Derivatives

1. Basis of Difference Capital Market Money Market
Time Span The time span for trading securities is
long-term in the capital market, meaning
the maturity is more than a year.
The time span for trading securities is
short-term in the money market, meaning
the maturity is less than a year.
Liquidity The securities traded in a capital market
are liquid, but they are not more fluid
than those sold in the money market.
The securities traded in a money market
are highly liquid.
Returns Expected Due to the long-term nature of
the capital market, the returns gained
here are high.
Due to the short-term nature of
the money market, the returns gained
here are low.
Instruments Capital market instruments are equity
shares, preference shares, debentures,
bonds, and other long-period securities.
Money market instruments are treasury
bills, commercial bills, certificates of
deposits, and other short-period
securities.
Risk In capital market securities, the risk of
the repayment of the principal amount is
high.
Due to the short-term nature of the
money market and the stable financial
position of issuers, the risk of repayment
is low in the money market.

2. Capital Market Instruments
• Equities: Refers to buying a company’s equity stock and becoming a
shareholder of that organization.
• Debt securities: Financial assets that entitle the owner to continuous
interest payments
• Derivatives: The values of these financial instruments are determined by
underlying assets like currency, bonds, stock, etc.
• Exchange-traded funds: A pool of financial resources of many investors
which are used to buy different capital market instruments
• Foreign exchange instruments: mainly consists of currency agreements
and derivatives and are represented on a foreign market.

3. Forwards
• It is a customised contract between two parties to buy or sell an asset or
any product or commodity at a predetermined price at a future date.
• It is to be noted that forwards are not traded on any central exchanges, but
over-the-counter and that they are not standardised to be regulated.
Therefore, it is mostly useful for hedging and to minimise risk even though
it doesn't guarantee any kind of profits.
• Over-the-counter Forwards are exposed to counterparty risk as well.
Counterparty risk is a kind of credit risk that the buyer or seller might not
be able to keep his part of the obligation. If the buyer or seller becomes
insolvent and is not able to deliver on his part of the bargain, the other
party may not have any recourse to save his position.

4. Futures
• Futures are financial contracts that are fundamentally similar to
forwards but the major difference is that features can be traded on
exchanges and therefore are standardised and regulated. They are
often used to speculate on commodities.

5. Options
• Options are financial contracts wherein the buyer or seller has the
right to but not an obligation to buy or sell a security or a financial
asset.
• Options are almost similar to Futures where in it is a contract or an
agreement between two parties to buy or sell any type of securities at
a predetermined rate in the future.
• However, the parties are under no legal obligation to keep their part of
the bargain i.e. they might or might not decide to sell or buy the
security at the predetermined time. It is literally an option given to
reduce risk in the future if there is a high volatility in the market.

6. Basic Terms
Term Meaning
Strike price  This is the price at which the buyer of a call option can buy a stock
on or before the expiry date of contract.
 This is the price at which the buyer of a put option can sell a stock
on or before the expiry date of contract.
Expiration date The date on which a derivative contract is settled.
European Option Option contract that can be exercised by the buyer only on the
expiration date.
American option Option contract that can be exercised by the buyer on any day on or
before the expiration date.

7. Basic Terms
Term Meaning
Contract value It is the notional value of a transaction, calculated by multiplying the
contract size with the future price of the stock.
Buyer of a Call /
Put Option
The Buyer of a Call/Put Option is one who buys the right (but not the
obligation) to buy/sell the underlying asset by paying the option premium.
Writer (or seller)
of a Call / Put
Option
The Writer of a Call/Put Option is one who agree to sell/buy the
underlying asset if the buyer of option desires so, against the receipt of
option premium.
Option Price Intrinsic Value + Time value
Intrinsic Value is difference between Strike Price and Current Market
Price.
Time value premium decreases as the option approaches maturity.

8. Basic Terms
Term Meaning
In-the-money
option
An option is said to be In-the-money at a given time, if on exercising the
option at that time, it would bring cash inflow for the buyer. This happens
when the strike price of the underlying asset is less than its spot price.
Out-of-the-
money option
An option is said to be Out-of-the-money at a given time, if on exercising the
option at that time, it would result in cash outflow for the buyer. This
happens when the strike price of the underlying asset is greater than its spot
price.
At-the-money
option
An option is said to be At-the-money at a given time, if on exercising the
option at that time, it would be cash neutral for the buyer. This happens
when the strike price of the underlying asset is equal to its spot price. But a
movement in either direction leads it to becoming in-the-money or out-of-
the-money option.

9. Particulars In the Money At the Money Out of the Money
Call Option Spot Price > Strike Price Spot Price = Strike Price Spot Price < Strike Price
Put Option Spot Price < Strike Price Spot Price = Strike Price Spot Price > Strike Price
Moneyness of Option Contracts

10. Swaps
• Swaps are a form of financial derivative commonly used to exchange
one kind of cash flow with another. Swaps are not traded in
exchanges but are private agreements between parties and are
mostly traded over-the-counter.
• The most common types of swaps are currency swaps and interest
rate swaps.
• For example, a trader may use an interest rate swap to change from a
variable interest loan to a fixed interest loan or vice versa.

11. Hedging
It is currently February and a US exporter expects to receive $5,00,000 in Jun.
Current spot rate now is $1 = INR 80
The quote for Jun Dollar futures is INR 81
Standard size of futures contract $1,000
The US exporter uses futures to hedge its currency risk by selling USD futures.
In June, the company receives $500,000
The spot rate in June moved to $ = INR 82
The futures rate in June was also INR 82

12. Solution
• Number of contracts = $500,000 ÷ $1000 = 500
• Exporter needs to sell futures (sell $s)
• In February – the hedge is set up by: Selling (500 contracts × $1000) =
$500,000 for Dec delivery at INR 81
• In June – the futures position is closed: Buying (500 contracts × $1000) =
$500,000 for June delivery at INR 82
• Summary of futures position:
• Sell $ for 81
• Buy $ for (82)
• Loss (1)

13. • Loss on futures position = INR 1 × (500 contracts × $1000) = INR 500,000
• The $500,000 received by the exporter is then sold in June at the prevailing
spot rate
• $500,000 @ INR 82 = INR 4,10,00,000
• Summary
INR
Increase in value of dollar remittance 10,00,000
Loss due to futures position (5,00,000)
Thus, the futures hedge removes risk – both upside potential (as above) and
downside risk.
Note: This example shows a perfect hedge.

14. Stock Exchange
The stock exchange in India serves as a market where financial
instruments like stocks, bonds and commodities are traded.
It is a platform where buyers and sellers come together to
trade financial tools during specific hours of any business day
while adhering to SEBI’s well-defined guidelines.
However, only those companies who are listed in a stock
exchange are allowed to trade in it.

15. Functions of Stock Exchange
• Role of an Economic Barometer: Stock exchange serves as an
economic barometer that is indicative of the state of the economy. It
records all the major and minor changes in the share prices. It is
rightly said to be the pulse of the economy, which reflects the state of
the economy.
• Valuation of Securities: Stock market helps in the valuation of
securities based on the factors of supply and demand. The securities
offered by companies that are profitable and growth-oriented tend to
be valued higher. Valuation of securities helps creditors, investors and
government in performing their respective functions.

16. Functions of Stock Exchange
• Transactional Safety: Transactional safety is ensured as the securities
that are traded in the stock exchange are listed, and the listing of
securities is done after verifying the company’s position. All
companies listed have to adhere to the rules and regulations as laid
out by the governing body.
• Contributor to Economic Growth: Stock exchange offers a platform
for trading of securities of the various companies. This process of
trading involves continuous disinvestment and reinvestment, which
offers opportunities for capital formation and subsequently, growth of
the economy.

17. Functions of Stock Exchange
• Making the public aware of equity investment: Stock exchange helps
in providing information about investing in equity markets and by
rolling out new issues to encourage people to invest in securities.
• Offers scope for speculation: By permitting healthy speculation of the
traded securities, the stock exchange ensures demand and supply of
securities and liquidity.
• Better Capital Allocation: Profit-making companies will have their
shares traded actively, and so such companies are able to raise fresh
capital from the equity market. Stock market helps in better
allocation of capital for the investors so that maximum profit can be
earned.