2. DERIVATIVES
A Financial Instrument That
Derives Its Value From An
Underlying Security
Derivative is a product/contract
which does not have any value
on its own i.e. it derives its value
from some underlying assets..
3. Derivatives Explanation
An easy way to think of derivatives is as
a “side bet” on interest rates, exchange
rates, commodity prices, and practically
ANYTHING that you can think of.
4. Why Derivatives?
• Not to raise capital
• Buy or sell to protect against adverse
changes in external factors
5. The need for a derivatives
market
The derivatives market performs a number of economic
functions:
1. They help in transferring risks from risk averse people to
risk oriented people
2. They help in the discovery of future as well as current
prices
3. They catalyze entrepreneurial activity
4. They increase savings and investment in the long run
8. Forwards Contracts
The agreement to pay for and pick up,
“Something” at a pre-determined date
and or time, for a pre-determined price.
Usually traded between two firms.
Forwards are not options, they are obligations
and should be
considered as a “cash transaction
9. • Forward contracts
• A forward contract is one to one bi-partite
contract, to be performed in the future, at
the terms decided today.
(E.g. forward currency market in India).
• Forward contracts offer tremendous
flexibility to the parties to design the
contract in terms of the price, quantity,
quality (in case of commodities), delivery
time and place.
• Forward contracts suffer from poor liquidity
and default risk.
10. A Modest Example
An agreement on Monday to buy a book,
(IFS) from a bookstore on Friday for Rs.500.
On Friday, you return to the bookstore and
take delivery of the book and pay the Rs. 500.
The contract is actually the agreement.
11. Features of Forward Contracts
1. Over the Counter Trading
2. No down Payment
3. Settlement at Maturity
4. Linearity
5. No Secondary Market
6. Necessity of a Third Party
7. Delivery.
12. On Feb 1 , A enters into an agreement
to buy 50 bales of cotton on December 1
at Rs. 1000/- per bale from B, a cotton
dealer. It is a case of a forward contract
where A has to pay Rs. 50000 on
December 1 to B and B has to supply 50
bales of cotton.
14. Futures
Future contracts are agreements
between two counterparties that fix
the terms of an exchange, or that
lock in the price today of an
exchange, which will take place
between them at some fixed future
date.
15. 1. The period of contract may be several
months
2. Futures contracts are transferable legal
agreements.
3. The terms cannot be changed during the
life of the contract
4. Futures are not securities.
5. They are paper contracts entered to
realise money difference.
16. • Future contracts
• Future contracts are organized/
standardized contracts, which are traded
on the exchanges.
• These contracts, being standardised and
traded on the exchanges are very liquid in
nature.
• In futures market, clearing corporation/
house provides the settlement guarantee.
17. Every futures contract is a forward contract.
They :
• are entered into through exchange, traded
on exchange and clearing
corporation/house provides the settlement
guarantee for trades.
• are of standard quantity; standard quality
(in case of commodities).
• have standard delivery time and place
18. Features of Future Contract
1. Highly Standardized
2. Down Payment
3. Settlements
4. Linearity
5. Secondary Market
19. A enters into a futures agreement with B to
buy 50 bundles of cotton at Rs. 100 per
bundle on Friday afternoon. At the closeof
trading on Monday, the futures price goes
up by Rs. 10. per bundle. Now, X will get a
cash profit of Rs. 500 for 50 bundles at the
rate of Rs 10. per bundle.
20. DIFFERENCE
• Forward Contract
• Not traded on exchange
• Differs from trade to
trade.
• No Down Payment
• Poor Liquidity as
contracts are tailor maid
contracts.
• Poor; as markets are
fragmented.
• Delivery of the assets
• Future Contract
• Traded on exchange
• Contracts are
standardized contracts.
• Margin Money
• .Very high Liquidity as
contracts are
standardised contracts.
• Better; as fragmented
markets are brought to
the common platform.
• Exchange of Difference
22. Options
• Options are instruments whereby the right
is given by the option seller to the option
buyer to buy or sell a specific asset at a
specific price on or before a specific date.
23. • Option Seller - One who gives/writes the option. He has
an obligation to perform, in case option buyer desires to
exercise his option.
• Option Buyer - One who buys the option. He has the
right to exercise the option but no obligation.
• Call Option - Option to buy.
• Put Option - Option to sell.
• American Option - An option which can be exercised
anytime on or before the expiry date.
• European Option - An option which can be exercised
only on expiry date.
• Strike Price/ Exercise Price - Price at which the option is
to be exercised.
• Expiration Date - Date on which the option expires.
• Exercise Date - Date on which the option gets exercised
by the option holder/buyer.
• Option Premium - The price paid by the option buyer to
the option seller for granting the option.
24. Calls
Long a call. Person buys the right (a contract) to buy
an asset at a certain price. They feel that the price
in the future will exceed the strike price. This is a
bullish position.
Short a Call. Person sells the right (a contract) to
someone that allows them to buy a asset at a certain
price. The writer feels that the asset will devalue
over the time period of the contract. This person is
bearish on that asset.
25. PUTS
Long a Put. Buy the right to sell an asset at a
pre-determined price. You feel that the asset will
devalue over the time of the contract. Therefore
you can sell the asset at a higher price than is the
current market value. This is a bearish position.
Short a Put. Sell the right to someone else. This
will allow them to sell the asset at a specific
price. They feel the price will go down and you
do not. This is a bullish position.
26. 1. An investor buys one European Call
option on one share of Reliance Petroleum
at a premium of Rs. 2 per share on 30Nov
. The strike price is Rs.60 and the contract
matures on 30 January.
29. • Put Options
The European Put Option is the reverse of the call option
deal. Here, there is a contract to sell a particular number
of underlying assets on a particular date at a specific
price.
Illustration 2:
An investor buys one European Put Option on one share
of Reliance Petroleum at a premium of Rs. 2 per share
on 31 July. The strike price is Rs.60 and the contract
matures on 30 September. The payoff table shows the
fluctuations of net profit with a change in the spot price.
32. Swaps: Swaps are private agreements between
two parties to exchange cash flows in the
future according to a prearranged formula. They
can be regarded as portfolios of forward
contracts. The two commonly used swaps are :
• Interest rate swaps:A swap in which a fixed
rate of interest is exchanged for a floating rate.
• Currency swaps: These entail swapping both
principal and interest between the
parties, with the cashflows in one direction being
in a different currency than those
in the opposite direction.
