INTRODUCTION TO DERIVATIVES

1. DERIVATIVES INTRODUCTION
MS. DAKSHA PATHAK
Assistant Professor
Department of Financial studies
IIS (Deemed to be) University , JAIPUR

2. INTRODUCTION
• The term “derivatives” is used to refer to financial instruments which
derive their value from some underlying assets.
• The underlying assets could be equities (shares), debt (bonds, T-bills,
and notes), currencies, and even indices of these various assets, such
as the Nifty 50 Index.
• Derivatives contracts are bought and sold by a large number of
individuals, institutions and other’s for a variety of purposes.
• When the price of the underlying changes, the value of the derivative
also changes.
• A Derivative is not a product. It is a contract that derives its value
from changes in the price of the underlying. Example : The value of a
gold futures contract is derived from the value of the underlying asset
i.e. Gold.

3. DEFINITION
• According to Securities Contracts (Regulation) Act, 1956
{SC(R)ACT derivatives is:
• A security derived from a debt instrument, share, loan, whether
secured or unsecured, risk instrument or contract for differences or
any other form of security.
• A contract which derives its value from the prices, or index of
prices, of underlying securities.
• Derivatives are securities under the Securities Contract (Regulation)
Act and hence the trading of derivatives is governed by the
regulatory framework under the Securities Contract (Regulation)
Act.

8. FUNCTIONS OF DERIVATIVES MARKET
• Risk management- Stop loss
• Transfer of risk
• Price discovery
• Transitional efficiency - low transaction cost
compare to rest like, brokerage, commission,
regulatory costs and margin requirements
• Financial Engineering- as it is new field
creating calls, puts, futures and other
derivatives

10. ADVANTAGES OF DERIVATIVES
• Since all transactions related to derivatives take place in future it provides
individuals with better opportunities because an individual who want to
short some stock for long time can do it only in futures or options hence the
biggest benefit of this is that it gives numerous options to an investor or
trader to execute all sorts of strategies.
• In derivatives market people can transact huge transactions with small
amounts and therefore it gives the benefit of leverage and hence even
people who have less amount of money can enter into this market.
• Intraday traders get the benefit of liquidity as these contracts are very
liquid and also the costs such as basis expense, brokerage are less as
compared to cash market.
• It is a great risk management tool and if applied judiciously it can produce
good results and benefit its user.

11. DISADVANTAGES OF DERIVATIVES
• Leverage is a double edged sword and therefore if you do not get it
right chances are you wound end up losing huge amount of money
because these contracts have specific maturities and on that date
they get expired unlike cash market where you can hold on to stocks
for long period of time.
• Since its inception many critics have been blaming derivatives for
huge fall which keeps happening frequently after the introduction of
derivatives and many people say that it increases unnecessary
speculation in the market which is not good for the small retail
investors who are the backbone of stock market.
• It is quite complex and various strategies of derivatives can be
implemented only by an expert and therefore for a layman it is
difficult to use this and therefore it limits its usefulness

12. MARKET
PLAYERS/PARTICIPANTS/TRADERS IN
DERIVATIVE MARKET

13. HEDGERS
• Hedge is the position taken in derivative exchange/markets
for the purpose of reducing risk. A person who takes such
position is called hedger.
• A hedger uses the derivatives market to reduce risk caused by
movement in prices of shares/securities, commodities,
exchange rates, interest rate, indices, etc.
• The position taken by hedger is opposite to the risk he is
exposed.
• Taking an opposite position to the risk exposure is called
hedging strategy

14. SPECULATORS
• A speculator may be defined as a investor who is
willing to take a risk by taking derivatives position
with the expectation to earn profits.
• The speculator forecasts the future economic
conditions and decides which position (long or short)
to be taken will yield a profit if his forecast is correct

15. ARBITRAGEUR
• An arbitrageur is an intelligent trader who attempts to
make profits in a derivatives market by
simultaneously entering into two transaction at a time
in two different markets and takes advantage of the
difference in pricing.
• The arbitrage opportunities available in two markets
usually do not last long because of heavy transaction
by arbitrageur when such opportunity arises.

16. TYPES OF DERIVATIVE MARKETS
• Exchange Traded Derivatives: Derivatives which
are traded on an exchange are called exchange traded
derivatives. Trades on an exchange generally take
place with anonymity i.e. buyer and seller do not
know each other. Generally go through the clearing
corporation. E.g. S&PCNX nifty futures, OPTINDX
nifty.
• OTC Derivatives: A derivative contract which is
privately negotiated is called the OTC derivative.
OTC trades have no anonymity and they generally do
not go through a clearing corporation. E.g. foreign
exchange transaction between banks and its cliants.

18. What is a Forward?
• A forward is a contract in which one party commits to buy and the
other party commits to sell a specified quantity of an agreed upon
asset for a pre-determined price at a specific date in the future.
• It is a customized contract, in the sense that the terms of the contract
are agreed upon by the individual parties.
• Hence, it is traded OTC.
Risks in Forward Contracts
• Credit Risk – Does the other party have the means to pay?
• Operational Risk – Will the other party make delivery? Will the
other party accept delivery?
• Liquidity Risk – Incase either party wants to opt out of the contract,
how to find another counter party?
Terminology
• Long position - Buyer
• Short position - seller
• Spot price – Price of the asset in the spot market.(market price)
• Delivery/forward price – Price of the asset at the delivery date

20. What are Futures?
• A future is a standardized forward contract.
• It is traded on an organized exchange.
• Standardizations- - quantity of underlying - quality
of underlying(not required in financial futures) -
delivery dates and procedure - price quotes
• Types of Futures Contracts
• Stock Futures Trading (dealing with shares)
• Commodity Futures Trading (dealing with gold
futures, crude oil futures)
• Index Futures Trading (dealing with stock market
indices)

22. Terminology
• Contract size – The amount of the asset that has to be
delivered under one contract. All futures are sold in multiples
of lots which is decided by the exchange board. Eg. If the lot
size of Tata steel is 500 shares, then one futures contract is
necessarily 500 shares.
• Contract cycle – The period for which a contract trades. The
futures on the NSE have one (near) month, two (next) months,
three (far) months expiry cycles.
• Expiry date – usually last Thursday of every month or
previous day if Thursday is public holiday.
• Strike price – The agreed price of the deal is called the strike
price.
• Cost of carry – Difference between strike price and current
price.

23. Margins
• A margin is an amount of a money that must be deposited with the
clearing house by both buyers and sellers in a margin account in order to
open a futures contract.
• It ensures performance of the terms of the contract.
• Its aim is to minimise the risk of default by either counterparty.
• Initial Margin - Deposit that a trader must make before trading any
futures. Usually, 10% of the contract size.
• Maintenance Margin - When margin reaches a minimum maintenance
level, the trader is required to bring the margin back to its initial level.
The maintenance margin is generally about 75% of the initial margin
Marking to Market
• This is the practice of periodically adjusting the margin account by
adding or subtracting funds based on changes in market value to reflect
the investor’s gain or loss.
• This leads to changes in margin amounts daily.
• This ensures that there are no defaults by the parties.

25. Options
• Contracts that give the holder the option to buy/sell specified
quantity of the underlying assets at a particular price on or before a
specified time period. The word “option” means that the holder
has the right but not the obligation to buy/sell underlying assets.
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.
• Puts 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.
Types of Options
• The other two types are – European style options and American
style options.
• 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

28. Features of Options
• A fixed maturity date on which they expire. (Expiry
date).
• The price at which the option is exercised is called
the exercise price or strike price.
• The person who writes the option and is the seller is
referred as the “option writer”, and who holds the
option and is the buyer is called “option holder”.
• The premium is the price paid for the option by the
buyer to the seller.
• A clearing house is interposed between the writer and
the buyer which guarantees performance of the
contract.

29. Options Terminology
• Underlying: Specific security or asset.
• Option premium: Price paid.
• Strike price: Pre-decided price.
• Expiration date: Date on which option expires.
• Exercise date: Option is exercised.
• Open interest: Total numbers of option contracts that have
not yet been expired.
• Option holder: One who buys option.
• Option writer: One who sells option.
• Option class: All listed options of a type on a particular
instrument. Option series: A series that consists of all
the options of a given class with the same expiry date and
strike price.
• Put-call ratio: The ratio of puts to the calls traded in the
market.

30. 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.
Types of Swaps
• There are 2 main types of swaps:
• Plain vanilla fixed for floating swaps or simply
interest rate swaps.
• Fixed for fixed currency swaps or simply currency
swaps

31. Interest Rate Swap
• 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.
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.

32. Currency Swap
• It is a swap that includes exchange of principal and
interest rates in one currency for the same in another
currency.
• It is considered to be a foreign exchange transaction.
• It is not required by law to be shown in the balance
sheets.
• The principal may be exchanged either at the
beginning or at the end of the tenure.
• However, 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.

33. The other kind of derivatives, which are not, much popular
are as follows :
• BASKETS -
Baskets options are option on portfolio of underlying asset. Equity Index Options
are most popular form of baskets.
• LEAPS –
Normally option contracts are for a period of 1 to 12 months. However, exchange
may introduce option contracts with a maturity period of 2-3 years. These long-term
option contracts are popularly known as Leaps or Long term Equity Anticipation
Securities.(created by investor who writes an option and keep the premium as
income)
• WARRANTS -
Options generally have lives of up to one year, the majority of options traded on
options exchanges having a maximum maturity of nine months. Longer-dated
options are called warrants and are generally traded over-the-counter.(directly
issued by the company)
• SWAPTIONS -
Swaptions are options to buy or sell a swap that will become operative at the
expiry of the options. Thus a swaption is an option on a forward swap. Rather than
have calls and puts, the swaptions market has receiver swaptions and payer
swaptions. A receiver swaption is an option to receive fixed and pay floating. A
payer swaption is an option to pay fixed and receive floating.