Introduction to Derivatives

Types of Derivatives
• Forward commitments
– Forward Contract
– Futures Contract
– Swaps
• Contingent claims
– Options
• Structured Instruments
– STRIPS; CMOs; CDOs
 Forward Contracts
• Bilateral contract with obligations on BOTH side
• Customized contracts; no regulation practically
• Have zero value at inception to either party
• Buy or sell a specific quantity of an asset, at a set
price, on a specific date in the future
• No upfront payments usually
– Counterparty risk is always there ( no clearing
houses)
• Buyer – long forward position
• Seller – short forward position
 Forward Contracts
Examples
• Currency forward – party A agrees to
exchange a certain amount of currency X for
a certain amount of currency Y at a future
date
• Fortune Inc. expects to receive EUR 50 mn
three months from now and enters into a
cash settlement currency forward to
exchange these euros for dollars at USD 1.23
per euro. If market rate turns out to be USD
1.25 per euro at settlement, what are the
payoffs for Fortune?
• Fortune is already LONG in EUR 50 mn
– Needs an offsetting position to hedge
– Takes SHORT position to sell EUR 50 mn at 1.23
• LONG position gains if asset price increase
• SHORT position gains if asset price increase
• EUR appreciated – increased in price relative to
USD
• Fortune Gains in LONG but loses EQUAL amount in
SHORT position
• EUR 50 mn X 1.23 = 61.5 mn USD
– Will get this contracted amount if contract was on
DELIVERY in exchange of EUR 50 mn
– Will PAY (50X1.25=62.5) -61.5 mn = 1 mn USD to
counterparty if on CASH basis
 Forward Payoffs
• Long position:
– ST-K
• Short Position:
– K-ST
Short
Long

0
K ST
 Futures Market & Contracts
• Standardized contracts; mostly exchange traded
– Specifies quality, quantity of goods at specific dates
and mode of delivery
• Cash or deliverable
• Have zero value at inception
• No counterpart risk (clearing house)
– Margin as performance guarantee
• Govt. regulates futures market
• Purchaser – long
• Seller - short
 Forward & Spot Prices
• The no arbitrage principle
– F=S x (1+rf)t
• Issues:
– No uniformity in Rf
– Nos. of hedgers Vs. arbitrageurs
 Option Contracts
• Right but no obligation to the buyer to
enter into a transaction involving an
underlying asset at a predetermined price
• Necessary obligation for seller to perform
if exercised by the buyer
• Buyer pays a premium upfront to the seller
of the option to acquire rights
• CASH or DELIVERY
 Basic Options
• Call Option:
– Right to purchase the underlying asset at
predetermined price during(at) the specific period
(date)
– American (European) Call
• Put Option:
– Right to sell the underlying asset at
predetermined price during(at) the specific period
(date)
– American (European) Put
• Index options – EUR; Stock options - AMR
 Option Combinations
• Long Call:
– The Buyer - has the right to buy the underlying asset
• Short Call:
– The Seller – has the obligation to sell the underlying
• Long Put:
– The Buyer - has the right to sell the underlying asset
• Short Put:
– The Seller – has the obligation to buy the underlying
 Swap Contracts
• Exchange of series of cash flows on periodic
settlement dates over a period
• No upfront payments – zero value at
inception
• Notional exchanged in currency swaps
• Customized, not traded in secondary markets
• Unregulated largely
• Counterparty risk exist
• Involves large institutions mostly
Swap Contracts
Examples
 Types of Swaps
• Currency
• Interest rate
• Equity
 Structured Notes
• STRIPS
– Zero coupon instruments extracted from
conventional bonds
• Collateralized Mortgage Obligation (CMOs)
– Banks → Securitization vehicles/agencies →
Investors (Tranches)
– Hedging of prepayment risk
• IO & PO CMOs
– Prepayment and interest rate risk
 Inverse Floaters
• Contract rates :
– (Reference – floating)
– Risk levered instruments
 Type of Traders
• Hedgers:
– Use Futures and Options

Scrip TATAMOTORS
No. of shares held 6000
Lot size 1500
Stock price (13 Jun 2018) 308.85
Contract expiry 28-Jun-18
Futures contract 309.2
Put Strike price 300
Option premium 4.1
 Type of Traders
• Speculators:
– Use Futures and Options
Scrip TATAMOTORS
No. of shares held 6000
Lot size 1500
Stock price (13 Jun 2018) 308.85
Contract expiry 28-Jun-18
Futures contract 309.2
Initial margin per share 2.75
Call Strike price 300
Call Option premium 13.3
• Arbitrageurs:
– Rf = 5%
 Overview of the Indian derivatives market
• Started in 1890s
• 1930- thriving in commodities
• 1952:
– the Forward Contract Regulation Act (1951) and
– the Securities Contract Regulation Act (1952)
• 1984- First swap deal for ONGC
• 1992 – Badla trades – Harshad Mehta Scam
• 2000- revival; Derivative trading - index futures on NSE
 Overview of the Indian derivatives market
• 2001- other equity market derivatives and
commodity futures
• 2003- Interest rate futures on G-secs (options
missing)
• 2008- currency futures (lot size $1000 cash settled
in INR)
• 2009- Bond futures
• 2010- currency options
 Growth the No. of contracts traded in India
Interest
Stock Currency Currency Volatility
Year Index Futures Stock Futures Index Options Rate
Options Futures Options Futures
Futures
2000 - 01 90580 -
2001 - 02 1025588 1957856 175900 1037529 -
2002 - 03 2126763 1067683 442241 3523062 -
2003 - 04 17191668 32368842 1732414 5583071 10781 -
2004 - 05 21635449 47043066 3293538 5045112 -
2005 - 06 58537886 80905493 12935116 5240776 -
2006 - 07 81487424 104955401 25157438 5283310 -
2007 - 08 156598579 203587952 55366038 9460631 -
2008 - 09 156484642 171422782 137949487 9190538 32672768 -
2009 - 10 178306889 145591240 341379523 14016270 160894 378606983 -
2010 - 11 165023653 186041459 650638557 32508393 3348 712181928 37420147 -
2011 - 12 146188740 158344617 864017736 36494371 215200 701371974 271972158 -
2012 - 13 96100385 147711691 820877149 66778193 12 684159263 275084185 -
2013 - 14 105270529 170414186 928565175 80174431 1502148 478301579 181890951 17546
2014 - 15 129303044 237604741 1378642863 91479209 20587036 355588963 125075731 11274
2015 - 16 140538674 234243967 1623528486 100299174 26056481 409759364 263823800 94
2016 - 17 66535070 173860130 1067244916 92106012 14807039 362615931 349835508 1
2017 - 18 57674584 214758366 1515034222 126411376 16186719 390433137 374530592 0
2018 - 19 69824522 255533869 2652457487 186986542 12764150 650024870 548359351 0
2019 - 20 94777881 257380338 4586692584 198377569 17661885 660128849 680133335 0
2020 - 21 127599626 252830922 7824035680 330394648 4800806 741484767 863602528 0
 Growth in turnover in INR (bn)
Currency Currency Volatility
Year Index Futures Stock Futures Index Options Stock Options
Futures Options Futures
2000 - 01 23.65
2001 - 02 214.83 515.15 12.99 13.0523
2002 - 03 439.52 2865.33 1.127 30.3397
2003 - 04 5544.46 13059.39 9.9148 80.5486
2004 - 05 7721.47 14840.56 23.5698 49.4895
2005 - 06 15137.55 27916.97 57.7052 48.9523
2006 - 07 25395.74 38309.67 176.5087 59.0431
2007 - 08 38206.6727 75485.6323 292.8609 135.8177
2008 - 09 35701.114 34796.4212 917.1558 82.5053 1622.7243
2009 - 10 39343.8867 51952.4664 1244.1658 152.7289 17826.0804
2010 - 11 43567.5453 54957.567 1926.3787 204.7497 32790.0213 1707.8559
2011 - 12 35779.9841 40746.7073 2530.6822 196.1293 33784.8892 12965.0098
2012 - 13 25271.3076 42238.7202 1843.8324 342.8856 37651.0533 15093.5932
2013 - 14 30831.0323 49492.8172 2440.9071 464.2841 29408.8592 10716.2754 21.9324
2014 - 15 41072.152 82917.6627 2653.1563 617.3259 22479.9234 7759.1532 22.5643
2015-16 45571.1364 78286.06 3512.2101 611.1839 27493.3296 17525.5262 0.1023
2016-17 43359.4078 111295.8714 3500.2153 955.7009 24897.7894 23672.9692 0.0009
2017-18 48104.5434 155975.1971 4606.5371 1482.175 25956.8567 24328.165 0
2018-19 55689.1447 161470.1086 6540.9995 2000.1031 46549.2735 38634.2417 0
2019-20 67010.7245 149195.5078 10825.1405 2290.3428 51163.3187 48477.5317 0
2020-21 90476.4565 180983.6539 26294.2605 5793.5162 59832.4232 64168.9651 0
 Countries Australia
Derivatives across Asia-Pacific
China Hong Kong India Japan Korea Singapore
Products
Index
Futures Yes No Yes Yes Yes Yes Yes
Options Yes No Yes Yes Yes Yes Yes
Options on Futures Yes No No No Yes No Yes

Stock
Futures Yes No Yes Yes No No Yes
Options Yes No Yes Yes Yes Yes No
Currency
Futures Yes No No Yes Yes Yes Yes
Options on Futures No No No No No Yes No

Interest Rate
Futures Yes No Yes Yes Yes Yes Yes
Options on Futures Yes No No No Yes No Yes

Bonds
Futures Yes No Yes No Yes Yes Yes
Options on Futures Yes No No No Yes Yes Yes

Commodities
Futures Yes Yes No No Yes Yes Yes
Options on Futures Yes No No No No No No