This document provides an overview of derivatives, including definitions, types of derivatives like forwards, futures, options, and swaps. It discusses how derivatives derive their value from underlying assets and how they can be used to hedge or speculate. Key terms related to derivatives markets and contracts are defined. The roles of various participants and how derivatives can help parties manage financial risks are also summarized.

1. Derivatives
Management

2. UNIT – 1 INTRODUCTION
Derivatives –definition – types – forward
contracts – Options – swaps – difference
between cash and future markets – types
of traders – OTC and Exchange Traders
Securities – types of Settlement – Uses
and Advantages of derivatives - Risks in
Derivatives.

3. Definition –
“A security whose price is dependent
upon or derived from one or more
underlying assets. The derivative itself is
merely a contract between two or more
parties. Its value is determined by
fluctuations in the underlying asset. The
most common underlying assets
include stocks,
bonds, commodities, currencies, interest
rates and market indexes. Most
derivatives are characterized by high
leverage”.

4. Derivatives
A financial contract of pre-determined
duration, whose value is derived from the
value of an underlying asset
Securities
 commodities
 bullion
 precious metals
 currency
 livestock
 index such as interest rates, exchange rates

5. What do derivatives do?
 Derivatives attempt either to minimize the
loss arising from adverse price movements of
the underlying asset
 Or maximize the profits arising out of
favorable price fluctuation. Since derivatives
derive their value from the underlying asset
they are called as derivatives.

6. Types of Derivatives
(UA: Underlying Asset)
Based on the underlying assets
derivatives are classified into.
Financial Derivatives (UA: Fin
asset)
Commodity Derivatives (UA: gold
etc)
Index Derivative (BSE sensex)

7. How are derivatives used?
 Derivatives are basically risk shifting
instruments. Hedging is the most important
aspect of derivatives and also their basic
economic purpose
 Derivatives can be compared to an insurance
policy. As one pays premium in advance to an
insurance company in protection against a
specific event, the derivative products have a
payoff contingent upon the occurrence of some
event for which he pays premium in advance.

8. What is Risk?
 The concept of risk is simple. It is the
potential for change in the price or value
of some asset or commodity. The meaning
of risk is not restricted just to the
potential for loss. There is upside risk and
there is downside risk as well.

9. What is a Hedge
 To Be cautious or to protect against loss.
 In financial parlance, hedging is the act of
reducing uncertainty about future price
movements in a commodity, financial
security or foreign currency .
 Thus a hedge is a way of insuring an
investment against risk.

10.  What is derivatives in stock market,
how it is different from equity
shares?
In derivatives u can buy a future stock
by paying 20% amount of the stock. its
always in lot sizes, and there are 3 way
available for trading in derivative
1)current month 2) next month 3)next to
next month.

11. It expires on the last Thursday of
every month. where in equity u can by a
stock by paying the price at spot. and u
can hold the stock for as much time as
much u want.
long term investments are done in
equity shares we can do short term
trading also but in derivatives we can do
only short term trading which can last for
maximum 3 months.
There are other options also in
derivatives like call , put ,forward options

12. Growth of Derivatives Market
 Analytical techniques
 Technology
 Globalization
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13. importance of derivatives
There are several risks inherent in
financial transactions. Derivatives are
used to separate risks from traditional
instruments and transfer these risks to
parties willing to bear these risks.

14.  . The fundamental risks involved in derivative
business includes:
 Credit Risk
 This is the risk of failure of a counterparty to
perform its obligation as per the contract.
Also known as default or counterparty risk, it
differs with different instruments.
 Market Risk
 Market risk is a risk of financial loss as a
result of adverse movements of prices of the
underlying asset/instrument.

15.  Liquidity Risk
The inability of a firm to arrange a
transaction at prevailing market prices is
termed as liquidity risk. A firm faces two
types of liquidity risks
Related to liquidity of separate products
Related to the funding of activities of the
firm including derivatives.
 Legal Risk
 Derivatives cut across judicial boundaries,
therefore the legal aspects associated
with the deal should be looked into
carefully.

16. Who are the operators in the
derivatives market?
 Hedgers - Operators, who want to
transfer a risk component of their
portfolio.
 Speculators - Operators, who
intentionally take the risk from hedgers in
pursuit of profit.
 Arbitrageurs - Operators who operate in
the different markets simultaneously, in
pursuit of profit and eliminate miss-
pricing.

17. Derivative Instruments.
 Forward contracts
 Futures
◦ Commodity
◦ Financial (Stock index, interest rate & currency
)
 Options
◦ Put
◦ Call
 Swaps.
◦ Interest Rate
◦ Currency

18. Forward Contracts
 An agreement where one party agrees
to buy (or sell) the underlying asset at
a specific future date and a price is set
at the time the contract is entered into.
 Characteristics
◦ Flexibility
◦ Default risk
◦ Liquidity risk
 Positions in Forwards
◦ Long position
◦ Short position
18

19. Hedging with Futures
 Hedging: Generally conducted
where a price change could
negatively affect a firm’s profits.
◦ Long hedge: Involves the purchase of
a futures contract to guard against a
price increase.
◦ Short hedge: Involves the sale of a
futures contract to protect against a
price decline in commodities or financial
securities.
◦ Perfect hedge: Occurs when gain/loss
on hedge transaction exactly offsets
loss/gain on unhedged position.
19

20. Option Contracts
 The right, but not the obligation, to buy
or sell a specified asset at a specified
price within a specified period of time.
 Option Terminology
◦ Call option versus put option
◦ Holder versus writer or grantor
◦ Exercise or strike price
◦ Option premium
◦ American versus European option
 Market Arrangements
20

21. Swap Contracts
 Financial contracts obligating one party to
exchange a set of payments it owns for
another set of payments owed by another
party.
◦ Currency swaps
◦ Interest rate swaps
 Usually used because each party prefers
the terms of the other’s debt contract.
 Reduces interest rate risk or currency risk
for both parties involved.
21

22.  Commodity Price Exposure
◦ The purchase of a commodity futures contract
will allow a firm to make a future purchase of
the input at today’s price, even if the market
price on the item has risen substantially in the
interim.
 Security Price Exposure
◦ The purchase of a financial futures contract will
allow a firm to make a future purchase of the
security at today’s price, even if the market
price on the asset has risen substantially in the
interim.
Using Derivatives to Reduce Risk
22

23.  Foreign Exchange Exposure
◦ The purchase of a currency futures or options
contract will allow a firm to make a future
purchase of the currency at today’s price, even
if the market price on the currency has risen
substantially in the interim.
Using Derivatives to Reduce Risk
23

24.  Increases financial leverage
 Derivative instruments are too complex
 Risk of financial distress
Risks to Corporations from
Financial Derivatives
24

25. Forward Contracts.
◦A one to one bipartite contract,
which is to be performed in
future at the terms decided
today.

26.  Eg: Jay and Viru enter into a contract to
trade in one stock on Infosys 3 months
from today the date of the contract @ a
price of Rs4675/-
 Note: Product ,Price ,Quantity & Time
have been determined in advance by both
the parties.
 Delivery and payments will take place as
per the terms of this contract on the
designated date and place. This is a
simple example of forward contract.

27.  The key elements of a futures contract are:
◦ Futures price
◦ Settlement or Delivery Date
◦ Underlying (infosys stock)

28. Illustration.
 Let us once again take the earlier example
where Jay and Viru entered into a contract to
buy and sell Infosys shares. Now, assume that
this contract is taking place through the
exchange, traded on the exchange and
clearing corporation/house is the counter-
party to this, it would be called a futures
contract.

29. Positions in a futures contract
 Long - this is when a person buys a
futures contract, and agrees to receive
delivery at a future date. Eg: Viru’s
position
 Short - this is when a person sells a
futures contract, and agrees to make
delivery. Eg: Jay’s Position

30. How does one make money in
a futures contract?
 The long makes money when the
underlying assets price rises above the
futures price.
 The short makes money when the
underlying asset’s price falls below the
futures price.
 Concept of initial margin
 Degree of Leverage = 1/margin rate.

31. Options
 An option is a contract giving the
buyer the right, but not the
obligation, to buy or sell an
underlying asset at a specific price
on or before a certain date. An option
is a security, just like a stock or bond,
and is a binding contract with strictly
defined terms and properties.

32. Options Lingo
 Underlying: This is the specific security /
asset on which an options contract is
based.
 Option Premium: Premium is the price
paid by the buyer to the seller to acquire
the right to buy or sell. It is the total cost
of an option. It is the difference between
the higher price paid for a security and the
security's face amount at issue. The
premium of an option is basically the sum
of the option's intrinsic and time value.

33.  Strike Price or Exercise Price :price of an
option is the specified/ pre-determined price of
the underlying asset at which the same can be
bought or sold if the option buyer exercises his
right to buy/ sell on or before the expiration
day.
 Expiration date: The date on which the option
expires is known as Expiration Date
 Exercise: An action by an option holder taking
advantage of a favourable market situation
.’Trade in’ the option for stock.

34.  Exercise Date: is the date on which the option
is actually exercised.
 European style of options: The European
kind of option is the one which can be
exercised by the buyer on the expiration day
only & not anytime before that.
 American style of options: An American
style option is the one which can be exercised
by the buyer on or before the expiration date,
i.e. anytime between the day of purchase of
the option and the day of its expiry.

35.  Asian style of options: these are in-between
European and American. An Asian option's
payoff depends on the average price of the
underlying asset over a certain period of time.
 Option Holder
 Option seller/ writer
 Call option: An option contract giving the
owner the right to buy a specified amount of
an underlying security at a specified price
within a specified time.
 Put Option: An option contract giving the
owner the right to sell a specified amount of an
underlying security at a specified price within a
specified time

36.  In-the-money: For a call option, in-the-
money is when the option's strike price is
below the market price of the underlying
stock. For a put option, in the money is when
the strike price is above the market price of
the underlying stock. In other words, this is
when the stock option is worth money and
can be turned around and exercised for a
profit.

37. ◦ Intrinsic Value: The intrinsic value of an option is
defined as the amount by which an option is in-the-
money, or the immediate exercise value of the option
when the underlying position is marked-to-market.
 For a call option: Intrinsic Value = Spot Price -
Strike Price
 For a put option: Intrinsic Value = Strike Price
- Spot Price

38. Example of an Option
 Elvis and crocodiles.

39. Positions
 Long Position: The term used when a
person owns a security or commodity and
wants to sell. If a person is long in a
security then he wants it to go up in price.
 Short position: The term used to describe
the selling of a security, commodity, or
currency. The investor's sales exceed
holdings because they believe the price will
fall.

40. Profit/Loss Profile of a Long call Position
Profit
0 Price
of
100 103
Asset
XYZ
-3 at
Option Price = Rs3 expira
Loss tion
Strike Price = Rs100
Time to expiration = 1month

41. Profit /Loss Profile for a Short Call Position
Profit
+3
Price of the
0 Asset XYZ
at
100 103 expiration
Initial price of the asset = Rs100
Option price= Rs3
Strike price = Rs100
Loss
Time to expiration = 1 month

42. Profit/Loss
Profile for a Long Put Position
Profit
Price of
0
the Asset
98 100
XYZ at
expiration
-2 Initial price of the asset XYZ = Rs100
Option Price = Rs2
Loss Strike price = Rs100
Time to expiration = 1 month

43. Profit/Loss Profile for a Short Put
Position
Profit
+2
Price of
the Asset
0 XYZ at
expiration
94 100
Initial price of the asset XYZ =
Rs100
Option Price = Rs2
Loss
Strike price = Rs100
Time to expiration = 1 month

44. Summary
 The profit and loss profile for a short put
option is the mirror image of the long put
option. The maximum profit from this
position is the option price. The theoritical
maximum loss can be substantial should the
price of the underlying asset fall.
 Buying calls or selling puts allows investor to
gain if the price of the underlying asset rises;
and selling calls and buying puts allows the
investors to gain if the price of the
underlying asset falls.

45. Long Call
Short Put
Price rises
Price Falls
Long Put
Short Call

46. Stock Index Option
 Trading in options whose underlying instrument is the
stock index.
 Here if the option is exercised, the exchange assigned
option writer pays cash to the options buyer. There is
no delivery of any stock.
 Dollar Value of the underlying index = Cash index
value * Contract multiple.
 The contract multiple for the S&P100 is $100. So, for
eg, if the cash index value for the S&P is 720,then
dollar value will be $72,000

47.  For a stock option, the price at which the buyer
of the option can buy or sell the stock is the
strike price. For an index option, the strike index
is the index value at which the buyer of the
option can buy or sell the underlying stock
index.

48.  For Eg: If the strike index is 700 for an S&P
index option, the USD value is $70,000. If an
investor purchases a call option on the S&P100
with a strike of 700, and exercises the option
when the index is 720, then the investor has the
right to purchase the index for $70,000 when
the USD value of the index is $72000. The
buyer of the call option then receive$2000 from
the option writer.

49. Binomial Model for Option
Valuation
 Current Price of the stock = S
 Two possible values it can take next year :- uS
or dS ( uS> dS)
 Amount B can be borrowed or lent at a rate of
r. The interest factor (1+r) may be represented
, for sake of simplicity , as R.
 d<R<u.
 Exercise price is E.

50.  Value of a call option, just before expiration,
if the stock price goes up to uS is
Cu = Max(uS-E,0)
 Value of a call option, just before expiration,
if the stock price goes down to dS is
Cd = Max(dS-E,0)
The value of the call option is
C=^S+B
^ = (Cu-Cd)/ S (u-d)
B = uCd-dCu/(u-d)R

51. Illustration:
S=200, u=1.4, d=.9 E=220 r=0.15 R=1.15
Cu = Max(uS-E,0) = Max(280-220,0)=60
Cd = Max(dS-E,0) = Max(180-220,0)=0
^=Cu-Cd/(u-d)S = 60/(1.4-.9)200=0.6
B=uCd-dCu/(u-d)R = -0.9(60)/0.5(1.15) = -93.91
(A negative value for B means that funds are
borrowed).
Thus the portfolio consists of 0.6 of a share plus a
borrowing of 93.91( requiring a payment of
93.91(1.15) = 108 after one year.
C=^S+B= 0.6*200-93.91 = 26.09

52. Swaps
 An agreement between two parties to
exchange one set of cash flows for another.
In essence it is a portfolio of forward
contracts. While a forward contract involves
one exchange at a specific future date, a
swap contract entitles multiple exchanges
over a period of time. The most popular are
interest rate swaps and currency swaps.

53. Counter Party Counter Party
LIBOR
A B
Fixed Rate of 12%
Rs50,00,00,000.00 – Notional Principle
Interest Rate Swap
‘A’ is the fixed rate receiver and variable rate payer.
‘B’ is the variable rate receiver and fixed rate payer.

54.  The only Rupee exchanged between the parties are the net
interest payment, not the notional principle amount.
 In the given eg A pays LIBOR/2*50crs to B once every six
months. Say LIBOR=5% then A pays be 5%/2*50crs=
1.25crs
 B pays A 12%/2*50crs=3crs
 The value of the swap will fluctuate with market interest
rates.
 If interest rates decline fixed rate payer is at a loss, If
interest rates rise variable rate payer is at a loss.
Conversely if rates rise fixed rate payer profits and floating
rate payer looses.