SHORT NOTES

DERIVATIVES

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 Derivatives

Derivatives are financial instruments whose value depend on the value of

some underlying assets.

• Performance of the derivatives depend on how the underlying assets

performed.
• A derivative does not have any value of its own but its value, in turn,
depends on the value of other physical assets which are called underlying
assets.
• These underlying assets may be shares, debentures, tangible commodities,
currencies or short-term or long-term financial securities, etc.

Derivatives do not have physical existence but emerge out of contract

between two parties.

For example, a derivative contract/security is issued, whose value is defined

based on price of rice in the market. As price of rice increases or decreases,
the value of derivative also goes up and down. If the asset (rice) underlying is
removed, the value of derivatives will become zero because this security has
no value on its own.

Economic Benefits of Derivatives

Derivatives reduce the risk of losses and therefore increase the

willingness of investors to invest in financial or commodity market and
remain “risk averse”

Derivatives increase the liquidity of underlying assets in

the financial market

The cost of trading a real or financial asset like shares,

bonds, commodities etc., is larger than cost of trading in
derivatives. By trading in derivatives, the total cost of 2
transaction goes down
 • Derivatives provide an opportunity to create an optimum portfolio
by adjusting “risk and return characteristic” of the portfolio.
• They help in shifting the risk from those who have it but don’t want
it, to those who have the appetite and are willing to take it.

Types of risk which can be avoided through derivatives are-

Market Risk
Interest Rate Risk
Market risk is also called as
This risk is related to income
systematic risk.
from securities like Bonds and
Market risk is the risk of the
debentures. This risk arises
whole market going down or
when interest rate on such
moving up. It cannot be
securities goes up or down,
diversified. It can only be
affecting the market value of
shifted from one person to
such securities.
another.

Exchange Rate Risk

Wherever foreign currency is
involved, it gives rise to
exchange rate risk in terms of
fluctuation in exchange rate of
currencies.

Participants in Derivative Market

In the derivative market, different types of parties participate. They are as

follows:

Speculators Arbitrageurs

Hedgers 3
q Speculator

Speculator are the participants who are ready to take a risk for some return.

They take a position in the market either expecting that the prices will go up
or expecting that the prices will go down.

q Hedgers

A hedger is a person who faces certain risk associated with price movement
of an asset and uses a derivative to reduce that risk. This is done by taking a
position opposite to movement of the underlying assets.

For example, if A feels that his asset X is going to lose value soon, she can
hedge by buying a derivative whose value moves opposite to movement of the
underlying asset. So, if the value of X goes down, the value of derivative will
go up by the same or more proportion, hedging the risk of A

q Arbitrageur

Arbitrage refers to a situation where an investor undertakes two simultaneous

actions to make risk-less profit.

These two actions may be taken up in two different markets or on 4 two

different securities.
For example, shares of Reliance India Ltd. are
being traded at Rs.1,250 at NSE and at Rs.1,260
at BSE. An investor may buy the shares at NSE
and simultaneously sell the shares at BSE.

In this process, she can make profit of Rs.10 per

share, without taking any risk.

The arbitrage process thus helps the investors (arbitrageurs) to make risk-
less profit by capitalizing the price differential of an asset in two markets.

Types of Derivatives

Futures Swaps

Forwards Options

q Forwards
A forward contract is an agreement between two
parties to buy or sell an asset at a future date at a
price agreed today.

The date All are

decided at
The rate
the contract
The quantity date

But the contract is implemented5 in

future on the agreed date.
For Instance, PK wants to have
carrots every month. But he
expects prices of carrots to rise
in the future. He will ask person
B to supply him “X” carrots at
the price of “Rs.Y” every month.
B expects prices of carrots to
fall so he immediately agrees to
supply ”X” carrots for Rs. “Y”
every month to PK.

Hence, forward contract is a

customized contract

Both parties to the forward have an obligation to perform. In

case of default by either party, the other party has a right to
seek a compensation. A forward contract is not an investment in
the strict sense. It is only a commitment now to transact in
future. However, forwards do provide a means to hedge.

q Futures

A futures contract is an agreement between buyer and a seller of the

contract that a specified asset will be bought and sold for a specific price, on
a specific day, in the future (expiration date)

A (Seller) Clearing House (Future Exchange) B (Buyer)

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 A futures contract is distinct from a forward contract in two
important ways-

• A futures contract is a legally binding agreement to buy

or sell a standardized asset on a specific date or during
a specific month

• the transaction in a futures contract is facilitated

through a futures exchanges

Features of a Future Contract

Security descriptor/symbol – CNX NIFTY FUT IDX, S&P BSE SENSEX

Underlying asset – stock, index, commodities

Trading cycle – 1 month (near month), 2-month, 3-month, long term

contracts – 6 months

Margin Requirement

Mark to market settlement

Settlement procedure – by cash (90%) or by delivery

Future Trading

Future contracts trade on ‘trading floor’ during official hours at Future

Exchanges

Future exchanges specialize in a limited range of commodities and by

standardizing contract terms, it overcomes the limitation of forward
contracts.

Trade must be executed by a broker and broker must trade through

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member of exchange.
• Problem with forward contract – Whether the traders will perform as
they have promised??
Ø Not always, Counterparty risk is there.
• But in case of future contracts, a clearing house is present to minimize
the risk.

• When transaction is completed, the Clearing House will have neither

funds or goods but act only to guarantee performance to both parties.

• Clearing House guarantees performance therefore, it has its own risk

exposure
• If traders default on their obligations, the clearing house suffers.

To protect clearing house, traders need to deposit funds (Initial

Margin) with their brokers

If traders default, broker seizes the money

Margin acts as a good faith deposit with the broker, although the
deposit is small relative to the value of goods being traded.

The potential losses on the future contracts could be much

larger.

Through daily Settlement, future traders realize their gains & losses in cash
as the result of each day trading

The traders may withdraw the day’s gain and must pay for day’s losses

If traders fail to settle the day’s losses, the broker may seize the margin
deposit and liquidate the trader’s position/

Exchange will loose on the default only when loss of one day > amount of the
margin.

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 Margin A/C and Mark to Market Settlement

At initial execution of a trade, each trader

establishes a margin account. The margin is a security
account consisting of cash or near-cash securities,
such as Treasury Bills, that ensures that the trader
can satisfy the obligations of the futures contract.
Because both parties to a contract are exposed to
losses, both must post margin.

The initial margin is usually set between 5% and 15% of the total value of
the contract.

The positions in the futures for each member is marked to market to the
daily settlement price of the futures contracts at the end of each trade
day.
The profits/losses are computed as the difference between the trade
price or the previous day’s settlement price, as the case may be, and the
current day’s settlement price. The traders who have suffered a loss are
required to pay the mark-to-market loss amount to the clearing house
(say NSE clearing house) which is passed on to the members who have
made a profit.

This is known as daily mark-to-

market settlement.

Forwards Futures
Difference between
Over Forwards and Futures Contracts
the Counter Exchange Traded

Customized Standardized

Less Liquidity More liquidity

Credit risk default is high because one Credit guarantee as they are traded
of the parties may default if the on the stock exchange
contract turns unfavorable
Paid at settlement date – this is not Marked to market – this means the
tradeable. Settlement between parties value of derivative changes every day
takes place at the end of the according to value of underlying asset.
commitment period. An investor can trade the derivative
9 in
the stock exchange.
q Options

An option is a contract which gives its buyer a right (not obligation) to buy or
sell a specified asset at a specified price (strike price) on or before a future
date.

Buyer of the Option Holder of the Option

Seller of the Option Writer of the Option

Right to buy Call Option

Right to sell Put Option

Stock based option trading was allowed by SEBI in 2002

Types of Options

Options can be classified in different groups as follows:

Call Options and Put American Options Naked Options and

Options and European Covered Options
Options

Call Options and Put Options

Call Options: A call option provides the holder a right to buy specified assets
at specified price on or before a specified date.
Put Options: A put option provides the holder a right to sell specified assets
at specified price on or before a specified date.
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 American Options and European Options

American Options: Here the option holder can exercise the right to buy or
sell, at any time before the expiration or on the expiration date.
European Options: Here, the right can be exercised only on the expiry date
and not before.

Naked Options and Covered Options

Naked Options: It is covered or backed by the asset which is owned by the

option writer. So, if the option holder exercises the option, option writer can
deliver the asset.
European Options: It is not covered by any physical asset.

Important terms in Option Contracts

1. Option Premium: It is the price paid by the buyer of the option to the
seller of the option to purchase the option. This is not the price at which
the assets are brought or sold, that price is called exercise price or strike
price.
• It is a minimal amount paid by the buyer of the option to get the "rights"
to buy or sell the option later

2. Expiration Date: The expiration date is the last date when the option can be
exercised.

3. Strike Price: The specified price at which the option can be exercised is
known as the strike price. On the specified date, the actual price of the
underlying assets may be different from the strike price of the option
contract.

When to exercise?? Losses are limited to premium paid to

the seller of the contract

v Call option is exercised when stock price at expiry is greater

than the exercise price.
v Put Option is exercised when stock price at expiry is lower
than the exercise price.

The potential profit of seller of an option is limited to the11

premium received for writing the put.
Moneyness of the Option

Relationship Call Option Put Option

Actual Price >
In the money Out of money
Strike Price
AP = SP At the money At the money

AP < SP Out of money In the money

Option Spread

The risk profile of option buyer and seller is different.

While Option buyer is exposed to limited losses but unlimited profits, option
seller is exposed to limited profits but unlimited losses.

To limit this profit and loss profile for both buyer and seller, a spread is
created. An option spread involves taking a position in two or more options of
the same type.

For example, buying a call and selling another call with different strike price
or different expiration dates.

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There are 3 kinds of spread -

Vertical Spread Horizontal Spread Diagonal Spread

Here, the investor Here, the It combines

involves in instruments features of both
simultaneous buying purchased and sold vertical and
and selling of have the same horizontal spread.
options of the same strike price but Both the expiration
instrument but with different dates. date and strike
different exercise price are different
price/strike price. in a diagonal
It is also called spread.
price spread.

Differences and Similarities between Futures and Options:

Bases Futures Options

Risk Profile Symmetric Asymmetric

Advance Advance payment in the form
No Advance payment
payment of premium
Both buyer and seller is Only seller (option writer) is
Margin required to deposit margin required to deposit margin
with their broker with his/her broker
Obligation of There is an obligation to Buyer has a right and not
the buyer execute the contract. obligation.
Obligation of There is obligation to There is obligation to execute
the seller execute the contract. the contract

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q Swaps

A swap is an agreement between two parties in which they agree to exchange

their cash flows. The parties to a swap contract are called as counter parties.

In the currency swap agreement, two currencies are exchanged, in the

beginning and again at maturity the currencies are re-exchanged.
They are traded over the counter and not on an exchange.

Examples: Currency Swaps, Interest Rate Swaps, Commodity swaps, etc.

Interest Rate Swaps

An interest rate swap is an exchange of interest flows in an underlying asset

or a liability.

In an interest rate swap, there is a shift of basis of interest rate calculation,

from fixed rate to floating rate or vice-versa. The cash flows representing the
interest payments during the swap period are exchanged accordingly.

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