Derivatives basic concept


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  • @Jamsheer Basheer Derivatives derives its value from the underlying, so if the price of the underlying (if at all) goes down to zero so will your derivative instrument's price.
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  • Hi Team, its is nice given below about the details of Basics of derivaties...can you send details or slide to email Id as looking for Job in investment banking it will help a lot to go throw
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  • what is the term used in derivative market for ' comparing derivative market is less less risk compare to cash market due to it price not fallen to zero. fall has limit'?????
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  • what is the term used for low risk in derivative due its price not fallen to zero, fallen it has limits in commodity market????
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  • well structured and executed project
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Derivatives basic concept

  1. 1. Derivatives Basic Concept Arihant Bhansali Neha Singhi & Company Mob+919831407321 Email:
  2. 2. Introduction <ul><li>Secondary market contributes significantly to the Indian financial market
  3. 3. Expansion- Variety of financial instruments vis-a-vis Scale of operations
  4. 4. Derivatives-a financial product becoming increasingly popular
  5. 5. Exchange traded financial derivatives were introduced in India in June 2000 at the two major stock exchanges, NSE and BSE </li></ul>
  6. 6. Derivative is…. <ul><li>A derivative is a financial instrument, whose value depends on the value of basic underlying variable
  7. 7. The value of derivative is linked to risk or volatility in either financial asset, transaction, market rate, or contingency, and creates a product </li></ul>
  8. 8. Underlying Assets T-Bill Interest Rates Index & Bonds Foreign Exchange Rate Crude Oil Precious Metals Agri Commodities Stocks
  9. 9. Features of Derivatives <ul><li>Traded on exchange
  10. 10. No compulsory physical trading of underlying assets
  11. 11. All transactions in derivatives take place in future specific date
  12. 12. Hedging Device-Reduces risk
  13. 13. Derivatives has low transaction cost
  14. 14. Derivatives are often leveraged, such that a small movement in the underlying value can cause a large difference in the value of the derivative. </li></ul>
  15. 15. Types of Derivatives Contract Derivatives Contract Forwards Futures Swaps Options
  16. 16. Forwards <ul><li>A forward contract is a customized contract between two entities, where settlement takes place as a specific date in the future at predetermined price. </li></ul>Ex: On 10th Novem, Ram enters into an agreement to buy 100 kgs of wheat on 1st May at Rs.10000 from Shyam, a farmer. It is a case of a forward contract where Ram has to pay Rs.10000 on 1st May to Shyam and Shyam has to supply 100 kgs of wheat. Ram has taken a long position assuming the price of the wheat will rise in the future six months . <ul><li>Normally traded outside exchange </li></ul>
  17. 17. Futures <ul><li>A financial contract obligating the buyer to purchase an asset, (or the seller to sell an asset), such as a physical commodity or a financial instrument, at a predetermined future date and price.
  18. 18. Futures contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures exchange.
  19. 19. Some futures contracts may call for physical delivery of the asset, while others are settled in cash. The futures markets are characterized by the ability to use very high leverage relative to stock markets.
  20. 20. Some of the most popular assets on which futures contracts are available are equity stocks, indices, commodities and currency. </li></ul>
  21. 21. Swaps <ul><li>Swaps are private agreement between two parties to exchange cash flows in the future according to a pre-arranged formula.
  22. 22. They can be regarded as portfolio of forward contracts.
  23. 23. The two commonly used Swaps are- </li></ul>i) Interest Rate Swaps: - A interest rate swap entails swapping only the interest related cash flows between the parties in the same currency. ii) Currency Swaps: - A currency swap is a foreign exchange agreement between two parties to exchange a given amount of one currency for another and after a specified period of time, to give back the original amount swapped.
  24. 24. Forward v/s Future Forward =/ Future Because Forward contract ….. <ul><li>Illiquid
  25. 25. No standardization
  26. 26. No centralized trading </li></ul>
  27. 27. Options… The owner of the option has option to sell or buy assets at a given price on or before given date . Options Put Option Call Option A right to sell the underlying assets , not a obligation A right to buy the underlying assets , not a obligation
  28. 28. American Option An option that may be exercised on any trading day on or before expiry . European Option An option that may only be exercised on expiry date
  29. 29. Important Concepts of Option <ul><li>In-the money </li></ul>A call option said to be in the money, when Future price> Option’s strike price A put option said to be in the money, when Future price < Option’s strike price <ul><li>At- the money </li></ul>A option is at the price, when Future price = Option’s strike price <ul><li>Out of the money </li></ul>A call option said to be out of the money, when Future price < Option’s strike price A put option said to be out of the money, when Future price > Option’s strike price
  30. 30. Types of Derivatives Markets Over-the-Counter derivatives- <ul><li>Contracts that are traded between two parties directly without going through a exchange.
  31. 31. Forward and swap contracts are OTC derivatives. </li></ul>Exchange -traded derivatives- <ul><li>Contracts that are traded in derivatives exchanges </li></ul>
  32. 32. Market Players <ul><li>Hedgers -Transfer of risk component of their portfolio. </li></ul><ul><li>Speculators - Intentionally taking the risk from the hedgers in pursuit of profit. </li></ul><ul><li>Arbitrageurs -Operating in different markets simultaneously, in pursuit of profit and eliminate mis-pricing. </li></ul>
  33. 33. Terminology <ul><li>Spot price- the price at which an assets trades in a spot markets.
  34. 34. Future price- the price at which the future contracts trades in future markets.
  35. 35. Strike price- the price specified in the option contract
  36. 36. Expiry date- the date specified in future and option contracts.
  37. 37. Contract size- the amount of assets that has to be delivered under one contract.
  38. 38. Basis= Future price- Spot Price
  39. 39. Initial Margin- the amount that must be deposited at the future contract is first entered into.
  40. 40. Marking to market
  41. 41. Maintenance Margin- A set minimum margin per outstanding future contract that a customer must maintain in his margin account </li></ul>
  42. 42. Indian History of derivatives <ul><li>The Bombay Cotton trade association started future trading in 1875
  43. 43. In 1952 the government banned cash settlement and option trading.
  44. 44. In 1995 a prohibition on trading options was lifted.
  45. 45. In 1996, NSE sent a proposal to SEBI for listing exchange traded derivatives.
  46. 46. In 1999, the Securities Contract (Regulation) Act of 1956 was amended and derivatives could be declared “securities”.
  47. 47. Index future were introduced in June 2000 and Index option in 2001.
  48. 48. NSE started trade in future and option by 2005 </li></ul>
  49. 49. Business Growth in Derivatives segment in NSE
  50. 50. Derivatives users in India... Financial Institution- <ul><li>Financial Institution have not been heavy users of exchanges traded derivatives.
  51. 51. Financial Institution contribution to NSE trade being less than 8% in October 2005
  52. 52. Banks use derivatives on interest rates and currencies to manage credit risk
  53. 53. Non financial institution are regulated differently from financial institution, and this affects their incentives to use derivatives
  54. 54. Foreign Investor must register as FII to trade equity derivatives and be subject to position limit as specified by SEBI </li></ul>Retails Investor- <ul><li>Retail Investor are the major participants in equity derivatives .
  55. 55. Retail Investor are familiar with “BADLA” trade which shared some features of derivatives trading.
  56. 56. Retails Investor also dominate the market of commodity derivatives for their long-standing expertise in trading . </li></ul>
  57. 57. Regulatory Framework in India <ul><li>Regulatory framework in India is based on International Organization of Securities Commissions (IOSCO) principles. </li></ul><ul><li>L.C. Gupta committee provided regulatory responsibility between SEBI and exchange. </li></ul><ul><li>J.R. Verma committee reports suggested a methodology for risk containment. </li></ul>
  58. 58. L C Gupta Committee states…. Derivatives Exchanges: <ul><li>Existing exchanges may start Derivatives segments or separate exchanges may be set up
  59. 59. Minimum 50 members
  60. 60. Online surveillance capability </li></ul>Regulatory Recommendations: <ul><li>SEBI to act as regulator and will approve rules, bye laws and regulations.
  61. 61. All members to inspected.
  62. 62. Exchange to provide the full details of proposed contract.
  63. 63. Trading days and hours to be stipulated in advance.
  64. 64. Contract expiration period may not exceed 12 months. </li></ul>Entry Rules: <ul><li>Minimum net worth Rs. 300 Lakhs
  65. 65. Minimum deposit Rs. 50 Lakhs
  66. 66. Registration with SEBI in addition to registration with exchange .
  67. 67. Brokers and dealers to pass a certification programme . </li></ul>
  68. 68. J R Verma Committee states… <ul><li>Cross margining not permitted
  69. 69. Collection of margins before trading hours next days from all clients
  70. 70. Initial margin to be based on 99% value at Risk
  71. 71. Liquid net worth shall be 50 Lac.
  72. 72. Initial margin applicable to total gross open position.
  73. 73. Trading software would provide volatility information on real-time basis. </li></ul>
  74. 74. SEBI guidelines for derivatives trading…. <ul><li>Investor protection
  75. 75. Quality of Markets
  76. 76. Fairness and transparency
  77. 77. Innovation
  78. 78. Safeguards of investors money
  79. 79. Market integrity </li></ul>