Derivatives

TYFM - Sem V
What it expresses?
What this picture is about ?
What this picture is about?
Anything in mind about this picture?
 Fear ?
 Uncertainty?
 What is beyond this?
 Not knowing what next?

We look forward to the future and also

view it with fear
What are Derivatives
 Derivatives are a different expression of
the underlying. They reflect by and large
the returns on the underlying assets
 Underlying can be any thing that can be
measured. Market will evolve if people
are interested in it
What are Derivatives
 A derivative is a contract which derives its
value from the price or rate of an
underlying item such as equity, bonds,
commodities, interest rate, exchange rate,
stock/other market indices, e.g.
Reliance stock is the underlying
Reliance future contract for August 2020 is a

derivative
Derivatives Products
Types of Derivatives Market
Types

OTC ETC

Forward Futures

Swaps Options
OTC Contracts
 Contracts are tailor made to fit in the
specific requirements of dealing
counterparties.
 The management of counter-party (credit)
risk is decentralized and located within
individual institutions.
 There are no formal centralized limits on

individual positions, leverage, or margining

OTC Contracts
 There are no formal rules or mechanisms
for risk management to ensure
market stability and integrity, and
for safeguarding the collective interest of
market participants.
 Transactions are private with little or no
disclosure to the entire market.
ETC Contracts
 Exchange-traded contracts are
standardized,
traded on organized exchanges
with prices determined by the interaction of
buyers and sellers (through anonymous auction
platform)
 A clearing house/ clearing corporation,
guarantees contract performance
(settlement of transactions).
COMMON UNDERLYING ASSETS FOR
DERIVATIVES ARE:
 Equity Shares
 Equity Indices
 Debt Market Securities
 Interest Rates
 Foreign Exchange
 Commodities
 Derivatives themselves
Functions of Derivatives Market :
 Derivatives help in discovery of future as well
as current prices.
 Helps to transfer risks
 Higher trade volumes
 Speculative trades shift to a more controlled
environment
 It acts as a catalyst for new entrepreneurial
activity
Forward Contracts
 We look forward to the future and also
view it with fear
 Forward Contract helps by removing (that
fear) - the pricing uncertainty

By locking into a price today for delivery at a future

time
Forward Contract
Time 0: Maturity Date:

Enter Contract. Agree Product, Pay Price, Take delivery of

Quantity, Price, Delivery Date underlying Quantity

At 60 th Day :
Gold, 100 gms
Gold at Rs. 45000/ 10 gms
Price Rs. 47000/10 gms You pay Rs. 47000 / 10 gm.

Delivery: 60 days Gold at Rs. 50000/ 10 gms

and take delivery
Forward Contract
Contract Structure & Effects

Obligatory OTC Contracts

Non Performance – Credit Default

Counter Party Risk – Major Issue

Cancellation Is by Reverse Contract

Forward Pricing Illustration
Pricing of Gold for Sale for 3 months Forwards

Spot Gold Interest Rate for Storage Cost

3 months @5% Rs. 20/gm for
Rs. 4700/gm 3 months
Forward Pricing Illustration

⁼
Borrow Rs. Interest of Forward Price
4700 + 20 for
⁼
Rs. 59 at least Rs. 4779
3 months
Forwards - Advantages
 Lock in to a future price on current date
 No worries about subsequent fluctuations
in the price
 Can enter in to contract for exact value of
exposure
Forwards - Disadvantages
 OTC (Over The Counter) Product and
hence not many participants that leads to
imperfect price discovery
 Not available in all products or currencies
 Not tradable, less liquid and hence
cancellation is dependant upon the OTC
dealer
Futures
 Futures are forward contracts quoted on
an exchange
 Futures are standardised products

What are Futures?

Futures – Product Structure
Futures are exchange traded

Quantity – One contract will be for

a defined quantity of underlying,
standardised products

e.g. Nifty = 75 Gold = 10 gms

Maturity – All contracts specified

in a particular manner will expire
on the same day e.g nifty contract
expires on last Thursday of a
month
Futures - Features
 By process of novation exchange
guarantees performance on the contract
 Greater liquidity and transparent
quotation results in better price discovery
Futures - Advantages
 Transparent pricing
 Exit by sale
 Standardised hence greater volume
 No counter party risk
Exchange is the guarantor for performance of contract
 Risk Management systems to control
market wide positions
Party wise positions
Market volatility

 Daily settlement
Futures - Disadvantages
 Imperfect hedge (both as to quantity and
maturity)
 Not available in all products
 Unlimited possible loss
Futures – Daily Settlement
 Daily settlement and margins are
important features of the contract
 Both the buyer and seller will be required
to place an initial margin to ensure their
due fulfillment of obligation
 Mark to Market settlement
Futures – Daily Settlement
Date Future Price Buyer Seller Amount Rs.
Rs.
01/06/20 683
02/06/20 686 Gain Loss 3
03/06/20 690 Gain Loss 4
04/06/20 680 Loss Gain 10
05/06/20 674 Loss Gain 6
08/06/20 678 Gain Loss 4
09/06/20 676 Loss Gain 2
Types of Futures
 Currencies
 Stocks
 Stock Indices
sensex and nifty etc
 Interest Rates
 Commodities
Swaps
 Swaps are contracts in which you swap
one contract for another
 e.g. Interest rate swaps involve one
counterparty paying a fixed interest rate in
exchange for receiving a floating interest
rate
Options
 An option contract grants a right to the
purchaser of the contract to buy or sell an
underlying asset at a specific price on/ up to a
specific date without a corresponding obligation
to perform on the contract
 The purchaser pays a premium for this right
 The writer (seller) receives the premium
 The seller has an obligation to perform on the
contract if the purchaser exercises his right
Options - Terminology
 Call and Put
 Option premium
 Option maturity
 Strike price
 In /at /out of money
 Open Interest
 Writer and buyer
Options - Terminology
 Call and Put
Call gives the buyer a right to buy the
underlying at a given strike price for the period
of contract at a premium
Put gives the buyer a right to sell the
underlying at a given strike price for the period
of contract at a premium
Options - Terminology
 Option premium
Itis the price buyer pays to the seller to gain
the right to buy or sell, without the obligation
This depends on the distance of price from strike
price, market trend and volatility
 Option maturity
It is the valid period of contract
Options - Terminology
 Strike price
theprice at which the underlying asset will be
bought or sold
 For a call option
In the money when price > strike price
At the money when price = strike price
Out of the money when price < strike price

 For a put option it is the other way

 Options - Example
31st May Daily Closing 1st July Daily Closing Price =
Price = Rs. 4700 Rs. 4800

Call Option Prices Call Option Prices

Out of
the
money 4800 62 112
At the money
4700 103 170

4600 157 240

In the
money 4500 221 328

Strike Prices
Examples of Derivative
Transactions
 Spot purchase
Assume you bought 125 shares of State Bank
of India on 30th August 2017 @ Rs. 2910
Sold the same on 1st of September 2017 @
Rs. 3125
Profits= 125 * Rs. 215 = Rs. 26875
% Return = 26875 / (125* 2910) = 7.39%
Examples of Derivative
Transactions
 Futures purchase
Assume you bought 1 lot (3000 shares) of State
Bank of India on 30th May 2020 @ Rs. 179 (spot
Rs. 175)
Sold the same on 1st of July 2017 @ Rs. 202 (spot
Rs. 190)
Profits= 3000 * Rs. 23 = Rs. 69000 Margin
required = Rs. 190000
% Return = 69000 / 190000 = 36% (that is
leverage!)
Leverage can help and hurt – be careful
Examples of Derivative
Transactions
 Options purchase
Assume you bought 1 lot (3000 shares) of
State Bank of India on 30th May
StrikePrice : Rs. 180
Option Premium: Rs. 8

Sold the same on 1st of July @ Rs. 20

Profits= 3000 * Rs.12 = Rs. 36000
% Return = 36000 / (8*3000) = 150%
Users of Derivatives Instruments
 Private or Institutional Investors buy derivative
contracts with a purpose.
 Some of the leading players in the derivatives
market are
hedgers,
speculators and
arbitrageurs.

These can also be traders investing in futures

and options on currency pairs.
Hedgers
 They are the investors who hedge a risk.
 Hedging means reducing a risk with a position
that will help tackle risky factors or influences
arising out of current market conditions.
 A hedger will try to achieve a position which is
opposite to the risk he takes.
 This investor will try to reduce or eliminate price
risk conditions when there is price volatility in
the market.
Speculators
 Speculators invest in the derivatives
markets by constantly studying the price
movements and taking a position that
gives them maximum gains.
 Their intention is primarily to make
maximum profits.
 Compared to Hedgers, they tend to take a
higher risk
Speculators

 This can lead to maximum returns or huge

loss in the markets.
 Speculators have to predict the future
trends in the market as accurately as
possible to place themselves in the right
position in the market.
 Speculators are the ones who wish to make
greater profit with short-term investments.
 https://soundcloud.com/user-106595422/
heding-speculation
Margin Trader
 Many speculators trade using of the payment
mechanism unique to the derivative markets.
 This is called margin trading.
 When you trade in derivative products, you
are only required to deposit only a fraction of
the total sum called margin.
 This is why margin trading results in a high
leverage factor in derivative trades.
Arbitrageurs
 Arbitrageurs take advantage of the price
differences that exist for a share in
different markets for a limited time.
 Arbitrageurs operate in a swift manner
with almost instant decisions being made
to earn positive gains without taking any
risk.
Arbitrageurs
 They increase the liquidity in the market
by grabbing the time-bound arbitrage
opportunities in the market and trading
the derivatives instruments immediately.
Uses of Derivative Contracts
 Speculation
Leveraging- Cheaper to speculate
Options can limit loss while allowing gains
Uses of Derivative Contracts
 Arbitraging
Making profits with certainty exploiting market
imperfections
Uses of Derivative Contracts
 Risk Management
Take a position in the derivative to provide a
cash flow opposite to the one in underlying
Various products in different combinations can
be used
Uses of Derivative Contracts
 Price Discovery
Futures in discount without reason indicative
of market being bearish
 To sum up
Derivatives Trading in India
As the initial step towards introduction of
derivatives trading in India, SEBI set up a 24–
member committee under the Chairmanship of
Dr. L. C. Gupta on November 18, 1996
Committee's role is to develop appropriate
regulatory framework for derivatives trading in
India.
Derivatives Trading in India

 The committee submitted its report on March

17, 1998
 It recommended that derivatives should be
declared as ‘securities’
 That imposes regulatory framework applicable
to trading of ‘securities’ could also govern
trading of derivatives.
Derivatives Trading in India

 SEBI set up a group in June 1998 under the

Chairmanship of Prof. J. R. Verma, to
recommend measures for risk containment in
derivatives market in India.
Derivatives Trading in India

It worked out the operational details of

margining system,

methodology for charging initial margins,

membership details and net-worth criterion,

deposit requirements and

real time monitoring of positions requirements.

Derivatives Trading in India

 In 1999, The Securities Contract Regulation Act

(SCRA) was amended to include “derivatives”
within the domain of ‘securities’
 Regulatory framework was developed for
governing derivatives trading.
 The exchange traded derivatives started in
India in June 2000 with SEBI permitting BSE
and NSE to introduce equity derivative
segment.
Derivatives Trading in India

 Trading in index futures commenced in June 2000.

 Trading in Index options commenced in June 2001
 Trading in options on individual stocks commenced
in July 2001.
 Futures contracts on individual stocks started in
November 2001.
 MCX-SX started trading in all these products in
February 2013.
Thank you