snapshot on Derivatives

1. Derivatives
Tool for Strategic Investment

2. Derivatives Defined
• Derivative is a product whose value is
derived from the value of underlying asset
in a contractual manner.
• In simple terms they are contracts for future
delivery of assets and payment for them.

3. Emergence of the Market
• Can be traced back to the willingness of
risk-averse economic agents to guard
themselves against uncertainties arising out
of fluctuations in asset prices.
• Through the use of derivative products, it is
possible to partially or fully transfer price
risks by locking in asset prices.

4. Role of Derivatives
• As instruments of risk management, these
generally do not influence the fluctuations in the
underlying asset prices.
• However, by locking-in asset prices, derivative
products minimize the impact of fluctuations in
asset prices on the profitability and cash flow
situation of risk-averse investors.

5. Initial Derivative Instruments
• Commodity derivatives
• Financial derivatives
• 1972 - CME started trading currency futures.
• 1973- CBOE – Equity options
• 1976 – CME Treasury Bill futures
• Now financial derivatives are very popular.
• Account for about two-thirds of total transactions
in derivative products.

6. Factors Driving Growth of
Derivatives Use
• Increased volatility in prices in financial
markets.
• Increased integration of stock markets
world-wide
• Improvement in communication facilities
• Development of sophisticated risk
management tools and strategies.
• Innovations in derivative markets.

7. Derivative Markets- Economic
Functions
• Derivatives help in discovery of future as well as
current prices.
• Helps to transfer risks from those who have them
but may not like them.
• Linkage to the underlying cash markets. Cash
markets witnesses higher trading volumes because
of participation by more players who would not
otherwise participate for lack of an arrangement to
transfer risk.

8. Derivative Markets- Economic
Functions (contd.)
• Speculative trades shift to a more controlled
environment.
• Derivatives have a history of attracting bright,
creative, well-educated people with an
entrepreneurial attitude. They create new products.
• Help increase savings and investments in the long
run. Transfer of risk enables market participants to
expand their volume of activity.

9. Development of Derivative
Exchanges
• Chicago Board of Trade (CBOT) in 1848.
Exchange for forward contracts.
• In 1865, first futures contract was
introduced in CBOT.
• In 1876 “Grain Call” trading established in
Kansas City Board of Trade.

10. Indian Derivatives Market

11. The Road Ahead
• CASH MARKET
• Investments
• Day Trading
• Rolling Settlement
• Derivatives Market
• Hedging
• Speculation
• Arbitrage
• Index Based
• Scrip Based

12. Stock Index Futures
• Is a derivative contract whose underlying is
a stock index.

13. Why index future??
 The market is conditioned to think in terms
of the index and therefore would prefer to
trade in stock index futures. Further, the
chances of manipulation are much lesser
 The transaction cost is lower.

14. Futures Terminology
• Spot price: The price at which an asset
trades in the spot market.
• Futures price: The price at which the futures
contract trades in the futures market.
• Contract cycle: The period over which a
contract trades. The index futures contracts
on the NSE have one-month, two-months
and three-months expiry cycles.

15. Futures Terminology (contd.)
• The index futures of a month expire on the last
Thursday of the month.
• On the Friday following the last Thursday of the
month, a new contract having three-month expiry
period would be introduced for trading.
• Expiry Date: It is the last day on which the
contract will be traded and at the end of which it
will cease to exist.

16. Futures Terminology (contd.)
• Contract Size: The amount of asset that has
to be delivered under one contract. For
instance, the contract size on NSE future
market is 200 Nifties.
• Future prices normally exceed spot prices.

17. QUESTION
If you have a portfolio of 2 crores
and you expect the market to come
down by 1000 points in the short
term, what will be the most
prudent way to reduce your risk?

18. CHOICES
• Sell your portfolio in the cash market
• Ask your Family Astrologer
• Use Index Derivatives to hedge your
Portfolio
• Do nothing and observe your portfolio
eroding.

19. Indexes
• In recent years, indexes have come to the
forefront owing to direct application in
finance in the form of index funds and
index derivatives.
• Index derivatvies allow people to cheaply
alter their risk exposure to an
index(hedging) and to implement forecasts
about index movements (speculation)

20. Purpose of Index Futures
• Hedging
• Speculation
• Arbitrage

21. Derivative Market Dynamics
• Hedgers – FII’s, Mutual Funds, Pension
Funds, Insurance Companies, HNI’s
• Speculators – Big Operators, HNI’s,
Proprietary Traders

22. Hedging
• A Hedge is a combination of positions, where one
position profits and the other position loses.
• So a hedge can be thought of as an insurance
against being wrong.
• A hedge can help lock existing profit.
• Its purpose is to reduce the volatility of a
portfolio, by reducing risk.
• Derivatives are widely used for hedging.

23. Speculation
• Bullish index, long Nifty futures
• Bearish index, short Nifty futures

24. Speculation
Buy(in July) {Spot Nifty-1120}
August contract at 1125 NSE Nifty
Exposure 1125 x200 = Rs.2,25,000
Margin @ 15% = Rs. 33,750/-
Sell (after a few days)
August Contract at 1165 NSE Nifty at 1160
Profit on square off = [1165-1125]x200 = Rs.8000
Return on margin = Rs.8000/33750 = 23.70%
Amount released on square off =Rs.33750 + Rs.8000

25. Pay-off for a future buyer
-80
-60
-40
-20
0
20
40
60
80
1065 1085 1105 1125 1145 1165 1185
Nifty

26. Pay-off for a future seller
-80
-60
-40
-20
0
20
40
60
80
1065 1085 1105 1125 1145 1165 1185
Profit

27. Arbitrage
• The cash markets and the futures markets are
tightly linked.
• On the day of maturity, cash and future market
index converge.
• Arbitrageurs bring price uniformity and help price
discovery.
• The cash market and index futures provide
arbitrage opportunities which arise due to
imbalance between hedgers and speculators.

28. Arbitrage
• Have funds, lend them to the market
• Have securities, lend them to the market

29. Example
• You own a 1 million portfolio with a beta of 1.25. Current
Nifty level 1250. Three month puts at a strike of 1100 are
available. How many put contracts should you buy for
insuring your portfolio against an index fall below 1100?
• 1. Four
• 2. Five
• 3. Eight
• 4. Ten
• The answer is -----

30. ….the answer is
At a spot Nifty level of 1250 for a portfolio value of
1 million with beta of 1.25, the number of puts to
buy is (10,00,000*1.25) / 1250 =1000 puts. At a
market lot of 200 per contracts you have to buy 5
contracts to insure your portfolio.

31. Advantage of Futures Trading
• Day traders delight
– At a single price buying/selling market lot.
– Ability to exit with small movement in price.
– Advantage of no circuits
– Fear of market lot negated with small price movements
• Highly leveraged position.(double edged sword)
• Positions carried overnight based on closing market
trend.
• Position can be carried forward for 1-3 months.

32. Standard Portfolio Analysis of Risk
(SPAN)
• A methodology to evaluate risk
• Risk-based, portfolio-approach
margining
• Part of the VAR family
• A flexible framework
• Efficient and understandable
• An industry-standard

33. SPAN History
• Developed by CME in 1988
• Rapidly adopted by all US futures markets
• The standard in financial capitals worldwide --
Tokyo, Osaka, Singapore, Hong Kong,
Sydney, London, Paris, Toronto, New York,
Chicago, and now Mumbai
• Numerous other markets are in the “SPAN
adoption pipeline”

34. Uses for SPAN
• Margin (performance bond) calculation
• General-purpose risk analysis
• Stress testing
• Real-time pre- or post-execution risk-
based credit controls
• Risk-based capital requirements

35. SPAN and margining
• SPAN makes it easy to support cross-
margin agreements between clearing
organizations
• Scan risk -- the core of SPAN --
determines the worst possible loss
assuming perfect correlation of price
movements across contract months

36. SPAN Mechanics
• The exchange sets the inputs to SPAN,
modifying them as often as desired
• Every day, the exchange calculates SPAN
risk arrays for all of its products and
packages all of its SPAN data into its daily
SPAN risk parameter file, which is then
published
• Members, firms, customers etc. then use the
data from the SPAN file, together with their
positions data, to calculate SPAN margin
requirements

37. PC SPAN
PC SPAN
Master file
Risk parameter
files
Position file
Output /
Margin
(Report form or
file form- XML)

38. Options

39. Options
An instrument which gives the buyer
substantial upside potential
but with
limited downside risk / cost

40. Options
• Deferred delivery contracts
• give the buyer the right
• not the obligation
• to buy or sell
• a specified underlying
• at a set price
• on or before a specified date

41. Option Premium
• Premium : The fee that the buyer pays the option
writer up front while buying. It is the maximum
loss the buyer can suffer.
• The premium is also referred to as value of the
option or price of the option.

42. Index Options
Index options are European options, which means
contracts will be settled on date of expiry only.
The date of expiry shall be the last Thursday of the
contract month.
The contracts shall be available for 1,2 and 3
months.
The underlying for Index Options
-for BSE- 30Sensex
-for NSE- Nifty

43. Strike Price or Exercise Price
• The price at which the buyer of a call option
has the right (but not the obligation) to
purchase the underlying.
• The price at which the buyer of a put option
has the right (but not the obligation) to sell
the underlying.

44. Call Option
• Right to BUY a specified underlying at a set
price on or before an expiration date.
• The holder of a RIL Dec 500 call option has
the right to buy (or go long) 100 RIL shares
at a price of 500 anytime between purchase
and expiration.

45. Call Buyer Vs Seller
• Call Buyer
– Pays premium
– Has choice to exercise to buy the asset
• Call Seller
– Collects premium
– Has obligation to give the asset

46. Example
Deepak is bullish about the index spot nifty 1250.
He decides to buy 3-month Nifty call contract
with strike of 1290. Three month later the
index closes at 1300. His pay-off on the
position is ..
1. Rs.7,000
2. Rs.2,000
3. Rs.19,000
4. None of the above.

47. Put Option
• Right to SELL a specified underlying at a
set price on or before an expiration date.
• The holder of a RIL Dec 250 put option has
the right to sell (or go short) a RIL share at
a price of 250 anytime between purchase
and expiration.

48. Put Buyer Vs Seller
• Put Buyer
– Pays premium
– Has choice to deliver asset
• Put Seller
– Collects premium
– Has obligation to take the asset.

49. Bearish Index- Buy Puts or Sell Call
Buy Put
First time you shall buy when you are bearish in
market.
If the index falls you gain and you lose premium if
index moves up.The premium and your belief
the fall in index again plays a big role in
selection of which PUT to BUY.

50. Example
• Anand is bearish when Nifty is at 1240.He decides
to buy one 2-month put option at strike of 1225
for a premium of Rs.34.50. Two months later
Nifty is 1280. His pay-off is :
• Rs. -6900
• Rs.-4000
• Rs.-5300
• Rs.-12000

51. Types of Options
• American Option
– can be exercised any time on or before the
expiration date
• European Option
– can be exercised only on the expiration date

52. Scrip Options
Scrip options shall be American which means it can be
settled same day
The writer of option will be strictly monitored with
MTM margins.
The value of premium shall be critical and bring in
speculators and arbitrageurs to take position.

53. Option Calculator
The premium calculator helps the user to
understand how a change in any one of the factors
or more, will affect the option price
Professional traders for trading & managing the
risk of large positions in options & stocks use
option Greeks which are available in the option
calculator

54. Option Pricing Models
• Black-Scholes Model
– Pce = S*N(d1) - X e -Rf.t
* N(d2)
– Normal Distribution Function
• Binomial (Cox-Ross-Rubenstein) Model
– Ppe = X e -Rf.t
* N(-d2) - S*N(-d1)
– Binomial Distribution Function

55. Factors affecting Option
Values
Current Price of the underlying asset (S)
Exercise Price of the option(X)
Time to Expiry (T)
Volatility of prices of the underlying asset
(σ)
Interest Rates (Rf)

56. Option Greeks
Option Greeks are:
Delta: is the option Greek that measures the estimated
change in option premium/price for a change in the price
of the underlying.
Gamma : measures the estimated change in the Delta of
an option for a change in the price of the underlying
Vega : measures the estimated change in the option price
for a change in the volatility of the underlying.
Theta: measures the estimated change in the option price
for a change in the time to option expiry.
Rho: measures the estimated change in the option price
for a change in the risk free interest rates.

57. Delta (∆)
• Derivative of the option pricing formula
with reference to the asset price (S)
• Measures the estimated change in the option
premium for a change in S
• For example: If underlying increases by 1
point, a call option whose delta is 0.5 would
increase only 0.5 points.
• Delta for futures is always near 100%

58. Delta
• In-the-money option: Higher Deltas (.8)
• At-the-money option: Average Deltas (.5)
• Out-of-the-money option: Lower Deltas (.2)

59. Delta
• Deep In-the-money options
– Delta converges to 1.00
– Premium will typically move bit-by-bit with
underlying
• Deep Out-of-the-money options
– Delta converges to Zero
– Premium will generally be very unresponsive to
movement in underlying

60. Knowing an Option’s Delta
• Can Help the Trader
– Estimate the change in the option premium
compared to the change in the underlying
– Determine the number of options needed to
equal one futures contract.
– Determine the probability that the option will
expire in-the-money
– In margining and risk analysis

61. Delta
• Bullish Positions
• Long futures
• Long call
• Short put
Have positive (+) deltas
• Bearish Positions
• Short futures
• Short call
• Long put
Have negative (-) deltas

62. Understanding “Delta”
15 Days to expiry – assumed
Call
Strike
price
Delta Premiums at different market price
Rs.240 Rs.250 Rs.260
200 0.99 40.95 50.85 60.83
220 0.88 22.20 31.35 41.05
240 0.54 8.30 14.65 22.60
260 0.19 2.00 4.60 9.00
280 0.04 0.25 0.91 2.40

63. Gamma (γ)
• Second derivative of the option pricing
formula with reference to the asset price (S)
• Measures the estimated change in the delta
of the option for a change in S

64. Sensex 4000 call
w ith 30 days to expiry
0
0.001
0.002
3600
3700
3800
3900
4000
4100
4200
4300
4400
Sensex level
Gamma

65. Gamma
• Sensex call 4000 at Sensex level of 4000
• Delta = 0.568 and gamma = 0.002 If Sensex
increases by one point to 4001 then delta (not the
premium) will increase by 0.002 points to 0.57
(0.0568 + 0.002). In other words, the option
premium will increase or decrease in value by
0.568 point when Sensex rises to 4001 and by
0.057 points when Sensex rises from 4001 to 4002
level.

66. Gamma
• Positive Gamma Position
– Long Calls
– Long Puts
• Negative Gamma Position
– Short Calls
– Short Puts
• (Delta)+(Gamma)=(New Delta) for incremental
increase in the underlying
• (Delta)-(Gamma)=(New Delta) for incremental
decrease in the underlying

67. Vega (κ)
• Derivative of the option pricing formula
with reference to the volatility of the asset
returns (σ)
• Measures the estimated change in the option
premium for a change in σ

68. Vega (κ)
• For Sensex Call 4000 at Sensex level of
4000 having 30 days to expire when
implied volatility is 20%, interest rate is
10% and dividend yield is nil, the premium
is 108 and Vega is 4.50, the premium would
increase to 112.50 when implied volatility
moves up to 21%.

69. Vega
• Positive Vega Position
– Long Calls
– Long Puts
• Negative Vega Position
– Short Calls
– Short Puts

70. Vega
• Original Option Premium + Vega = New
Option Premium for 1% increase in Implied
Volatility
• Original Option Premium - Vega = New
Option Premium for 1% de crease in
Implied Volatility

71. Theta (τ)
• Derivative of the option pricing formula
with reference to the time to option expiry
(T)
• Measures the estimated change in the option
premium for a change in T

72. Theta (τ)
• For Sensex Call 4000 at Sensex level of
4000 having 30 days to expire when
implied volatility is 20%, interest rate is
10% and dividend yield is nil, the premium
is 108 and Theta is 2.1, the premium would
decrease to 105.9 on next day when days to
expiry remains 29.

73. Rho (ρ)
• Derivative of the option pricing formula
with reference to the risk free rate (Rf)
• Measures the estimated change in the option
premium for a change in Rf

74. Premium Value
• Option premium is based on factors
Intrinsic value
Time value
Volatility

75. Intrinsic value
• The difference between strike and spot
when it is in-the-money option.
• Intrinsic value is Zero for all out-of-the
money option.

76. Time Value of option
• Value of an option is usually greater than
intrinsic value because of probability that
spot will rise / fall in future.
• The time value of an option decreases as the
time to maturity decreases.

77. Intrinsic value & Time Value
Current market price of Satyam Rs.240
Call Strike
Price
Premium Intrinsic
Value
Time Value
200 40.95 40 0.95
220 22.20 20 2.20
240 8.30 0 8.30
260 2.00 0 2.00
280 0.25 0 0.25

78. Understanding Time value
0
1
2
3
4
5
6
7
8
6 5 4 3 2 1
No. of balls remaining
Runrate
Run Rate
Probability to win

79. Volatility
Scrip Volatility STRIKE SPOT Premium
HLL 3% 200 190 5
Satyam 12% 200 190 10

80. Futures V/s Options
• Trading Futures may be viewed as a one-
dimensional game. Only the market price
has an impact on your profit and loss.

81. Futures V/s Options
• Risk- Futures have unlimited & Options
buying have limited risk
• Trading Options may be viewed as a two
dimensional game. Changes in an:
– Option’s underlying price, and/or
– Option’s implied volatility will have an impact
on your profit or loss

82. Index Options -Margins
Margins is the sum of following 3 parts
Part A -SPAN Margin
1. Risk Parameter file shall be generated 3 times
and uploaded to trading member for margins.
Opening
Afternoon(1.00PM)
Closing
2 Net Option Value(NOV)=(Long Option value-
Short Option Value)* the number of contracts

83. Index Options -Margins
• Margin (Part A)
Span margin-Net Option value
Part B.SEBI prescribed 3% margin on exposure
Future exposure= No.of contracts*50*last closing
price*0.03
+
Long Option= No exposure margin reqd.
+
Short Option= No.of contracts*50*last closing
price*0.03

84. Options trading
Basic Methods:
Bullish on index = Buy call
Bearish on index= Buy Put
Anticipate volatility = Buy a Call and a Put
at same strike price
Sideways Market = Sell a Call and a Put of
different strike price

85. Long Options Contracts
• Highly leveraged positions with limited
risk.
– Risk is limited to the original premium paid.

86. Bullish market- BUY CALL
Buying Call
The spot Nifty is 1100. Which call to buy???
The call with strike 1060 is deep-in-the-money and hence
has higher premium.The call with strike 1120 is out-of-
money and trades at lower premium. The 1180 call is
deep-out-of-money and buying this is buying lottery.
Decide your trade based on where you feel the Nifty will
move and then the premium comes in play. (Generally at
the money call has good chance of making profit)

87. Pay-off for Call buyer at 1080
-30
-20
-10
0
10
20
30
40
50
60
70
1040 1060 1080 1100 1120 1140 1160
Pay-off

88. Economic Payoff for Call Option
-20
-15
-10
-5
0
5
10
15
20
80
82
84
86
88
90
92
94
96
98
100
102
104
106
108
110
112
114
116
118
120
Asset Price
Gain/Loss
Buy Call
Sell Call

89. Bearish on market- Buy Put
Buying Put
• First time you shall buy when you are
bearish in market.
• If the index falls you gain and you lose only
premium if index moves up.
• The premium and your market study on
extent of index fall again plays a big role in
selection of which PUT to BUY.

90. Pay-off for Put buyer at 1120
-30
-20
-10
0
10
20
30
40
50
60
70
1040 1060 1080 1100 1120 1140 1160
Pay-off

91. Economic Payoff for Put Option
-20
-15
-10
-5
0
5
10
15
20
80
82
84
86
88
90
92
94
96
98
100
102
104
106
108
110
112
114
116
118
120
Asset Price
Gain/Loss
Buy Put
Sell Put

92. Volatile market
• BUY a CALL and a PUT at same strike
A variation combining the buy call and buy put
strategy is called a straddle.
It involves holding both a long call and long put
position with same strike price and time to
expiration.
E.g. Buy Call = 1100 Premium = 10
Buy Put = 1100 Premium = 10

93. Pay-off for straddle at strike of 1100
-30
-20
-10
0
10
20
30
40
50
1040 1060 1080 1100 1120 1140 1160
Pay-off

94. Option Strangles
• Consist of buying a put and buying a call
(Long Strangle) with the put strike lower
than the call strike, and both option legs
have the same expiration;
OR
• Consist of selling a put and selling a call
(Short Strangle) with the put strike lower
than the call strike, and both options legs
have the same expiration

95. Long Strangles
• Maximum loss is equal to net debit, or total
premium paid
• Maximum profit is unlimited
• Breakeven levels are equal to:
– put strike minus net debit
– call strike plus net debit
• Net delta is approximately zero when
strikes are equi-distant from current
underlying price

96. Economic Pay off for Long Strangle
-200
-100
0
100
200
300
400
500
600
Sensex level
Profit/Loss

97. Short Strangles
• Maximum profit is equal to net credit
• Maximum loss = unlimited
• Breakeven levels are equal to:
– put strike minus net credit
– call strike plus net credit
• Net delta is approximately zero when
strikes are equi-distant from current
underlying price

98. Economic Pay off for Short
Strangle
-600
-400
-200
0
200
Sensex level
Profit/Loss

99. Bullish on index-Buy Call or Sell puts
Buying Call
The spot nifty is 1250. Which call to buy???
The call with strike 1200 is deep-in-the-money and hence
higher premium.The call with strike 1275 is out-of-
money and trades at lower premium. The 1300 call is
deep-out-of-money and buying this is buying lottery.
Decide your call based on where you feel the Nifty move
and then the premium comes in play. (Generally at the
money call has good chance of making profit)

100. Vertical Spreads
• Buying a call (put) and selling a call (put)
with different strike prices but the same
expiration month.
• Two types of vertical spreads
– Bull Spreads
– Bear Spreads

101. Debit / Credit Spreads
• Debit Spreads entail a net pay-out of option
premium
• Credit Spreads entail a net collect of option
premium

102. Bear Vertical Spreads
• Bear Call Spread (Credit Spread)
• Bear Put Spread (Debit Spread)
Bear Spreads have a negative delta and
consist of:
– Buying the higher strike call (put)
– Selling the lower strike call (put)

103. Economic Payoff of Bear Spread
-200
-150
-100
-50
0
50
100
150
200
3000
3100
3200
3300
3400
3500
3600
3700
3800
3900
4000
4100
4200
4300
4400
4500
4600
4700
4800
4900
5000
Sensex Level
Profit/Loss

104. Bear Vertical Spreads
• Maximum loss occurs above upper strike
price
• Maximum profit occurs below lower strike
price
• Breakeven level equals:
– Lower strike plus credit (call spread)
– Upper strike minus debit (put spread)
• Have net negative delta, that is, benefit
from a decline in market price levels.

105. Bull Vertical Spreads
• Bull Call Spread (Debit Spread)
• Bull Put Spread (Credit Spread)
Bull Spreads have a positive delta and consist
of:
– Buying the lower strike price call (put)
– Selling the higher strike price call (put)

106. Bull Vertical Spreads
• Maximum loss occurs below lower strike
price
• Maximum profit occurs above upper strike
price
• Breakeven level equals:
– Lower strike plus debit (call spread)
– Upper strike minus credit (put spread)
• Have net positive delta, that is, benefit from
an increase in market price levels.

107. Economic Pay off for Bull Spread
-150
-100
-50
0
50
100
150
Sensex level
Profit/Loss