This document provides an introduction to derivatives. It defines derivatives as financial instruments whose value is derived from an underlying asset. The three main types of derivatives discussed are forwards, futures, and options. Forwards are customized bilateral contracts to buy or sell an asset in the future at a predetermined price. Futures are standardized exchange-traded versions of forwards that have no counterparty risk. Daily mark-to-market settlements determine profits and losses on futures positions. Options provide the right but not the obligation to buy or sell an asset at a future date.

1. Introduction To Derivatives
Prepared and Presented B
• Kiran Shinde

2. Derivatives
Some say the world will end in
fire, Some say in ice
“Fire and Ice ” Poem by Robert
Frost (1874–1963)
This is what the Derivative world is….

3. Contents
 Introduction to Derivatives
 Derivatives in India
 Basic purpose of derivatives
 Application of Derivatives
 for Risk Management & Speculation (Leveraging)
 Basic Terms
 Properties of –
 Forwards
 Futures
 Options

4. What is „Derivatives‟?
 “A derivative can be defined as a financial instrument whose value
depends on (or derives from) the values of other, more basic underlying
variables.” -John C. Hull
 “A derivative is simply a financial instrument (or even more simply an
agreement between two people) which has a value determined by the
price of something else.” -Robert L. McDonald
 The Securities Contracts (Regulation) Act, 1956 defines "derivatives" to
include:
1. 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.
2. A contract which derives its value from the prices, or index of prices,
of underlying securities.

5. Cont…
In simple words, „Derivative‟ is Financial instrument whose price is dependent
upon or derived from the value of underlying assets.
The underlying not necessarily has to be an asset. It could be any other
random/uncertain event like temperature/weather etc.
 The most common underlying assets includes:
 Stock, Bonds, Commodities
 Currencies, Interest rates
 Derivatives cannot exist without the underlying
 Derivatives do not convey any ownership in the underlying
 Settlement : Cash settled or delivery of underlying
 Physical Delivery : Exchange money and goods on final settlement
 Cash : Settle profit / loss on final settlement
Origin of derivatives - Protection of Farmers Interest

6. Derivatives in India
 In India, derivatives markets have been functioning since the
nineteenth century with organized trading in cotton through
the establishment of the Cotton Trade Association in 1875.
 Derivatives, as exchange traded financial instruments were
introduced in India in June 2000. (Nifty 50 index futures
contract)
 First to be traded were futures contract on Index.
 After this came, options on individual securities and index
 Futures contract on individual stocks were launched in
November,2001
 In 1999, the Securities Contracts (Regulation) Act of 1956, or
SC(R)A, was amended so that derivatives could be declared
as “securities”.
 The Act considers derivatives on equities to be legal and
valid, but only if they are traded on exchanges.

7. Milestones in the development of
Indian derivative market
 November 18, 1996 L.C. Gupta Committee set up to draft a policy
framework for introducing derivatives
 May 11, 1998 L.C. Gupta committee submits its report
on the policy framework
 May 25, 2000 SEBI allows exchanges to trade in index
futures
 June 12, 2000 Trading on Nifty futures commences on
the NSE
 June 4, 2001 Trading for Nifty options commences on the
NSE
 July 2, 2001 Trading on Stock options commences on the
NSE
 November 9, 2001 Trading on Stock futures commences on the
NSE
 August 29, 2008 Currency derivatives trading commences on the
NSE

8. Derivatives Markets
 Exchange Traded Contracts
 Over The Counter Market

9. Market Participants
Hedger
Hedgers face risk associated with the price of an asset. They
use futures or options markets to reduce or eliminate this risk
Speculators
Speculators wish to bet on future movements in the price of an
asset. Derivatives can give them an extra leverage to enhance
their returns
Arbitrageurs
Arbitragers work at making profits by taking advantage of
discrepancy between prices of the same product across
different markets

10. Basic purpose of derivatives
 In derivatives transactions, one party‟s loss is always
another party‟s gain.
 The main purpose of derivatives is to transfer risk
from one person or firm to another, that is, to provide
insurance.
 If a farmer before planting can guarantee a certain
price he will receive, he is more likely to plant
 Derivatives improve overall performance of the
economy
 Thus, the basic purpose of derivatives is to transfer
the price risk (inherent in fluctuations of the asset
prices) from one party to another; they facilitate the
allocation of risk to those who are willing to take it.

12. Example of Derivatives
 a reimbursement program for college credit.
Consider that if your firm reimburses 100% of
costs for an “A”, 75% of costs for a “B”, 50% for a
“C” and 0% for anything less.
 Your “right” to claim this reimbursement, then is
tied to the grade you earn. The value of that
reimbursement plan, therefore, is derived from
the grade you earn.

13. Applications of Derivatives
Derivatives are used by investors for the following:
1. Provide leverage (or gearing), such that a small movement
in the underlying value can cause a large difference in the
value of the derivative
2. Speculate and make a profit if the value of the underlying asset moves the
way they expect (e.g., moves in a given direction, stays in or out of a
specified range, reaches a certain level)
3. Hedge risk in the underlying, by entering into a derivative contract whose
value moves in the opposite direction to their underlying position and
cancels part or all of it out
4. Obtain exposure to the underlying where it is not possible to trade in the
underlying (e.g., weather derivatives)
5. Create option ability where the value of the derivative is linked to a specific
condition or event (e.g. the underlying reaching a specific price level)

14. Types of Financial Derivative
 There is no definitive list of derivative products
and the types of derivative products that can be
developed are limited by human imagination only.
However the most common financial derivatives
can be classified as
1. Forwards
2. Futures
3. Options

15. Forwards
 A forward contract is an agreement between two
parties to buy or sell an asset at a certain future time
for a certain future price.
Features:
 These are bilateral contract
 These contracts are customized
 There is a counter party risk
 Forward contracts are normally not exchange traded.
 The party that agrees to buy the asset in the future is
said to have the long position.
 The party that agrees to sell the asset in the future is said
to have the short position.
 The specified future date for the exchange is known as
the delivery (maturity) date.

16. Forwards – An example
 11th August 2012
 Mr. Tushar wants to buy 20 grm Gold, but his wife says
he should buy Gold only on the occasion of Diwali (on
11th November, 2012-Dhantreys)
 Worried about price fluctuations
 Jeweler thinks Prices of gold are very high currently
and may not go up during this Diwali
 Worried about price fluctuations
 Current gold price is Rs. 29000 per 10 grm
 Both face a Price Risk

17. Transaction
 Mr. Tushar and Jeweler enter into a contract on
11th August 2012
Mr. Tushar Jeweler
Will buy 20 grm. Gold Will sell 20 grm.
gold
Will Pay Rs. 30,000 per 10grm Will receive Rs.
30,000 per 10grm
Date of settlement : 11th Nov, 2012
This is a Forward contract,
trade happens today, settlement in future
Jewelers OBLIGATION is to give Gold and Mr.
Tushar’s OBLIGATION is to pay

18. Contract
Terms :
 Underlying : Gold
 Contract Date : August 11, 2012
 Contract Price : Rs. 30,000 per 10 grm
 Quantity : 20 grm.
 Settlement date : November 11, 2012
 By entering into the contract on August 11, 2012
what have the two parties done?
Locked in a future price of Rs. 30,000/- per
10grm.

19. Settlement
 On November 11, 2012 :
 Mr. Tushar buys 20 grm Gold from Jeweler
 Jeweler Recieves Rs. 60,000
 The contract entered on Aug 11, 2012 is settled.
 Price of Gold quoting in the spot market
(underlying price) is Rs. 28000/- per 10 grm.

20. Cash Settlement
 On Nov11, 2012 :
 Price of Gold quoting in the spot market (underlying price)
is Rs. 28000/- per 10 grm.
 Who gains? By how much?
 Jeweler Rs. 2000 per 10 grm.
 Settlement :
 Loser pays to the Gainer the profit / loss
 Jeweler receives Rs. 4000 from Mr. Tushar

21. Pay Off
Pay Off = ST – K (for the long forward) - Buyer
Pay Off = K – ST (for the short forward) – Seller
Where,
T = Time to expiry of the contract
ST = Spot Price of the underlying asset at time T
K = Strike Price or the price at which the asset will be
bought/sold

22. Forward Contract Payoff
K

24. Futures
 Futures were designed to solve the problems that existed in the
forward markets
 Counter Party risk
 Liquidity
 A future is a forward contract that has been standardized and
sold through an organized exchange
 Structure of a futures contract:–
 Seller (has short position) is obligated to deliver the commodity or a
financial instrument to the buyer (has long position) on a specific
date, this date is called settlement, or delivery date
 The long and short party usually do not deal with each other
directly or even know each other for that matter. The
exchange acts as a clearinghouse. As far as the two sides
are concerned they are entering into contracts with the
exchange. In fact, the exchange guarantees performance of
the contract regardless of whether the other party fails.

25. Futures …….exchange traded forwards
1. Exchange Traded (transperancy)
2. Standardised contracts (reduce complexity)
3. Counter - Party Risk is absent (settlement is guaranteed
by a Clearing Corporation)

26. Futures terminology
 Spot price : Price at which asset trades in the spot market
 Futures : Price at which Futures contracts trade in the
futures market
 Contract cycle : The period over which a contract trades
 Expiry Date : Last date of the contract
 Contract size : Amount or value of each contract
 Initial margin : Amount deposited initially to trade futures
(by both buyer & seller)
 Cost of Carry : Relationship between futures and spot price is
determined by cost of carry. For
financial assets it is interest cost.

27. Contract Life Cycle - example
Futures contracts in NIFTY on Feb 2012: Any given time upto 3
months duration contracts.
Contract Month Expiry/settlement date
Feb 2012 25th Feb
March 2012 25th March
April 2012 29th April
*Expiry – last Thursday of the month
You are on Feb 10.
You have a Near Month, Middle Month and Far Month contracts
to choose from.

28. Steps in trading Futures
 Pay Initial Margin
 Buy or Sell Futures
 Daily Mark to Market Settlement

29. Initial Margin (IM)
Stock (ABC Ltd.) Futures (ABC Ltd. Futures)
Rs. 500 Rs. 510
Buy 1000 shares Buy 1000 Futures
Value = Rs. 5,00,000 Value = Rs. 5,10,000
Pay Rs. 5,00,000 Pay IM = Rs. 51,000
After 10 days :
Rs. 600 Rs. 610
RETURN = 20% RETURN = 196%

30. Pricing of Futures
 Futures price = Spot Price + Cost of carry
 Cost of carry = interest rate*
 At expiry : Futures price = Spot price
*for financial futures

31. Pricing - Futures
Feb 10, you have Rs. 100.
How much will it become on March 10.
Depends on how much interest you can earn
If it is 12% p.a., then after 1 month Rs. 100 will become =
Rs. 101
F = S + Int.
Rs. 101 = Rs. 100 + Re. 1

32. Points to remember……….
 Long – Buy …(going long) [Bullish view]
 Short – Sell …(going short) [Bearish view]
 Squaring off (turn around trades) – opposite
transaction to the previous one
 Buy low, sell high - gives a profit
 Sell high, buy low - also gives a profit
 Sell low, buy high – gives a loss
 Buy high, sell low – also gives a loss

33. Daily Mark to Market Settlement – Futures contracts
Date Spot Price of Mr. Raju Buys MTM Gain Mr. Ajay Sells MTM Gain Remarks :
ABC Ltd. : ABC Ltd. / Loss ABC Ltd. / Loss Gainer receives
Futures @ Futures @ MTM amount from
Oct 1, 2008 the loser on a daily
11:00 am Rs. 510 Rs. 510 basis
Rs. 490
Oct 1, 2008 Ajay Pays Rs. 2 to
Rs. 500 Rs. 512 + Rs. 2 Rs. 512 - Rs. 2
3:30 pm Raju
Ajay Pays Rs. 8 to
Oct 2, 2008
Rs. 510 Rs. 520 + Rs. 8 Rs. 520 - Rs. 8 Raju
3:30 pm
Raju Pays Rs. 10 to
Oct 3, 2008
Rs. 495 Rs. 510 - Rs. 10 Rs. 510 + Rs. 10 Ajay
3:30 pm
Oct 4, 2008 Ajay Pays Rs. 5 to
3:30 pm Rs. 505 Rs. 515 + Rs. 5 Rs. 515 - Rs. 5 Raju
Ajay Pays Rs. 10 to
Oct 5, 2008
Rs. 515 Rs. 525 +Rs. 10 Rs. 525 - Rs. 10 Raju
3:30 pm

34. Futures Payoff
 A payoff is the likely profit or loss that would
accrue to a market participant with change in the
price of the underlying asset
 Futures have a linear payoff, i.e. the losses as
well as profits for the trader of futures contract are
unlimited

35. Payoff diagram for futures
P
R
O
F Rs. 50
I
T
S
0 Rs. 250 Rs. 300 Rs. 500
L
O Buy RELIANCE
S
S FUTURES @ Rs. 250
E
S
Sell @ Rs. 300
Linear Pay Off

36. Payoff diagram for futures
P
R
O
F
I
T
S
Rs. 200 Rs. 250
L
O
S
S
Sell RELIANCE
E FUTURES @ Rs. 250
S
Buy @ Rs. 200
Linear Pay Off

37. Final Settlement – convergence of Futures to Spot
•No Arbitrage Principle
Futures
Price •On the final settlement day/
expiry day, the Futures
Spot Price contract is settled at the
underlying closing price
(spot price)
Time
• Cash Settlement
(a)

38. DISTINCTIONS BETWEEN FUTURES
& FORWARDS
Forwards Futures
 Traded in dispersed  Traded in centralized
interbank market 24 hr a day. exchanges during specified
Lacks price transparency trading hours. Exhibits price
transparency.
 Transactions are customized
and flexible to meet  Transactions are highly
customers preferences. standardized to promote
trading and liquidity.

39. DISTINCTIONS BETWEEN FUTURES
& FORWARDS
Forwards Futures
 Counter party risk is variable  Being one of the two parties,
the clearing house
standardizes the counterparty
risk of all contracts.
 No cash flows take place  On a daily basis, cash may
until the final maturity of the flow in or out of the margin
contract. account, which is marked to
market.

41. Options
Example :-
 TATA is launching a car – Nano
 Price is Rs. 1Lakh. [Purchase price]
 You can book the car by paying Rs. 20,000 [deposit]
 By booking the car, what have you bought?
o A RIGHT to buy the car
 When booking matures, can TATA force you to buy
Nano?
o TATA has only OBLIGATION
 Can you force TATA to sell Nano?

42. Introduction to Options
An options contract gives the buyer the
right, but not the obligation to Buy or Sell a
specified underlying at a set price on or
before a specified date
: eg. Car Purchase, Insurance

43. Options Terminology
 Index options
 Stock Options
 Option buyer
 Option seller
 Option premium
 Strike / Exercise price
 Expiry date: It‟s last Thursday of the month for
options to be exercised/ traded. Options cease to
exist after expiry

44. Options
Calls give the buyer the right but not the obligation
to buy.
Puts give the buyer the right, but not the obligation
to sell.
 CALL OPTIONS : Gives the buyer of the Call Option
the RIGHT to buy at the STRIKE PRICE
 CALL OPTIONS : The Seller of the Call Option has to
meet his OBLIGATION of selling when the buyer
EXERCISES his right
 The Buyer retains the RIGHT to Exercise or not
Exercise

45. Call Option
 Exercise Point : U > SP
 Break Even point : U = SP + Premium
 Net profit : U > SP + Premium

46. Call Option
December 15,
Underlying Price Strike Price Premium
Rs. 100 Rs. 80
Rs. 30
December 28,
Underlying Price can be above, at or below Strike Price
Rs. 112
Rs. 80
Rs. 75
At which underlying price Buyer will exercise the Option ?

47. Certain Concepts - Options
 In the money- positive cash flow if
exercised
immediately
 At the money - zero cash flow if
exercised immediately
 Out of the money - negative cash flow if
exercised
immediately

48. Call Option
 The Buyer of an Options needs to pay to the
Seller the PRICE of the Option.
 This is called as the PREMIUM.
 It is paid immediately on buying the Option.
 The Seller receives the Premium on T+1 day.

49. Call Option
 Buyer : Unlimited Profits, Limited Losses
 Seller : Unlimited Losses, Limited Profits
 Buyer : Losses Limited to the premium (max. loss)
 Seller : Profits Limited to the premium
(max. gain)

50. Classification of Options
 Type
 Call or Put
 Exercise style
 EUROPEAN is an option that can be exercised only
on its expiration date
 AMERICAN is an option that can be exercised any
time up until and including its expiration date
 Settlement
 Cash or physical

51. CALLS & PUTS – RIGHTS AND OBLIGATION
RIGHT
CALLS Buyer Buy at the strike price at expiry
OBLIGATION
Seller Sell at the strike price at expiry
RIGHT
PUTS Buyer Sell at the strike price at expiry
OBLIGATION
Seller Buy at the strike price at expiry

52. BUYER OF AN OPTION
PAYS PREMIUM
PREMIUM IS THE MAXIMUM LOSS THE BUYER CAN SUFFER
SELLER OF AN OPTION
RECEIVES PREMIUM
PREMIUM IS THE MAXIMUM PROFIT THE SELLER CAN MAKE
APPLICABLE FOR BOTH CALLS AND PUTS

53. Intrinsic value
Price of an option is called „Premium‟
Premium = Intrinsic value + time value
Intrinsic value is the amount the contract is in
the money –
e.g. Spot = 1000, Strike Price = 990 March Call
Premium = Rs 15 (Intrinsic value = Rs. 10, time
value = 5)

54. Options Pricing
 Intrinsic Value (IV )
Difference between spot and strike
ITM has IV, ATM and OTM have zero IV
 Time Value ( TV )
Difference between the premium and intrinsic value
ITM have both IV and TV, ATM and OTM have only
TV
Longer the expiry more the TV, on expiry TV is 0

55. Options Payoff
 Optional characteristics of options results in a non
linear payoff for options. Non linear payoffs provide
flexibility to create combinations
 Losses of the buyer is limited to the premium paid and
profits are unlimited
 For writers/sellers losses are unlimited and profits
limited to the premium received

56. Options Payoffs
Payoff profile of buyer of asset: Long asset
Payoff for investor who went Long Nifty at 2220

57. Payoff profile for seller of asset:
Short asset
Payoff for investor who went Short Nifty at
2220

58. Payoff profile for buyer of call
options: Long call
Payoff for the buyer of a three month call
option with a strike of 2250 bought at a
premium of 86.60

59. Payoff profile for writer of call
options: Short call
Payoff for the writer of a three month call
option with a strike of 2250 sold at a premium
of 86.60.

60. Payoff profile for buyer of put options:
Long put
Payoff for the buyer of a three month put
option with a strike of 2250 bought at a
premium of 61.70.

61. Payoff profile for writer of put options:
Short put
Payoff for the writer of a three month put
option with a strike of 2250 sold at a premium
of 61.70

62. THE PAY OFF DIAG. - OPTIONS
 PROFITS AND LOSSES ON CALLS AND PUTS
 Security – ACC
PROFITS PROFITS
CALLS PUTS
100 100 20
20 120 80
LOSSES LOSSES

63. Any Questions?
Now we have some Questions….

64. Spot value of NIFTY is 2240. An investor buys a one
Month NIFTY 2227 put option for a premium of Rs.17.
The option is
________.
• Out of the money
• In the money
• At the money
• Above the money

65. A call option that is out-of-the-money or at-the-money
has ________.
only time value only intrinsic face value no value
value

66. A put option is in-the-money if the price of
the underlying asset is __________ the
strike price.
 Above
 Below
 Equal to
 Between the premium and strike price

67. Spot value of NIFTY is 2230. An investor buys a one
Month NIFTY 2245 call option for a premium of Rs.5.
After One month the spot value of NIFTY is 2250. The
Option is _________.
 In the money
 At the money
 Above the money
 Out of the money

68. An index put option at a strike of Rs.
2176 is selling at a premium of Rs. 28.
At what index level will it break even for
the buyer of the option?
•Rs. 2148
•Rs. 2196
•Rs. 2204
•Rs. 2194

69. Thank You !!