INTRODUCTION TO FINANCIAL DERIVATIVES

Presented By Arjun Parthasarathy 28th June 2006

Introduction
Derivatives are synthetic instruments They derive value from an underlying asset class Asset classes range from financial instruments to commodities to even classes such as weather and industrial effluents However the common underlying theme of derivatives is that they are leveraged products Derivatives are not always priced at respective asset value (fair value)

Derivative Market
The derivative market has its own dynamics Though the value of the derivative is derived, the market can and does move in complete tangent to the underlying asset class This is because the participants in the derivative market do not always hold positions in the underlying instrument and have different intentions on their positions

Derivative Positions and Types of Derivative Market Players

Naked open position taking a directional call on the markets Hedge against underlying asset class Arbitrage position within an asset class Speculators Hedgers Arbitrageurs

Underlying Asset Class

It is important to understand the underlying asset class before using derivatives Asset classes can be classified into two broad categories- financial which includes currencies and commodities Financial asset classes can be broadly categorised into interest rates, equities and currencies Commodities range from agricultural commodities to minerals and metals

Financial Asset Classes Broadly categorised into equity, interest rates and currencies Equity as an asset class will include single stocks and equity indices Interest rates as an asset class will include government bonds, government bond benchmarks and money market benchmarks. Currencies as an asset class will include currency pairs such as USD/INR, USD/JPY etc Credits as defined by corporate bonds can also be categorised into financial assets and derivatives on them are called credit derivatives

Equity Derivatives
Equity derivatives can be classified into single stock derivatives and index derivatives Single stock derivatives are derivatives on specific stocks eg. Reliance Index derivatives are derivatives on stock exchange indices eg- nifty Hybrid derivatives on equity include convertible shares (partly or fully) Employee stock options are also equity derivatives

Interest Rate Derivatives

Interest rate derivatives have many different types Derivatives on government bonds Derivatives on bond indices/ benchmark Derivatives on short term money market benchmarks Examples are bond futures and interest rate swaps based on benchmarks such as libor/ mibor

Currency Derivatives
Currency derivatives are based on currency pairs Currency forwards and options egUSD/INR forwards and options Currency derivatives are combined with interest rate derivatives to offer exotics Exotics include principle only swaps, currency swaps

Exchange Traded and OTC Derivatives

Derivatives traded on an exchange such as NSE are exchange traded derivatives Derivatives not traded on exchange are over the counter derivatives eg- Overnight index swaps (OIS) Exchange traded derivatives are standardised in contract size, settlement, maturity OTC derivatives can be structured to suit different needs Equity and bond derivatives are usually exchange traded while interest rate swaps, currency derivatives and exotics are usually OTC derivatives

Derivative Exchanges
Derivative exchanges are separate from stock exchanges In US CBOT and CME are the largest exchanges for derivatives In UK LIFFE is the premier derivative exchange In India NSE is the largest equity derivative exchange while commodity exchanges are NCDEX and MCX What are the derivative exchanges in Japan and Singapore?

Exchange Traded and OTC Derivatives- Compare and Contrast

Exchange traded derivatives are standardised contracts while OTC derivatives can be both standardised and customised The exchange takes on settlement risk in exchange traded derivatives while OTC derivatives counterparty risk is present Margin system is followed by exchanges while OTC derivatives do not usually follow margining system

Compare and Contrast Continued

Exchange traded derivatives can be accessed by retail and institutional investors while OTC derivatives is typically traded within institutions Exchange traded derivatives come under regulatory purview while many OTC derivatives are outside the purview of regulators More examples? Hints- Liquidity, price discovery,

Hedging or Leveraging
Derivatives are viewed as a hedging instrument The holder of an underlying asset can hedge fluctuations in prices of the asset using derivatives However derivatives are increasingly being used for taking up leveraged positions in an underlying asset This enables higher returns for taking on higher risk

Derivatives in India
The structured derivative market in India is relatively new (about 7 years old) However derivatives have caught the fancy of the market and exchange traded equity and commodity derivatives are vibrant Interest rate derivatives have not taken off on an exchange platform though the OTC market for Interest rate derivatives is active Currency derivatives are dominated by currency forwards though options are starting to come of age at present

Equity Derivatives in India

Equity index futures are the most widely traded futures contract while single stock futures on the whole contribute to a larger percentage of the traded volumes Equity index options are the most widely traded options contract in the exchange FIIs are very active in the equity derivative markets in India Retail presence is also high in the equity derivative market

Interest Rate and Currency Derivatives in India

The market for Overnight Index Swaps (OIS) is the most active is the most active interest rate derivative OIS is based on the overnight call money benchmark, NSE Mibor Other interest rate derivatives include swaps on government bond benchmarks Currency derivatives is dominated by forward market though options are picking up

Homework
What are most active derivative exchanges in USA, UK, Japan, Singapore, Germany and India What are the three most active contracts traded in these exchanges What is the volume (average monthly volumes over the last one year) in USD Billion in these exchanges What are the volumes (average monthly volumes) in Nifty index futures, Nifty index options, single stock futures and single stock options in the NSE over the last one year in USD Billion

Introduction to Futures
Futures are essentially deferred spot contracts Spot is the immediate delivery for settlement of a bond or stock Futures are purchase or sale contracted for settlement for a later date Futures are exchange traded derivatives Forwards are the OTC version of futures Futures are traded on margin

 Futures give ability to leverage positions Futures can also lead to large gains or losses without any floor or ceiling How? An example If I buy 10 contracts of Nifty index near month futures at Rs 2900 For every 1 point move in the index I stand to lose or gain Rs 1000 (10*100) If index falls 100 points, then I have lost Rs 100,000. My investment for 10 contracts was Rs 400,000 (margin money)

Futures

Futures
Future contracts have maturities ranging from one month to one year or more In India futures contracts have a maximum tenor of three months Future price and spot price converge on settlement date Futures are marked to market on a daily basis and settlement of mark to market profit or loss is also on a daily basis Futures can be cash settled or settled by physical delivery- In India futures are cash settled

Pricing of Futures
Futures should theoretically trade at a fair price The fair price is the price adjusted for cost of carry for delivery at a later date The cost of carry is the interest cost on the amount actually paid for an asset on a spot purchase Cost of carry is adjusted for any dividends receivable in case of equities Cost of carry = Interest cost over period expected dividend yield The fair price of a future contract is always at a premium to the spot price

Introduction to Options
Options give the right but not the obligation to buy or sell an asset at a future date Options are either call or put options Call options give the holder the right to buy an asset at a future date Put options give the holder the right to sell an asset at a future date

Options
Options can be American or European American options allow the buyer to exercise the option before expiry date European options give the buyer the right to exercise the option only on expiry date Index options in India are European options while stock options are American options

Options
Options protect downside risk to the buyer The buyer of the option limits losses to the premium paid on the purchase of the options Eg. If I buy a nifty 2900 put at Rs 34, my loss is limited to Rs 34 while gain potential is limitless If the price goes above Rs 2900 I do not exercise the option limiting my loss to the premium paid

Options
Options have a buyer and a writer The option writer receives premium for giving the buyer the right but not the obligation to sell an asset at a future date The option writer is not protected on the downside risk Option writers have to settle mark to market profit or loss on a daily basis Options can be cash settled or settled by physical delivery Options in India are cash settled

Option Pricing
Black Scholes formula is the most widely used for pricing options The factors going into the pricing of options are the share price(S), time to expiry (t), risk free rate of interest r, and risk of underlying asset measured by standard deviation or volatility These are also called the greeks as changes in any one of these variables affect the option price Options contracts can be classified into out of the money, at the money and in the money

The Greeks
Delta is the change in option price to the change in the underlying Gamma is the rate at which an options delta changes as the price of the underlying changes Theta is the time decay factor and is the rate at which option loses value as time passes Vega or Kappa is the change in option price to change in the volatility of the option Rho is the change in value of option to change in interest rates

Interest Rate Swaps

Interest rate swaps are derivatives that exchange cash flows from fixed to floating or floating to fixed An example is the Overnight Index Swaps (OIS), the floating rate benchmark being the NSE Mibor The payer of OIS pays fixed rate while receiving the floating rate or mibor The receiver of an OIS receives fixed rate while paying the floating rate

Currency Forwards
Currency forwards are the most widely used currency derivatives The currency forwards are basically futures contracts where the payers or receivers of forwards contract to buy or sell a currency pair at a future date The prices are determined by the cost of carry that is the interest payable on paying or receiving forwards

Equity Derivatives in India

Nifty index futures are the highest traded contracts Single stock futures are actively traded for arbitrage Nifty index options are also traded actively Single stock options do not trade actively

Traded Volumes in NSE F&O

Total Traded Volume Rs crores
30000 25000 20000 15000 10000 5000 0 6/19/2006 6/20/2006 6/21/2006 6/22/2006 6/23/2006 Total Index Futures Stock Futures Index Options Stock Options

Nifty Index Futures

19-Jun-06 Nifty Futures Spread Over Spot Points 20-Jun-06 21-Jun-06 22-Jun-06 23-Jun-06 -9.1 -26.8 -15.5 -11 9

Nifty Index Futures 29h June 2006 Series Spread betwee n future price and spot price Rs -4.00 9.00

Open Interest '000* 16-Jun-06 23-Jun-06 27685 28767

Change in Open Interest over the week -4.51% 3.91%

Price of future contract Rs 2909 3065

Change over the week % 2.97% 5.36%

Nifty Index 2913 3056

4.91%

*Includes July series open interest

Factors to Study in Nifty Futures

Open interest Traded volumes as % to total derivative volumes Basis spread Movement of spread Roll overs Calendar Spreads

Nifty Index Options

Optio n Type CE CE CE Price as on 16th June 2006 Rs 38 68 111 Price as on 23rd June 2006 Rs 39 93 176 Open Interest as on 16th June 2006 '000 1021 1592 1075 Open Interest as on 23rd June 2006 '000* 1400 2230 1439 Change in price over week % 2.63% 36.76% 58.56%

Symbol NIFTY NIFTY NIFTY

Expiry Date 29-Jun06 29-Jun06 29-Jun06 29-Jun06 29-Jun06 29-Jun06 29-Jun06

Strike Price 310 0 300 0 290 0 300 0 290 0 280 0 270 0

Change in Open Interest over week '000

379.00 638.00 364.00

NIFTY
NIFTY NIFTY NIFTY

PE
PE PE PE

160
106 65 38

34
16 7 3

1044
545 1033 815

1560
1577 1724 1039

-78.75%
-84.91% -89.23% -92.11%

516.00
1032.00 691.00 224.00

Factors to Study in Nifty Options

Changes in price Open interest Implied Volatility Put call parity

Single Stock Futures

Spread betwee n futures price and spot price as of 16th June 2006 Points -2.70 -2.60 -2.85 -11.3 -5.45 Spread between futures price and spot price as of 23rd June 2006 Points 3.00 1.80 0.75 -0.95 1.8

Open Interes t as of 16th June 2006 '000* Reliance Sterlite Reliance Capital Tata Motors Tata Steel 29-Jun06 29-Jun06 29-Jun06 29-Jun06 29-Jun06 10191 7862 3575 3333 6073

Open Interes t as of 23rd June 2006 '000* 11734 9931 3851 3505 7353

Chang e in open interest over week % 15.14% 26.32% 7.72% 5.16% 21.08%

Price as of 16th June 2006 Rs 929 355 433 719 467

Price as of 23rd June 2006 Rs 1016 401 516 780 520

Chang e in price over week % 9.36% 12.96 % 19.17 % 8.48% 11.35 %

Change in spread over week Points 5.70 4.40 3.60 10.35 7.25

Factors to Study in Single Stock Futures

Open interest Basis Spread Cost of carry Volumes Top traded single stock futures

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