Derivatives

market
Group Members
Mitul Miyani -72
Priyanka Kapila -54
Ramya Iyer -39
Vishal Gupta-36
Sejal Hethwadia -37
What is a Derivative?
The term Derivative stands for a contract whose
price is derived from or is dependent upon an
underlying asset.
The underlying asset could be a financial asset
such as currency, stock and market index, an
interest bearing security or a physical commodity.
As Derivatives are merely contracts between two
or more parties, anything like weather data or
amount of rain can be used as underlying assets.
Need for Derivatives
The derivatives market performs a number of
economic functions. They help in :
Transferring risks
Discovery of future as well as current prices
Catalyzing entrepreneurial activity
Increasing saving and investments in long run.
Participants in Derivative
markets
Hedgers use futures or options markets to
reduce or eliminate the risk associated with price
of an asset.

Speculators use futures and options contracts to

get extra leverage in betting on future
movements in the price of an asset.

Arbitrageurs are in business to take advantage

of a discrepancy between prices in two different
markets.
What is OTC (Over the
counter)??
Over the Counter (OTC) derivatives are those
which are privately traded between two parties
and involves no exchange or intermediary.

Non-standard products are traded in the so-called

over-the-counter (OTC) derivatives markets.

The Over the counter derivative market consists

of the investment banks and include clients like
hedge funds, commercial banks, government
sponsored enterprises etc.
Exchange Traded
Derivatives Market
A derivatives exchange is a market where
individuals trade standardized contracts that have
been defined by the exchange.

A derivatives exchange acts as an intermediary to

all related transactions, and takes initial margin
from both sides of the trade to act as a guarantee.
 Classification of
Derivatives
OTC (Over the
Future Contracts counter ) trading
Forward Contracts
Options
Swaps Exchange Traded
Derivatives

OTC Exchange Traded

Rupee Interest Rate Forward Rate Interest Rate futures
Derivatives agreements, Interest
rate Swaps
Foreign Currency Forwards, Swaps, Currency Futures
Derivatives Options
Equity Derivatives Index Futures, Index
Options, Stock futures,
Stock options
 Basic Terminologies
Spot Contract: An agreement to buy or sell an asset
today.
Spot Price: The price at which the asset changes hands
on the spot date.
Spot date: The normal settlement day for a transaction
done today.
Long position: The party agreeing to buy the underlying
asset in the future assumes a long position.
Short position: The party agreeing to sell the asset in
the future assumes a short position
Delivery Price: The price agreed upon at the time the
contract is entered into.
 Forward Contract
A forward contract is a customized contract
between two parties to buy or sell an asset at a
specified price on a future date.
A forward contract can be customized to any
commodity, amount anddelivery date.
A forward contract settlement can occur on a cash
or delivery basis.
Forward contracts do not trade on a centralized
exchange and are therefore regarded as over-the-
counter (OTC) instruments.
Example
Suppose that Bob wants to buy a house a year from
now. At the same time, suppose that Andy currently
owns a $100,000 house that he wishes to sell a year
from now. Both parties could enter into a forward
contract with each other. Suppose that they both
agree on the sale price in one year's time of $104,000
At the end of one year, suppose that the current
market valuation of Andy's house is $110,000. Then,
because Andy is obliged to sell to Bob for only
$104,000, Bob will make a profit of $6,000. To see why
this is so, one needs only to recognize that Bob can
buy from Andy for $104,000 and immediately sell to
the market for $110,000. Bob has made the difference
in profit. In contrast, Andy has made a potential loss of
$6,000, and an actual profit of $4,000.
 Futures Contract
Futures contract is a standardized contract between two
parties to exchange a specified asset of standardized
quantity and quality for a price agreed today with delivery
occurring at a specified future date.

Since such contract is traded through exchange, the purpose

of the futures exchange institution is to act as intermediary
and minimize the risk of default by either party.

There is an expiry date for all Futures Contracts. As in India,

All the future contracts are expired on every month last
Thursday.

Thus the exchange requires both parties to put up an initial

amount of cash, the margin.
 Concept of Margin
In thefuturesmarket,marginrefers to the initial
deposit of "good faith" made into an account in order
to enter into afutures contract.

Thismarginis referred to as good faith because it is

this money that is used to debit any day-to-day losses.

The exchange will draw money out of one party's

margin account and put it into the other's so that each
party has the appropriate daily loss or profit.

Thus on the delivery date, the amount exchanged is

not the specified price on the contract but the spot
value.
Example
Suppose you buy NIFTY future contract with a lot size of
50 on 1st February 2016 of one month expiry at Rs.
7200.
This means that future contract will get expire on 25th
February 2016 (last Thursday of the Month).
Margin required to buy the future contract is around
11%; which means to buy the future contract you will
require Rs.39,600 (Rs.7200 * 50 (lot size) * 11%).
If NIFTY moves 50 points upside and reaches to 7250;
which means that you are making profit of Rs.2,500 (50 *
50 (lot size).
You can sell the future contract even before expiry. If you
sell with rise of 50 points in future market, then you are
making Rs.2,500 as a profit out of it.
 Options
An option is a derivative financial instrument that
specifies a contract between two parties for a
future transaction on an asset at a reference
price.

The buyer of the option gains the right, but not

the obligation, to engage in that transaction,
while the seller incurs the corresponding
obligation to fulfill the transaction.
 Some Terminologies
Call Option: Right but not the obligation to buy
Put Option: Right but not the obligation to sell
Option Price: The amount per share that an
option buyer pays to the seller
Expiration Date: The day on which an option is
no longer valid
Strike Price: The reference price at which the
underlying may be traded
Long Position: Buyer of an option assumes long
position
Short Position: Seller of an option assumes
short position
Option Pay Off
 Option Styles
European option an option that may only be
exercised on expiration.

American option an option that may be

exercised on any trading day on or before expiry.

Bermudan option an option that may be

exercised only on specified dates on or before
expiration.
Swaps
An agreement between two parties to exchange a series
of cash flows over a specific period of time
Swaps are customized contracts that are traded in the over-
the-counter (OTC) market between private parties
There is always the risk of a counterparty defaulting on the
swap.
The types of Swaps are:
Interest rate swaps
Currency swaps
Commodity swaps
Equity Swap
Credit default swaps
 Interest Rate Swaps
The most common and simplest swap is a "plain vanilla" interest rate
swap
In this swap, Party A agrees to pay Party B a predetermined, fixed
rate of interest on a notional principal on specific dates for a
specified period of time.
Concurrently, Party B agrees to make payments based on a floating
interest rate to Party A on that same notional principal on the same
specified dates for the same specified time period.
In a plain vanilla swap, the two cash flows are paid in the same
currency. The specified payment dates are called settlement dates,
and the time between are called settlement periods.
Because swaps are customized contracts, interest payments may be
made annually, quarterly, monthly, or at any other interval
determined by the parties.
 Interest Rate Swaps example
For example, on Dec. 31, 2006, Company A and Company B enter into a five-
year swap with the following terms:
Company A pays Company B an amount equal to 6% per annum on a notional
principal of $20 million.
Company B pays Company A an amount equal to one-year LIBOR + 1% per
annum on a notional principal of $20 million.
At the end of 2007, Company A will pay Company B $20,000,000 * 6% =
$1,200,000. On Dec. 31, 2006, one-year LIBOR was 5.33%; therefore,
Company B will pay Company A $20,000,000 * (5.33% + 1%) = $1,266,000.
Normally, swap contracts allow for payments to be netted against each other to
avoid unnecessary payments. Here, Company B pays $66,000, and Company
A pays nothing.

Figure 1: Cash flows for a plain vanilla interest

Thank You !!