Disclaimer

The information provided in this booklet is accurate to the best of our knowledge at
the time of publication. We have taken utmost care to ensure the correctness and
reliability of the information presented. However, we cannot guarantee that future
developments or updates may not affect the accuracy or applicability of the
content.
All rights reserved. No part of this booklet may be reproduced, stored in a retrieval
system, or transmitted in any form or by any means, electronic, mechanical,
photocopying, recording, or otherwise, without prior written permission from the
publisher. Unauthorized reproduction or distribution of this booklet is strictly
prohibited.
We value your feedback and welcome any comments or suggestions you may
have. Your input is valuable in helping us improve the quality and relevance of our
content. Please contact us at [email protected] with your feedback

Editorial Team
We would like to acknowledge the valuable contributions of our team
members who have worked tirelessly to provide valuable insights and
content for this material.

Mentor :
Maddikera Vijay
Coordinators :
Aditya Upadhyay
Sagnik Dey
Aryush Tripathi
Technical Team :
Aditya Dubey
Gouri Verma
Contributors -
Anubhav Mishra, Annem Sidhartha, Debtanu Das, Divyanshu Dubey, Sukirti
Garg

Arshad Amaan Kumar Saurabh

Finance Head Secretary
FEBS, IIT Bhubaneswar FEBS, IIT Bhubaneswar
About FEBS

FEBS is IIT Bhubaneswar's society of finance, economics, and

business. The community is an agglomerate of enthusiastic people
brought together by their love for finance, economics, and business and
their aspiration to spread the importance of financial literacy in IIT
Bhubaneswar. The prime motto of our society is to encourage the
development of financial literacy, economic thought, and business
ideas. We aim to familiarize everyone with the economic lens of issues
and make everyone adroit in handling personal finance. The society
members bond over different ideas and try to uphold the economic
ideals, incubate the awareness of financial issues, thereby fostering
leadership in members. We host exciting lectures and talks by eminent
personalities and our alumni apart from competitions like virtual trading,
stock war, auction war, etc., stimulating quizzes and engaging debates
and whatnot. We also manage an online website with articles on
different economic concepts and reviews, financial capacities, and
business models. Society plans to build a repository of fundamental
concepts of our domains. We also aim to provide roadmaps and career
guidance for those interested in a career in the supply chain, product
management, finance, consulting, investment banking, etc. We seek to
guide and direct anyone who has a keen interest in Finance,
Economics, and Business. If you find these domains attractive, this is a
place for you. Follow us on our social media handles for regular
updates from us. Team FEBS wishes you a happier day ahead!
 Derivatives

DERIVATIVES

Derivatives are a financial contract between two or more parties. They

derive their value from an underlying asset or a group of assets, such as
stocks, bonds, commodities, currencies, interest rates, or market indices
The value of a derivative instrument changes in relation to the value of the
underlying asset(s) it tracks. They are widely used for various purposes,
including hedging against risk, speculating on price movements, and
gaining exposure to different markets.

Types of Derivatives
There are several types of derivatives, including options, futures,
forwards, and swaps.
Each type has its unique characteristics and applications in managing
financial risk or enabling investment strategies.

For better understanding a financial derivative, let us take an example

of Company ABC. You are certain that the share prices of Company
ABC are likely to go up. You can buy a derivative contract by placing
an accurate bet to leverage the price movement. Furthermore,
derivative contracts can also act as a cushion for your investment to
limit losses.

Taking another example, derivative contracts are used to fix the price
of a commodity to minimise losses. For instance, dealing in the
commodities market doesn’t necessarily involve the physical delivery
of the commodity. To elaborate, a futures contract for onions doesn’t
involve buying and selling onions. The value of the contract is derived
from the cost of buying and selling onions.
 Derivatives

Uses Of Derivatives
Risk Hedging:
Purpose: Derivatives are extensively used for risk management to
mitigate potential losses arising from adverse price movements in various
assets or markets.
Example: A company involved in international trade may use currency
forwards or options to hedge against fluctuations in exchange rates. This
strategy helps protect the company's profits or costs related to foreign
transactions.

Speculation:
Purpose: Traders and investors use derivatives to speculate on the
future direction of asset prices, aiming to profit from anticipated market
movements.
Example: An investor purchasing call options on a stock believes the
stock price will rise. If the price indeed increases, the investor can buy
the stock at a lower price through the options and profit from the
difference.

Arbitrage opportunities:
Purpose: Traders use derivatives to exploit price inefficiencies or
discrepancies between related assets or markets, aiming to profit from
these differences.
Example: If the price of an asset differs between two different markets,
arbitrageurs might simultaneously buy the asset at the lower price in one
market and sell it at the higher price in another, capturing the price
differential.
 Derivatives

Portfolio Diversification:
Purpose: Derivatives enable investors to diversify their portfolios by
gaining exposure to assets or markets that might otherwise be
inaccessible or difficult to include directly.
Example: Index futures or options allow investors to gain exposure to an
entire market index, providing diversification benefits without needing to
purchase individual stocks within the index.

FORWARDS
A forward contract is an agreement to buy or sell an asset on a fixed
date in the future, called the delivery time, for a price specified in
advance, called the forward price. The party to the contract who agrees
to sell the asset is said to be taking a short forward position. The
other party, obliged to buy the asset at delivery, is said to have a long
forward position.
Example: A farmer wishing to fix the sale price of his crops in advance,
an importer arranging to buy foreign currency at a fixed rate in the future,
a fund manager who wants to sell stock for a price known in advance.
(An Introduction to Financial Engineering by
Marek Capinski Tomasz Zastawniak)

Indeed, one of the oldest and most commonly used derivatives is the
forward contract, which serves as the conceptual basis for many other
types of derivatives that we see today. Here, we take a closer look at
forwards and understand how they work and where they are used.

Forward contracts trade in the over-the-counter (OTC) market,

meaning they do not trade on an exchange. When a forward contract
expires, the transaction is settled in one of two ways. The first way is
through a process known as physical delivery.
 Forwards

Under this type of settlement, the party that is long the forward contract
position will pay the party that is short the position when the asset is
actually delivered and the transaction is finalised. While the transactional
concept of “delivery” is simple to understand, the implementation of
delivering the underlying asset may be very difficult for the party holding
the short position. As a result, a forward contract can also be completed
through a process known as “cash settlement”.

A cash settlement is more complex than a delivery settlement, but it is still

relatively straightforward to understand. For example, suppose that at the
beginning of the year a cereal company agrees through a forward
contract to buy 1 million bushels of corn at $5 per bushel from a farmer
on Nov. 30 of the same year.

At the end of November, suppose that corn is selling for $4 per bushel
on the open market. In this example, the cereal company, which is long
the forward contract position, is due to receive from the farmer an asset
that is now worth $4 per bushel. However, since it was agreed at the
beginning of the year that the cereal company would pay $5 per bushel,
the cereal company could simply request that the farmer sell the corn in
the open market at $4 per bushel, and the cereal company would make a
cash payment of $1 per bushel to the farmer. Under this proposal, the
farmer would still receive $5 per bushel of corn.

In terms of the other side of the transaction, the cereal company would
then simply purchase the necessary bushels of corn in the open market
at $4 per bushel. The net effect of this process would be a $1 payment
per bushel of corn from the cereal company to the farmer. In this case, a
cash settlement was used for the sole purpose of simplifying the delivery
process.
 Futures

FUTURES
A futures contract is very similar to a forward contract. Futures contracts
are usually traded through an exchange, which standardises the terms of
the contracts.
The profit or loss from the futures position is calculated every day and
the change in this value is paid from one party to the other. Thus with
futures contracts there is a gradual payment of funds from initiation until
maturity. (Paul Wilmott On Quantitative Finance)

Setting the price of rice in Japan

One of the oldest futures markets was created in 1697 in the province of
Osaka, Japan to organise the purchase and sale of rice. Known as the
Dojima Rice Exchange, it filled a very important role in the Japanese
Shogunate economy. During this period, Samurai, including the feudal
lords, were paid exclusively in rice. You can imagine how this might be a
frustrating currency to be paid in; as the value of rice fluctuated, so, too,
would the value of this annual payment. The Samurai needed a solution,
and the financiers of the Dojima Rice Exchange created one: a futures
market. Now, samurai and their lords could offer to sell their future pay-
checks (in rice) for a set value, eliminating the fluctuations in their pay.
This meant that they could take out loans and provide an expectation of
repayment, regardless of the price of rice. Soon, the samurai were
converting their rice futures-based value into paper money and holding
bank accounts at the Dojima Rice Exchange. This exchange would
become one of the forerunners to the modern Japanese banking system.
 Futures

Let us denote the time when the forward contract is exchanged by 0,

the delivery time by T, and the forward price by F(0,T).

The time t market price of the underlying asset will be denoted by

S(t).

No payment is made by either party at time 0, when the forward

contract is exchanged.

At delivery the party with a long forward position will benefit if F (0, T
) < S(T ).

They can buy the asset for F (0, T ) and sell it for the market price S
(T ), making an instant profit of S(T ) − F (0, T ).

Meanwhile, the party holding a short forward position will suffer a loss
of S(T ) − F (0, T ) because they will have to sell below the market
price. If F(0,T) > S(T), then the situation will be reversedThis is the
relationship between the spot price and the forward price.

(Paul Wilmott On Quantitative Finance)

 Futures

(An Introduction to Financial Engineering by

Marek Capinski Tomasz Zastawniak)

This is the relationship between the spot price and the forward
price.It is a linear relationship, the forward price is proportional to the
spot price.

If the contract is initiated at time t < T rather than 0, then we shall

write F(t,T) for the forward price, the payoff at delivery being S(T)
−F(t,T) for a long forward position and F (t, T ) − S(T ) for a short
position
 Options

OPTIONS

In the Futures, we understood how both transacting parties must honour

the contract. That means that parties have to shoulder the possibility of
unlimited losses on Futures positions. They can also make more profits.
However, to manage losses, an Options contract is a better product.

Options contracts are different from Futures contracts because one party
has the right to buy or sell an underlying while another party has an
obligation.

The right to buy is a Call Option while the right to sell is a Put Option.

The buyer of an Option is also known as the holder.

The seller of an Option is also known as the writer.

The obliged party has to compensate the party with the obligation.
When a buyer purchases a right, he needs to pay the cost of that right,
known as a premium, upfront to the seller. In other words, a buyer needs
to make an upfront compensation to the seller for taking on a risk.

Example
Options contracts are not new to us. We often use them in day-
to-day life. For example, let us assume that you decide to
purchase a property for Rs 50 lakh and plan to complete the
transaction in 2 months and proceed with legal formalities. As a
buyer, you need to pay some non-refundable token amount, let’s
say Rs. 1 lakh, to the seller to secure the deal. Now let’s assume
two scenarios:
 Options

Scenario 1:
Next month, you realise that litigation has come up in that area,
and the same property is now available at Rs. 40 lakh. As a buyer,
you don’t have any obligation to purchase that property now, and
you can forgo the token amount of Rs. 1 lakh. This way, you
safeguard yourself from a more significant loss. You still save
yourself Rs. 9 lakh on the transaction. The seller can choose to
sell the property to someone else at Rs. 40 lakh. However, the
seller will earn Rs. 1 lakh extra since you did not purchase.

Scenario 2:
In the next month, you realise that the government had sanctioned
a significant project nearby and consequently, the same property
is now available at Rs. 60 lakh. As a buyer, you will exercise your
right and purchase the property as per the already agreed price
of Rs. 50 lakh. A seller needs to honour the contract and can’t
refuse now. You earn an immediate profit of Rs. 9 lakh, and the
seller loses the same amount.