Derivatives
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  • 1. Derivatives Derivative is a product which does not have any value on its own but it derives its value from some underlying assets
  • 2. Types of Derivatives  Forward  Futures  Options  Swaps contracts
  • 3. Forward Contracts It is one to one bi-partite contract  To be performed in the future  At the terms decided today.  Offer tremendous flexibility to design the contract in terms of the price, quantity, quality ( in case of commodities)  Delivery time  Place 
  • 4. Forward contracts - continue For example, if you agree on March 1 buy 15 gms of Gold on June 1 at a price of Rs.870 per gm from a goldsmith, you have bought forward gold or you are long forward gold. Whereas the goldsmith has sold forward gold or is short forward gold. No money or gold changes hand when the deal is signed. Short position – which commits the seller to deliver an item at the contracted price on maturity Long position – which commits the buyer to purchase an item at the contracted price on maturity.
  • 5. Futures Agreement Between two parties  To Buy or sell an asset  At a certain time in the future  At a certain price  Every futures contract is a forward contract but it is a standardised contract. 
  • 6. Futures Vs Forward contracts The key difference between OPTION CONTRACT and FORWARD & FUTURES contracts is: The holder of a option enjoys the right to buy or sell. A forward or futures contract imposes a firm obligation to go through the transaction. The forward or futures contract is not an investment because no cash is paid to buy an asset. It is just commitment to do a transaction in future.
  • 7. Features Operational mechanism Contract specifications Counterparty risk Forward contract Not traded on exchange. No secondary market. Futures Differs from trade to trade. Tailor-made contract. Contracts are standardized contracts Exists, but assumed by clearing house. Traded on organised exchange
  • 8. To continue Features Security Forward No collateral is required Futures A margin is required. settlement They are settled They are on the maturity ‘marked to date. market’ on a daily basis. This means that profits and losses on
  • 9. Futures Terminology Spot Price :- The price at which an asset trades in Spot Market  Futures Price :- Price at which the futures contract trades in the futures market  Contract Cycle : - Period over which a contract trades in the futures market  Expiry Date :- last day on which the contract will be traded 
  • 10. Futures Terminology cont. Contract Size : - Amount of Asset that has to be delivered under one contract  Initial Margin :- Deposited at the time a futures contract is first entered into. It may about 10% of the value of contract – it is fixed by the exchange. The margin has to be posted by both the parties to the futures contract are exposed to losses. 
  • 11. Continue Mark to the Market :- This means that the profits and losses on futures contracts are settled on a periodic basis. Ex. The marking-to-market feature implies that the value of the futures contract is set to zero at the end of each trading day.  Open Interest :- Total number of outstanding contracts (long/short) at any point of time. It is either the number of long or short contracts outstanding. At the beginning of trading cycle open interest is zero. When maturity date nears open interest declines sharply. 
  • 12. Settlement of Futures Contracts The NSCCL ( the National Stock Exchange Clearing Corporation Limited) clears and settles all the deals executed on the NSE’s F & O segment. Currently F&O contracts in India are cashsettled. Daily Mark to Market Settlement   Open Positions are marked to daily settlement price and settled on T+1 basis Open positions are reset to the Daily Settlement price Final Settlement   On the expiry day, open positions are marked to the final settlement price Settlement takes place on T+1 basis
  • 13. Types of Futures Commodity Futures : is a a futures contract in a commodity like cocoa/aluminium/cotton/gold/crude oil/. Futures have their origins in commodities.  Financial Futures : is a futures contract in a financial instrument like treasury bonds, currency or stock index.  Equity futures, interest rate futures and currency futures dominate market today. 
  • 14. Equity Futures in India Equity futures are of two types : Stock index futures Futures on individual securities  STOCK INDEX FUTURES The NSE and BSE have introduced the stock index futures. NSE stock index futures based – S&P CNX Nifty index. BSE – Sensex.
  • 15. Index futures - continue Item Date of start Underlying Contract Size BSE June 9, 2000 Sensex Sensex value x 50 NSE June 12, 2000 S&P CNX Nifty 200 or multiples of 200 Expiration months Trading cycle 3 near months 3 near months The near month(1), the next month (2)and the far Same
  • 16. Continue Item Settlement BSE NSE In cash T + 1 Same basis Final settlement Index closing same price on the last price trading day Daily settlement Closing of Same price futures contract price
  • 17. Futures on individual securities        Introduced in India in 2001. Both NSE and BSE have introduced futures on individual securities. Three months trading cycle Currently available for 31 securities. Daily mark-to-market settlement/final mark-tomarket settlement on expiry of a futures contract. T+1 basis Lot size may be stipulated by the exchange from time to time.
  • 18. Pricing of Future contracts Equity futures :  F = S(1 + r – d)(power t) S = stock index r = risk free interest rate d = dividend yield t = no. of months Commodity futures ( storable commodities) Futures price -------------= Spot price + present value of (1 + r)power t storage costs – present val convenience yield.
  • 19. Use of Futures contracts Participants in the Futures market are : Either Hedgers or Speculators. Hedgers are parties who are exposed to risk because they have a prior position in the commodity or the financial instrument specified in the futures contract. They buy or sell futures contract to protect themselves against the risk of price changes. Speculators do not have a prior position that they want to hedge against price fluctuation. Rather they are willing to assume the risk of price fluctuation in the hope of profiting from them. It attracts them because - Leverage - Ease of transaction - Lower transaction cost. 
  • 20. Option Contracts Deferred delivery contracts  Gives the buyer the right  not the obligation  to buy or sell  a specified underlying  at a set price  on or before a specified date 
  • 21. Types of Options Call Option  Right to BUY ( but not the obligation) a specified underlying ( commodity or a financial instrument) at a set price on or before an expiration date.  If a investor feels that the price of gold will increase in the future, the investor can hedge the inherent risk by buying a gold call option.
  • 22. Put Option Put Option  Right to SELL ( but not the obligation) a specified underlying ( commodity or a financial instrument) at a set price on or before an expiration date.  For example, if an investor expects a decline in the price of silver in the near future, he can buy a silver put option.
  • 23. To continue A ‘call’ is way to profit if prices go up.  A ‘put’ is way to profit if prices go down.
  • 24. Options Terminology      Index Options : Index in the underlying security. The first derivative product to be introduced in the Indian securities market – ‘index futures’ Stock Options : Options on individual stocks American Options : Options that can be exercised at any time European Option : Option that can be exercised only on the expiration date Asian options : option that can be exercised at the best price prevalent during option duration.
  • 25. Options Terminology cont.  Option Buyer – holder of the option   Option Writer/Seller   Price at which the underlying may be purchased or sold Expiration Date   Price paid by the buyer to acquire the right to the seller. Strike Price OR Exercise Price   Has the right to sell a stock at a fixed price but not the obligation Option Premium   has the right to buy an asset but not the obligation Last date for exercising the option. Or is the date of which option expires. Exercise Date  Date on which the option is actually exercised
  • 26. Options Terminology cont.  In-the-Money Option (ITM)  Is an option that would lead to a positive cash flow to the holder if it were exercised immediately  At-the-Money Option (ATM)  Is an option that would lead to a zero cash flow if it were exercised immediately.  Out-of-the-Money Option (OTM)  Is an option that would lead to a negative cash flow if it were exercised immediately
  • 27. Market Call Put Scenar option option ios s Market In-the- Out-ofprice > money thestrike money price Market At-the- At-theprice = money money strike price Market Out-of- In-theprice < themoney Strike money price
  • 28. Settlement of Option Contracts Daily premium settlement  On T+1 basis
  • 29. Option valuation Binomial Model for Option Valuation  Black and Scholes Model  Binomial Model for Option Valuation C=#S-B
  • 30. Black and Scholes Model One of the complicated formulae in finance, it is one of the most practical. C = S N (d1) – E N ( d2) --e(power rt) Steps : 1. calculate d1 and d2 2. Find N (d1) and N(d2) 3. Estimate the P.V. of the exercise price. E / e(power rt) 4. Apply the formula. 
  • 31. Equity options in India Two popular types of equity options : Index options Options on individual stocks. Index Options They are options on stock market indices. The S&P CNX Nifty is the most traded on NSE in India. ( other rules are the same as futures) 
  • 32. Option on individual stocks        introduced by NSE and BSE. Trade cycle – maximum of 3 months The exchange shall provide a minimum of five strike price for every option type ( call and put) during the trading month. ( 2 contracts ITM, 2 contracts OTM and one contract ATM) Expire on the last Thursday The value of the option contract shall not be less than Rs.2 lakhs at the time of introduction. The permitted lot size multiples of 100 Settlement is on T+3 days.
  • 33. Options Vs Futures In options, there is no obligation to honor the contract. Only there is right. In options, the buyer has to premium to the writer of the option. In futures both the parties are equally responsible to honor their obligations. Both the parties have to deposit the initial margin with the clearing house and then have to pay variation margin. AO & EO No such distinctions exists and the parties
  • 34. To continue In options the buyer limits the downside risk to the extent of premium paid. he retains the upside potential. In futures, the buyer is exposed to the whole of the downside risk and has the potential for all the upside return. Employed by both hedgers and speculators. Trading in futures is largely done by speculators.
  • 35. Swaps Swap contract is a spot purchase and simultaneous futures sale or a spot sale with a simultaneous buy from the futures market. It is the agreed exchange of future cash flows with spot cash flows.  Types of swaps : Interest rate swaps Currency swaps Equity swaps. 
  • 36. How can you trade ?          Open account with a Derivatives Member Sign a client-broker agreement Understand & sign the Risk Disclosure Document Decide on the exposure you want to have in derivatives Pay Initial Margin on up front basis Take Positions Get Contract Notes for the trades executed Receive / Pay daily Mark to Market Periodic Billing.