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How do derivatives work? Perspective from Indian market

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  1. 1. By: Amit Mittal Nitin Mittal
  2. 2. Introduction to Derivatives <ul><li>Derivatives are the financial instruments which derive their value from the value of the underlying asset. </li></ul><ul><li>The underlying asset can be equity, fixed income instruments, interest rates, foreign exchange or commodities. </li></ul><ul><li>The price movements of derivative products are related to that of the underlying securities. </li></ul>
  3. 3. Various types of Derivatives
  4. 4. History of Derivatives <ul><li>Chicago Board of Trade (CBOT) for derivatives trading, became functional in 1848 and by 1865 futures contract in commodities started trading. </li></ul><ul><li>In 1972 currency futures were introduced, followed by equity options in 1973. </li></ul><ul><li>Year 1975 saw introduction to Interest Rate futures. </li></ul><ul><li>Currency Swaps were introduced in 1981 and in 1982 Index futures, Interest Rate swaps and Currency Options were started. </li></ul><ul><li>In 1983, Index Options and Options on futures were started. </li></ul>
  5. 6. Advantages of using Derivatives <ul><li>Leveraged Positions </li></ul><ul><li>Lesser transaction costs </li></ul><ul><li>Ease of creating positions </li></ul><ul><li>Derivatives as Risk Management Products </li></ul><ul><li>Derivatives as Trading Products </li></ul>
  6. 7. Structured or Over The Counter versus Exchange traded Derivatives <ul><li>Exchange traded derivatives are standardized contracts which can only be traded on a recognized exchange. </li></ul><ul><li>The clearing house of the exchange provides the counterparty guarantee </li></ul><ul><li>OTC derivatives on the other hand are customized contracts and the terms of the contract are flexible. </li></ul><ul><li>There is no counterparty guarantee. </li></ul><ul><li>The liquidity of an OTC derivative can be limited as it is a customized contract. </li></ul>
  7. 8. Derivatives to be discussed <ul><li>Futures </li></ul><ul><li>Forwards </li></ul><ul><li>Options </li></ul>
  8. 9. <ul><li>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- </li></ul><ul><li>Contract through an exchange </li></ul><ul><li>To exchange obligations on a future date </li></ul><ul><li>At a price decided today </li></ul><ul><li>For a quantity / quality standardized by the exchange </li></ul><ul><li>Settlement guaranteed by the clearing corporation of the exchange </li></ul>
  9. 10. Difference between forwards and futures Forwards 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 daily basis Valuation Not Done Done on daily basis
  10. 11. <ul><li>Underlying </li></ul><ul><li>Contract Multiplier </li></ul><ul><li>Tick size </li></ul><ul><li>Contract months </li></ul><ul><li>Expiry date </li></ul><ul><li>Daily settlement price </li></ul><ul><li>Final settlement price </li></ul>
  11. 12. <ul><li>Pricing of Futures </li></ul><ul><li>Trading of futures </li></ul><ul><li>Margins required for futures contracts </li></ul><ul><li>Settlement of futures </li></ul>
  12. 14. Forward Contracts <ul><li>Forward Contract is an OTC derivative product. </li></ul><ul><li>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. </li></ul><ul><li>There is no counterparty guarantee provided by any third party. </li></ul><ul><li>Forward contracts unlike futures, are deliverable contracts (Though there are non-deliverable forward contracts also). </li></ul>
  13. 15. Different Types of Forward Contracts <ul><li>Depending on the underlying asset, the most common types of forward contracts are: </li></ul><ul><li>Currency Forwards </li></ul><ul><li>Interest Rate Forwards, and </li></ul><ul><li>Commodity Forwards </li></ul>
  14. 16. Participants in Forward Contracts <ul><li>Hedgers – They participate in the forward market with a view to protect or cover an existing exposure in the spot market. </li></ul><ul><li>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. </li></ul><ul><li>Arbitrageurs – These players neither hedge nor speculate. They try to take advantage of the price differences in the spot and forward markets. </li></ul>
  15. 17. Options <ul><li>Options or option contracts are instruments </li></ul><ul><li>Right, but not the obligation, is given </li></ul><ul><li>To buy or sell a specific asset </li></ul><ul><li>At a specific price </li></ul><ul><li>On or before a specified date </li></ul><ul><li>Options can be exchange traded derivatives or even over the counter derivatives. </li></ul>
  16. 18. Differences in equity shares and equity options
  17. 19. Option Terminologies <ul><li>Strike Price or Exercise Price </li></ul><ul><li>Expiration Date </li></ul><ul><li>Exercise Date </li></ul><ul><li>Option Buyer </li></ul><ul><li>Option Seller </li></ul><ul><li>American option </li></ul><ul><li>European option </li></ul><ul><li>Option Premium </li></ul>
  18. 20. Option Classifications <ul><li>Call Option : an option which gives a right to buy the underlying asset at a strike price. </li></ul><ul><li>Put Option : an option which gives a right to sell the underlying asset at strike price. </li></ul>
  19. 21. Call Option Buying <ul><li>A Call option buyer basically is bullish about the underlying stock. </li></ul>
  20. 22. Put Option buying <ul><li>A buyer of put option is bearish on underlying stock. </li></ul>
  21. 23. <ul><li>Both the Call and Put option buyers are buying the rights, that is they are transferring their risks to the sellers of the option. </li></ul><ul><li>For this transfer of risk to the sellers, buyers have to compensate by paying Option Premium . </li></ul><ul><li>Option premium is also known as Price of the option, Cost or Value of the option. </li></ul>
  22. 24. Option Selling: Motives for selling options <ul><li>The seller is ready to assume the risk in option exercise. The incentives for the seller to assume that risk are two : </li></ul><ul><li>Option Premium – This is the actual amount received by him for selling an option to the buyer. </li></ul><ul><li>The possibility of non-exercise of option – In seller’s view the possibility of option being exercised by the buyer may be low. </li></ul>
  23. 25. Factors influencing Option Pricing <ul><li>Time to expiration – greater the time to expiration, higher the value of the options. </li></ul><ul><li>Volatility –higher the volatility, higher the value of the options. </li></ul><ul><li>Risk free Rate of Interest – If interest rate goes up, calls gain in value while puts lose value. </li></ul>
  24. 26. ITM, ATM, OTM Options <ul><li>In the money </li></ul><ul><li>At the money </li></ul><ul><li>Out of money </li></ul>
  25. 27. Intrinsic and Time value of the option <ul><li>Intrinsic value is equal to the amount by which option is in the money. </li></ul><ul><li>Time value is the difference between market price of the option and intrinsic value. </li></ul>
  26. 28. Settlement of Options <ul><li>Physical Delivery </li></ul><ul><li>Cash settlement </li></ul>
  27. 29. Exercise of calls
  28. 30. Exercise of Puts
  29. 31. Pay off from a Long Call
  30. 32. Payoff from Short Call
  31. 34. Summary of basic option strategies
  32. 35. <ul><li>Thank You! </li></ul>