Derivative Contracts

..the instrument for future trading.

 Meaning

 The word Derivative originates from

mathematics and refers to a variable whose
value is derived from another variable.

 They have no value of their own. They derive

their value from value of some other asset,
which is known as the ‘underlying asset.’
 Concept of Underlying asset

 Unlike an equity share which has its value because of its

goodwill, demand and supply factors of its shares etc.
the value of the derivative is arrived from the value of
some other asset i.e., underlying asset.

 For example- A derivative of the share of Infosys, will

derive its value from the share price of Infosys.
Hence here the underlying asset for derivative contract
for Infosys will be share of Infosys.
 Derivative Contract-
Derivative contracts are specialized
contract which signify an agreement or an
option to buy or sell the underlying asset up
to a certain time in future at a pre-
arranged price.
Such contracts has a fixed period mostly in
the range of 3-12 months from the date of
commencement of contract.
 Example of Derivative contract-

 A farmer fears that at the time of delivery of crop…

Cost of production – Rs.5000/ ton

To avoid uncertainty,
Farmer enters into a derivative contract with a merchant,
who agrees to buy the wheat @ Rs.6000/ ton. (Exercise
Price) at end of 3 months ( Expiry period).
Now at the expiry of the contract,

the contract becomes valuable for farmer as he can sell

Wheat for Rs.6000/ ton, even though the
Current market price is much more lower ( Rs.4000).

 Hence we say,
the value of the derivative contract depends on the
value of the underlying asset.
 Types of Derivative contracts –

Derivative
Contracts

Trading Nature

Forwards

Over The Counter Options

(OTC) Futures

Exchange Traded
 Forward Contracts
 It is an agreement between two parties whereby
one party agrees to buy from, or sell to the other
party an asset at a future time for an agreed price.
 Parties can be individuals, corporate, or financial
institutions.
 A forward contract is settled by delivery of the
asset by seller to the buyer against respective
payment.
Example -
 ‘A’ agrees to buy 10 gms of Gold from ‘B’ after
90 days for Rs.1000/ gm.

Hence, at the end of 90 days ‘A' would buy gold

for Rs.10000 from ‘B’.
 Now, at the end of 90 days,
CASE 1- Market price of Gold becomes Rs.1200/ gm.

(overall gain of Rs.2000 to ‘A’)

Here ‘A’ would make gain of Rs.200/ gm.

‘B’ will lose Rs.2000.
CASE 2- Market price of Gold becomes Rs.700/ gm.

(overall gain of Rs.3000 to ‘B’)

Here ‘A’ would lose Rs.300/ gm.
‘B’ would gain Rs.3000.
 Futures Contract
 Gives the holder the option to buy or sell underlying at
prespecified price in future date.
 All exchange traded forward contracts are called
as future contract.
 Standardized contracts
 Traded on specified exchanges like BSE & NSE.
 Terms / Prices of the contract cannot be negotiated.
 Two types :-
(a) Equity Index Future
(b) Equity Stock Future.
Equity Index Futures
1.Underlying asset is an
Equity Index. E.g. Sensex, Nifty
2. Mode of settlement-
Payment of difference between
the price as agreed in the
contract and the value of index on
the maturity date.
Equity Stock Future
1. Underlying asset is an security
E.g. Shares of TCS Ltd.
2. Mode of settlement-
(a) Delivery of shares
(b) By receipt/payment of
difference between contract
price & value of security on
maturity date.
Example- Equity Index Future

On the settlement date, price of BSE Index is 3500/ unit, then…

price of BSE INDEX is 2700/ unit, then..

Example - Equity Stock Futures
 Mr.A enters Equity Stock Futures of L&T to buy 1000 shares
of Rs.200/ shares…

On settlement date,

(a) Mr.A will have purchase 1000 shares ( Delivery settled) OR

(b) By payment/ receipt of the difference between the contract price
of Rs.200/ share & the current price of L&T as on that date.

If CMP is Rs.250/ share then Mr.A will receive Rs.50/ Share

If CMP is Rs.180/ share then Mr.A will have to pay Rs.20/share

 Options
 An option is a type of derivative instrument whereby a person
gets the right to buy or sell the underlying asset on or before
the specified future date.

 The person is not under any obligation to do so.

For example,
An option on a piece of property gives the buyer the
right, but not the obligation, to purchase the property
during a stated period of time at a stipulated price.
If the buyer decides to exercises his option to purchase,
the seller is obligated to turn over the property at the
agreed upon price.

 An option, which is left unexercised, expires worthless after a

stated period of time.
Important concepts of Options
 Option premium –
In order to acquire the right of option, the buyer / holder pays to
the seller / writer fee which is known as the option premium, that
is the price paid for the right.
 Option holder / Option buyer –
The buyer of the option is the person who pays the option
premium upfront and buys the right, but not the obligation, to
exercise his option against the writer of the option. (seller)
 Option writer / Option seller –
The seller of an option is the person who sells the right of
exercising the option to the buyer and receives and option
premium upfront in return and is thereby obliged to buy / sell the
underlying asset if the buyer exercises his option.
 Strike price –
It is also called as exercise price.
Denotes the price at which the buyer of the option has a right to
purchase or sell the underlying asset.
This price is a fixed number and does not change during the life
of the option.

 Expiration date -
All options have specified date of maturity known as expiration
date.
Options expire on the last Thursday of the expiry month.
If last Thursday trading holiday contract expires on
previous trading day.
 Maximum 3 months trading cycle..
Near month ( 1st month )
Next month ( 2nd month )
Far month ( 3rd month )

On expiry of the near month contract new contracts are introduced

at new strike price for both Call and Put
options
 Types of Options

Options

Expiry Nature

American European Call Put

 Call Option -
It gives the holder the right to
Option Buyer of Seller of
purchase the underlying asset
Type Option Option
at the stated strike price, on or
Right to Obligation
before the expiration of date.
Call buy the to sell the
 Put Option –
asset asset
It gives the buyer the right to
sell the underlying asset at the
Right to sell Obligation
stated strike price on, or before
Put the to buy the
the expiration date.
asset asset
 American Option –
Such options can be exercised on or before expiry date.
 European Option –
Such options can be exercised only on the expiry date.
In India we have,
Index options – European Options
Stock options – American Options
 Equity Stock Options -
 It gives a person the right to buy or sell no. of security
( e.g. Shares of Ltd. Co. ) on or before a specified future date.
 Allowed only in specified securities of companies listed on the
stock exchange.
 Underlying asset – Security of a company.
 American style – Exercise on or before expiry date.
 Settlement –
Delivery of security
OR
Receipt / payment of difference between the strike price &
value of security on expiry day, in cash.
 In India, at present equity stock options are settled through cash.
 Example of Equity Stock Option
of Bharti Airtel

For this Mr.A pays premium of Rs.5/ unit to the writer of option.
If on or before the expiry date,
Price of equity shares > Rs.250, Mr.A will exercise his right to call
Delivery settled –
Mr.A will acquire 1000 shares of Airtel & make profit [ CMP > 250]
Cash settled –
Mr.A will get difference [ CMP - strike price]

If CMP is below Rs.250 then he will not exercise his call option.
 Equity Index Options -
 It gives a person the right to buy or sell no. of units of equity
index ( e.g. Units of SENSEX ) on or before a specified future
date.
 Underlying asset – Equity Index
 European style – Exercise only on expiry date.
 Settlement –
Receipt / payment of difference between the strike price &
value of security on expiry day, in cash.
 Example of Equity Index Option

of Sensex

( Strike Price)

j
for this Mr.B pays premium of Rs.25/ unit to the writer of option. j

If on the expiry date,

..

Now Mr. B will exercise his right to put ( Sell ) ,

By doing so he will receive [Strike price – Current Mkt. price ]
Suppose if CMP is Rs.3450 / unit,

Profit of Rs.150 /unit

 How to read derivatives in newspaper
Contracts Premium (Rs.) Open Interest

Type – Stk.Price – Expiry Open High Low Close ( in 000)

Nifty (50)
CE – 4200 – FEB 628.00 628.00 628.00 628.00 3

PE – 4400 – FEB 15.00 15.00 7.55 8.70 3244

 Column 1- Contracts
(a) Type – Specifies the type of option i.e. call or put.
Since here the contract is Nifty ( Equity Stock Option ) it is European
CE Call European
PE Put European
(b) Strike price – price at which the underlying asset can be purchased or sold
when the contract is exercised.
(c) Expiry date – Shows the expiration month of the contract .
Expiry day would be last Thursday of the specified month.
 Column 2 – Premium
(a) Shows for how much premium contract was opened.
(b) Its high, low and the final close of that particular contract on a particular
day.

 Column 3 - Open Interest

It is the number of options contracts that are open, these are contracts that
have neither expired nor have been exercised.
 Risk Management Tool
 Current market price of Infosys – Rs.2471 (as on 11-02-2010)
 Infosys call options expiring on are traded on NSE which gives the
owner the right to buy shares of Infosys @ Rs.2500
If ,

then, he would lose the premium paid.

NOTE – Premium is the maximum amount that the owner of the

contract can lose.
Made and presented by, JINESH RAJPARA

If the share price of Infosys goes above 2500 then, he will exercise call.

Rs.2800 – Rs.2500 = Rs.300

Rs.300 – Rs.10 (Premium paid) = Rs.290 profit per share.
“ Derivatives are generally placed in the
realm of advanced or technical investing,
but there is no reason why they should
remain mystery to common investors”

Made and presented by,

JINESH RAJPARA.