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BY- Amit Kumar Singh

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.

SCRA Act defines Derivatives as :


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.

Trading on derivatives initiated on


Commodities and no one knows when
it started trading, earlier it was OTC
( Over the Counter) in the form of
Forward Contracts.
Was there because of hedging
objective where long position holder
and short position holder use derivative
to fix future price uncertainty.

A one to one bipartite contract, which


is to be performed in future at the
terms decided today.
Eg: Jay and Viru enter into a contract
to trade in one stock on Infosys 3
months from today the date of the
contract @ a price of Rs4675/Note: Product ,Price ,Quantity & Time
have been determined in advance by
both the parties.

Liquidity risk: these contracts a biparty


and not traded on the exchange.
Default risk/credit risk/counter party
risk.
Say Jay owned one share of Infosys
and the price went up to 4750/- three
months hence, he profits by defaulting
the contract and selling the stock at
the market.

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
Exchange act like counterparty for
long and short position holder by
playing the concept of Novation

Both the long position holder and short


position holder need to deposit Initial
Margin to exchange depending upon
volatility of underlying in the market
Exchange follows MTM Settlement,
where every day closing price/rate is
compared with last day closing
price/rate and difference get
debited/credited from each position
holder account if-

Today closing price>Yesterday Closing


price, then today closing price-yesterday
Closing price get debited from short
position holder account and vice versa.
MTM Settlement is followed till any of
account touches Maintenance Margin
which is the threshold margin where the
account holder receives Margin Call to
continue the settlement

Derivative Market in India is divided


into 3 types of derivatives:a. Financial Derivative- Cash Settlement
b. Commodity Derivative- Physical
Settlement, Cash Settlement
c. Currency Derivative- Cash Settlement in
INR.
Final Settlement depends upon Exercise
price at the time of entry of contract
and maturity date closing price

In case of Commodities, short position


holder at the time of entering into future
contract need to deposit underlying in
the warehouse where the warehouse
receipt need to deposit into exchange.
At the time of expiration, warehouse
again access the underlying commodity
and figure out any deviation in
quality/quantity which then assigned to
required long position holder

Derivatives contracts trading in India and


their maturities are mentioned below;a. Financial Derivative- 1 month Contract,
2 month Contract, 3 month Contract.
Last Thursday of every month contracts
gets mature
b. Commodity Derivative- 1 month
Contract, 2 month Contract, 3 month
Contract. 20th of every month contracts
gets mature

c. Currency Derivative- Contracts


ranging from 1 month to 12 months
are available for trading where they
mature on the last day of each month
( settlement date) where last trading
day is 2 day before

Hedgers - Operators, who want to transfer a


risk component of their portfolio.

Speculators - Operators, who intentionally


take the risk from hedgers in pursuit of profit.

Arbitrageurs - Operators who operate in the


different markets simultaneously, in pursuit of
profit and eliminate mis-pricing.

Hedging: long security, sell future

Hedging: short security, long future

Speculation: bullish security, buy Futures

Speculation : bearish Security, Sell Futures

Arbitrage: overpriced Futures: buy spot, sell futures

Arbitrage: underpriced Futures: buy spot, sell futures

Derivative being considered as risk


minimization instrument is used by
hedger to fix the future price on which
transaction will happen in future

In forex market exporter expecting to


receive foreign currency will short,
importer expecting to pay foreign
currency will long on currency future

Concern that price can go up, individuals


will long, concern that price can go down
will short on Commodity/ Financial Future

Speculator go for naked position in


the market will leverage on market
by taking long position when
expecting to gain from bullish
behavior, will short on market when
expecting bearish behavior

Cash Settlement favors Speculative


activities in the market

Stock is chosen among top 500


stocks in term of market
capitalization and avg traded value in
previous 6 months on a rolling basis
Stock median quarter sigma order
size over the last 6 month should not
be less than 5 lakh
Market wide position limit on a stock
should not be less than 100 cr

For existing stocks to act like


derivative trading MWPL should not
be less than 60 crore, and stock
median quarter sigma order size shall
less than 2 lakh
For Index Derivative, 80% stocks in
the portfolio should be individually
eligible and no ineligible stock should
have weightage above 5%

Commission Broker- Follow client trading


and get commission for their services
Locals- or called proprietary trader who
trades for themselves
Scalpers- Follow short term trends and
generate profits from short term price
change
Position trader- go for Investment put
funds for longer period of time

Market Order-Request to execute trade


immediately at the current market price

Limit Order- Request to execute trade


immediately at the mentioned price,
when the trade is entered then it is
called active order otherwise it remain
outstanding as a passive order

Stop Loss- consist of limit price, trigger


price. Buying is activated when trigger
price touched and selling is done when
limit price is touched

Interest determined on Investment


can be calculated through Compound
Interest which works on the principle
of time value of money where we get
Interest on Interest
Continuous Compounding is a
derivative of Compound Interest
works on a principle that interest
changes per seconds so,
F=P((1+r)^n) becomes F=P*e^(r*n)

For Financial Assets with no income,

For Financial Assets with Income,


F=(S*e^(r*t1))-(I*e^(r*t2))
or F=(S-Present Value of Income)*e^(r*t)

For Commodity Assets,


F= (S+U)*e^(r*t) or F=S*e^((u+r)*t)

For Commodity Assets with convenience yield,


F= S*e^((r+u-y)*t)

For Currency , F=S*e^((rh-rf)*t)

F=S*e^(rt)

For Financial asset with dividend yield


or of Index Future
F=S*e((r-y)*t)

where, S= Spot Price, r= cost of financing,


t= time to expiration, u= storage cost,
rh= Interest rate on home country,
rf= Interest rate on foreign country
y=yield

If the contract does qualify as a


hedge, then the gains/losses are
generally recognized for accounting
purposes in the same period in which
gains or losses for the item being
hedged, then it is called hedge
accounting.

Prior to Finance Year 2005-06


transaction in Derivatives were
considered as speculative transaction
while after amendment in Sec 43(5)
transaction over recognized stock
exchange is not considered as a
speculative activities.
Loss on derivative transaction can be
carried forward to 8 assessment year
STT is 0.017% for sale of futures and
Options on securities

For long position holder,


a. f=S-k*e^(-rt).forward contract
with
no income
b. f=S-I-K*e^(-rt). forward contract
with
income
c. f=S*e^(-yt)-k*e^(-rt)..forward
contract with yield
Where k=delivery price

Currency always trade in pairs,


appreciation of one currency means
depreciation of another currency
Arbitration exists on currency when
Interest rate differential is not equal
to forward rate differential
FR differential= ((FR-SR)/SR)*(360/n),
Interest Rate differential=
((1+IRcountry1)/(1+IRcountry2))-1

If future price is above the spot price,


it is called Contango, if spot price is
above future price then it is called
Backwardation
Contango and Backwardation we use
frequently in Commodities Market,
Backwardation is the phenomenon
which happens because of
Convenience Yield, as physically
owing securities creates a value

Financial Stocks trading in Derivative


Market need to traded in Exchange in
minimum worth of 2 lakh rupees, so
in this basis SEBI has prescribed lot
sizes , means that much number
need to buy or in multiple to trade
over derivatives

Stock Prices
a. Above 1600
b. 801-1600
c. 401-800
d. 201-400
e. 101-200
f. 51-100
g. 25-50
h. Less than 25

Lot Size
125
250
500
1000
2000
4000
8000
10000

Open Interest is the total number of


future and option contracts that are not
closed or delivered on a particular day
Rising Market with high OI indicates
market is strong while high OI in
bearish market or low OI in bullish
market indicates weak market with
artificial demand may be creating only
for profit booking

Badlawas an indigenouscarryforwardsystem invented on


theBombay Stock Exchangeas a
solution to the perpetual lack
ofliquidityin thesecondary market
It was banned in 1993, then again
introduced in 1996 with carry forward
limit of 20 crore then again banned in
2001 with the introduction of Future
contracts

Badlatrading involved buying stocks


with borrowed money in thestock
exchangeacting as
anintermediaryat aninterest
ratedetermined by thedemandfor
the underlying stock and a
maturitynot greater than 70 days

The act of hedging ones position by taking an


offsetting position in another good with similar
price movements
Although the two goods are not identical, they
arecorrelated enough to create a hedged
position as long as the prices move in the same
direction. A good example is cross hedging a
crude oil futures contract with a short position
in natural gas. Even though these two products
are not identical, their price movements are
similar enough to use for hedging purposes.

In order to determine optimum number


of contracts need to short or long, hedge
ratio should be determined first
h=*(s/f)

h= hedge ratio,
=coefficient of correlation
s= standard deviation of underlying
asset
f= standard deviation of commodity use
for hedging

Number of contract need to short or


long = h*( size of underlying/value of
1 future -contract)
In the case of Financial Future,
Number of contract need to short or
long = beta*( size of underlying/value
of 1 future -contract)

Rolling the hedge forward holds good


when the hedge matures in the distant
point of time and all the future contract
are available at moment before their
expiry

This involves long or short positions after


every regular period of time till maturity
and closing them before maturity in case
of commodity or may at maturity date in
case of financial assets as they do not
involve physical settlement

Option is financial derivative


instrument giving right but no
obligation to long position holder to
follow the terms of contract in the
future by paying initial premium to
short position holder, while the short
position holder has the obligation to
follow what long position wants
him/her to follow

Initial Premium paid by long position


holder to the short position holder is
the maximum loss which long
position holder can bear, while the
initial premium received by short
position holder is the maximum profit
which short position holder can get.
While the max. profit for long position
holder is unlimited and maximum loss
for short position holder is unlimited

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/ predetermined 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 .Trade in
the option for stock.
Exercise Date: is the date on which
the option is actually exercised.
European style of options: The
European kind of option is the one
which can be exercised by the buyer
on the expiration day only & not
anytime before that.

American style of options: An


American style option is the one
which can be exercised by the buyer
on or before the expiration date, i.e.
anytime between the day of purchase
of the option and the day of its
expiry.

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.
Call option holder can be long position
holder, short position holder
Long call position holder are bullish on
underlying where they have right, while
short call holder are bearish on
underlying where they have obligation

Figure in next slide shows the illustration of


long call option at strike value of Nifty at 2250
by paying a premium of 86.60 . If Nifty closes
above 2250, long position will earn unlimited
profit however if Nifty closes below strike of
2250, then he lets the option expire and will
lose the premium of 86.60. Profit of long
position is the loss of short position holder
and vice versa

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
Long and short positions can be
taken on put options while long put
holder has the right while short put
holder has the obligation.
Long Put holder is bearish on market
while short put holder is bullish

Bullish on underlying- long call, short


put
When underlying price/rate increases
above strike price/rate then long call
holder will get unlimited profit however
short put holder will receive only
limited amount of initial premium.
Bearish on underlying- long put, short
call

In the Money Option- ITM options


leads to positive cash flow to the
holder if it is exercised immediately
At the Money Option- ATM options
leads to zero cash flow if it is
exercised immediately.
Out of Money Option- leads to
negative cash flow if it is exercised
immediately

Call Option Put Option


ITM
ATM
OTM

S>K
S=K
S<K

S= Spot Price
K= Strike Price

K>S
S=K
S>K

Premium
Highest
Lowest

Depending upon the difference


between spot price and strike price
options under call and put option can
be classified under ITM, ATM ,OTM and
upon expiration if any option expires
ITM will result into positive cash flow
Initial Premium paid by long position
holder to the short position holder also
depends upon ITM, ATM ,OTM options.

Intrinsic Value of Option at the given


time is the amount the holder will get if
he exercises the option at that time
For call=max(st-k,0), put=max(k-st,0)
Time value of Option=premium-Intrinsic
value
Payoff of long call=max( st-k,0)-p
Payoff of short call=p-max(st-k,0)
Payoff of long put=max(k-st,0)-p
Payoof of short put=p-max(k-st,0)

Stock price is the upper bound of call


option. For American call or European call
, c,C<=S
Lower bound for non dividend paying
European Option, c= S-k*e^(-r*t)
Lower bound for dividend paying
European Option, c>=S-D-k*e^(-r*t)
where c= Premium on European option
C= Premium on American option
D= Dividend, k= strike price

For European and American put option,


upper bound is p,P<=K
For Non dividend paying European
option lower bound is K*e^(-r*t)-S
For Dividend paying European option,
lower bound is K*e^(-r*t)+D-S
Put Call Parity, C+K*e^(-r*t)=S+P
Put Call parity with dividend,
C+D+K*e^(-r*t)=S+P

With no dividend(S-K)<=(C-P)<=(S-K*e^(-r*t))
With dividend
(S-K-D)<=(C-P)<=(S-K*e^(-r*t))
Stocks are tends to follow lognormal
distribution, % age change in stock
prices over the shorter period of time
are normally distributed

Lower bound of European call option


with dividend yield=(So*e^(-q*t))(k*e^(-r*t))
Lower bound of European put option
with dividend yield= (K*e^(-r*t))(So*e^(-q*t))
Put Call Parity, c+(k*e^(-r*t))=p+
(so*e^(-r*t))

For the valuation of Index Option and


Currency Option the same formula is
used which we use for European option
with dividend yield feature
Lower bound of Currency Call Option
=(So*e^(-rf*t))-(k*e^(-rh*t))
Lower bound of Currency put option=
(K*e^(-rh*t))-(So*e^(-rf*t))
Put Call Parity, c+(k*e^(-rh*t))=p+
(so*e^(-rf*t))

Where, rh=Interest rate in home country


rf= Interest rate in foreign
country
q= dividend yield
Index Options are cash settled option
which are basically European option
deriving their value as a multiple of 100
or 50 where the payoff of long holder is
p, 100 or 50*((max(Final Index-Strike
Index),0)

(s/s)=( *t, *((t)^0.5))


Continuous Compounding pattern when
follows lognormal distribution has a
mean of (-(^2/2), standard deviation
of (/((t^(.5)))
where = expected return
= standard deviation
Volatility per annum= Volatility per
trading day*(number of trading day pa)

Function N(x) is the cumulative


probability distribution function for a
standardized normal distribution
= expected volatility on stock also
called implied volatility
For dividend paying stocks, we make
changes in BSM Model where s*=spresent value of dividends, instead of
So in BSM formula we will use s*

Insurance against the price fall


Have a OTM or ATM long put along
with buying position on a stock
In order to save himself from
unexpected volatility when investors
are short on a stock, investor for
hedging take OTM long call ultimately
deriving the payoff of
long put

Covered Call is taken when investor


is neutral to moderately bullish on
stock while Covered put is taken
when investor is pessimistic on a
stock but not expecting much
movement

Long combo or zero cost derivative is


taken when investor is bullish on
movement
Combination of OTM long call+ OTM
short put
If taken at a same strike price it leads
to payoff of a long forward contract

Expecting high volatility in any side


Combination of long call+ long put at
the same strike price
Combination of long call+ long put at
the same strike price
Combination of OTM long call+ OTM
long put

Adopt by the investor when are


expecting not much movement in
market. Gain premium by the silent
movement in the market as long
position holder does not exercise the
contract
Combination of short call+ short put at
same strike price in short straddle
Combination of OTM short call+ OTM
short put in short strangle

Use when investor is moderately bullish


Combination of ITM long call+ OTM short
call or lower strike price OTM long put+
higher strike price OTM short put
Objective is to minimize the initial
cost( initial premium) through short call
or short put but that reduce the upside
unlimited profit to limited profit

Combination of ITM long put+ OTM


short put or OTM long call+ ITM short
call

Conservatively bearish on the market

Taken when investor is expecting very


little movement in the stock/index.
Investor is looking to gain from low
volatility at low cost.
Long butterfly spread= 1 ITM long
call+ 2 ATM short call+ 1 OTM long call
Long Condor=1 ITM long call+ 1 short
call (lower middle)+ 1 short call
( higher middle) + 1 OTM long call

Strategy for volatile market


Short butterfly spread= 1 ITM short
call+ 2 ATM long call+ 1 OTM short
call
Long Condor=1 ITM short call+ 1
long call (lower middle)+ 1 long call (
higher middle) + 1 OTM short call

An agreement between two parties to


exchange one set of cash flows for
another. In essence it is a portfolio of
forward contracts.
While a forward contract involves one
exchange at a specific future date, a
swap contract entitles multiple
exchanges over a period of time.
The most popular are interest rate
swaps and currency swaps.

LIBOR

Fixed Rate of
12%
Rs50,00,00,000.00 Notional Principle
A is the fixed rate receiver and
variable rate payer.
B is the variable rate receiver and

The only Rupee exchanged between the


parties are the net interest payment, not
the notional principle amount.
In the given eg A pays LIBOR/2*50crs to
B once every six months. Say LIBOR=5%
then A pays be 5%/2*50crs= 1.25crs
B pays A 12%/2*50crs=3crs
If interest rates decline fixed rate payer
is at a loss, If interest rates rise variable
rate payer is at a loss and vice versa

There are four types of basic currency swaps:


fixed for fixed.
fixed for floating.
floating for fixed.
floating for floating.

Typically, the Notional Principal is


exchanged at the swaps initiation
and termination dates.

An agreement to pay 1% on a
Japanese Yen principal of
1,040,000,000 and receive 5% on a
US dollar principal of $10,000,000
every year for 3 years.

At initiation
A

$10,000,000

Party A

1,040,000,000

Party B

At each annual settlement date:

Party A

$500,000

Party B

10,400,000
At maturity:

$10,000,000

Party A

Party B
1,040,000,000

Tenor is three years. NP1 = 1,040,000,000 yen, and r1 = 1%


fixed in yen. NP2 = $10,000,000, and r2 = 6 month $-LIBOR
(floating). Settlement dates are every 6 months, beginning 6
months hence.

On the origination date, 6 month LIBOR is 5.5%.

Assume that subsequently, 6 mo. LIBOR is:


Time
6 mo. LIBOR
0.5 5.25%
1.0 5.50%
1.5 6.00%
2.0 6.20%
2.5
6.44%

6-month
time
0.0
0.5
1.0
1.5
2.0
2.5
3.0

LIBOR
5.50%
5.25%
5.50%
6.00%
6.20%
----

Fixed rate
Floating rate
Payment
Payment
$10MM
1,040MM
5.2MM
$275,000
5.2MM
$262,5001
5.2MM
$275,000
5.2MM
$300,000
6.44% 5.2MM
$310,000
5.2MM
$322,000
1,040MM
$10MM

Credit derivatives are derivative


instruments that seek to trade in
credit risks.
Basically there are 3 types of Credit
derivative instruments:a. Credit Default Swap
b. Credit Spread Option
c. Credit linked Notes

Credit default swaps allow one party to "buy"


protection from another party for losses that
might be incurred as a result of default by a
specified reference credit (or credits).

The "buyer" of protection pays a premium for


the protection, and the "seller" of protection
agrees to make a payment to compensate
the buyer for losses incurred upon the
occurrence of any one of several specified
"credit events."

Suppose Bank A buys a bond which


issued by a Steel Company. To hedge
the default of Steel Company: Bank A
buys a credit default swap from
Insurance Company C. Bank A pays a
fixed periodic payments to C, in
exchange for default protection.

A credit spread option grants the buyer the right, but


not the obligation, to purchase a bond during a
specified future exercise period at the
contemporaneous market price and to receive an
amount equal to the price implied by a strike spread stated
in the contract.

Credit Spread is the different between the yield on the


borrowers debt (loan or bond) and the yield on the referenced
benchmark such as U. S. Treasury debt of the same
maturity. An investor may purchase from an insurer an option
to sell a bond at a particular spread above LIBOR
Credit spread. If the spread is higher on the exercise date, then
the option will be exercised. Otherwise it will lapse.

A credit-linked note (CLN) is essentially a funded


CDS, which transfers credit risk from the
note issuer to the investor.

The issuer receives the issue price for each


CLN from the investor and invests this in low-risk
collateral.

If a credit event is declared, the issuer sells the


collateral and keeps the difference between the
face value and market value of the reference
entitys debt.

If we refer to the Steel company case again.


Bank A would extend a $1 million loan to the
Steel Company.
At same time Bank A issues to institutional
investors an equal principal amount of a creditlinked note, whose value is tied to the value of the
loan.
If a credit event occurs, Bank As repayment
obligation on the note will decrease by just
enough to offset its loss on the loan.

Thank
You