DERIVATIVDERIVATIVE MARKET E MARKET IN INDIAIN INDIA

Financial derivatives are Financial derivatives are financial instruments whose financial instruments whose prices are derived from the prices are derived from the prices of other financial prices of other financial instruments which are also know instruments which are also know as underlying. It relates to as underlying. It relates to equities, loans, bonds, interest equities, loans, bonds, interest rates and currencies. rates and currencies.

TYPES OF TYPES OF DERIVATIVESDERIVATIVES

OPTIONSOPTIONSFUTURESFUTURESSWAPSSWAPS

OPTIONSOPTIONSTYPES:TYPES: EXCHANGE TRADED OPTIONSEXCHANGE TRADED OPTIONS OVER THE COUNTER OPTIONSOVER THE COUNTER OPTIONS EMPLOYEE STOCK OPTIONSEMPLOYEE STOCK OPTIONS STOCK INDEX OPTIONSSTOCK INDEX OPTIONS INTREST OPTIONSINTREST OPTIONS CURRENCY OPTIONSCURRENCY OPTIONS RANGE FORWARD(RF)RANGE FORWARD(RF) RATIO RANGE FORWARDS RATIO RANGE FORWARDS

CONTRACTS(RRF’S)CONTRACTS(RRF’S) SWAPTIONSSWAPTIONS

BENEFITSBENEFITS CALLS- Control a claim on CALLS- Control a claim on

underlying asset.underlying asset.

PUTS- Duplicate a short sale PUTS- Duplicate a short sale without margin account.without margin account.

Possibility of windfall profits.Possibility of windfall profits. Investment opportunities.Investment opportunities. Reduction of total portfolio Reduction of total portfolio

transaction cost.transaction cost. Participation in overall market Participation in overall market

movement.movement.

FUTURESFUTURES

CHARACTERISTICS:CHARACTERISTICS:TRADINGTRADINGRISKRISKSETTLEMENTSETTLEMENT

SERVICES SERVICES RENDEREDRENDERED

Provide hedging facilities to Provide hedging facilities to buyers and sellers to protect buyers and sellers to protect them against unpredictable them against unpredictable price fluctuations over time.price fluctuations over time.

Introduce an element of Introduce an element of stability market prices.stability market prices.

Indicate expected future prices.Indicate expected future prices.

SWAPSSWAPS It is an agreement It is an agreement

between two parties to between two parties to exchange sequences of exchange sequences of cash flows for a set period cash flows for a set period of time.of time.

INTREST RATE INTREST RATE SWAPSWAP

EXAMPLE:EXAMPLE: TERMS: Notional

amount- 100 lakhMaturity- 5 years

Fixed rate payer- Alpha Corp. Floating rate payer-

Gamma Corp.Fixed Rate- 5 %, semiannual

Floating rate- 3 month

Alpha Corp Gamma Corp

Fixed rate payment(5% semi-annual)

Floating rate payment

(3-month Libor)

Alpha Corp agrees to pay 5 % of 100 lakhs on a Alpha Corp agrees to pay 5 % of 100 lakhs on a semiannual basis to Gamma Corp. for the next 5 semiannual basis to Gamma Corp. for the next 5 years.years.

That is, Alpha will pay 2.5 % of 100 lakhs, or 2.5 That is, Alpha will pay 2.5 % of 100 lakhs, or 2.5 lakhs, twice a year.lakhs, twice a year.

Gamma Corp agrees to pay 3-month LIBOR on a 3-Gamma Corp agrees to pay 3-month LIBOR on a 3-monthly basis (or quarterly basis) to Alpha Corp for monthly basis (or quarterly basis) to Alpha Corp for the next 5 years.the next 5 years.

That is, Gamma will pay the 3-month LIBOR rate, That is, Gamma will pay the 3-month LIBOR rate, divided by four and multiplied by the notional divided by four and multiplied by the notional amount, four times per year. amount, four times per year.

For example, if the 3-month LIBOR is 2.4 % on the For example, if the 3-month LIBOR is 2.4 % on the reset date, Gamma will pay 2.4% / 4 = 0.6% of 100 reset date, Gamma will pay 2.4% / 4 = 0.6% of 100 lakhs = 0.6 lakhs every 3 months.lakhs = 0.6 lakhs every 3 months.

VALUATION OF VALUATION OF DERIVATIVESDERIVATIVES

Pricing futuresPricing futures: : Following factors Following factors affect the future prices:affect the future prices:

a)a) Spot Price.Spot Price.b)b) Basis=Current cash price – Future Basis=Current cash price – Future

price.price.c)c) Spreads.Spreads.d)d) Expected future spot priceExpected future spot pricee)e) Cost of storageCost of storage

Pricing options:Pricing options:

Explained with the help of following ModelExplained with the help of following Model THE BLACK SCHOLES MODEL:THE BLACK SCHOLES MODEL:

COV = MPS [N (d)] – EP [antilog (-rt)] [N (d2)]COV = MPS [N (d)] – EP [antilog (-rt)] [N (d2)] Where;Where; COV= Call option valueCOV= Call option value MPS = Current price of underlying assetMPS = Current price of underlying asset N(d) = Cumulative density functionN(d) = Cumulative density function EP = Exercise price of optionEP = Exercise price of option R = Continuity compounded risk less rate of interest on an R = Continuity compounded risk less rate of interest on an

annual basis.annual basis. T = Time remaining before the expiration of optionT = Time remaining before the expiration of option N(d2) = Cumulative density function of d2N(d2) = Cumulative density function of d2

IMPORTANCEIMPORTANCE To minimize risk.To minimize risk. To protect the interest of individual and To protect the interest of individual and

institutional investors.institutional investors. Offers high liquidity and flexibility.Offers high liquidity and flexibility. Does not create new risk and minimizes Does not create new risk and minimizes

existing ones.existing ones. Lowers transaction cost.Lowers transaction cost. Provides information on market movement.Provides information on market movement. Provides wide choice of hedging.Provides wide choice of hedging. Convenient, low cost and simple to operate.Convenient, low cost and simple to operate.