INTRODUCTION TO DERIVATIVES

BY: NILIMA DAS

GOLD CONTENT:50gms

AGREEMENT Date:1st Jan 2008 Three month after words I will sell to Mr. BISWO 50 gm 22ct gold @14,000 per 10gm. Signature

Define a derivative?
A derivative is an instrument whose value is derived from, and therefore, depends upon, the value of some underlying asset or factor.

What kind of underlying assets are derivatives generally available on?

Common underlying assets for derivatives are: Equity Shares Equity Indices Debt Market Securities Interest Rates Foreign Exchange Commodities Derivatives themselves etc.

Differentiate between Exchange-traded and over-the-counter derivatives Exchange-traded derivatives are contracts that trade on an organized exchange. Contracts can be bought and sold any time the exchange is open. The contracts have standardized terms set by the exchange or the clearinghouse. Prices are publicly available.

Differentiate between Exchange-traded and over-the-counter derivatives

Over-the-counter derivatives result from agreements between two parties. The parties can negotiate contract terms that are mutually acceptable. Contracts can be terminated only with the agreement of the other party. Prices are not available

Players in the derivatives market?

Hedgers Speculators Arbitrageurs

HEDGER
A hedge is a position taken in futures for the purpose of reducing exposure to one or more types of risk. The hedging strategy can be undertaken in all the markets like futures, forwards, options, SWAP etc.

SPECULATOR
Speculators use derivatives to bet on the future direction of the markets. Their objective is to gain when the prices move as per their expectation. 3 types based on duration i. SCALPERS hold for very short time (in minutes) ii. DAY TRADERS- one trading day iii.POSITION TRADERS- long period (week, month, a year).

ARBITRAGEURS
Arbitrageurs try to make risk-less profit by simultaneously entering in to transactions in two or more market. Arbitrageurs assist in proper price discovery and correct price abnormalities.

What role does each person play in the derivatives market?

Speculators provide liquidity and volume to the market. Hedgers provide depth. Arbitrageurs assist in proper price discovery and correct price abnormalities. Speculators are willing to take risks. Hedgers want to give away risks (generally to the speculators

Types of derivatives
Standardised derivatives Exotic derivatives

Types of derivatives
Standardised derivatives are as specified by exchanges and have simple standard features. These are also called vanilla derivatives or plain vanilla derivatives. Exotic derivatives have many non-standard features, which might appeal to special classes of investors. These are generally not exchange traded and are structured between parties on their own.

Standardised derivatives
Futures Options Swaps

Exotic derivatives
FORWARD CONTRACT

Forward contracts
A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. .

Essential features of a forward contract---- Contract between two parties (without any exchange between them) Price decided today Quantity decided today (can be based on convenience of the parties) Quality decided today (can be based on convenience of the parties) Settlement will take place sometime in future (can be based on convenience of the parties) No margins are generally payable by any of the parties to the other

Essential features of a forward contract---- They are bilateral contracts and hence exposed to counter-party risk. Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality. The contract price is generally not available in public domain. On the expiration date, the contract has to be settled by delivery of the asset.

Limitations of forward markets

Lack of centralization of trading Illiquidity Counterparty risk

Futures
Futures markets were designed to solve the problems that exist in forward markets . A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. But unlike forward contracts, the futures contracts are standardized and exchange traded.

Futures-- 1. 2. To facilitate liquidity in the futures contracts, the exchange specifies certain standard features of the contract . The standardized items in a futures contract are: Quantity of the underlying Quality of the underlying A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. More than 99% of futures transactions are offset this way

Essential features of a Futures contract

Contract between two parties through an exchange Exchange is the legal counterparty to both parties Price decided today Quantity decided today (quantities have to be in standard denominations specified by the exchange) Quality decided today (quality should be as per the specifications decided by the exchange)

Essential features of a Futures contract

Tick size- the minimum amount is decided by the Exchange. Striking price- the price of the underlying asset specified in the contract.(delivery price) Delivery will take place in future &expiry date is specified by the exchange. Margins are payable by both the parties to the exchange the price limits can be decided by the exchange

Distinction between futures and forwards

Forwards OTC in nature Futures Trade on an organized exchange Customized contract Standardized contract terms terms Hence less liquid Hence more liquid No margin payment Requires margin payments Settlement happens Follows daily settlement at end of period

Do Futures suffer from any limitation?

Futures suffer from lack of flexibility. Suppose you want to buy 103 shares of Satyam for a future delivery date of 14th February, you cannot. The exchange will have standardized specifications for each contract. Thus, you may find that you can buy Satyam futures in lots of 1,200 only. You may find that expiry date will be the last Thursday of every month.

Thus, while forwards can be structured according to the convenience of the trading parties involved, futures specifications are standardized by the exchange.

What is the meaning of expiry of Futures?

Futures contracts will expire on a certain prespecified date. In India, futures contracts expire on the last Thursday of every month. For example, a February Futures contract will expire on the last Thursday of February. In this case, February is referred to as the Contract month. If the last Thursday is a holiday, Futures and Options will expire on the previous working day. On expiry, all contracts will be compulsorily settled. Settlement can be effected in cash or through delivery.

What does Cash Settlement mean?

Cash Settlement means settlement by payment/receipt in cash of the difference between the contracted price and the closing price (spot price) of the underlying on the expiry day.

In the Cash settled system, you can buy and sell Futures on stocks without holding the stocks at any time. For example, to buy and sell Futures on Satyam, you do not have to hold Satyam shares

What does Delivery based Settlement mean?

In Delivery based Settlement, the seller of Futures delivers to the Buyer (through the exchange) the physical shares, on the expiry day. For example, if you have bought 1,200 Satyam Futures at Rs 250 each, then you will (on the day of expiry) get 1,200 Shares of Satyam at the contracted Futures price of Rs 250. It might happen that on the day of expiry, Satyam was actually quoting at Rs 280. In that case, you would still get Satyam at Rs 250, effectively generating a profit of Rs 30 for you.

What is the Current System in India?

Currently in India 99.9% Futures transactions are settled in Cash. It is widely expected that we will move to a physical delivery system soon. However, Index based Futures and options will continue to be based on Cash Settlement system.

How many month Futures are available at any point of time?

Exchanges have currently introduced three series in Futures and Options. For example during the month of February on any day on or before last Thursday, you will find three Series available viz. February, March and April. The February Series will expire on the last Thursday of February. On the next working day, the May Series will open. Thus, on a rolling basis, three Series will be made available

Futures: Concluding Remark

In a forward or futures contract, the two parties have committed themselves to doing something. It costs nothing except margin requirements) to enter into a futures contract

Options
Options are fundamentally different from forward and futures contracts. An option gives the holder of the option the right to do something (right to sale or right to buy). The purchase of an option requires an up-front payment called premium. Option contract adjust your position according to any situation that arises.

Option terminology
Buyer of an option: The buyer of a call/put option is the one who by paying the option premium, buys the right . Writer of an option: The writer of a call/put option is the one who by receives the option premium , sale the right.

Other Option terminology

Option price/premium: Option price is the price which the option buyer pays to the option seller. It is also referred to as the option premium. Expiration date: The date specified in the options contract is known as the expiration date, the exercise date, the strike date or the maturity. Strike price: The price specified in the options contract is known as the strike price or the exercise price.

What type of Options are available?

Call Options Put Options.

What are Call Options?

Call Options give the buyer the right to buy a specified underlying at a set price on or before a particular date. For example, Satyam 260 Feb Call Option gives the Buyer the right to buy Satyam at a price of Rs 260 per share on or before the last Thursday of February. The price of 260 in the above example is called the strike price or the exercise price.

What are Put Options?

Put Options give the buyer the right to sell a specified underlying at a set price on or before a particular date. For example, Satyam 260 Feb Put Option gives the Buyer the right to sell Satyam at a price of Rs 260 per share on or before the last Thursday of February.

Style of option contract- American style European style

Two basic styles of options

American options: American options are options that can be exercised at any time up to the expiration date. Most exchange-traded options are American .

European options: European options are options that can be exercised only on the expiration date itself.

Swaps
Swaps are the contracts between two to exchange cash flows in the future as prespecified.

Two commonly used swaps

Interest rate swaps Currency swaps

Interest rate swaps

These entail swapping only the interest related cash flows between the parties in the same currency.

Currency swaps
These entail swapping both principal & interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction.

INFORMATION
NSE,s is the largest derivative exchange in India. Currently, the derivatives contracts have a maximum of 3-months expiration cycle. Three contracts are available for trading, with 1 month, 2 months, & 3 months expiry.& a new contract is introduced on the next trading day following the expiry of the near month contract. Future trading commenced first on Chicago Board of Trade. The first exchange traded financial derivative in India commenced with the trading of Index futures. BASIS= the difference between a future price & cash price (spot price) of the asset is known as the basis.

 LONG POSITION- One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. SHORT POSITION-The other party assumes a short position and agrees to sell the asset on the same date for the same price.

 SHORT SELLING- short selling involves selling securities you do not own. Means borrows the security from another client & sells them in the market. PAY OFF- the losses as well as profits for the buyer and the seller of a futures contract are known as pay-off.

Forward Contracts
The specified price for the sale is known as the delivery price, we will denote this as K. Note that K is set such that at initiation of the contract the value of the forward contract is 0. As time progresses the delivery price doesnt change, but the current spot (market) rate does. Thus, the contract gains (or loses) value over time. Consider the situation at the maturity date of the contract. If the spot price is higher than the delivery price, the long party can buy at K and immediately sell at the spot price ST, making a profit of (ST-K), whereas the short position could have sold the asset for ST, but is obligated to sell for K, earning a profit (negative) of (K-ST).

Forward Contracts
Example: Lets say that you entered into a forward contract to buy wheat at $4.00/bushel, with delivery in December (thus K=$4.00.) Lets say that the delivery date was December 14 and that on December 14th the market price of wheat is unlikely to be exactly $4.00/bushel, but that is the price at which you have agreed (via the forward contract) to buy your wheat. If the market price is greater than $4.00/bushel, you are pleased, because you are able to buy an asset for less than its market price. If, however, the market price is less than $4.00/bushel, you are not pleased because you are paying more than the market price for the wheat. Indeed, we can determine your net payoff to the trade by applying the formula: payoff = ST K, since you gain an asset worth ST, but you have to pay $K for it. We can graph the payoff function:

Forward Contracts
Payoff to Futures Position on Wheat Where the Delivery Price (K) is $4.00/Bushel
4 3

Payoff to Forwards

2 1 0 -1 -2 -3 -4 Wheat Market (Spot) Price, December 14 0 1 2 3 4 5 6 7 8

Forward Contracts
Example: In this example you were the long party, but what about the short party? They have agreed to sell wheat to you for $4.00/bushel on December 14. Their payoff is positive if the market price of wheat is less than $4.00/bushel they force you to pay more for the wheat than they could sell it for on the open market. Indeed, you could assume that what they do is buy it on the open market and then immediately deliver it to you in the forward contract. Their payoff is negative, however, if the market price of wheat is greater than $4.00/bushel. They could have sold the wheat for more than $4.00/bushel had they not agreed to sell it to you. So their payoff function is the mirror image of your payoff function:

Forward Contracts
Payoff to Short Futures Position on Wheat Where the Delivery Price (K) is $4.00/Bushel
4 3

Payoff to Forwards

2 1 0 -1 -2 -3 -4 Wheat Market (Spot) Price, December 14 0 1 2 3 4 5 6 7 8

Forward Contracts
Clearly the short position is just the mirror image of the long position, and, taken together the two positions cancel each other out:

Forward Contracts
Long and Short Positions in a Forward Contract For Wheat at $4.00/Bushel
4 3 2 1

Short Position Long Position

0 1 2 3 4 5 6 7 8

Payoff

0 -1 -2 -3 -4 Wheat Price

Net Position

Valuing a Forward Contract

No storage costs: gold Price set so that initial value of contract is zero. How is this possible? Gold, one year hence sale contract. Let current price is = $400, interest rate = 10% Suppose: forward price = $450 Strategy: "Buy the asset now"

Now: Borrow funds Buy gold

Net cash flow One year later: Deliver gold at contract price Pay off loan Net cash flow Risk?

+400 -400 _______ 0

+450 -440 +10

Suppose: Forward price =$420, Let current price is = $400, interest rate = 10%. Buy contract. Strategy: "Sell the asset now" Now: Short gold in cash market Invest funds in 10% loan Net cash flow One year later: Buy gold at contracted price Deliver on short position Receive payment on loan Net cash flow Risk? - 420 + 440 + 20 +400 -400 _______ 0

PRICING FUTURE
Calculation of fair value of a contract.(Cost-of- carry logic method)F = Sert Where F= fair value, S= spot price, e= 2.71828, t= time till expiration in years, r= cost of financing or interest rate. Q- security XYZ ltd trades in the spot market at Rs. 1150. money can be invested at 11% p.a.. Calculate the fair value of a one-month futures contract of XYZ .? F= Sert

1150 * e0.11*1/12 = 1160

Types of future contract

Index future (stock) Index future (bond) Cost of living index future Interest rate currency Foreign currency

INDEX DERIVATIVE
INDEX
Indexes have been used as information sources. by looking at an index , we know how the market if fairing. Index movements reflect the changing expectations of stock market about future dividends of the corporate sectors. Index goes up, if the stock market thinks that the prospective dividends in future will be better & vise-versa. Example: Suppose an index contains two stocks, A and B. A has a market capitalization of Rs.1000 crore and B has a market capitalization of Rs.3000 crore. Then we attach a weight of 1/4 to movements in A and 3/4 to movements in B.

INDEX DERIVATIVE
Index derivatives are derivative contracts which derive their value from an underlying index. Most popular index derivative are- index future & index option. Stock index being an average, is much less volatile than individual stock price. Index derivatives are cash setteled, hence do not suffer from forged/fake certificates.

FUTURE INDEX
Stock index future is an index derivative that draws its value from an underlying stock index like Nifty or Sensex Futures contracts have linear payoffs. In simple words, it means that the losses as well as profits for the buyer and the seller of a futures contract are unlimited.

Major Stock index futures

Stock Exchange Name Korean Stock Exchange Simex Osaka Stock Exchange
Chicago Mercantile Exchange

Index Future Contract KOSPI 200 Nikkei Stock Average Nikkei 300 S&P 100 NYSE Composite

Hong Kong Future Exchange Hang Seng

New york Future Exchange

More on Index Future

A stock index future contract gives the buyer (seller) the right and obligation to buy sell) the portfolio of stock represented by the index. The settlement is in cash mode.

Why physical delivery not possible?

The reason for non-existence of physical delivery is that it would be impractical for a trader to deliver all the stocks in exactly the same proportion as they make up the index.

Index Future in India

BSE Underlying SENSEX Contract Multiplier 50 Trading Cycle Near,Next,Far Tick size 0.05 index point Expiry Date Last Thursday Final Settlement Cash NSE NIFTY 200 Near,Next,Far 0.05 index point Last Thursday Cash

Settlement in Index Future

MTM Settlement Final Settlement

MTM Settlement--- All future contracts are marked to market to the daily settlement price at the end of each day. The traders who incurred a loss are required to pay the MTM loss amount in cash, which in turn is passed on to those traders who have made an MTM gain.

---MTM Settlement
Once the daily settlements are worked out ,all the open positions are reset to the daily settlement price and they become the open position for the next day. On NSE, the daily settlement price or MTM settlement price is calculated as the last half an hour weighted average price of the contract .

Final Settlement for Futures

After the trading on expiry day ends, all positions are settled by marking the contract to final settlement price and the resulting profit/loss is settled in cash. Final settlement price is the closing price of relevant underlying index/security in cash market ,on the last trading day of the contract. The closing price of the underlying index/security is the last half an hour weighted average value.

Why Buy Index Futures

Leverage trading Ease of short-selling

1. Leverage trading- trading that does not require you to pay the full amount of the position. Allow to leverage the difference. 2. Ease of short selling means making profit in a short while. short selling involves selling securities you do not own.

Payoff for buyer of future index: Long futures

Take the case of a speculator who buys a two month Nifty index futures contract when the Nifty stands at 2220. The underlying asset is- Nifty portfolio.

When the index moves up, the long futures position starts making profits, and when the index moves down it starts making losses. Payoff diagram for a buyer of Nifty futures-

Payoff for seller of future index: Short futures

a speculator who sells a two-month Nifty index futures contract when the Nifty stands at 2220. The underlying asset is - Nifty portfolio.

When the index moves down, the short futures position starts making profits, and when the index moves up, it starts making losses

Payoff for a seller of Nifty futures

BOND INDEX
Like stock, these are based on bond indices. Exa- US municipal bond index traded on Chicago Board of Trade (CBOT).

FOREIGN CURRENCY FUTURE

Here underlying asset is foreign currency started in early 1970s.

Interest rate future

Started in 1975 . Here trading is made on interest bearing securities. Underlying asset- treasury bill, notes, bonds, debentures, Euro-dollars, municipal bonds.

COST OF LIVING INDEX FUTURE OR INFLATION FUTURES

Based on specific cost of living index. Exa- consumer price index (CPI) whole sale price index (WPI)

Options Contracts
Options on stocks were first traded in 1973. There are two basic types of options: A Call option is the right, to buy the underlying asset by a certain date for a certain price.

A Put option is the right, to sell the underlying asset by a certain date for a certain price.

Note that unlike a forward or futures contract, the holder of the options contract does not have to do anything - they have the option to do it or not.

Options Contracts
The date when the option expires is known as the exercise date, the expiration date, or the maturity date. The price at which the asset can be purchased or sold is known as the strike price. If an option is said to be European, it means that the holder of the option can buy or sell (depending on if it is a call or a put) only on the maturity date. If the option is said to be an American style option, the holder can exercise on any date up to and including the exercise date.

New terminology (option) In-the-money option:

An in-the-money (ITM) option is an option that would lead to a positive cashflow to the holder if it were exercised immediately. A call option on the index is said to be in-the-money when the current index stands at a level higher than the strike price (i.e. spot price >strike price). If the index is much higher than the strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the strike price.

At-the-money option:
An at-the-money (ATM) option is an option that would lead to zero cash-flow if it were exercised immediately. An option on the index is at-the-money when the current index equals the strike price(i.e. spot price = strike price).

Out-of-the-money option
An out-of-the-money (OTM) option is an option that would lead to a negative cashflow if it were exercised immediately. A call option on the index is out-of-the-money when the current index stands at a level which is less than the strike price (i.e. spot price < strike price). If the index is much lower than the strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the index is above the strike price.

Intrinsic value of an option

The option premium can be broken down into two components intrinsic value and time value. Intrinsic value is the payoff if the option were to be exercised immediately. Intrinsic value is always greater than or equal to zero. For example, a certain asset is trading for $30. The intrinsic value of a $25 call is therefore $5.

Time value of an option

The time value of an option is the difference between its premium and its intrinsic value. Both calls and puts have time value.

Option Contracts Defined

Question 1:
An option gives the holder...
A. the obligation to buy the underlying asset. B. the right to sell the underlying asset. C. the obligation to buy or sell the underlying asset. D. the right to buy or sell the underlying asset.

Option Contracts Defined

Question 1: Answer D
An option gives the holder...
A. the obligation to buy the underlying asset. B. the right to sell the underlying asset. C. the obligation to buy or sell the underlying asset. D. the right to buy or sell the underlying asset.

Option Contracts Defined

Question 2:
What is the difference between an American option and a European option?
A. An American option is traded on American exchanges, while European options are traded on European exchanges. B. An American option is written on an the assets of an
American company, while a European option is written on the assets of a European company.

C. An American option can only be exercised at expiration,

while a European option can be exercised at anytime up to expiration.

D. An American option can be exercised at anytime up to

expiration, while a European option can be exercised only at expiration.

Option Contracts Defined

Question 2: Answer D
What is the difference between an American option and a European option?
A. An American option is traded on American exchanges, while European options are traded on European exchanges. B. An American option is written on an the assets of an
American company, while a European option is written on the assets of a European company.

C. An American option can only be exercised at expiration,

while a European option can be exercised at anytime up to expiration.

D. An American option can be exercised at anytime up to

expiration, while a European option can be exercised only at expiration.

Examples Of More Sophisticated Derivatives

Barrier Options Compound Options Options On Futures Swap Options or Swaption

Barrier Options
A type of option whose payoff depends on whether or not the underlying asset has reached or exceeded a predetermined price. A barrier option is a type of exotic option. It can be either a knock-in or a knock-out. Are exotic options that are traded , not on stock exchanges but over-the counter (OTC), in finance banks For example, if you believe that IBM will go up this year, but are willing to bet that it won't go above $100, then you can buy the barrier and pay less premium than the vanilla option.

barrier is triggered when the option is in the money (i.e. above spot for a call, or up and in and below spot for a put or down and in. example- A European call option may be written on an underlying with spot price of $100, and a knockout barrier of $120. This option behaves in every way European call, except if the spot price ever moves above $120, the option "knocks out" and the contract is void. Note that the option does not reactivate if the spot price falls below $120 again.

IN/OUT
IN / knock-in Options start worthless and are activated when asset price reaches the predetermined barrier level OUT/ knock-out Options start active and canceled or become null and void in the event that the barrier value is breached

Compound Options
A compound option is simply an option on an option. The exercise payoff of a compound option involves the value of another option. A compound option then has two expiration dates and two strike prices.

 There are four types of these options:

Call on a call. Call on a put. Put on a call. Put on a put.

Swap Options or Swaption

An option on a swap, usually an interest rate swap. The agreement will specify whether the buyer of the swaption will be a fixed-rate receiver (like a call option on a bond) or a fixed-rate payer (like a put option on a bond).

SPREADS
The difference in pricing among two relative contracts. A spread trading strategy can be constructed by taking a position in two or more options at the same type. That means combining two or more calls or two or more puts at same time.

VERTICAL BULL SPREAD This is one popular strategy. One buy a call option at a certain strike price. Sell a call option at a higher price of same stock. The asset choosen is having same expiry date. The investor pay the premium while buying. The investor receives the premium while selling option. So the investment by trader is the difference in two price Max. loss= lower premium to receive- higher premium to pay Max profit= higher strike price- lower strike price-net premium paid Break even price= lower strike price+net premium paid.

Bearish vertical spread

This will give profit, when there is a decline in price of underlying asset. Here the trader purchase one option at higher strike price Selling one option at relatively lower strike price having same expiration date. Max.profit= premium on selling option at lower strike price-premium on buying at higher strike price. Max. loss= higher strike price-lower strike price-net premium earned. Break even price= higher strike price-net premium earned.

Butterfly spread

Means a position in options with different strike price. The investor purchase a call option with a relative low strike price(x1) & high strike price(X3) & selling two call options in between (X2).

DIAGONAL SPREAD

A combination of one option trading which involves taking positions of several horizontal (call, put), vertical (bull, bear) spread where both expiration dates & strike prices are differ.

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