Derivatives - Options and SWAP

1. Derivative
Options and SWAP
Prepared by:
Mr. Mohammed Jasir PV
Asst. Professor
MIIMS, Puthanangadi
Contact No: 9605 69 32 66

2. Topics
• Derivative
• Types with Example

3. Derivatives
• Derivatives: derivatives are instruments which include
– Security derived from a debt instrument share, loan, risk instrument or contract
for differences of any other form of security and ,
– a contract that derives its value from the price/index of prices of underlying
securities. Derivatives (Definition)
• A financial instrument whose characteristics and value depend upon the
characteristics and value of an underlier, typi- cally a commodity, bond, equity or
currency,

4. Derivatives (Definition)
• A financial instrument whose characteristics and value depend upon the
characteristics and value of an underlier, typically a commodity, bond, equity
or currency.
• Examples of derivatives include futures and options.
• Advanced investors sometimes purchase or sell derivatives to manage the risk
associated with the underlying security, to protect against fluctuations in value,
or to profit from periods of inactivity or decline.
• These techniques can be quite complicated and quite risky.

5. Advantages of Derivative Market
• Diversion of speculative instinct form the cash market to the derivatives
• Increased hedge for investors in cash market
• Reduced risk of holding underlying assets
• Lower transactions costs
• Enhance price discovery process
• Increase liquidity for investors and growth of savings flowing into these
markets
• It increase the volume of transactions

6. Types of Derivatives
Derivatives
Financial
Derivatives
Stock, Bond,
Forex
Commodity
Derivatives
Sugar, Cotton,
gold, silver

7. Types of Derivatives
There are two types of derivatives
1. Financial derivatives
– Financial Derivatives the underlying instruments is stock, bond,
foreign exchange.
2. Commodity Derivatives
– Commodity derivatives the underlying instruments are a commodity
which may be sugar, cotton, copper, gold, silver.

8. Types of Financial Derivatives
Financial Derivatives
Basic
Forward
Future
Options
Warrants & Convertibles.
Complex.
Swap
Exotioc

9. What are Options?
• An option is the right, but not the obligation to buy or sell
something on a specified date at a specified price.
• In the securities market, an option is a contract between two
parties to buy or sell specified number of shares at a later
date for an agreed price.

10. Features of Options
• A fixed maturity date on which they expire (Expiry date)
• The price option is exercised is called the exercise price or strike price
• There are three parties involved
1. The option seller or writer
2. The option buyer
3. The securities broker / Clearing House
• The premium is the price paid for the option by the buyer to the seller

11. Types of Option
1
Call Option
Put Option
2
European style options
American style options

12. Types of Options
Options are of two types – call and put
• Call option give the buyer the right but not the obligation to buy a given
quantity of the underlying asset, at a given price on or before a particular
date by paying a premium
• Put Option: Give the buyer the right, but not obligation to sell a given
quantity of the underlying asset at a given price on or before a particular
date by paying a premium

13. Types of Options (cont.)
The other two types are
• European style options can be exercised only on the maturity date of
the option, also known as the expiry date.
• American style options can be exercised at any time before and on the
expiry date.

14. Right to buy 100 Reliance share
at price of Rs. 300 / Share after
one month.
Current price 250
Demo - Call Option
Premium Rs. 25/ share
Amount to buy Call option = 2500
Suppose after a month, Mkt price is
Rs.400, Then the option is exercised.
Means the shares are brought.
Net gain= 40000 – 30000 – 2500 = 7500
Suppose after a month, Mkt price is
Rs.200, Then the option is not
exercised.
Net Loss = Premium = 2500

15. Right to sell 100 Reliance share
at price of Rs. 300 / Share after
one month.
Current price 250
Demo – Put Option
Premium Rs. 25/ share
Amount to buy put option = 2500
Suppose after a month, Mkt price is
Rs.200, Then the option is exercised.
Means the shares are sold.
Net gain= 30000 – 20000 – 2500 = 7500
Suppose after a month, Mkt price is
Rs.400, Then the option is not exercised.
Net Loss = Premium Amt= 2500

16. Options Terminology
• Option holder : One who buys option
• Option writer : One who sells option
• Underlying : Specific security or asset
• Option premium : Price paid (Advance)
• Strike price : Pre-decided price
• Expiration date : Date on which option expires
• Exercise date : Option is exercised

17. What are SWAPS?
• In a swap, two counter parties agree to enter into a contractual
agreement wherein they agree to exchange cash flows at periodic
intervals
• Most swaps are traded “Over The Counter”
• Some are also traded on futures exchange market
• Portfolio of Forward Contract

18. Types of Swaps
Plain vanilla fixed for floating
swaps
(Interest rate swaps)
Fixed for fixed currency swaps
(Currency swaps)

19. What is an Interest Rate Swap?
• It is a contractual agreement between two parties to exchange interest payments
• A company agrees to pay a pre-determined fixed interest rate on a notional principal
for a fixed number of years
• In return, it receives interest at a floating rate on the same notional principal for the
same period of time
• The principal is not exchanged. Hence, it is called a notional amount

20. Floating Interest Rate
• LIBOR – London Interbank Offered Rate
• It is the average interest rate estimated by leading banks in London
• It is the primary benchmark for short term interest rates around the world
• Similarly, we have MIBOR i.e. Mumbai Interbank Offered Rate
• It is calculated by the NSE as a weighted average of lending rates of a group
of banks

22. Company A Company B
Bank A Bank B
Fixed 7%
Variable LIBOUR
Fixed 10%
Variable LIBOUR+1
Aim 5 Million $ at Variable Aim 5 Million $ at Fixed
SWAP Bank
5 M$
5 M$
7%
8% 8.5%
LIBOR LIBOR
LIBOR+1%
Notional Amount = $5 Million

23. Using a Swap to Transform a Liability
• Firm A has transformed a fixed rate liability into a floater
o A is borrowing at LIBOR – 1%
o A savings of 1%
• Firm B has transformed a floating rate liability into a fixed rate liability
o B is borrowing at 9.5%
o B saving of 0.5%.
• Swaps Bank Profits = 8.5%-8% = 0.5%

24. What is a Currency Swap?
• It is a swap that includes exchange of principal and interest rates in one
currency for the same in another currency
• The principal may be exchanged either at the beginning or at the end of the
tenure
• If it is exchanged at the end of the life of the swap, the principal value may
be very different
• It is generally used to hedge against exchange rate fluctuations
€ to $

25. Direct Currency Swap Example
• Firm A is an American company and wants to borrow €40,000 for 3 years.
• Firm B is a French company and wants to borrow $60,000 for 3 years.
• Suppose the current exchange rate is €1 = $1.50.

26. Firm A Firm B
Bank A Bank B
€ 6%
$ 7%
Aim €40,000 Aim $60,000
$60,000
€40,000
7%
5%
7%
5%
€ 5%
$ 8%

27. Comparative Advantage
• Firm A has a comparative advantage in borrowing Dollars
• Firm B has a comparative advantage in borrowing Euros
• This comparative advantage helps in reducing borrowing cost and hedging
against exchange rate fluctuations

28. Thank You !!!