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Derivatives

Jignesh Shah Dhiren Prajapati Kaustubh Parkar Akash Jadhav Deepali Jain Rahul Gavali

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What will we look at?
 Basic concepts of Derivatives  Futures

 Options

Derivatives

What is Derivatives? Classification of Derivatives Risk Associated with Derivatives Participants of Derivatives

What is Derivatives?

A Derivative is a financial instrument which derives its value from its underlying assets. It does not have any value of its own The underlying assets can be Futures, Equities, Index and Currency

Classification of Derivatives  Futures Options Forward Contracts   .

on or before a given expiry date. but not the obligation to buy or sell the underlying assets and other financial instrument at an agreed price.  Forward Contracts :  Its an agreement between two persons for purchase and sale of commodity or financial asset at specified price to be delivered at specified future date. where the seller is obligated to deliver a specific assets to a buyer on the specified date and buyer is obligated to pay the future price prevailing in the exchange on the delivery of the asset.Definition  Futures :  It’s a standardized agreement between buyer and seller.  Options :  An option is the right. .

Risk Associated With Derivatives  Market Risk : It is price sensitive to fluctuation in interest rate and foreign exchange rate. Credit Risk : Derivatives are traded in over the counter market which are subject to counter party default. Regulatory Risk : The regulatory controls are some time too oppressive for market participants. it the anticipated risk do not develop it may limit the total return. Liquidity Risk : Most derivatives are customized instrument hence they have substantial liquidity risk. Hedging Risk : Hedge are used to reduce specific risk.     .

farmers who sell future contracts for the crops that guarantee a certain price. For eg. Also. large number of strategies are being formulated and traded.Participants of Derivatives  Hedgers Those who are interested in the underlying and want to hedge out their risk of price changes.  Speculators Those who seek to make profit by predicting market movements and have no interest in the underlying equity / commodity.  Strategist / Traders With the help of cash and derivative products. . hedging against an existing equity position with a view to earn on short term fluctuation while keeping the original position as intact.

Futures        What is Futures? Futures Vs Forwards Characteristics of Futures Types of Futures Example Margin Components Advantages .

What is futures ?  Definition: A future contract is a standardised contract traded on an exchange. . at a pre-set price. to buy or sell a certain underlying instrument at a certain date in the future.

Forwards    Standardized Standard Lot size Exchange Traded    Not Standardized Odd lot size Over the Counter (OTC) .Futures vs.

Some of the Exchanges      Chicago Mercantile Exchange (CME) Chicago Board of Trade (CBOT) New York Board of Trade (NYBOT) New York Mercantile Exchange (NYMEX) National Stock Exchange (NSE) .

Characteristics  Standardisation  Pricing Margin   Always traded on an Exchange Settlement  .

iv. .Standardisation  The contract usually specifies the following: i. iii. v. ii. Last date of delivery – This varies from exchange to exchange. The underlying instrument Whether the settlement would be in cash or physical The amount and number of units of the underlying assets. vi. Currency in which the future contract is quoted. Date of delivery & month.

Types of Futures  Equity  Commodity Index   Foreign Currency .

$5.00 3 $425. Futures Price of Gold is $ 415 at the beginning of the day.00 Net Cash Flow $10.00 $10.Mark to Market Example: Spot price of Gold is $ 400.00 2 $430.00 . The movements over 3 days as shown below explains the concept of Mark to Market: Time period Gold Future Buyer's Cash Flow 1 $420.00 $5.00 .

.Margin Components  Initial margin – VAR technique Maintenance margin – minimum requirement Margin Call -Variation margin Additional margin –market trends / volatility     Any credit balance in a margin account can be withdrawn.

000/.000/Margin fixed by Exchange = 15% = Initial Margin Amount deposited with Broker = Rs.* 50% = 45. 1000/= Rs.Simple Illustration Reliance Future having lot size of 600 @ Rs.* 15% = Rs.000/Maintenance margin = 50% of initial margin = 90. 600. 600.000/. 90.000/- .

900/.000.00 (570.00 30.000/Calculation : Current Margin Less : Notional loss 60.000/Current Margin Less : Notional loss 3rd day: Next day. 950/.00 < 45. 570.00) margin call 90.000. the rate of Reliance future is Rs.000 – 570.000.00 30. 950/Mark to market: 600 lots @ Rs.2nd day : Next day.000) 30. 540.000.000) > 45.000 – 540.000.000.000 Required margin 90.= Rs.= Rs. 900/Mark to market: 600 lots @ Rs.000 .00 Variation Margin required (60.00 60.00 15% (600.000.000. the rate of Reliance future is Rs.

(2 lots * 10 * 3.639.514.514.460.70.607. Fees 25.10/- Cash Flow: On 16th June: Commission fees: 25.10 = 2.00/.790.10 .292.790.00/* 3.Calculation: Future Contract: Date 16th June 30th June B / S Lot Sell Buy 10 * 2 * Multiplier Price 10 10 Mark-to-market Comm.19 * 3.60) = 2.2 .505 = 72.60 = 351.10 + Commission Fees 109.00 109.00 is the cash flow generated on this day. On 30th June: 72.498.

Options         What is Options? Kinds of Options. Characteristics of Options. Call Options Put Options In / At / Out the Money Options Benefits of Options Trading . Types of Options.

but not the obligation. to buy or sell a certain underlying instrument at a pre-set price called the strike price. .What is an options ?  Definition: An option contract is a standardised contract traded on an exchange. offering the right.

This presentation presumes European options for ease of calculation. . the option buyer's right to exercise the option (and the seller's obligation to perform) ends.Kinds of Options  European Options: These are exercised only on the maturity date. On the expiry date.  American Options: These can be exercised at any time prior to or up to the maturity date.

Types of Options  Equity  Commodity Index   Foreign Currency Future Contracts  .

Characteristics  Standardisation Premium Call / Put option Always traded on an Exchange Settlement     .

Date of delivery & month. ii. vi. Last date of delivery – This varies from exchange to exchange. iv. iii. Currency in which the option contract is quoted.Standardisation  The contract usually specifies the following: i. . The underlying instrument Whether the settlement would be in cash or physical The amount and number of units of the underlying assets. v.

To SELL underlying shares at a price.Call / Put Options  CALL OPTIONS    Buyer gets a RIGHT. To BUY underlying shares at a price. .  On or before a determined date.  PUT OPTIONS   Buyer gets a RIGHT. On or before a determined date.

Options-Positions  BUY CALL: Buyer gets right to BUY underlying at the strike price  BUY PUT: Buyer gets right to SELL underlying at the strike price  SELL CALL: Seller has an obligation to SELL the underlying at strike price  SELL PUT: Seller has an obligation to BUY the underlying at strike price .

.  Call option is in the money when the Strike price is < Spot price  Put option is in the money when the strike price is > spot price  Eg. 50 is said to be the intrinsic value of the option. Strike Price 250 Call option of Satyam Computers when the Spot price is 300.  The difference of Rs.  Option is said to be in the money when the option has intrinsic value.Spot & Strike price Relationship  In The Money  Concepts from the buyers perspective.Options.

Options.  At The Money  Strike price = Spot Price . Strike Price 350 Call option of Satyam Computers when the Spot price is 300.Spot & Strike price Relationship  Out of The Money    Option is said to be out of money when it does not have any intrinsic value Call option is out of the money when the Strike price is > CMP Put option is out of the money when the strike price is < CMP Eg.

e. X The Higher the Microsoft rises. Call option on Microsoft with 3 months maturity is available at various strikes. $ 500. Mr. X holds a bullish view on Microsoft. Lets takes strike of $ 100. During this time Microsoft may go up. If Microsoft remains same or goes down i. .Call Option Buyer . X. Hence the maximum profit potential of Mr. Mr. He waits for 3 months. He Pays a premium. If the Microsoft rises above $ 105 (Strike Price of $ 100 + Premium of $ 5) Option would generate money for Mr. the higher the profit to Mr. In other words.Example            Mr. below $ 100. While the maximum lose is limited to premium paid ($ 500).e. X is unlimited. $ 500. X Buys one call Options contract with 3 months maturity (Say one contract has 100 underline shares). Mr. say @ $ 5 per share i.X will not exercise his option and would loose the premium amount i. it may go down or it may remain stable.e. Microsoft is trading on NASDAQ in the cash market at $ 100. X lose is Capped at this value.

Y collects the Premium amount of $ 500 from Mr. However if the Stocks moves up Mr.Example      Consider the Option on Microsoft. X. If Microsoft falls below $ 100. Y pockets the premium amount. X’s gain. The Position of Call Option Seller i. Mr.Call Option Seller . . X.e Mr. Say for Mr. Y. which is the Maximum Profit he can make. Which Mr.e Mr. Y is exactly the opposite of the Option Buyer i. Y’s loss is unlimited which is proportional to Mr. Mr. X had bought.

Benefits of Option Trading  Leverage Limited risk No margin. only premium   .

Advantages over Delivery Trading  You can take 4 – 5 times more than limits Close positions anytime before expiry. On expiry day. Keep your positions open up to 3 months    Profits / losses are paid / recovered on a daily basis If you feel the market will be bearish. take short positions in futures. exchange automatically closes out positions. which is not possible in delivery based trading without actual shares in demat.Futures .  .

other factors remaining same   .Pricing  Intrinsic Value  Difference between the Strike Price and Spot Price Time Value .Beta  Higher volatility of stock would attract higher premium  Premium in HINLEV (low beta) would be lesser than SATCOM (high beta) . the options premium decays Volatility of underlying.Theta  Time to expiry of the contract  As the expiry date comes nearer.Options.

Options-Risk  BUYER of CALL / PUT options  Maximum loss : PREMIUM Maximum Gain : UNLIMITED   SELLER of CALL / PUT options  Maximum loss : UNLIMITED Maximum Gain : PREMIUM  .

Options-Exercise  Only In the Money (ITM) options are allowed to be exercised Buyer/Holder receives the difference  Call Option: Spot price-Strike price  Put Option: Strike price-Spot price Writer/Seller pays the difference  Call Option : Spot price-Strike price  Put option: Strike price-Spot price    All At the Money (ATM) and Out of the Money (OTM) contracts expires worthless Assigned to seller/writer who is Out of the Money (OTM)  .

Options . SQUARE-OFF can be made by both BUYER & SELLER  .Exercise v/s Square-off EXERCISE STRIKE PRICE and CLOSING PRICE of underlying on exercise day SQUARE-OFF PREMIUM Amounts at the time of Square-off. Difference between Difference between  EXERCISE can be done only by the BUYER.

very bullish / bearish .Which strike price to select? Speculator or investor?  Buying an OTM options .  .very cheap  Same expiry OTM cheaper than ITM Less investment Speculator may look for more leverage with OTM    Your perceptions of the market movement Your perceptions of the volatility and interest rates in the market.

To sum up Some of the key uses of options are… Leverage Protecting the value of equity positions Limiting risk Alternative to direct investment in equity markets. .

How can you get the most out of these instruments? Adopt the appropriate strategy that suits… Your personal circumstances and Your market view .

Right or Wrong. Your Destiny will unfold according to the Choices you make” .“Life is all about Choices. Good or Bad.

Thank You… .

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