Derivatives are financial contracts whose value is derived from an underlying asset such as a stock, bond, commodity, currency, or market index. The three main types of derivatives are futures, forwards, and options. Futures and forwards are contracts to buy or sell an asset at a future date, while options provide the right but not obligation to buy or sell an asset. Derivatives allow investors to hedge risk or speculate on changes in the price of the underlying asset. Major derivatives exchanges include the Chicago Board of Trade, Chicago Mercantile Exchange, and the National Stock Exchange of India.

1. Session 11 Derivatives &
Derivatives Market

2. • Derivative comes from the word “ to derive”
• A derivative is a contract whose value is
derived from the value of another asset called
underlying asset
• If the price of underlying asset/security
changes the price of derivative security also
changes.

3.  Commodity derivative –
 Underlying is wheat, cotton, pepper, corn, oats,
soyabean, crude oil, natural gas, gold, silver, turmeric
etc.
 Financial derivatives –
 Underlying is stocks, bonds, indexes, foreign
exchange, Eurodollar etc.
• Derivative minimises the risk of owning things
that are subject to unexpected price fluctuations
like foreign currencies, bulk of wheat, stocks &
bonds.

4. Under lying Derivative
Price Change Price Change
Change in Spot Change in
or Cash Market Prices in
Price of Derivatives
Underlying market

5. Two Purposes
HEDGING SPECULATION

6. • Forwards
• Futures
• Options
• Swaps

8. FORWARDS
• It is a contract between two parties to buy or sell an
underlying asset at today’s pre-agreed price (known as
Forward Price) on a specified date in the future.
• This forward price is set at the inception of contract
• It is the most basic form of derivative contract.
• These contracts are not standardized, the end users can
tailor make the contracts to fit their very specific needs.
• Traded at Over The Counter exchange.

9.  An Indian Company has ordered machinery from
USA. The price of $ 5,00,000 is payable after six
months. The current exchange rate is 49.08 as on
28th Feb 2012. At the current rate the company
needs 49.03*5,00,000 = 2,45,40,000
 If the company anticipates depreciation of Indian
rupee over time. The company can enter into a
forward contract & forget about any exchange rate
fluctuations. Suppose the exchange rate becomes
50, then also the company has to pay Rs.
2,45,40,000 for buying $ 5,00,000 though the value
is 2,50,00,000.

10. FUTURES
Futures are financial contracts to eliminate the
risk of change in price in the future date. Futures
are highly standardized exchange traded
contracts to buy or sell specified quantity of
financial instruments/commodity in a designated
future month at a future price.
Futures Price: The price agreed by the two
traders on the floor of exchange.

11.  In India, two exchanges offer derivatives trading: the Bombay
Stock Exchange (BSE) and the National Stock Exchange
(NSE).
 OTC derivative trading are considered as illegal in Indian Law.
OTC Contract Exchange Traded Contract
Customised Terms Standardized Terms
Substantial Credit Risk No risk
Unregulated Regulated
Transparency Information Asymmetry
Overleveraged positions Less leveraged

12. A farmer supplies Barley to a Breakfast cereal
manufacturer, he fears fall in future prices of
Barley, so he can enter into a futures contract
for selling 20 metric ton of barley.
 If he wants to sell less than 20 metric ton he
has to enter into a forward agreement & not
futures.
 This is b’coz standard contract size for barley
in barley international exchange is 20 metric
ton or its multiples.

13. Futures vs Forwards

15. • It is the initial deposit required to open a
trading account in a futures trading
exchange.
• The initial margin is fixed by the broker,
but has to satisfy an exchange minimum.
The variation margin i.e. the change in the
amount of an account on a given day in
response to a market –to-market process,
is settled on daily basis.

16.  The exchange requires both parties to put up an
initial amount of cash, the margin. Additionally, since
the futures price will generally change daily, the
difference in the prior agreed-upon price and the
daily futures price is settled daily
 The exchange will draw money out of one party's
margin account and put it into the other's so that
each party has the appropriate daily loss or profit.
 If the margin account goes below a certain value,
then a margin call is made and the account owner
must replenish the margin account. This process is
known as marking to market.

17. • Initial Margin – The amount that must be
deposited in the margin account when
establishing a position. The margin requirement
is about 12% futures & 8% for options.
• Marking to Market – In the futures market at the
end of each trading day, the margin account is
adjusted to reflect the investor’s gain or loss
depending upon the futures closing account.
• Maintenance Margin – This is set to ensure that
the balance in the margin account never
becomes negative. If the balance in the margin
account falls below the maintenance margin, the
investor is expected to top up the initial level
before trading commences on the next day.

18. For example say you have bought 100 shares of XYZ at Rs.100 and
Threshold MTM Loss is 20% and the applicable margin % is 35%. You
would be having a margin of Rs.3500 blocked on this position. The
current market price is now say Rs.75. This means the MTM loss is 25%
which is more than the threshold MTM loss % of 20% and hence
additional margin to be called in for. Additional margin to be calculated as
follows:
(a) Margin available 100*100*35% Rs.3500
(b) Less : MTM Loss (100-75)*100 Rs.2500
(c) Effective available (a-b) Rs.1000
margin
(d) Required Margin 75*100*35% Rs.2625
(e) Additional Margin (d-c) Rs.1625
required

19.  NEAT F & O system is used.
 The minimum contract size in derivative
market is 2 lakhs & it changes based upon the
prices of stock.
 In 2005 the lot size in infosys shares was
pruned from 200 to 100.
 Now lot size is 50 for most of the shares.

20.  NSCCL settles all deals on NSE’s derivative
segment.
 It acts as a legal counter party to all deals on
derivative segment & guarantees settlement.
 Members are required to settle the mark to
market losses by T + 1 day.

21. Major Derivatives Exchanges in the
World
• Chicago Board of Trade
• Chicago Mercantile Exchange
• Australian Options Market
• Commodity Exchange, New York
• London Commodity Exchange
• London Securities and Derivatives Exchange
• London Metal Exchange
• Singapore International Financial Futures Exchange
• Sydney Futures Exchange
• Tokyo International Financial Futures Exchange
• National Stock Exchange, India

22.  On December 1999, the Securities Contract Regulation Act
was amended to include derivatives within the sphere of
securities.
 Derivatives trading commenced in India in June 2000 after
SEBI granted the final approval to this effect in May 2000 on
the recommendation of L. C Gupta committee.
 Securities and Exchange Board of India (SEBI) permitted the
derivative segments of two stock exchanges, NSE and BSE,
and their clearing house/corporation to commence trading
and settlement in approved derivatives contracts.
• Trading in index options commenced in June 2001, options on
individual securities in July 2001 and Futures on individual
stocks in November 2001.

23. Types of Futures
• Commodity futures (Wheat, corn, etc.) and
• Financial futures
Financial futures include:
– Foreign currencies
– Interest rate
– Market index futures (Market index futures are
directly related with the stock market)
– Individual stock.

24. Open Interest
It is the number of outstanding futures
contracts. In other words, the number of
futures contracts that have to be settled on
or before maturity date.

25. OPTIONS
• An option is a contract between two parties in
which one party has the right but not the
obligation to buy or sell some underlying asset
on a specified date at a specified price.
• The option buyer has the right not an obligation
to buy or sell.
• If the buyer decides to exercise his right the
seller of the option has an obligation to deliver or
take delivery of the underlying asset at the price
agreed upon.

26. Types of Options
On the basis of the nature of the rights
and obligations in the option contract,
options are classified in to two categories.
They are:
• Call Options and
• Put Options.

27. CALL OPTIONS
A call option is a contract that gives the option
holder the right to buy some underlying asset from
the option seller at a specified price on or before a
specified date.
Eg. The current market price Ashok Leyland is
Rs.69. An option contract is created and traded on
this share. A call option on the share would give
the right to buy the share at a specified price
(Rs.70) during September 2010. This call option
would be traded between two parties P (the
purchaser and S ( the seller). The purchaser P
would be prepared to pay a small price known as
option premium (Rs.2) to S, the seller of the
option.

28. PUT OPTIONS
A put option is a contract which gives
its owner the right to sell some underlying
asset at a specified price on or before a
specified date.
The seller of the put option has the
obligation to take delivery of the
underlying asset, if the owner of the option
decides to exercise the option.

29. • Option Writer or Option Grantor: The
seller of option.
• Strike price or Exercise price : The price
at which the option holder may purchase
the underlying asset from the option seller.
• Time to Expiration or Time to Expiry :
The period of time specified for exercising
the option.
• Expiration Date : The precise date on
which the option right expires.

30. Types of Options
On the basis of maturity pattern of
options, option contracts are categorized
in to two. They are:
• European Style Options
• American Style Options

31. • European Style Options
Options which can be exercised only
on the maturity date of the option or on the
expiry date.
• American Style Options
Options which can be exercised at any
time up to and including the expiry date.
Most of the exchange traded options
are American style. In India stock options
are American style while index options are
European style.

32. Types of Options
Based on the mode of trading options
are classified in to two:
• Over-the-counter Options
• Exchange Traded Options

33. Moneyness of Options
Moneyness of an option describes the
relationship between the strike price of the
option and the current stock price. This
takes three forms:
1. In the Money
2. At the Money
3. Out of the Money

34. 1. In the Money Options
When the strike price of a call option is
lower than the current stock price, the option is
said to be in the money. This is because the
owner of the option has the right to buy the
stock at a price which is lower than the price
which he has to pay if he had to buy it from the
open market.
Similarly in the case of put option, when the
strike price is greater than the stock price, the
option is said to be in the money.
If an in the money option is exercised, there
will be an immediate cash inflow.

35. When the strike price of a call option
is equal to the current stock price, the
option is said to be at the money option.
In the case of a put option if the strike
price of the option is equal to the stock
price, the put option is said to be at the
money.

36. When the strike price of a call option is
more than the stock price, the option is
termed as out of the money option.
In the case of put option, if the strike
price is less than the stock price, the
option is said to be out of the money
option.

37. When the Shares of A Ltd. is
Trading at Rs.450
Strike Price (Rs.) Call Option Put Option
420
430 In the Money Out of the Money
440
450 At the Money At the Money
460
470 Out of the Money In the Money
480

38. 1991 Liberalization process initiated
14-Dec-95 NSE asked SEBI for permission to trade index futures.
SEBI setup L.C.Gupta Committee to draft a policy framework for index
18-Nov-96
futures.
11-May-98 L.C.Gupta Committee submitted report.
RBI gave permission for OTC forward rate agreements (FRAs) and interest
07-Jul-99
rate swaps.
24-May-00 SIMEX chose Nifty for trading futures and options on an Indian index.
25-May-00 SEBI gave permission to NSE and BSE to do index futures trading.
09-Jun-00 Trading of BSE Sensex futures commenced at BSE.
12-Jun-00 Trading of Nifty futures commenced at NSE.
25-Sep-00 Nifty futures trading commenced at SGX.
02-Jun-01 Individual Stock Options & Derivatives