Professional Documents
Culture Documents
Introduction
What are derivatives?
A derivative is a financial instrument that derives its value from an underlying asset. This underlying asset can be stocks, bonds,
currency, commodities, metals and even intangible, pseudo assets like stock indices.
Derivatives can be of different types like futures, options, swaps, caps, floor, collars etc. The most popular derivative instruments are
futures and options.
There are newer derivatives that are becoming popular like weather derivatives and natural calamity derivatives. These are used as a
hedge against any untoward happenings because of natural causes.
2. Futures
Future, as the name indicates, is a trade whose settlement is going to take place in the future. However, before we take a look at
futures, it will be beneficial for us to take a look at forward rate agreements
What is a future?
A future is similar to a forward rate agreement, except that it is not a negotiated contracted but a standard instrument.
A future is a contract to buy or sell an asset at a specified future date at a specified price. These contracts are traded on the stock
exchanges and it can change many hands before final settlement is made.
The advantage of a future is that it eliminates counterparty risk. Since there is an exchange involved in between, and the exchange
guarantees each trade, the buyer or seller does not get affected with the opposite party defaulting.
Futures Forwards
Futures are traded on a stock Forwards are non tradable, negotiated
exchange instruments
Exit route is provided because of high No exit route for these contracts
liquidity on the stock exchange
Highly regulated with strong margining No such systems are present in a
and surveillance systems Forward market.
There are two kinds of futures traded in the market- index futures and stock futures.
There are three types of futures, based on the tenure. They are 1, 2 or 3 month future. They are also known as near and far futures
depending on the tenure.
Example 2.4:
The spot price of Reliance is Rs 300. The bank rate prevailing is 10%. Reliance declares a dividend of 5%. What will be the price of
one-month future?
Solution:
The benefit accrued due to the dividend will be reduced from the cost of the future. One month future will be priced at
F= 300(1+0.10) (1/12)
F = 302.39
Cost of Carry= Rs 302.39-Rs 300 = Rs 2.39
The interest benefit of the dividend is available for 15 days, ie 0.5 months. Dividend for 15 days = 300(1+0.05) (0.5/12)
Dividend Benefit = Rs300.61- Rs 300= Rs0.61
Therefore, net cost of the carry is,
Rs2.39-Rs0.61 = Rs 1.78
Therefore the price of the future is Rs 300+Rs 1.78 = Rs 301.78
In practice, the market discounts the dividend and the prices are automatically adjusted. The exchange steps into the picture if the
dividend declared is more than 10 % of the market price. In such cases, there is an official change in the price. In other cases, the
market does the adjustment on its own.
What happens in case a bonus/ stock split is declared on the stock in which I have a futures position?
If a bonus is declared, the settlement price is adjusted to reflect the bonus. For example, if you have 200 Reliance at Rs 300 and there
is a 1:1 bonus, then the position becomes 400 Reliance at Rs 150 so that the contract value is unaffected.
What happens if I buy an index future and there is a dividend declared on a stock that comprises the index?
Practically speaking, the index is corrected for these things in case there is a dividend declared for such a stock. Theoretically,
dividend is adjusted in the following manner:
1.The contribution of the stock to the index is calculated. The index, as discussed earlier, is a market capitalization index.
2. Then the number of shares in the index is calculated. This is obtained by dividing the contribution to the index by the market price.
3. The dividend on the index is the dividend on the number of shares of the stock in the index.
4. The interest earned on the dividend is calculated and reduced from the cost of carry to obtain the net cost of carry.
Example 2.5:
The index is at 1000. There is a dividend of Rs 5 per share on HLL. HLL contributes to 15 % of the index. The market price of HLL is
Rs 150. What will be the cost of the 1 month future if the bank rate is 10%?
Solution:
The future will be priced at
F= 1000(1+0.10)(1/12)
F= 1008
The weight of HLL in the index is 15% ie 0.15*1000=150.
The market price of HLL is Rs 150. Therefore, the number of shares of HLL in the index=1
The dividend earned on this is Rs 5
Dividend benefit on Rs 5 is 5(1+0.10) (1/12)
Dividend benefit = Rs 0.04
Cost of the future will be Rs 1008-Rs 0.05= Rs 1007.95
But in practice, the market discounts the dividends and price adjustment is made accordingly.
All that is okay in theory, but what happens in the real world?
In the real world, derivatives are highly volatile instruments and there have been lot of losses in the various financial markets. The
classic examples have been Long Term Capital Markets (LTCM) and Barings. We will examine what happened exactly at various
places later in the book.
As a result, the regulators have decided that a minimum of Rs 2 lacs should be the contract size. This is done primarily to keep the
small investors away from a volatile market till enough experience and understanding of the markets is acquired. So the initial players
are institutions and high net worth individuals who have a risk taking capacity in these markets. Because of this minimum amount, lots
are decided on the market price such that the value is Rs 2 lacs. As a result one has to buy a minimum of 200 Nifties or in case of
Sensex, 50.
Similarly minimum lots are decided for individual stocks too. Thus you will find different stock futures having different market lots.
The lots decided for each stock was such that the contract value was Rs 2 lacs. This was at the point of introduction of these
instruments. However the lot size has remained the same and has not been adjusted for the price changes. Hence the value of the
contract may be slightly lower in case of certain stocks. Trading, i.e. Buying and Selling take place in the same manner as the stock
markets. There will be an F & O terminal with the broker and the dealer will enter the orders for you. Another fact of the real world is
that, since the future is a standard instrument, you can close out your position at any point of time and need not hold till maturity.
3. Options
What are options?
As seen earlier, futures are derivative instruments where one can take a position for an asset to be delivered at a future date. But there
is also an obligation as the seller has to make delivery and buyer has to take delivery.
Options are one better than futures. In option, as the name indicates, gives one party the option to take or make delivery. But this
option is given to only one party in the transaction while the other party has an obligation to take or make delivery. The asset can be a
stock, bond, index, currency or a commodity But since the other party has an obligation and a risk associated with making good the
obligation, he receives a payment for that. This payment is called as premium.
The party that had the option or the right to buy/sell enjoys low risk. The cost of this low risk is the premium amount that is paid to the
other party. Thus we have seen an option is a derivative that gives one party a right and the other party an obligation to buy /sell at a
specified price for a specified quantity.
The buyer of the right is called the option holder. The seller of the right (and buyer of the obligation) is called the option writer. The
cost of this transaction is the premium.
For example, a railway ticket is an option in daily life. Using the ticket, a passenger has an option to travel. In case he decides not to
travel, he can cancel the ticket and get a refund. But he has to pay a cancellation fee, which is analogous to the premium paid in an
option contract. The railways, on the other hand, have an obligation to carry the passenger if he decides to travel and refund his money
if he decides not to travel. In case the passenger decides to travel, the railways get the ticket fare. In case he does not, they get the
cancellation fee.
The passenger on the other hand, by booking a ticket, has hedged his position in case he has to travel as anticipated. In case the travel
does not materialize, he can get out of the position by canceling the ticket at a cost, which is the cancellation fee.
But I hear a lot of jargons about options? What are all these jargons?
There are some basic terminologies used in options. These are universal terminologies and mean the same everywhere.
a. Option holder: The buyer of the option who gets the right
b. Option writer: The seller of the option who carries the obligation
c. Premium: The consideration paid by the buyer for the right
d. Exercise price: The price at which the option holder has the right to buy or sell. It is also called as the strike price.
e. Call option: The option that gives the holder a right to buy
f. Put option: The option that gives the holder a right to sell
g. Tenure: The period for which the option is issued
h. Expiration date: The date on which the option is to be settled
i. American option: These are options that can be exercised at any point till the expiration date
j. European option: These are options that can be exercised only on the expiration date
k. Covered option: An option that an option writer sells when he has the underlying shares with him.
l. Naked option: An option that an option writer sells when he does not have the underlying shares with him
m. In the money: An option is in the money if the option holder is making a profit if the option was exercised immediately
n. Out of money: An option is in the money if the option holder is making a loss if the option was exercised immediately
o. At the money: An option is in the money if the option holder evens out if the option was exercised immediately
Call option:
A call option gives the holder a right to buy shares. The option holder will make money if the spot price is higher than the strike price.
The pay off assumes that the option holder will buy at the strike price and sell immediately at the spot price. But if the spot price is
lower than the strike, the option holder can simply ignore the option. It will be cheaper to buy from the market. The option holder loss
is to the extent of premium he has paid.
But if the spot price increases dramatically then he can make wind fall profits. Thus the profits for an option holder in a call option is
unlimited while losses are capped to the extent of the premium.
Conversely, for the writer, the maximum profit he can make is the premium amount. But the losses he can make are unlimited.
Put option
The put option gives the right to sell. The option holder will make money if the spot price is lower than the strike price. The pay off
assumes that the option holder will buy at spot price and sell at the strike price, But if the spot price is higher than the strike, the
option holder can simply ignore the option. It will be beneficial to sell to the market. The option holder loss is to the extent of
premium he has paid. But if the spot prices fall dramatically then he can make wind fall profits. Thus the profit for an option holder in
a put option is unlimited while losses are capped to the extent of the premium. This is a theoretical fallacy as the maximum fall a stock
can have is till zero, and hence the profit of a option holder in a put option is capped.
Conversely, the maximum profit that an option writer can make in this case is the premium amount. But in the above pay off, we had
ignored certain costs like premium and brokerage. These are also important, especially the premium.
So, in a call option for the option holder to make money, the spot price has to be more than the strike price plus the premium amount.
If the spot is more than the strike price but less than the sum of strike price and premium, the option holder can minimize losses but
cannot make profits by exercising the option. Similarly, for a put option, the option holder makes money if spot is less than the strike
price less the premium amount.
If the spot is less than the strike price but more than the strike price less premium, the option holder can minimize losses but cannot
make profits by exercising the option.
Example 3.1:
The call option for Reliance is selling at Rs 10 for a strike price of Rs 330. What will be the profit for the option holder if the spot
price touches a) Rs. 350 b)337
Solution
a. The option holder can buy Reliance at a price of Rs 330. He has also paid a premium of Rs 10 for the same. So his cost of a share of
Reliance is Rs 340. He can sell the same in the spot market for Rs 350. He makes a profit of Rs 10
b. The option holder can buy Reliance at a price of Rs 330. He has also paid a premium of Rs 10 for the same. So his cost of a share of
Reliance is Rs 340. He can sell the same in the spot market for Rs 337
He makes a loss of Rs 3.
But he has reduced his losses by exercising the option. Had he not exercised the option, he would have made a loss of Rs 10, which is
the premium that he paid for the option.
But should one always buy an option? The buyer seems to enjoy all advantages, then why should one write an option?
This is not always the case. The writer of the option too can make money. Basically, the option writers and option holders are people
who are taking a divergent view on the market. So if the option writer feels the markets will be bearish, he can write call options and
pocket the premium. In case the market falls, the option holder will not exercise the option and the entire premium amount can be a
profit But if the option writer is bullish on the market, then he can write put options. In case the market goes up, the option holder will
not exercise the option and the premium amount is a profit for the option writer.
The other area that an option writer makes money is the spot price lying in the range between the strike price and the strike plus
premium For example, if you write a call option on Reliance for a strike price of Rs 300 at a premium of Rs 30. If the spot price is Rs
320, then the option holder will exercise the option to reduce losses and buy it at Rs 300. But you have already got the premium of Rs
30. So in effect, you have sold the stock at Rs. 330, which is Rs 10 above the spot price! This profit increases even more if you
calculate the opportunity cost of Rs 30 as this amount is received up front.
Let us look at a typical pay off table for a call option, for the buyer as well as writer. Let us assume a call option with a strike price of
Rs 200 and a premium of Rs 10
Table 3.1: Pay off Table for buyer and writer of an option
Spot Price Whether Buyer’sgain/loss Writergain/loss Net
Exercised
180 No -10 +10 0
190 No -10 +10 0
195 No -10 +10 0
200(=Strike rice) Yes/No -10 +10 0
205 Yes -5 +5 0
210 Yes 0 0 0
220 Yes +10 -10 0
In the above pay off table, if we take 200 as the median value, we see that the writer has made money 5 out of 7 occasions. He has
made money even when the option is exercised, as long as the spot price is below the strike price plus the premium. Thus writers also
make money on options, as the buyer is not at an advantage all the time.
What are the options that are currently traded in the market?
The options that are currently traded in the market are index options and stock options on the 30 stocks. The index options are
European options. They are settled on the last day. The stock options are American options.
There are 3 options-1, 2,3 month options. There can be a series of option within the above time span at different strike prices.
Another lingo in option is Near and Far options. A near option means the option is closer to expiration date. A Far option means the
option is farther from expiration date. A 1 month option is a near option while a 3 month option is a far option.
In option trading, what gets quoted in the exchange is the premium and all that people buy and sell is the premium.
We said we could have different option series at various strike prices. How is this strike price arrived at?
The strike price bands are specified by the exchange. This band is dependent on the market price.
. .
Market Price Rs Strike Price Intervals Rs
<50 2.5
50-150 5
150-250 10
250-500 20
500-1000 30
>1000 50
Thus if a stock is trading at Rs. 100 then there can be options with strike price of Rs 105,110,115, 95, 90 etc.
I keep reading about option Greeks? What are they? They actually sound like Greek and Latin to me.
There are something called as option Greeks but they are nothing to be scared of. The option Greeks help in tracking the volatility of
option prices.
The option Greeks are
a. Delta: Delta measures the change in option price (the premium) to the change in underlying. A delta of 0.5 means if the
underlying changes by 100 % the option price changes by 50 %.
b. Theta: It measures the change in option price to change in time
c. Rho: It is the change in option price to change in interest rate
d. Vega: It is the change in option price to change in variance of the underlying stock
e. Gamma: It is the change in delta to the change in the underlying. It is a double derivative (the mathematical one) of the
option price with respect to underlying. It gives the rate of change of delta.
a. These are just technical tools used by the market players to analyze options and the movement of the option prices.
We saw that the stock options are American options and hence can be exercised any time. What happens when one decided to
exercise the option?
When the option holder decides to exercise the option, the option will be assigned to the option writer on a random basis, as decided
by the software of the exchange. The European options are also the similarly decided by the software of the exchange. The index
options are European options. In future, there is a possibility that the options may result in delivery. In such a scenario, the option
market will be merged with the spot market on the expiration day and it will follow the T+ 3 rolling settlement prevalent in the stock
markets
So far, we have seen a lot of theoretical stuff on derivatives. But how is it going to help me in practice?
There are a lot of practical uses of derivatives. As we have seen, derivatives can be used for profits and hedging. We can use
derivatives as a leverage tool too.
Suppose I don’t want to lend/borrow money. I want to speculate and make profits?
When you speculate, you normally take a view on the market, either bullish or bearish. When you take a bullish view on the market,
you can always sell futures and buy in the spot market. If you take a bearish view on the market, you can buy futures and sell in the
spot market.
Similarly, in the options market, if you are bullish, you should buy call options. If you are bearish, you should buy put options
Conversely, if you are bullish, you should write put options. This is so because, in a bull market, there are lower chances of the put
option being exercised and you can profit from the premium
If you are bearish, you should write call options. This is so because, in a bear market, there are lower chances of the call option being
exercised and you can profit from the premium
We have seen that the risk for an option holder is the premium amount. But what should be the strategy for an option writer
to cover himself?
An option writer can use a combination strategy of futures and options to protect his position. The risk for an option writer arises only
when the option is exercised. This will be very clear with an example.
Suppose I sell a call option on Reliance at a strike price of Rs 300 for a premium of Rs 20. The risk arises only when the option is
exercised. The option will be exercised when the price exceeds Rs 300. I start making a loss only after the price exceeds Rs 320(Strike
price plus premium). More importantly, I have to deliver the stock to the opposite party. So to enable me to deliver the stock to the
other party and also make entire profit on premium, I buy a future of Reliance at Rs 300.
This is just one leg of the risk. The earlier risk was of the call being exercised. The risk now is that of the call not being exercised. In
case the call is not exercised, what do I do? I will have to take delivery as I have bought a future. So minimize this risk, I buy a put
option on Reliance at Rs 300. But I also need to pay a premium for buying the option. I pay a premium of Rs 10.Now I am fully
covered and my net cash flow would be:
Premium earned from selling call option : Rs 20
Premium paid to buy put option : (Rs 10)
Net cash flow : Rs 10
But the above pay off will be possible only when the premium I am paying for the put option is lower than the premium that I get for
writing the call. Similarly, we can arrive at a covered position for writing a put option too, Another interesting observation is that the
above strategy in itself presents an opportunity to make money. This is so because of the premium differential in the put and the call
option. So if one tracks the derivative markets on a continuous basis, one can chance upon almost risk less money making
opportunities.
5. SETTLEMENT OF DERIVATIVES
Final Settlement
On the expiry of the futures contracts, exchange marks all positions to the final settlement price and the resulting profit / loss is settled
in cash.The final settlement of the futures contracts is similar to the daily settlement process except for the method of computation of
final settlement price. The final settlement profit / loss is computed as the difference between trade price or the previous day’s
settlement price, as the case may be, and the final settlement price of the relevant futures contract. Final settlement loss/ profit amount
is debited/ credited to the relevant broker’s clearing bank account on T+1 day (T= expiry day). This is then passed on the client from
the broker. Open positions in futures contracts cease to exist after their expiration day