DERIVATIVES

DERIVATIVE
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.
In the Indian context the securities contracts (Regulation)Act, 1956(SC(R)A) defines Derivative to include :
A security derived from a debt instrument ,share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security. A contract which derives its value from the prices, or index of prices, of underlying securities.

What are Derivatives ?

A financial contract of pre-determined duration, whose value is derived from

the value of an underlying asset such as : Securities commodities bullion precious metals currency livestock index such as interest rates, exchange rates

What do derivatives do?

Derivatives attempt either to minimize the

loss arising from adverse price movements of the underlying asset Or maximize the profits arising out of favorable price fluctuation. Since derivatives derive their value from the underlying asset they are called as derivatives.

Types of Derivatives (UA: Underlying Asset)

Based on the underlying assets derivatives

are classified into.

Financial

asset Commodity Derivatives where UA: gold, silver, brass etc Index Derivative where eg. BSE sensex

Derivatives where UA : Financial

How are derivatives used?

Derivatives are basically risk shifting instruments. Hedging is the most important aspect of derivatives and also their basic economic purpose Derivatives can be compared to an insurance policy. As one pays premium in advance to an insurance company in protection against a specific event, the derivative products have a payoff contingent upon the occurrence of some event for which he pays premium in advance.

Derivative Instruments
Forward contracts Futures Commodity Financial (Stock index, interest rate & currency )

Options Put Call Swaps Interest Rate Currency

Forward Contracts
A one to one contract, which is to be performed in future

at the terms decided today.

Eg: Amrit and Ritu enter into a contract to trade in one

stock on Infosys 3 months from today the date of the contract @ a price of Rs 500/Note : Product ,Price ,Quantity & Time have been determined in advance by both the parties.

Delivery and payments will take place as per the terms of

this contract on the designated date and place. This is a simple example of forward contract.

Risks in a forward contract

Liquidity risk: these contracts a biparty and not traded on the exchange. Default risk/credit risk/counter party risk. Say Amrit owned one share of Infosys and the price went up to 550/- three months hence, she profits by defaulting the contract and selling the stock at the market.

Forward Exchange Contract

This particular derivative is used to hedge the Direct Exposure in foreign Exchange due at a future date. An example for Forward Exchange Contract is that an importer has to import certain raw material and that the importer desires to fix the Exchange Rate so that he can arrive at the costing of the finished product. He can achieve this by booking a Forward Exchange Contract whereby he fixes the Exchange Rate at which he can buy the Foreign Currency at a future date. Thus, the importer achieves the desired result without affecting his balance sheet or without using capital till the actual payment date. This derivative is OTC traded product and the important condition in this type of product is that the actual delivery of the underlying takes place on the maturity. We have similar type of products in all financial segments other than Foreign Exchange.

Forward Rate Agreement

This product is very similar to the Interest Rate Swap, which is for a longer duration. However, the Forward Rate Agreement is a derivative product, which is generally for a short duration, say up to 24 months. A borrower needs to borrow certain sum of funds from the market for certain period of time after some time but he desires to fix his cost today itself. The borrower can achieve this by buying a FRA and shall fix his interest liability today itself without waiting for the day when he is to actually borrow in the market. This product too is OTC product. The actual delivery of interest rates does not take place but the difference in the movement in rates is only settled.

Futures
Future contracts are organized/standardized contracts in terms of quantity, quality, delivery time and place for settlement on any date in future. These contracts are traded on exchanges. These markets are very liquid In these markets, clearing corporation/house becomes the counter-party to all the trades or provides the unconditional guarantee for the settlement of trades i.e. assumes the financial integrity of the whole system. In other words, we may say that the credit risk of the transactions is eliminated by the exchange through the clearing corporation/house.

The key elements of a futures contract are:

Futures price Settlement or Delivery Date Underlying (infosys stock)

Illustration
Take the earlier example where Amrit and Ritu entered into a contract to buy and sell Infosys shares. Now, assume that this contract is taking place through the exchange, traded on the exchange and clearing corporation/house is the counter-party to this, it would be called a futures contract.

Positions in a futures contract

Long - this is when a person buys a futures contract, and agrees to receive delivery at a future date. Eg: Ritus position
Short - this is when a person sells a futures contract, and agrees to make delivery. Eg: Amrits Position

How does one make money in a futures contract?

The long makes money when the underlying assets price rises above the futures price.

The short makes money when the underlying assets price falls below the futures price.

Options
An option is a contract giving the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An option is a security, just like a stock or bond, and is a binding contract with strictly defined terms and properties.

Options Lingo
Underlying: This is the specific security / asset on which an options contract is based.

Option Premium: Premium is the price paid by the buyer to the seller to acquire the right to buy or sell. It is the total cost of an option. It is the difference between the higher price paid for a security and the security's face amount at issue. The premium of an option is basically the sum of the option's intrinsic and time value.

 Strike Price or Exercise Price :price of an option is

the specified/ pre-determined price of the underlying asset at which the same can be bought or sold if the option buyer exercises his right to buy/ sell on or before the expiration day

Expiration date: The date on which the option expires

is known as Expiration Date

Exercise: An action by an option holder taking

advantage of a favourable market situation actually exercised.

Exercise Date: is the date on which the option is

Call option: An option contract giving the owner the right to buy a specified amount of an underlying security at a specified price within a specified time Put Option: An option contract giving the owner the right to sell a specified amount of an underlying security at a specified price within a specified time

In-the-money: For a call option, in-themoney is when the option's strike price is below the market price of the underlying stock. For a put option, in the money is when the strike price is above the market price of the underlying stock. In other words, this is when the stock option is worth money and can be turned around and exercised for a profit.

Intrinsic Value: The intrinsic value of an option is defined as the amount by which an option is inthe-money, or the immediate exercise value of the option when the underlying position is marked-tomarket

For a call option: Intrinsic Value = Spot Price Strike Price For a put option: Intrinsic Value = Strike Price - Spot Price

Positions
Long Position: The term used when a person owns a security or commodity and wants to sell. If a person is long in a security then he wants it to go up in price.
Short position: The term used to describe the selling of a security, commodity, or currency. The investor's sales exceed holdings because they believe the price will fall.

Warrants
Apart from the commonly used short-dated options which have a maximum maturity period of 1 year, there exists certain long-dated options as well, known as Warrant (finance). These are generally traded over-the-counter.

Swaps
are contracts to exchange cash (flows) on or before a specified future date based on the underlying value of currencies exchange rates, bonds/interest rates commodities exchange, stocks or other assets. Another term which is commonly associated to Swap is Swaption which is basically an option on the forward Swap. Similar to a Call and Put option, a Swaption is of two kinds: a receiver Swaption and a payer Swaption. While on one hand, in case of a receiver Swaption there is an option wherein you can receive fixed and pay floating, a payer swaption on the other hand is an option to pay fixed and receive floating.

Interest Rate Swap

This derivative product is used to hedge the Interest Rate Risk in the Financial Markets. In an Interest Rate Swap, the inflow of interest and outflow of interest is exchanged. However, this product is also used to reduce the costs. The example for this product is that a company has a long term borrowing at a fixed rate of interest. However, the company expects the rate of interest to soften during the currency of the borrowing. To get the benefit of the falling interest rate scenario, the company can undertake an Interest Rate Swap wherein the company pays to the other counterparty floating interest rate and receives fixed interest. The fixed interest rate, which the company receives from counterparty, shall be paid to the lender of the company to service the interest. Thus, the fixed rate borrowing is converted into floating interest rate borrowing. This product be is OTC traded. The actual inflow and outflow of interest amount takes place.

Currency Swap
This derivative product is used when the user intends to change the interest liability from one currency to another currency. This product is a hybrid of the Forward Exchange Contract and Interest Rate Swap. This is also known as "Cross Currency Interest Rate Swap". This derivative product can be explained by an example where a Company can borrow in GBP at competitive rate whereas the company has to import in USD. It could be done by undertaking a conversion of GBP to USD but the company has regular inflow of USD by which he can service the interest in USD. Thus, to hedge his exposure in GBP interest liability he can undertake Currency Swap where he receives GBP interest and pays USD interest. The GBP interest received from the counterparty shall service the company's interest liability on its GBP borrowing whereas USD interest outflow will be serviced by its regular USD inflows. In a Currency Swap, the principals are normally exchanged at the beginning and at the termination of Swap. In effect, a Currency Swap creates a notional asset and a notional liability. On the notional assets, the interest is received whereas the interest is paid on the notional liability. This derivative product is also OTC traded product. Both the parties settle the actual interest inflows and outflows.

The overall derivatives market has five major classes of underlying asset:
Interest rate derivatives (the largest) Foreign exchange derivatives Credit derivatives Equity derivatives Commodity derivatives

An Interest rate derivative is a derivative where the underlying asset is the right to pay or receive a notional amount of money at a given interest rate. These structures are popular for investors with customized cash flow needs or specific views on the interest rate movements (such as volatility movements or simple directional movements) and are therefore usually traded OTC; see financial engineering.
The interest rate derivatives market is the largest derivatives market in the world. The Bank for International Settlements estimates that the notional amount outstanding in June 2009 were US$437 trillion for OTC interest rate contracts, and US$342 trillion for OTC interest rate swaps. According to the International Swaps and Derivatives Association, 80% of the world's top 500 companies as of April 2003 used interest rate derivatives to control their cash flows. This compares with 75% for foreign exchange options, 25% for commodity options and 10% for stock options. A Foreign exchange derivative is a financial derivative where the underlying is a particular currency and/or its exchange rate. These instruments are used either for currency speculation and arbitrage or for hedging foreign exchange risk.

Credit Derivative
A credit derivative is a legal contract between two parties that provides for the transfer of risk on some extension of credit (such as bond or other loan) A lender anticipates receiving interest and principal from borrower. Credit risk stems from the fact ;that sometimes the borrower is unable (or unwilling) to comply with the terms of loan. With the creation of Credit Derivative, one party (the protection seller) essentially sells credit risk protection to other party (protection buyer) A Credit Derivative; is the over the counter derivative, so the parties ;involved determine mutually agreed terms. The simple form of credit derivative is a guarantee, the protection seller agrees to step ;in and make good on a contract in the event of default by borrower. The guarantee often takes the form of a total return swap ;in which protection seller guarantees a certain return to the protection buyer in exchange of some premium.

EQUITY DERIVATIVES
Equity options Equity options are the most common type equity derivative. They provide the right, but not the obligation, to buy (call) or sell (put) a quantity of stock (1 contract = 100 shares of stock), at a set price (strike price), within a certain period of time (prior to the expiration date). Warrants In finance, a warrant is a security that entitles the holder to buy stock of the company that issued it at a specified price, which is much lower than the stock price at time of issue. Warrants are frequently attached to bonds or preferred stock as a sweetener, allowing the issuer to pay lower interest rates or dividends. They can be used to enhance the yield of the bond, and make them more attractive to potential buyers. Convertible bonds Convertible bonds are bonds that can be converted into shares of stock in the issuing company, usually at some pre-announced ratio. It is a hybrid security with debt- and equity-like features. It can be used by investors to obtain the upside of equity-like returns while protecting the downside with regular bond-like coupons. Equity futures, options and swaps Investors can gain exposure to the equity markets using futures, options and swaps. These can be done on single stocks, a customized basket of stocks or on an index of stocks. These equity derivatives derive their value from the price of the underlying stock or stocks. Stock market index futures Stock market index futures are futures contracts used to replicate the performance of an underlying stock market index. They can be used for hedging against an existing equity position, or speculating on future movements of the index. Indices for futures include well-established indices such as S&P, FTSE, DAX, CAC40 and other G12 country indices. Indices for OTC products are broadly similar, but offer more flexibility. Equity basket derivatives Equity basket derivatives are futures, options or swaps where the underlying is a non-index basket of shares. They have similar characteristics to equity index derivatives, but are always traded OTC (over the counter, i.e. between established institutional investors), as the basket definition is not standardized in the way that an equity index is. These are used normally for correlation trading.

Single-stock futures Single-stock futures are exchange-traded futures contracts based on an individual underlying security rather than a stock index. Their performance is similar to that of the underlying equity itself, although as futures contracts they are usually traded with greater leverage. Another difference is that holders of long positions in single stock futures typically do not receive dividends and holders of short positions do not pay dividends. Single-stock futures may be cash-settled or physically settled by the transfer of the underlying stocks at expiration, although in the United States only physical settlement is used to speculation in the market.... Equity index swaps An equity index swap is an agreement between two parties to swap two sets of cash flows on predetermined dates for an agreed number of years. The cash flows will be an equity index value swapped, for instance, with LIBOR. Swaps can be considered as being a relatively straightforward way of gaining exposure to an asset class you require. They can also be relatively cost efficient. Equity swap An equity swap, like an equity index swap, is an agreement between two parties to swap two sets of cash flows. In this case the cash flows will be the price of an underlying stock value swapped, for instance, with LIBOR. A typical example of this type of derivative is the Contract for difference (CFD) where one party gains exposure to a share price without buying or selling the underlying share making it relatively cost efficient as well as making it relatively easy to transact. Exchange-traded derivatives Other examples of equity derivative securities include exchange-traded funds.

APPENDIX

Contract Types
UNDERLYING

Exchangetraded futures
Single-stock future

Exchangetraded options
Single-share option Option on Eurodollar future

OTC swap

OTC forward Back-to-back Repurchase agreement

OTC option Stock option Warrant

Equity

Equity swap

Eurodollar Interest rate future

Interest rate swap

Forward rate agreement

Interest rate cap and floor Swaption

Credit

Bond future

Credit default Option on Bond swap future Option on Currency swap currency future Weather derivatives Commodity swap

Repurchase agreement Currency forward Iron ore forward

Credit default option Currency option Gold option

Foreign exchange Commodity

Currency future WTI crude oil futures

DIFFERENCE BETWEEN FUTURES & OPTIONS

FUTURES OPTIONS

Futures contract is an agreement to buy or sell specified quantity of the underlying assets at a price agreed upon by the buyer and seller, on or before a specified time. Both the buyer and seller are obliged to buy/sell the underlying asset.

In options the buyer enjoys the right and not the obligation, to buy or sell the underlying asset.

Unlimited upside & downside for both buyer and seller.

Limited downside (to the extent of premium paid) for buyer and unlimited upside. For seller (writer) of the option, profits are limited whereas losses can be unlimited.

Futures contracts prices are affected mainly by the prices of the underlying asset

Prices of options are however, affected by a)prices of the underlying asset, b)time remaining for expiry of the contract and c)volatility of the underlying asset.

Call Option Option Buyer

Buys the right to buy the underlying asset at the Strike Price Has the obligation to sell the underlying asset to the option holder at the Strike Price

Put Option
Buys the right to sell the underlying asset at the Strike Price Has the obligation to buy the underlying asset from the option holder at the Strike Price

Option Seller

REFERENCES
1. S&P CNX Nifty Futures 2. S&P CNX Nifty Options 3. Futures on Individual Securities 4. Options on Individual Securities 5. www.wikipedia.com 6. www.investopedia.com

Thank you