By:Amit MittalNitin Mittal

Introduction to Derivatives

Derivatives are the financial instruments which derive their value from the value of the underlying asset.

The underlying asset can be equity, fixed income instruments, interest rates, foreign exchange or commodities.

The price movements of derivative products are related to that of the underlying securities.

Various types of Derivatives

History of DerivativesChicago Board of Trade (CBOT) for derivatives

trading, became functional in 1848 and by 1865 futures contract in commodities started trading.

In 1972 currency futures were introduced, followed by equity options in 1973.

Year 1975 saw introduction to Interest Rate futures.

Currency Swaps were introduced in 1981 and in 1982 Index futures, Interest Rate swaps and Currency Options were started.

In 1983, Index Options and Options on futures were started.

Advantages of using DerivativesLeveraged PositionsLesser transaction costs Ease of creating positionsDerivatives as Risk Management ProductsDerivatives as Trading Products

Structured or Over The Counter versus

Exchange traded Derivatives

Exchange traded derivatives are standardized contracts which can only be traded on a recognized exchange.

The clearing house of the exchange provides the counterparty guarantee

OTC derivatives on the other hand are customized contracts and the terms of the contract are flexible.

There is no counterparty guarantee.The liquidity of an OTC derivative can be limited as

it is a customized contract.

Derivatives to be discussedFuturesForwardsOptions

In simple terms, a futures contract is a contract that allows the counterparties to exchange the underlying assets in future at a price agreed upon today. Following are the features of a futures contract-Contract through an exchangeTo exchange obligations on a future dateAt a price decided todayFor a quantity / quality standardized by the exchangeSettlement guaranteed by the clearing corporation of the exchange

Difference between forwards and futuresForwards Futures Forwards Futures

Nature of the contract

Customized Standardized

Counterparty Any entity Clearing house of exchange

Credit Risk Exists Assumed by the exchange

Liquidity Poor Very High

Margins Not Required Received / Paid on dailybasis

Valuation Not Done Done on daily basis

Underlying Contract Multiplier Tick size Contract monthsExpiry dateDaily settlement priceFinal settlement price

Pricing of FuturesTrading of futuresMargins required for futures contractsSettlement of futures

Forward ContractsForward Contract is an OTC derivative

product.It is a contract between two parties, which

enables the buyer to lock a desired value of the underlying that will become applicable at some future date, now.

There is no counterparty guarantee provided by any third party.

Forward contracts unlike futures, are deliverable contracts (Though there are non-deliverable forward contracts also).

Different Types of Forward Contracts

Depending on the underlying asset, the most common types of forward contracts are:

Currency ForwardsInterest Rate Forwards, andCommodity Forwards

Participants in Forward Contracts

Hedgers – They participate in the forward market with a view to protect or cover an existing exposure in the spot market.

Speculators – These dealers based on their opinion about the market movements take an exposure in the forward market with a view to make profits from the expected movement in the underlying element.

Arbitrageurs – These players neither hedge nor speculate. They try to take advantage of the price differences in the spot and forward markets.

OptionsOptions or option contracts are instrumentsRight, but not the obligation, is givenTo buy or sell a specific assetAt a specific priceOn or before a specified dateOptions can be exchange traded derivatives

or even over the counter derivatives.

Differences in equity shares and equity options

Option TerminologiesStrike Price or Exercise PriceExpiration DateExercise DateOption BuyerOption SellerAmerican optionEuropean optionOption Premium

Option ClassificationsCall Option : an option which gives a right to

buy the underlying asset at a strike price.

Put Option : an option which gives a right to sell the underlying asset at strike price.

Call Option Buying A Call option buyer basically is bullish about the

underlying stock.

Put Option buyingA buyer of put option is bearish on underlying stock.

Both the Call and Put option buyers are buying the rights, that is they are transferring their risks to the sellers of the option.

For this transfer of risk to the sellers, buyers have to compensate by paying Option Premium.

Option premium is also known as Price of the option, Cost or Value of the option.

Option Selling: Motives for selling options

The seller is ready to assume the risk in option exercise. The incentives for the seller to assume that risk are two :

Option Premium – This is the actual amount received by him for selling an option to the buyer.

The possibility of non-exercise of option – In seller’s view the possibility of option being exercised by the buyer may be low.

Factors influencing Option Pricing

Time to expiration – greater the time to expiration, higher the value of the options.

Volatility –higher the volatility, higher the value of the options.

Risk free Rate of Interest – If interest rate goes up, calls gain in value while puts lose value.

ITM, ATM, OTM OptionsIn the moneyAt the money Out of money

Intrinsic and Time value of the option

Intrinsic value is equal to the amount by which option is in the money.

Time value is the difference between market price of the option and intrinsic value.

Settlement of Options

Physical Delivery

Cash settlement

Exercise of calls

Exercise of Puts

Pay off from a Long Call

Payoff from Short Call

Summary of basic option strategies

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