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Nuts and Bolts

ofDerivatives


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UnderstandingDerivatives


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Derivatives Defined

Derivatives are instruments whose

value is derived, in whole or in part,

from the value of one or more underlyingassets.

*Financial Market


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Key features of Derivatives

The value of a derivative instrument is derived fromthe value of the underlying

A derivative contract is priced separately from theasset

The derivative contract is traded not the underlyingasset

No ownership rights associated with the asset sold


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Classification of Derivatives

Based on the underlying:

Commodity Derivatives

Financial Derivatives


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Origin of Derivatives

Originated as hedging devices against fluctuation incommodity prices

Chicago Mercantile Exchange

Chicago Board of Trade

Financial derivatives emerged post 1970

Volatility of financial market an important reason

Index based and stock based are most popular today Today the volumes of financial derivatives trade is many times

more than volumes in commodity derivatives trade.


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Derivatives in India

In India, derivative trading commenced on Jun 09, 2000(BSE) & Jun 12, 2000 (NSE) with index futures andsubsequently index options (Jun 2001), stock options

(Jul 2001) and stock futures (Nov 2001) were introduced

Commodity derivatives started much later in 2003 andare also popular but the market is smaller in comparison

Futures & Options are the more popular forms

Separate segment for derivatives (NEAT- F&O on NSEand DTSS on BSE)

Today the trading volumes on derivative segment are inexcess of INR 15,000 crores per day

In 2004-05, 77+ crores trades with volumes of 25 lakh-crores were done.


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Popularity of Derivatives

Hedging:

Interest rate volatility Stock price volatility Exchage rate volatility Commodity prices volatility

VOLATILITY

Derivative markets have attained an overwhelming popularity for avariety of reasons...

To hedge or insure risks; i.e., shift risk.


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Popularity of DerivativesDerivative markets have attained an overwhelming popularity for avariety of reasons...

Arbitrage: Take advantage of price differentialby taking offsetting positions

PRICE DIFFERENTIAL

To lock in an profit on the basis of price differential inthe market i.e. an arbitrage opportunity


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!STOP!!CHECK!

The following could be an underlying in a derivative? ITC Stock

Coffee

USD/GBP rate

All the above

The price of a derivate is separate from but dependent on the price of the underlying TRUE

FALSE

While Commodity based derivatives started before financial derivatives, the trading volumes

in financial derivatives across the world are higher than commodity derivatives TRUE

FALSE

Which of the following was the 1st financial derivative traded in India?a. Index Option

b. Index Future

c. Stock Futured. Stock option

The strategy that involves taking advantage of price differential between two markets iscalled: Hedging

Speculating

Arbitraging

Diversifying


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Option

Swap

Forward

Future

The owner of an option has the OPTION to buy or sell

something at a predetermined price on or before apredetermined date.

The owner of a forward has the OBLIGATION to sell or buy

something in the future at a predetermined price. The difference

to a future contract is that forwards are customized, notstandardized. These are bilateral contracts between 2

private parties.

The owner of a future has the OBLIGATION to sell or buy

something in the future at a predetermined price. A future

contract has standardizedconditions.

A swap is an agreement between two parties to

exchange a sequence of cash flows.

Types of Derivatives


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OTC vs. Exchange-Traded Derivatives

Primarily, Forwards and Swaps are OTC

derivatives Considered risky because:

There is no formal margining system

These are not settled on a clearing houseThese do no follow any formal rules or

mechanisms

Futures and Options are exchange-traded, a safer option.


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!STOP!!CHECK!

If I commit to sell gold to you in the month of Dec and we agree to a price of Rs. 12,000per 10 gm, we have just entered into a: Future contract

Option contract

Forward contract Swap agreement

All derivatives are obligatory on both buyer and seller, except: Futures

Forwards

Options

Swaps

The following are OTC derivatives, hence have higher element of risk involved: Swaps and options

Options and futures

Futures and forwards

Swaps and forwards

The following is not true about exchange-traded derivatives? There is a settlement mechanism

There is a margining system

there is no loss of margin money ever

There are formal rules or mechanism


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UnderstandingFutures


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Future The owner of a future contract

has the OBLIGATION to sell or

buy something in the future at

a predetermined price.

Future Contract


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Future Contract

Standardized Items in Future

Quantity of the underlying

Quality of the underlying

The date and month of delivery Location of settlement


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Future Contract

Future Terminology Spot Price

Future Price

Contract Cycle

Expiry Date

Contract Size Basis

Cost of Carry

Initial Margin

Marking to Market

Maintenance Margin


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Futures Terminology

Spot Price the price at which an asset trades in the spotmarket

Future Price the price at which the future contract trades inthe futures market

Contract Cycle the period over which the contract trades.

The index futures contracts on the NSE have a one-month, two-month and three-month expiry cycles which expire on the lastThursday of the month. On the Friday following the last Thursday,a new contract having a three-month expiry is introduced fortrading.

Expiry Date the date specified in the futures contract.

Contract Size the amount of asset that has to be deliveredunder one contract. For instance, the contract size on NSE futuresmarket is 100 Nifties.


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Futures Terminology

Basis the future price minus the spot price. There will be adifferent basis for each delivery month for each contract. In anormal market, basis will be positive. This reflects that future

prices normally exceed spot prices.

Cost of Carry the storage cost plus the interest that is paidto finance the asset less the income earned on the asset.

Initial Margin the amount that must be deposited in themargin account at the time the future contract is first entered into

Marking to Market the adjustment made at the end ofeach trading day to the investors margin account to reflect theinvestors gain or loss depending upon the future closing price.

Maintenance Margin somewhat lower than the initialmargin; the balance in the margin account must never becomenegative and in case it does, the investor receives a margin callwho must top-up the account to the initial margin level beforetrade commences the following day


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A long position is an agreement

to buy

LONG => BUY

A short position is an agreement

to sell

SHORT => SELL


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Futures Payoffs

Future contracts have linear pay-offs unlimited profits or losses

Payoff for buyer of future: long future

An obligation to take delivery at a future

date Similar to that of a person who holds an asset

Example - A speculator buys a two-month nifty index

futures contract when the nifty stands at 3250. whenthe index starts moving up, the long futures positionmakes profits and when the index moves down thefuture starts making losses.


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NIFTY

3250

Profit

Loss

Long Future


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Futures Payoffs

Future contracts have linear pay-offs unlimited profits or losses

Payoff for seller of future: short future

An obligation to give/make delivery at a

future date Similar to that of a person who sells/shorts an asset

Example - A speculator sells a two-month nifty indexfutures contract when the nifty stands at 3250. whenthe index starts moving down, the short futuresposition makes profits and when the index moves upthe future starts making losses.


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NIFTY

3250

Profit

Loss

Short Future


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Futures Payoffs

Profit

Current

Price

Purchase Priceof Contract

Gain

Loss

SoldFuture

Gain/Loss =Sale Price Purchase Price

Profit

CurrentPrice

Purchase Priceof Contract

Gain/Loss =Purchase Price - Sale Price

BoughtFuture

Gain

Loss


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General Rule for Hedgers:

If you are going to sell something in the near future but

want to lock in a secured price, you take a short position.

If you are going to receive/buy something in the future but

want to lock in a secured price, you take a long position.

Futures Contracts

The Role of Speculators:

As the name implies, speculators are involved inprice betting and take the risk of price movementsagainst them.


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Application of Futures

Hedging a risk management tool

long security, short future

Example an investor holds a security but getsuncomfortable with the movements in the short run. Seesprices falling from 450 to 390. in the absence of stockfutures, he either live with it or sells the security.

With security futures he can minimize the price risk. Hecan enter into an off-setting short futures position.

Assuming spot price is 390. He sells a two-months futurefor 400, for which he pays an initial margin. If prices fall,so does the price of futures. As a result, his short futuresposition starts making profits. The loss incurred on thesecurity will be made up by the profit on his short futuresposition.

N.B. Hedging does not always make money! It removes

unwanted exposure i.e. unnecessary risk.


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Speculation bullish security, buy (long) future

Case 1 a speculator believes a security at 1000 is

undervalued; in the absence of a deferred product, he hasto buy it and hold on to it till his hunch proves correct.assume he buys 100 shares which cost him one lakhrupees. Two-months later, say the security closes at 1010.He makes a profit of 1000 on an investment of 100,000 for

a period of two-months. This works out to be an annualreturn of 6% .

Case 2 the security trades at 1000 and the two-monthfuture at 1006. for the sake of comparison, assume the

minimum contract value is 100,000. he buys 100 securityfutures for which he pays a margin of Rs. 20,000. twomonths later, the security closes at 1010. Assuming, on thedate of expiration, the future price converges to the spotprice, he makes a profit of Rs. 400 on an investment of Rs.

20,000. this works out to an annual return of 12 percent.There lies the power of leverage.


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Speculation bearish security, Sell (Short) future

Example take a trader who expects to see a fall inprice of X. he sells one two-month contract of futureson X at Rs. 240 (each contract for 100 underlyingshares). He pays a small margin on the same, say48,000. Two months later, when the futures contractexpires, X closes at Rs. 220. on the day of expiration,the spot and futures price converge. He has made aclean profit of Rs. 20 per share. For the one contractthat he bought, this works out to Rs. 2000.


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Arbitrage

Overpriced futures: buy (long) spot, sell (short) future

Cash-and-carry arbitrage opportunity The cost-of-carry ensures that futures price stay in tune with

the spot price. Whenever futures price deviates from its fairvalue, arbitrage opportunities arise.

Say X trades at 1000. one month future trades at 1025 and

seems overpriced. As an arbitrageur, you can enter into thefollowing trade to make riskless profit: Borrow funds to buy the security in cash/spot market for 1000.

Take delivery of the security and hold for a month.

Simultaneously, sell the security future for 1025.

On futures expiration date, spot and future prices converge.Unwind the position.

Say the security closes at 1015. sell the security.

Futures position expires with a profit of Rs. 10

The result is also a riskless profit of Rs. 15 on the spot position.

Return the borrowed funds.


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Arbitrage

Underpriced futures buy (long) future, sell (short) spot

A reverse cash-and-carry arbitrage where the risklessreturn is more than the arbitrage trades

A security X trades at 1000. a one-month future trades at 965and seems underpriced. You can make riskless profit by

entering into the following transaction. on day 1, sell the security in cash/spot for 1000.

make delivery of the security.

simultaneously, buy the futures on the security at 965.

on the futures expiration date, the spot and the future pricesconverge. Now unwind the position.

say, the security closes at 975.

buy backthe security. the result is a riskless profit of Rs. 25 onthe spot position

And, the futures position expires with a profit of Rs. 10.


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Index Arbitrage

- Buy NIFTY Futures- Sell Stock Futures on the

composition stocks


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Open Interest

The outstanding open long or short positions inthe market

230-505-155100-25125

-5020-45100-7550Day 3

125-15-1105075

-15-1050-25Day 2

100-100100Day 1

Open

InterestS3S2Seller1B3B2Buyer1INFY


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!STOP!!CHECK!

Ram sold a Nov ABB futures contract at Rs. 1000. Each contract is for delivery of 200shares. Current Spot Price is Rs. 995. On future expiry date the spot price has slipped toRs. 950. Rams profit/loss in the transaction is: Profit of Rs. 5,000

Loss of Rs. 5,000

Profit of Rs. 10,000

Loss of Rs. 10,000

Ganesh bought a Dec ITC futures at Rs. 650. Each contract is for delivery of 400 shares.Current Spot is Rs. 660. on Futures expiry date, ITC has moved down to 625. Ganeshsprofit/loss on the transaction is: Profit of Rs. 10,000

Profit of Rs. 7,000 Loss of Rs. 10,000

Loss of Rs. 7,000

The adjustments made to the margin account at the end of each trading day to reflect theinvestors gain/loss is called: Maintenance margin

Marking to market Margin call

Initial margin

Hedge using futures involves: Have underlying, buy futures

Have underlying, sell futures

Sell underlying, buy futures Sell underlying, sell futures


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UnderstandingOptions


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Option The owner of an option has the OPTION

to buy or sell something at apredetermined price

Right to BUY CALL OPTION

Right to SELL PUT OPTION

Options Contracts


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Options Contracts

Option Terminology Stock options

Buyer of an option Writer of an option

Call Option

Put Option

Option price/premium

Expiration date

Strike Price

American Options

European options

In-The-Money Option (ITM)

At-The-Money (ATM)

Out-Of-The-Money Option (OTM)


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Options Contracts

Option Terminology

Stock options options on individual stocks. A contractgives the buyer the right to buy or sell shares at the specifiedprice

Buyer of an option the one who by paying price(premium) buys the right but not the obligation to exercisehis/her option on the seller/writer

Writer of an option the one who by receiving premium,is obliged to sell/buy the asset if the buyer exercises on him

Call Option gives the buyer the right but not theobligation to buy an asset by a certain date for a certain price

Put Option gives the buyer the right but not theobligation to sell an asset by a certain date for a certain price

O C


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Options Contracts

Option Terminology

Option price/premium the price that the buyer pays tothe seller/writer

Expiration date the date specified in the optionscontract; also called exercise date or strike date or maturitydate

Strike Price the price specified in the options contract;also called exercise price

American Options options that can be exercised at anytime upto the expiration date. Most exchange-traded optionsare American

European options options that can be exercised only onthe expiration date

O ti C t t


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Options Contracts

In-The-Money Option (ITM) an option that would lead toa positive cash-flow to the holder if it were exercisedimmediately.

A call option on the index is said to be ITM if the current indexstands higher than the strike price (Spot Price > Strike Price).

A put option is ITM if the index is below the Strike price (SpotPrice < Strike Price).

At-The-Money (ATM) an option that would lead to zerocash flows to the holder if it were exercised immediately.

Out-Of-The-Money Option (OTM) an option that wouldlead to a negative cash-flow to the holder if it were

exercised immediately. A call option on the index is said to be OTM if the current index

stands at a level which is less than the strike price (Spot Price Strike Price).

O ti C t t


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The option premium has two components intrinsicvalue and time value.

The intrinsic value of an option - is the amount theoption is ITM, if it is ITM. If the call is OTM, its intrinsicvalue is zero.

Intrinsic value of a call is Max [0, (St K)]

Intrinsic value of a put is Max [0, (K St)]where, K= Strike Price and St = spot price

Time value of an option the difference between theoption premium and its intrinsic value. Both calls and

puts have time value. An option that is ATM or OTM onlyhas time value. Usually, the maximum time value existswhen option is ATM. The longer the expiration, thegreater the time value of an option, all else being equal.

At expiration, an option should have no time value.

Options Contracts

O ti C t t


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Call Option Contracts

A call option is a contract that gives the owner of the call

option the right, but not the obligation, to buy anunderlying asset, at a fixed price (K), on (or sometimesbefore) a pre-specified day, which is known as the expirationday.

The seller of a call option, the call writer, is obligated todeliver, or sell, the underlying asset at a fixed price, K on (orsometimes before) expiration day (T).

The fixed price, K, is called the strike price, or the exerciseprice.

Because they separate rights from obligations, calloptions have value.

Options Contracts

O ti C t t


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Put Option Contracts

A put option is a contract that gives the owner of the put

option the right, but not the obligation, to sell anunderlying asset, at a fixed price, on (or sometimes before)a pre-specified day, which is known as the expiration day(T).

The seller of a put option, the put writer, is obligated totake delivery, or buy, the underlying asset at a fixed price(K), on (or sometimes before) expiration day.

The fixed price, K, is called the strike price, or the exerciseprice.

Because they separate rights from obligations, putoptions have value.

Options Contracts

Options Contracts


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Call Option

Put Option

Write (SHORT)

Buy (LONG)

Write (SHORT)

Buy (LONG)

The four basic positions:

Options Contracts

Profit Diagram for a Long Call


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g gPosition, at Expiration

Profit

0K STcall premium

Profit Diagram for a Short Call


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gPosition, at Expiration

K

0

ST

Profit

Call premium


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Covered Call- Your Short call position is

covered if you have theunderlying asset

Profit Diagram for a Long Put


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g gPosition, at Expiration

ST

Profit

0K put premium


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Protective Put- Your Long Put Position is

protective if you have theunderlying asset

Profit Diagram for a Short Put


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Position, at Expiration

ST

0

Profit

K

Call Option Payoffs


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Payoff

Price

CurrentStockPrice

Stock Payoffs

Payoff

Price

OptionExercisePrice

Call Option Payoffs

Out ofthe Money

Inthe Money

Call Option Payoff = Max[ 0 , S - X ]

Call Option Payoffs

Put Option Payoffs


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Payoff

Price

CurrentStockPrice

Stock Payoffs

Payoff

Price

OptionExercisePrice

Put Option Payoffs

Inthe Money

Out ofthe Money

Put Option Payoff = Max[ 0 , X - S ]

Put Option Payoffs

Application of Options


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Hedging have underlying, buy (go LONG on) puts(Protective Puts)

One way to protect your portfolio from potentialdownside due to market drop is to buy insuranceusing put options

Buy the right no. of puts at the right exercise price

when the stock prices fall, your stock will lose value andthe put options bought by you will gain, effectivelyensuring that the portfolio value does not fall below aparticular level.

Portfolio insurance by buying put options is a hedgingtool for funds who own well-diversified portfolios

By buying puts, funds can limit the downside in case of amarket fall.



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Speculation bullish security, buy (LONG) calls or sell(SHORT) puts

Buying a call option The downside is limited to the option premium

The upside is potentially unlimited

Selling a Put Option

The upside is the option premium

The downside is potentially unlimited

!STOP!!CHECK!


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!STOP!!CHECK!

A call writer could have:

Limited profit; unlimited losses

Unlimited profit, unlimited losses

Unlimited profit, limited losses

Limited profit, limited losses

Spot S&P CNX Nifty is Rs. 3200. An investor boughta one-month S&P CNX 3220 calloptionfor a premium of Rs.10. As on date the option is: In the money

At the money

Out of the money

None of these

In a rising market, the right strategy would be to go:

long puts and/or long calls

long puts and/or short calls

Short puts and/or short calls

Short puts and/or long calls

When Spot


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Purchasers of options have rights but no obligationsand Sellers have obligations, no rights. Whereas, bothpurchasers and sellers of futures have obligations.

Options also lock in a future price, but do not have tobe exercised. Futures lock in prices and must beexecuted at specified future date.

To enter into a future contract one must maintain amargin, while option buying requires an up-frontpayment (premium).

Futures vs. Options

Futures vis--vis Options


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p

Futures Options

Exchange traded Same as futures

Exchange defines the product Same as futures

Price is zero, strike price moves Strike price is fixed, price moves

Price is zero Price is always positive

Linear payoff Non-linear payoff

Both long and short at risk Only short at risk

Remember


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Future and Option markets have a short-terminvestment horizon ONLY.


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Thank You!


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Telefax: 91-11-3268 1735 E-mail: [email protected]

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