BASICS OF DERIVATIVESBASICS OF DERIVATIVES

BY- MasoodkhanrabbaniBY- Masoodkhanrabbani

Dated-july 28Dated-july 28thth 2009 2009

DerivativesDerivatives A financial contract of pre-determined A financial contract of pre-determined

duration, whose value is derived from the duration, whose value is derived from the value of an underlying assetvalue of an underlying asset SecuritiesSecurities commoditiescommodities bullionbullion precious metalsprecious metals currencycurrency livestock livestock index such as interest rates, exchange ratesindex such as interest rates, exchange rates

What do DERIVATIVES do?What do DERIVATIVES do?

Derivatives attempt either to Derivatives attempt either to minimize the minimize the lossloss arising from adverse price movements of arising from adverse price movements of the underlying assetthe underlying asset

Or Or maximize the profitsmaximize the profits arising out of arising out of favorable price fluctuation. Since derivatives favorable price fluctuation. Since derivatives derive their value from the underlying asset derive their value from the underlying asset they are called as derivatives.they are called as derivatives.

Types of DerivativesTypes of Derivatives((UA: Underlying Asset)UA: Underlying Asset)

Based on the Based on the underlying assetsunderlying assets derivatives are classified into.derivatives are classified into. Financial Derivatives (UA: Fin asset)Financial Derivatives (UA: Fin asset) Commodity Derivatives (UA: gold etc)Commodity Derivatives (UA: gold etc) Index DerivativeIndex Derivative (BSE sensex) (BSE sensex)

How are derivatives used?How are derivatives used? Derivatives are basically Derivatives are basically risk shiftingrisk shifting

instruments. Hedging is the most important instruments. Hedging is the most important aspect of derivatives and also their basic aspect of derivatives and also their basic economic purposeeconomic purpose

Derivatives can be compared to an insurance Derivatives can be compared to an insurance policy. As one pays premium in advance to an policy. As one pays premium in advance to an insurance company in protection against a insurance company in protection against a specific event, the derivative products have a specific event, the derivative products have a payoff contingent upon the occurrence of some payoff contingent upon the occurrence of some event for which he pays premium in advance.event for which he pays premium in advance.

What is Risk?What is Risk?

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

What is a What is a HedgeHedge To Be cautious or to protect against loss.To Be cautious or to protect against loss. In financial parlance, hedging is the act of In financial parlance, hedging is the act of

reducing uncertainty about future price reducing uncertainty about future price movements in a commodity, financial security movements in a commodity, financial security or foreign currencyor foreign currency . .

Thus a hedge is a way of insuring an Thus a hedge is a way of insuring an investment against risk. investment against risk.

Derivative Instruments.Derivative Instruments. Forward contractsForward contracts FuturesFutures

CommodityCommodity Financial (Stock index, interest rate & currency )Financial (Stock index, interest rate & currency )

OptionsOptions PutPut CallCall

Swaps.Swaps. Interest RateInterest Rate CurrencyCurrency

Forward Contracts.Forward Contracts. A one to one bipartite contract, which is to be A one to one bipartite contract, which is to be

performed in future at the terms decided today.performed in future at the terms decided today. Eg: Jay and Viru enter into a contract to trade in one Eg: Jay and Viru enter into a contract to trade in one

stock on Infosys 3 months from today the date of the stock on Infosys 3 months from today the date of the contract @ a price of Rs4675/-contract @ a price of Rs4675/-

Note: Product ,Price ,Quantity & Time have been Note: Product ,Price ,Quantity & Time have been determined in advance by both the parties.determined in advance by both the parties.

Delivery and payments will take place as per the terms Delivery and payments will take place as per the terms of this contract on the designated date and place. This of this contract on the designated date and place. This is a simple example of forward contract.is a simple example of forward contract.

Risks in a forward contractRisks in a forward contract Liquidity risk: these contracts a biparty and Liquidity risk: these contracts a biparty and

not traded on the exchange.not traded on the exchange. Default risk/credit risk/counter party risk.Default risk/credit risk/counter party risk. Say Jay owned one share of Infosys and Say Jay owned one share of Infosys and

the price went up to 4750/- three months the price went up to 4750/- three months hence, he profits by defaulting the contract hence, he profits by defaulting the contract and selling the stock at the market.and selling the stock at the market.

Futures.Futures. Future contracts are organized/standardized Future contracts are organized/standardized

contracts in terms of quantity, quality, delivery time contracts in terms of quantity, quality, delivery time and place for settlement on any date in future. These and place for settlement on any date in future. These contracts are traded on exchangescontracts are traded on exchanges..

These markets are very liquid These markets are very liquid In these markets, clearing corporation/house becomes In these markets, clearing corporation/house becomes

the counter-party to all the trades or provides the the counter-party to all the trades or provides the unconditional guarantee for the settlement of trades unconditional guarantee for the settlement of trades i.e. assumes the financial integrity of the whole i.e. assumes the financial integrity of the whole system. In other words, we may say that the credit risk system. In other words, we may say that the credit risk of the transactions is eliminated by the exchange of the transactions is eliminated by the exchange through the clearing corporation/house.through the clearing corporation/house.

The key elements of a futures contract are:The key elements of a futures contract are: Futures priceFutures price Settlement or Delivery DateSettlement or Delivery Date Underlying (infosys stock)Underlying (infosys stock)

Illustration.Illustration. Let us once again take the earlier example Let us once again take the earlier example

where Jay and Viru entered into a contract to where Jay and Viru entered into a contract to buy and sell Infosys shares. Now, assume that buy and sell Infosys shares. Now, assume that this contract is taking place through the this contract is taking place through the exchange, traded on the exchange and exchange, traded on the exchange and clearing corporation/house is the counter-party clearing corporation/house is the counter-party to this, it would be called a futures contract.to this, it would be called a futures contract.

Positions in a futures contractPositions in a futures contract

LongLong - this is when a person buys a - this is when a person buys a futures contract, and agrees to receive futures contract, and agrees to receive delivery at a future date. Eg: Viru’s delivery at a future date. Eg: Viru’s position position

ShortShort - this is when a person sells a - this is when a person sells a futures contract, and agrees to make futures contract, and agrees to make delivery. Eg: Jay’s Positiondelivery. Eg: Jay’s Position

How does one make money in a How does one make money in a futures contract?futures contract?

The long makes money when the The long makes money when the underlying assets price rises above the underlying assets price rises above the futures price.futures price.

The short makes money when the The short makes money when the underlying asset’s price falls below the underlying asset’s price falls below the futures price.futures price.

Concept of initial margin Concept of initial margin Degree of Leverage = 1/margin rate.Degree of Leverage = 1/margin rate.

OptionsOptions An option is An option is a contract giving the buyer the a contract giving the buyer the

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

Options LingoOptions Lingo Underlying:Underlying: This is the specific security / This is the specific security /

asset on which an options contract is asset on which an options contract is based.based.

Option Premium:Option Premium: Premium is the price Premium is the price paid by the buyer to the seller to acquire paid by the buyer to the seller to acquire the right to buy or sell. It is the total cost of the right to buy or sell. It is the total cost of an option. It is the difference between the an option. It is the difference between the higher price paid for a security and the higher price paid for a security and the security's face amount at issue. The security's face amount at issue. The premium of an option is basically the sum premium of an option is basically the sum of the option's intrinsic and time value. of the option's intrinsic and time value.

Strike Price or Exercise PriceStrike Price or Exercise Price : :price of an price of an option is the specified/ pre-determined price of option is the specified/ pre-determined price of the underlying asset at which the same can be the underlying asset at which the same can be bought or sold if the option buyer exercises his bought or sold if the option buyer exercises his right to buy/ sell on or before the expiration day.right to buy/ sell on or before the expiration day.

Expiration dateExpiration date:: The date on which the option The date on which the option expires is known as Expiration Dateexpires is known as Expiration Date

Exercise:Exercise: An action by an option holder taking An action by an option holder taking advantage of a favourable market advantage of a favourable market situationsituation .’Trade in’ the option for stock. .’Trade in’ the option for stock.

Exercise Date:Exercise Date: is the date on which the option is the date on which the option is actually exercisedis actually exercised..

European style of options:European style of options: The European The European kind of option is the one which can be kind of option is the one which can be exercised by the buyer on the expiration day exercised by the buyer on the expiration day only & not anytime before that.only & not anytime before that.

American style of options:American style of options: An American style An American style option is the one which can be exercised by the option is the one which can be exercised by the buyer on or before the expiration date, i.e. buyer on or before the expiration date, i.e. anytime between the day of purchase of the anytime between the day of purchase of the option and the day of its expiry.option and the day of its expiry.

Asian style of optionsAsian style of options: these are in-between : these are in-between European and American. An Asian option's payoff European and American. An Asian option's payoff depends on the average price of the underlying asset depends on the average price of the underlying asset over a certain period of time.over a certain period of time.

Option HolderOption Holder Option seller/ writerOption seller/ writer Call optionCall option: An option contract giving the owner the : An option contract giving the owner the

right to buyright to buy a specified amount of an underlying a specified amount of an underlying security at a specified price within a specified time.security at a specified price within a specified time.

Put OptionPut Option: An option contract giving the owner the : An option contract giving the owner the right to sell a specified amount of an underlying right to sell a specified amount of an underlying security at a specified price within a specified timesecurity at a specified price within a specified time

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

Intrinsic Value:Intrinsic Value: The intrinsic value of an option is The intrinsic value of an option is defined as the amount by which an option is in-the-defined as the amount by which an option is in-the-money, or the immediate exercise value of the money, or the immediate exercise value of the option when the underlying position is marked-to-option when the underlying position is marked-to-market.market.

For a call option: Intrinsic Value = Spot Price - For a call option: Intrinsic Value = Spot Price - Strike PriceStrike Price

For a put option: Intrinsic Value = Strike Price - For a put option: Intrinsic Value = Strike Price - Spot PriceSpot Price

Example of an OptionExample of an Option

Elvis and crocodiles.Elvis and crocodiles.

Positions Positions Long Position: Long Position: The term used when a The term used when a

person owns a security or commodity and person owns a security or commodity and wants to sell.wants to sell. If a person is long in a security If a person is long in a security then he wants it to go up in price.then he wants it to go up in price.

Short positionShort position: The term used to describe : The term used to describe the selling of a security, commodity, or the selling of a security, commodity, or currency. The investor's sales exceed currency. The investor's sales exceed holdings because they believe the price will holdings because they believe the price will fall. fall.

Profit/Loss Profile of a Profit/Loss Profile of a LongLong call call PositionPosition

0

-3

100 103

Profit

Loss

Price of Asset XYZ at expiration

Option Price = Rs3

Strike Price = Rs100

Time to expiration = 1month

Profit /Loss Profile for a Short Call Profit /Loss Profile for a Short Call PositionPosition

100 103

0

Profit

Loss

Price of the Asset XYZ at expiration

+3

Initial price of the asset = Rs100Option price= Rs3Strike price = Rs100Time to expiration = 1 month

Profit/Loss Profit/Loss Profile for a Long Put PositionProfile for a Long Put Position

0

-2

98 100

Price of the Asset XYZ at expiration

Profit

Loss

Initial price of the asset XYZ = Rs100

Option Price = Rs2

Strike price = Rs100

Time to expiration = 1 month

Profit/Loss Profile for a Short Profit/Loss Profile for a Short Put PositionPut Position

0

+2

94 100

Price of the Asset XYZ at expiration

Profit

Loss

Initial price of the asset XYZ = Rs100Option Price = Rs2Strike price = Rs100Time to expiration = 1 month

SummarySummary The profit and loss profile for a short put The profit and loss profile for a short put

option is the mirror image of the long option is the mirror image of the long put option. The maximum profit from put option. The maximum profit from this position is the option price. The this position is the option price. The theoritical maximum loss can be theoritical maximum loss can be substantial should the price of the substantial should the price of the underlying asset fall.underlying asset fall.

Buying calls or selling puts allows Buying calls or selling puts allows investor to gain if the price of the investor to gain if the price of the underlying asset rises; and selling calls underlying asset rises; and selling calls and buying puts allows the investors to and buying puts allows the investors to gain if the price of the underlying asset gain if the price of the underlying asset falls.falls.

Long Call

Short Put

Long Put

Short Call

Price rises

Price Falls

Stock Index OptionStock Index Option Trading in options whose underlying Trading in options whose underlying

instrument is the stock index.instrument is the stock index. Here if the option is exercised, the Here if the option is exercised, the

exchange assigned option writer pays exchange assigned option writer pays cash to the options buyer. There is no cash to the options buyer. There is no delivery of any stock.delivery of any stock.

Dollar Value of the underlying index = Dollar Value of the underlying index = Cash index value * Contract multiple.Cash index value * Contract multiple.

The contract multiple for the S&P100 The contract multiple for the S&P100 is $100. So, for eg, if the cash index is $100. So, for eg, if the cash index value for the S&P is 720,then dollar value for the S&P is 720,then dollar value will be $72,000value will be $72,000

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

SwapsSwaps An agreement between two parties An agreement between two parties

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

Interest Rate SwapInterest Rate Swap

A B

Fixed Rate of 12%

LIBOR

‘A’ is the fixed rate receiver and variable rate payer.

‘B’ is the variable rate receiver and fixed rate payer.

Rs50,00,00,000.00 – Notional Principle

Counter Party

Counter Party

The only Rupee exchanged between the The only Rupee exchanged between the parties are the net interest payment, not parties are the net interest payment, not the notional principle amount.the notional principle amount.

In the given eg A pays LIBOR/2*50crs to B In the given eg A pays LIBOR/2*50crs to B once every six months. Say LIBOR=5% once every six months. Say LIBOR=5% then A pays be 5%/2*50crs= 1.25crs then A pays be 5%/2*50crs= 1.25crs

B pays A 12%/2*50crs=3crsB pays A 12%/2*50crs=3crs The value of the swap will fluctuate with The value of the swap will fluctuate with

market interest rates.market interest rates. If interest If interest rates declinerates decline fixed rate payerfixed rate payer

is at a is at a lossloss, If interest , If interest rates riserates rise variable variable rate payerrate payer is at a is at a lossloss. Conversely if rates . Conversely if rates rise fixed rate payer profits and floating rise fixed rate payer profits and floating rate payer looses.rate payer looses.

How Swaps work in real lifeHow Swaps work in real life

Maruti BOA

BOT

LIBOR +3/8%

10.5% Fixed

LIBOR +3/8%