introductiontoderivatives-1

8/10/2019 introductiontoderivatives-1

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Introduction To Derivatives


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Der i v a t i v e s

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.


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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


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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

Aderivative 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 securedor 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.


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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 andvalid, but only if they are traded on exchanges.


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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 theNSE


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Derivatives Markets

Exchange Traded Contracts

Over The Counter Market


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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


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Basic purpose of derivatives In derivatives transactions, one partys loss is always

another partys 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.


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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.


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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 derivative2. 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 specificcondition or event e. . the underl in reachin a s ecific rice level


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Types of Financial Derivative

There is no definitive list of derivative productsand 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


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Forwards

A forward contract is an agreement between twoparties 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 asthe delivery (maturity) date.


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ForwardsAn example

11thAugust 2013

Mr. Tushar wants to buy 20 grm Gold, but his wife says

he should buy Gold only on the occasion of Diwali (on

11thNovember, 2013-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


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Transaction

Mr. Tushar and Jeweler enter into a contract on11thAugust 2013

Mr. Tushar Jeweler

Will buy 20 grm. Gold Will sell 20 grm.

goldWill Pay Rs. 30,000 per 10grm Will receive Rs.

30,000 per 10grm

Date of settlement : 11thNov, 2013

This is a Forward contract,

trade happens today, settlement in futureJewelers OBLIGATION is to give Gold and Mr.

TusharsOBLIGATIONis to pay


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ContractTerms :

Underlying : Gold Contract Date : August 11, 2013

Contract Price : Rs. 30,000 per 10 grm

Quantity : 20 grm.

Settlement date : November 11, 2013

By entering into the contract on August 11, 2013what have the two parties done?

Lo cked in a futu re price of Rs . 30,000/- per10grm.


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Settlement

On November 11, 2013 :

Mr. Tushar buys 20 grm Gold from Jeweler

Jeweler Recieves Rs. 60,000

The contract entered on Aug 11, 2013 is settled. Price of Gold quoting in the spot market

(underlying price) is Rs. 28000/- per 10 grm.


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CashSettlement

On Nov11, 2013 :

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


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PayOff

Pay Off = STK (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 bebought/sold


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Forward Contract Payoff

K


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Futures Futures were designed to solve the problems that existed in theforward markets

Counter Party risk

Liquidity

A future is a forward contract that has been standardized andsold 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 specificdate, this date is called settlement, or delivery date

The long and short party usually do not deal with each otherdirectly or even know each other for that matter. Theexchange acts as a clearinghouse. As far as the two sidesare concerned they are entering into contracts with theexchange. In fact, the exchange guarantees performance of

the contract regardless of whether the other party fails.


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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.


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Contract Life Cycle- exampleFutures contracts in NIFTY on Feb 2012: Any given time upto 3

months duration contracts.

Contract Month Expiry/settlement date

Feb 2012 25thFeb

March 2012 25thMarch

April 2012 29thApril

*Expirylast Thursday of the month

You are on Feb 10.You have a Near Month , Middle Month and Far Month c on tracts

to choose from.


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Steps in trading Futures

Pay Initial Margin

Buy or Sell Futures

Daily Mark to Market Settlement


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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%


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Pricing of Futures

Futures price = Spot Price + Cost of carry

Cost of carry = interest rate*

At expiry : Futures price = Spot price

*for financial futures


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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


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Points to remember.

LongBuy (going long) [Bullish view]

ShortSell (going short) [Bearish view]

Squaring off (turn around trades) opposite

transaction to the previous one

Buy low, sell highgives a profit

Sell high, buy lowalso gives a profit

Sell low, buy highgives a loss Buy high, sell lowalso gives a loss


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Daily Mark to Market SettlementFutures contracts

Date

Oct 1, 200811:00 am

Spot Price of

ABC Ltd. :

Rs. 490

Mr. Raju Buys

ABC Ltd.

Futures @

Rs. 510

MTM Gain

/ Loss

Mr. Ajay Sells

ABC Ltd.

Futures @

Rs. 510

MTM Gain

/ Loss

Remarks :

Gainer receives

MTM amount from

the loser on a daily

basis

Oct 1, 2008

3:30 pmRs. 500 Rs. 512 + Rs. 2 Rs. 512 - Rs. 2

Ajay Pays Rs. 2 to

Raju

Oct 2, 2008

3:30 pmRs. 510 Rs. 520 + Rs. 8 Rs. 520 - Rs. 8

Ajay Pays Rs. 8 toRaju

Oct 3, 2008

3:30 pmRs. 495 Rs. 510 - Rs. 10 Rs. 510 + Rs. 10

Raju Pays Rs. 10 to

Ajay

Oct 4, 2008

3:30 pm Rs. 505 Rs. 515 + Rs. 5 Rs. 515 - Rs. 5

Ajay Pays Rs. 5 to

Raju

Oct 5, 2008

3:30 pmRs. 515 Rs. 525 +Rs. 10 Rs. 525 - Rs. 10

Ajay Pays Rs. 10 to

Raju


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Futures Payoff

A payoff is the likely profit or loss that wouldaccrue 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


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Payoff diagram for futures

P

R

O

F

I

T

S

L

O

S

S

E

S

Rs. 2500 Rs. 500

Buy RELIANCE

FUTURES @ Rs. 250

Rs. 300

Sell @ Rs. 300

Linear Pay Off

Rs. 50


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P

R

O

F

I

T

S

L

O

S

S

E

S

Payoff diagram for futures

Sell RELIANCE

FUTURES @ Rs. 250

Buy @ Rs. 200

Linear Pay Off

Rs. 250Rs. 200


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Final Settlementconvergence of Futures to Spot

Time

(a)

Futures

Price

Spot Price

No Arbitrage Principle

On the final settlement day/

expiry day, the Futures

contract is settled at the

underlying closing price

(spot price)

Cash Settlement


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DISTINCTIONS BETWEEN FUTURES

& FORWARDS

Forwards

Traded in dispersed

interbank market 24 hr a day.

Lacks price transparency

Transactions are customized

and flexible to meet

customers preferences.

Futures

Traded in centralized

exchanges during specified

trading hours. Exhibits price

transparency.

Transactions are highly

standardized to promote

trading and liquidity.


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DISTINCTIONS BETWEEN FUTURES

& FORWARDSForwards

Counter party risk is variable

No cash flows take placeuntil the final maturity of the

contract.

Futures

Being one of the two parties,the clearing housestandardizes the counterpartyrisk of all contracts.

On a daily basis, cash mayflow in or out of the marginaccount, which is marked tomarket.


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Options

Example :-

TATA is launching a carNano

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?

oA 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?


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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


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Options Terminology

Index options

Stock Options

Option buyer

Option seller

Option premium Strike / Exercise price

Expiry date: Its last Thursday of the month for

options to be exercised/ traded. Options cease toexist after expiry


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Options

Calls give the buyer the right but not the obligationto 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 notExercise


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Call Option

Exercise Point : U > SP

Break Even point : U = SP + Premium

Net profit : U > SP + Premium


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Call Option

December 15,

Underlying Price Strike Price PremiumRs. 100 Rs. 80Rs. 30

December 28,

Underlying Price can be above, at or below Strike PriceRs. 112

Rs. 80

Rs. 75

At which underlying price Buyer will exercise the Option ?


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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


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Call Option

The Buyer of an Options needs to pay to theSeller 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.


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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)


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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

CALLS & PUTS RIGHTS AND OBLIGATION


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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

OBLIGATIONSeller Buy at the strike price at expiry

CALLS & PUTSRIGHTS AND OBLIGATION


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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


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Intrinsic value

Priceof an option is called Premium

Premium = Intrinsic value + time value

Intrinsic value is the amount the contract is inthe moneye.g. Spot = 1000, Strike Price = 990 March CallPremium = Rs 15 (Intrinsic value = Rs. 10, time

value = 5)

O


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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

TVLonger the expiry more the TV, on expiry TV is 0

Options Payoff


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Options Payoff

Optional characteristics of options results in a non

linear payoff for options. Non linear payoffs provideflexibility to create combinations

Losses of the buyer is limited to the premium paid and

profits are unlimited

For writers/sellers losses are unlimited and profitslimited to the premium received


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Options Payoffs

Payoff profile of buyer of asset: Long assetPayoff for investor who went Long Nifty at 2220

Payoff profile for seller of asset:


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Payoff profile for seller of asset:

Short asset

Payoff for investor who went Short Nifty at2220

Payoff profile for buyer of call


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Payoff profile for buyer of call

options: Long call

Payoff for the buyer of a three month calloption with a strike of 2250 bought at a

premium of 86.60

Payoff profile for writer of call


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Payoff profile for writer of call

options: Short call

Payoff for the writer of a three month calloption with a strike of 2250 sold at a premium

of 86.60.

Payoff profile for buyer of put options:


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Payoff profile for buyer of put options:

Long put

Payoff for the buyer of a three month putoption with a strike of 2250 bought at a

premium of 61.70.

Payoff profile for writer of put options:


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Payoff profile for writer of put options:

Short put

Payoff for the writer of a three month putoption with a strike of 2250 sold at a premium

of 61.70

THE PAY OFF DIAG - OPTIONS


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THE PAY OFF DIAG. OPTIONS

PROFITS AND LOSSES ON CALLS AND PUTS

SecurityACC

100

PROFITS

CALLS

LOSSES

100

LOSSES

PROFITS

PUTS

20 120

20

80


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Any Questions?

Now we have some Questions.


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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


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A call option that is out-of-the-money or at-the-moneyhas ________.

only time value only intrinsic

value

face value no value


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A put option is in-the-money if the price of

the underlying asset is __________ thestrike price.

Above

Below

Equal to

Between the premium and strike price


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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


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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. 2204Rs. 2194


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Thank You !!

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