything from mortgage to insurance. . Most people remain puzzled by Options. the price you pay for it called the option premium. your only cost is the option premium. Derivative products are structured precisely for this reason. namely. The truth is that most people have been using options for some time now. but not the obligation to buy or sell shares of the underlying security at a specific price on or before a specific date. Which we shall explain presently. In the stock markets. Investing in stocks has two sides to it: • • Unlimited profit potential from any upside. if you never returned. more often than not the scenario is the reverse.5.6. you would give up your security deposit. However. Index futures and stock options are instruments that enable the investor to hedge his portfolio or open positions in the market. is an option to buy a stock at a specific price on or before a certain date. the "Call" option and the "Put" option. you want to rent a certain property and left a security deposit for it. The money would be used to insure that you could in fact rent the property at the price agreed upon when you returned. Call options usually increase in value as the value of the underlying instrument rises.1. If you decide not to use the option to buy the stock and you are not obliged to. call options are like security deposits. secures your right to buy that certain underlying stock at a specified price called the strike price on or before a specified date.

the investor can "insure" a stock by fixing a selling price. the primary function of listed options is to allow investors ways and means to manage market risk. the Put option gains in value as the value of the underlying instrument decreases. And once again. you can use your insurance policy to regain the insured value of the car. the investor can exercise the put option and sell it at its "insured" price level. and are hence protected if the asset is damaged in an accident. thereby causing damage to the asset. then there is no damage to the asset. Then. You are advised to follow the thought. possibly on or before a predetermined date. The names and the prices in the illustrations below are not in real time and have only been used to help explain these options. In this way. If adverse market action causes the stock price to fall. To acquire this right the buyer pays a premium to the writer (or seller) of the contract. Then you the investor do not need to use the insurance. to buy or sell a parcel of stocks (or shares) at a predetermined price. put options are like insurance policies. If on the other hand the price of your stock goes up due to favourable market action. In similar fashion. The buyer receives a privilege for which he pays a premium.A "Put Option". And the seller accepts an obligation for which he receives a fees. namely:  Call options  Put options We shall discuss both these types of options. an option is a contract between two parties. . If this accident were to happen. your only cost is the option premium paid by you. If all goes well and the insurance is not needed. Types of Options An option is a contract between two parties giving the taker (or buyer) the right. Technically. With the Put option. Thereby causing the underlying asset to regain its value. You pay a premium to the insurance company. Thus. to understand the concept. There are two types of options. Let's say you buy a car. is an option to sell a stock at a specific price on or before a certain date. and then buy auto insurance for the car. the insurance company keeps your premium amount in return for taking on the risk of damage or loss. but not the obligation.

For this privilege. However. That is he has purchased the right to buy that underlying share for BIRR 40. Now. to buy the underlying stocks (or shares) at a predetermined price. Then Raj would choose not to exercise the option and forgo the premium of BIRR 15.00 (that is BIRR 40. That is to say that the price of the underlying stock would have to rise to BIRR 55.00 + BIRR 15. the trader books a profit of BIRR 20.00) he will break even and start making a profit.00.00 and thus limit his loss to this amount only. Now. He sells the Call Options or exercises the option and takes the difference between the Nifty Spot and the Strike price of his Call Option contracts (that is BIRR 1365. He pays a premium for buying these Call Options (that is the right to buy these contract) for BIRR 500. as he had . Raj purchases a December Call option at BIRR 40. on or before a determined date. So. but does not want the risk of prices going down.00). Therefore.00 before Raj would break even in his transaction. Raj pays a fee of BIRR 800.00 for a premium of BIRR 15.BIRR 1345 = BIRR 20. Now.00 and the Strike price of the Call Option = BIRR 40. let us see how one can profit from buying an option. suppose the price of the underlying stock does not rise but falls. Let's say Raj purchases 1 Satyam Computer (SATCOM) AUG 150 Call at a Premium of 8. to book this profit he would have to exercise this option on or before the expiry date.00 by the end of December.00 X 200 = BIRR 4.000. If the price of the underlying stock rises above BIRR 55.00. Now the market lot of the Nifty contract is 200. In January.000.00.Call Options The call options give the taker (or buyer) the right.00 = BIRR 55.00 . If the Premium = BIRR 15. he buys 10 Options of January contracts at 1345.00 a share for 100 shares. A trader is of the view that the index or Nifty would go up to 1400 in January. that is BIRR 8. the Nifty index goes up to 1365.00.00 per contract. then the Breakeven point = BIRR 15.00 + BIRR 40. but not the obligation.00 per share at any time between the current date and the end of August.00.00 X 10 = BIRR 5. This contract allows Raj to buy 100 shares of SATCOM at BIRR 150. The buyer of a "call" has purchased the right to buy and for that he pays a premium.

but the profit potential is unlimited. Raj pays a premium of BIRR 20. Let's say Raj purchases 1 Infosys Technology Aug 3500 Put . Put Options A Put Option gives the holder the right to sell a specified number of shares of an underlying security at a fixed price for a period of time. If. Call Options: Long and Short Positions: • When you expect prices to rise.00 (that is BIRR 200.00 less BIRR 5.00 he had paid initially.00. .00 per share for 100 shares).500. This contract allows Raj to sell 100 shares of Infosys Technology at BIRR 3. but he does not want to take the risk in the event of the price rising. but he has to pay a premium of BIRR 15.00 when he exercised these Call Option contracts. • When you expect prices to fall. You are bullish on the underlying security.000. He had paid BIRR 5. he purchases a Put option at BIRR 70.000.Premium 200. then the trader will not exercise his right and would opt to forego the premium of BIRR 5. So he would have earned BIRR 40. then you take a short position by selling the Call Option.000. So.bought 10 Call Options contracts his total profit would be BIRR 4.00 per share at any time between the current date and the end of August. in case the Nifty falls further below the 1345 level the traders loss is limited to the premium he paid upfront. You are bearish on the underlying security. on the other had the Nifty had fallen below 1345.00 towards the premium for buying these Call Options.00.00 which is BIRR 35.000. let's say Raj is of the view that a stock is overpriced and its price would fall in the future.000.000. To explain this further. then you take a long position by buying the Call Option. The buyer of a put has purchased a right to sell.000.00 for this contract.00 X 10 = BIRR 40. So. To have this privilege.000. By purchasing the put option Raj has the right to sell the stock at BIRR 70.00 on Stock 'X'.

In the second price situation. which totals BIRR 50. So.So Raj would breakeven only after the stock falls below BIRR 55.000. In this case he would have to let his Put option expire unexercised.000.00 (that is BIRR 70.00. • When you expect prices to rise.00. but does not want to take the risk in the event the price rises. By exercising the Put option he earns BIRR (1070 . His position in the following price point’s situations is discussed below:   Jan Spot price of Wipro = 1020 Jan Spot price of Wipro = 1080 In the first situation.00 less BIRR 30. the Spot price of which is BIRR 1. His loss here would be initial premium paid for the Put option contracts that is BIRR 30.000. the trader has the right to sell 1000 Wipro shares at BIRR 1.00 The trader purchases 1000 Wipro Put at Strike price 1070 at Put price of BIRR 30. He pays a Put premium of BIRR 30.070. You are bullish Option Concepts .00. then you take a long position by buying Puts. then you take a short position by selling Puts.000.00  Jan Put 1050 BIRR 10. Let us illustrate this further.00 per put. The quotes are as under:  Spot BIRR 1.00 (that is the premium paid upfront) = BIRR 20. You are bearish.00 less BIRR 15. His net income is BIRR 50. so the trader would not sell at a lower price. A trader on 15 December is of the view that Wipro is overpriced and would fall in the future.00 .000. the price is higher in the Spot market.00.020.000. he purchases a Put option on Wipro. Put Options: Long and Short Positions: • When you expect price to fall.00.00.040.1020) = BIRR 50.00  Jan Put 1070 BIRR 30.00) and would start making a profit on this contract when the stock price falls below BIRR 55.00.

Out-of-the-money. Five different strike prices will be available at any point of time. if the strike price is les than the market price of the underlying (whether stock or index). 1390. we would like to reiterate. 1430 and 1450. and Covered Put At this stage. when the strike price is greater than the market price of the underlying. In-the-money. The strike price interval would be of 20. In-the-money A Call option is said to be "in-the-money". It is always better to be on the side of caution and have a healthy margin of safety available to us at all times in our financial transactions. . 1410. These terms are listed below: • • • • • • Strike price. the profit or loss from the contract would depend on the price movement of the underlying stock or index in the Cash market. The strike price is also called the exercise price. that the visitors who have not dealt in stocks and share. Let's say that the index is currently at 1410.The investor would find it useful to know certain important terms used with regard to transactions in options. or investors who have dealt in stocks and shares but have not indulged in the leverage provided by options as a speculative instrument would be well advised to meet a qualified investment advisor to understand the nuances of this instrument. then the strike prices available would be 1370. Strike price The strike price denotes the price at which the buyer of the option has a right to purchase or sell the underlying. At-the-money. A Put option is "in-the-money". This strike price is fixed for the entire duration of the option. Covered Call.

the option is "in-the-money" till the market price of SATCOM is ruling above the strike price of BIRR 190. And of course.500. Similarly. then the option would be "out-of-the-money". This is the price at which Raj would like to buy 100 shares of SATCOM anytime before the end of August. "in-the-money" strike prices would be 1370 and 1390 which are lower than the underlying of 1410. if the market price of INFTEC is ruling below the strike price of BIRR 3. if the market price of ACC is ruling at BIRR 150. if Raj has purchased a Put option at the same strike price. In this case.00.500. 1430 and 1450. At-the-money The option with a strike price equal to that of the market price of the underlying stock is considered to be "at-the-money" or near-the-money. then the option would be "in-the-money" if the market price of SATCOM was lower than BIRR 190.00.00 per share. 1410. then the option is said to be "at-the-money". if Raj has purchased a Put option at the same strike price.00. To explain this further. and then the strike prices available would be 1370.00. Here. Let's say Raj purchases 1 ACC AUG 150 Call or Put at a premium of BIRR 10.00.Let's say Raj purchases 1 SATCOM AUG 190 Call at a premium of BIRR 10. The strike price for a Call option that are greater than the underlying Index are said to be "out-of-the-money" for strike prices 1430 and 1450 considering that the underlying in the cash market is at 1410. which is equal to the strike price. . a Put option is "out-of-the-money" if the strike price is les than the market price of the underlying stock. 1390. Similarly. if the market price of INFTEC was above BIRR 3. the strike price 1410 would be "at-the-money". let's say the Index is at 1410. The option is "out-of-the-money". Out-of-the-money A Call option is said to be "out-of-the-money" if the strike price of the contract is greater than the market price of the underlying stock. This is the same price at which Raj would like to buy 100 shares of INFTEC anytime before the end of August. let's say Raj purchases 1 INFTEC AUG 3500 Call at a premium of BIRR 150. To explain this further. Similarly. Similarly.00 per share.00.

00 per share. and considering that there are 3 series. if it is already owned). Here again. that is both Call and Put options would be available.00 and that it would move up in a narrow range.00 and collect a premium of BIRR 5. He can take a long position in HUL shares and at the same time write a Call option with a strike price of BIRR 185. he is able to reduce his average cost of acquisition in the cash market (which would be the cost of acquisition less the option premium received).00 till expiry.00). However.00 and the option is exercised. as the underlying asset has already been sold. a total of 30 options would be available to take a position.4. the writer of a Put option can create a covered position by selling the underlying security (that is.At these prices an investor can take a positive or negative view on the market. If on the other hand the price goes above BIRR 185. This would bring down the effective cost of HUL shares to him to BIRR 177. the writer of the call option takes a corresponding long position in the stock in the cash market. Covered Put options Similarly. if the there is a sharp decline in the price of the underlying asset.00 less BIRR 5. If the price stays below BIRR 185. in case there is a sharp increase in the price of the stock. this would cover his loss in the options position. the investor is not in a position to take advantage of any sharp increase in the price of the stock. the option would be exercised and the investor would be left only with the premium amount. Covered Call options Covered option helps the writer to minimize his loss. Therefore. let's say Raj believes that HUL has hit rock bottom at a price level of BIRR 182. The loss in the option exercised would be equal to the gain in the short position of the underlying asset 6.00 per share he had collected as premium. In a covered call option. then the Call option would not be exercised and Raj the writer of the Call option would keep the BIRR 5.00 (that is BIRR 182. Further. Swaps . for a single series 10 options (that is 5 Calls and 5 Puts) would be available. The effective selling price will increase by the premium amount (if the option is not exercised at maturity). then Raj would deliver the shares acquired in the cash market. To illustrate this.

base metals. can have quite high liquidity (larger than many forward contracts.g. Interest rate swap is a contract in which the counterparties swap payments in the same currency based on an interest rate. For example. the counterparties to a swap are exposed to counter party risk.e. food. and credit default swaps. long-term) forward contracts). in which two parties agree to swap payments based on different currencies. The types of swaps typically used by non-finance corporations are: • • • • Interest rate swaps.A swap is an agreement whereby two parties (called counterparties) agree to exchange periodic payments. The cash amount of the payments exchanged is based on some predetermined principal amount. particularly long-dated (i. e. A swap is an over-the-counter (OTC) contract. not the notional amount. it is negotiated separately. The only cash that is exchanged between the parties are the agreed-upon payments. Hence. crude oil. . which is called the notional principal amount or simply notional amount. Currency swap is a contract. Physical commodities include precious metals. commodity swaps. according to which the exchange of payments by the counterparties is based on the value of a particular physical commodity. The floating interest rate is commonly referred to as the reference rate. a package of forward contracts. However. Swap can be decomposed into a package of derivative instruments. The cash amount each counterparty pays to the other is the agreed-upon periodic rate times the notional amount. its maturity can be longer than that of typical forward and futures contracts.. one of the counterparties can pay a fixed interest rate and the other party a floating interest rate. currency swaps. natural gas. Commodity swap is a contract.

Futures and options contracts can give them an extra leverage. they can increase both the potential gains and potential losses in a speculative venture. The derivative market performs a number of economic functions. At this time.trade in the derivatives market. Second. Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets. . speculators. The prices of derivatives converge with the prices of the underlying at the expiration of derivative contract. If a credit event does occur. they see the futures price of an asset getting out of line with the cash price. The specific credit-related events are identified in the contract that will trigger a payment by the credit protection seller to the credit protection buyer are referred to as credit events. Speculators wish to bet on future movements in the price of an asset. the protection buyer is obligated to fulfill its obligation.” it does not have the general characteristics of a typical swap. First. There are two parties in the CDS contract: the credit protection buyer and credit protection seller. Thus derivatives help in discovery of future as well as current prices. Over the life of the CDS. the protection buyer agrees to pay the protection seller a payment at specified dates to insure against the impairment of the debt of a reference entity due to a credit-related event. If. prices in an organized derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level.A credit default swap (CDS) is an OTC derivative that permits the buying and selling of credit protection against particular types of events that can adversely affect the credit quality of a bond such as the default of the borrower. Although it is referred to as a “swap.hedgers. The reference entity is a specific issuer. that is. They use futures or options markets to reduce or eliminate this risk. Hedgers face risk associated with the price of an asset. the derivatives market helps to transfer risks from those who have them but may not like them to those who have appetite for them.3 Participants and Functions Three broad categories of participants . for example. they will take offsetting positions in the two markets to lock in a profit. the credit protection buyer only makes a payment up to the credit event date and makes no further payment. and arbitrageurs . The contract will call for the protection seller to compensate for the loss in the value of the debt obligation 1.

if the reference rate differs from a predetermined level. Fifth. Margining. Sixth. whereby one party for an upfront fee agrees to compensate the other if a designated interest rate (called the reference rate) is different from a predetermined level. an important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. In the absence of an organized derivatives market. Fourth. and the party that must potentially make payments is called the seller. new products and new employment opportunities. creative. the benefit of which are immense. With the introduction of derivatives. The terms of an interest rate agreement include: (1) the reference rate. . The predetermined interest rate level is called the strike rate. the underlying market witnesses higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk. The party that benefits. CAPS AND FLOORS Caps and floors are agreements between two parties. An interest rate cap specifies that the seller agrees to pay the buyer if the reference rate exceeds the strike rate. Transfer of risk enables market participants to expand their volume of activity.Third. An interest rate floor specifies that the seller agrees to pay the buyer if the reference rate is below the strike rate. and (5) the notional amount (which determines the size of the payments). well-educated people with an entrepreneurial attitude. (4) the frequency of reset. Derivatives thus promote economic development to the extent the later depends on the rate of savings and investment. The derivatives have a history of attracting many bright. monitoring and surveillance of the activities of various participants become extremely difficult in these kind of mixed markets. derivatives. They often energize others to create new businesses. derivatives markets help increase savings and investment in the long run. (3) the length of the agreement. the payment by the seller is typically made in arrears. speculative trades shift to a more controlled environment of derivatives market. speculators trade in the underlying cash markets. (2) the strike rate that sets the cap or floor. is called the buyer. If a cap or a floor is in the money on the reset date. are linked to the underlying cash markets. due to their inherent nature.

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