BY- Amit Kumar Singh

A product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index or reference rate ), in a contractual manner.

The underlying asset can be equity , forex commodity or any other asset.

SCRA Act defines Derivatives as :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.

A contract which derives its value from the prices, or index of prices, of underlying securities.

Trading on derivatives initiated on Commodities and no one knows when it started trading, earlier it was OTC ( Over the Counter) in the form of Forward Contracts.Was there because of hedging objective where long position holder and short position holder use derivative to fix future price uncertainty.

A one to one bipartite contract, which is to be performed in future at the terms decided today. Eg: Jay and Viru enter into a contract to trade in one stock on Infosys 3 months from today the date of the contract @ a price of Rs4675/-Note: Product ,Price ,Quantity & Time have been determined in advance by both the parties.

Liquidity risk: these contracts a biparty and not traded on the exchange.Default risk/credit risk/counter party risk.Say Jay owned one share of Infosys and the price went up to 4750/- three months hence, he profits by defaulting the contract and selling the stock at the market.

Future contracts are organized/standardized contracts in terms of quantity, quality, delivery time and place for settlement on any date in future. These contracts are traded on exchanges.These markets are very liquidExchange act like counterparty for long and short position holder by playing the concept of Novation

Both the long position holder and short position holder need to deposit Initial Margin to exchange depending upon volatility of underlying in the marketExchange follows MTM Settlement, where every day closing price/rate is compared with last day closing price/rate and difference get debited/credited from each position holder account if-

Today closing price>Yesterday Closing price, then today closing price-yesterday Closing price get debited from short position holder account and vice versa.MTM Settlement is followed till any of account touches Maintenance Margin which is the threshold margin where the account holder receives Margin Call to continue the settlement

Derivative Market in India is divided into 3 types of derivatives:-Financial Derivative- Cash SettlementCommodity Derivative- Physical Settlement, Cash SettlementCurrency Derivative- Cash Settlement in INR.Final Settlement depends upon Exercise price at the time of entry of contract and maturity date closing price

In case of Commodities, short position holder at the time of entering into future contract need to deposit underlying in the warehouse where the warehouse receipt need to deposit into exchange.At the time of expiration, warehouse again access the underlying commodity and figure out any deviation in quality/quantity which then assigned to required long position holder

Derivatives contracts trading in India and their maturities are mentioned below;-Financial Derivative- 1 month Contract, 2 month Contract, 3 month Contract. Last Thursday of every month contracts gets matureCommodity Derivative- 1 month Contract, 2 month Contract, 3 month Contract. 20th of every month contracts gets mature

c. Currency Derivative- Contracts ranging from 1 month to 12 months are available for trading where they mature on the last day of each month ( settlement date) where last trading day is 2 day before

Hedgers - Operators, who want to transfer a risk component of their portfolio. Speculators - Operators, who intentionally take the risk from hedgers in pursuit of profit. Arbitrageurs - Operators who operate in the different markets simultaneously, in pursuit of profit and eliminate mis-pricing.

Hedging: long security, sell future

Hedging: short security, long future

Speculation: bullish security, buy Futures

Speculation : bearish Security, Sell Futures

Arbitrage: overpriced Futures: buy spot, sell futures

Arbitrage: underpriced Futures: buy spot, sell futures

Derivative being considered as risk minimization instrument is used by hedger to fix the future price on which transaction will happen in future

In forex market exporter expecting to receive foreign currency will short, importer expecting to pay foreign currency will long on currency future

Concern that price can go up, individuals will long, concern that price can go down will short on Commodity/ Financial Future

Speculator go for naked position in the market will leverage on market by taking long position when expecting to gain from bullish behavior, will short on market when expecting bearish behavior

Cash Settlement favors Speculative activities in the market

Stock is chosen among top 500 stocks in term of market capitalization and avg traded value in previous 6 months on a rolling basisStock median quarter sigma order size over the last 6 month should not be less than 5 lakhMarket wide position limit on a stock should not be less than 100 cr

For existing stocks to act like derivative trading MWPL should not be less than 60 crore, and stock median quarter sigma order size shall less than 2 lakhFor Index Derivative, 80% stocks in the portfolio should be individually eligible and no ineligible stock should have weightage above 5%

Commission Broker- Follow client trading and get commission for their servicesLocals- or called proprietary trader who trades for themselvesScalpers- Follow short term trends and generate profits from short term price changePosition trader- go for Investment put funds for longer period of time

Market Order-Request to execute trade immediately at the current market price

Limit Order- Request to execute trade immediately at the mentioned price, when the trade is entered then it is called active order otherwise it remain outstanding as a passive order

Stop Loss- consist of limit price, trigger price. Buying is activated when trigger price touched and selling is done when limit price is touched

Interest determined on Investment can be calculated through Compound Interest which works on the principle of time value of money where we get Interest on InterestContinuous Compounding is a derivative of Compound Interest works on a principle that interest changes per seconds so, F=P((1+r)^n) becomes F=P*e^(r*n)

For Financial Assets with no income, F=S*e^(rt)

For Financial Assets with Income, F=(S*e^(r*t1))-(I*e^(r*t2)) or F=(S-Present Value of Income)*e^(r*t)

For Commodity Assets, F= (S+U)*e^(r*t) or F=S*e^((u+r)*t)

For Commodity Assets with convenience yield, F= S*e^((r+u-y)*t)

For Currency , F=S*e^((rh-rf)*t)

For Financial asset with dividend yield or of Index Future F=S*e((r-y)*t)

where, S= Spot Price, r= cost of financing, t= time to expiration, u= storage cost,rh= Interest rate on home country, rf= Interest rate on foreign countryy=yield

If the contract does qualify as a hedge, then the gains/losses are generally recognized for accounting purposes in the same period in which gains or losses for the item being hedged, then it is called hedge accounting.

Prior to Finance Year 2005-06 transaction in Derivatives were considered as speculative transaction while after amendment in Sec 43(5) transaction over recognized stock exchange is not considered as a speculative activities.Loss on derivative transaction can be carried forward to 8 assessment yearSTT is 0.017% for sale of futures and Options on securities

For long position holder, a. f=S-k*e^(-rt).forward contract with no income b. f=S-I-K*e^(-rt). forward contract with incomec. f=S*e^(-yt)-k*e^(-rt)..forward contract with yield

Where k=delivery price

Currency always trade in pairs, appreciation of one currency means depreciation of another currencyArbitration exists on currency when Interest rate differential is not equal to forward rate differentialFR differential= ((FR-SR)/SR)*(360/n), Interest Rate differential= ((1+IRcountry1)/(1+IRcountry2))-1

If future price is above the spot price, it is called Contango, if spot price is above future price then it is called BackwardationContango and Backwardation we use frequently in Commodities Market, Backwardation is the phenomenon which happens because of Convenience Yield, as physically owing securities creates a value

Financial Stocks trading in Derivative Market need to traded in Exchange in minimum worth of 2 lakh rupees, so in this basis SEBI has prescribed lot sizes , means that much number need to buy or in multiple to trade over derivatives

Stock Prices Lot SizeAbove 1600 125801-1600 250401-800 500201-400 1000101-200 200051-100 400025-50 8000Less than 25 10000

Open Interest is the total number of future and option contracts that are not closed or delivered on a particular dayRising Market with high OI indicates market is strong while high OI in bearish market or low OI in bullish market indicates weak market with artificial demand may be creating only for profit booking

Badlawas an indigenouscarry-forwardsystem invented on theBombay Stock Exchangeas a solution to the perpetual lack ofliquidityin thesecondary marketIt was banned in 1993, then again introduced in 1996 with carry forward limit of 20 crore then again banned in 2001 with the introduction of Future contracts

Badlatrading involved buying stocks with borrowed money in thestock exchangeacting as anintermediaryat aninterest ratedetermined by thedemandfor the underlying stock and a maturitynot greater than 70 days

The act of hedging ones position by taking an offsetting position in another good with similar price movements Although the two goods are not identical, they arecorrelated enough to create a hedged position as long as the prices move in the same direction. A good example is cross hedging a crude oil futures contract with a short position in natural gas. Even though these two products are not identical, their price movements are similar enough to use for hedging purposes.

In order to determine optimum number of contracts need to short or long, hedge ratio should be determined first h=*(s/f)

h= hedge ratio, =coefficient of correlations= standard deviation of underlying assetf= standard deviation of commodity use for hedging

Number of contract need to short or long = h*( size of underlying/value of 1 future -contract)In the case of Financial Future, Number of contract need to short or long = beta*( size of underlying/value of 1 future -contract)

Rolling the hedge forward holds good when the hedge matures in the distant point of time and all the future contract are available at moment before their expiry

This involves long or short positions after every regular period of time till maturity and closing them before maturity in case of commodity or may at maturity date in case of financial assets as they do not involve physical settlement

Option is financial derivative instrument giving right but no obligation to long position holder to follow the terms of contract in the future by paying initial premium to short position holder, while the short position holder has the obligation to follow what long position wants him/her to follow

Initial Premium paid by long position holder to the short position holder is the maximum loss which long position holder can bear, while the initial premium received by short position holder is the maximum profit which short position holder can get. While the max. profit for long position holder is unlimited and maximum loss for short position holder is unlimited

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

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

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

Exercise: An action by an option holder taking advantage of a favourable market situation .Trade in the option for stock.Exercise Date: is the date on which the option is actually exercised.European style of options: The European kind of option is the one which can be exercised by the buyer on the expiration day only & not anytime before that.

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

An option contract giving the owner the right to buy a specified amount of an underlying security at a specified price within a specified time.Call option holder can be long position holder, short position holderLong call position holder are bullish on underlying where they have right, while short call holder are bearish on underlying where they have obligation

Figure in next slide shows the illustration of long call option at strike value of Nifty at 2250 by paying a premium of 86.60 . If Nifty closes above 2250, long position will earn unlimited profit however if Nifty closes below strike of 2250, then he lets the option expire and will lose the premium of 86.60. Profit of long position is the loss of short position holder and vice versa

An option contract giving the owner the right to sell a specified amount of an underlying security at a specified price within a specified timeLong and short positions can be taken on put options while long put holder has the right while short put holder has the obligation.Long Put holder is bearish on market while short put holder is bullish

Bullish on underlying- long call, short put When underlying price/rate increases above strike price/rate then long call holder will get unlimited profit however short put holder will receive only limited amount of initial premium.Bearish on underlying- long put, short call

In the Money Option- ITM options leads to positive cash flow to the holder if it is exercised immediatelyAt the Money Option- ATM options leads to zero cash flow if it is exercised immediately.Out of Money Option- leads to negative cash flow if it is exercised immediately

Call Option Put Option Premium

ITM S>K K>S HighestATM S=K S=KOTM SK Lowest

S= Spot PriceK= Strike Price

Depending upon the difference between spot price and strike price options under call and put option can be classified under ITM, ATM ,OTM and upon expiration if any option expires ITM will result into positive cash flowInitial Premium paid by long position holder to the short position holder also depends upon ITM, ATM ,OTM options.

Intrinsic Value of Option at the given time is the amount the holder will get if he exercises the option at that timeFor call=max(st-k,0), put=max(k-st,0)Time value of Option=premium-Intrinsic valuePayoff of long call=max( st-k,0)-pPayoff of short call=p-max(st-k,0)Payoff of long put=max(k-st,0)-pPayoof of short put=p-max(k-st,0)

Stock price is the upper bound of call option. For American call or European call , c,C=S-D-k*e^(-r*t) where c= Premium on European option C= Premium on American option D= Dividend, k= strike price

For European and American put option, upper bound is p,P

With no dividend- (S-K)

Lower bound of European call option with dividend yield=(So*e^(-q*t))-(k*e^(-r*t))Lower bound of European put option with dividend yield= (K*e^(-r*t))-(So*e^(-q*t))Put Call Parity, c+(k*e^(-r*t))=p+(so*e^(-r*t))

For the valuation of Index Option and Currency Option the same formula is used which we use for European option with dividend yield featureLower bound of Currency Call Option =(So*e^(-rf*t))-(k*e^(-rh*t))Lower bound of Currency put option= (K*e^(-rh*t))-(So*e^(-rf*t))Put Call Parity, c+(k*e^(-rh*t))=p+(so*e^(-rf*t))

Where, rh=Interest rate in home country rf= Interest rate in foreign country q= dividend yieldIndex Options are cash settled option which are basically European option deriving their value as a multiple of 100 or 50 where the payoff of long holder is p, 100 or 50*((max(Final Index-Strike Index),0)

(s/s)=( *t, *((t)^0.5)) Continuous Compounding pattern when follows lognormal distribution has a mean of (-(^2/2), standard deviation of (/((t^(.5))) where = expected return = standard deviationVolatility per annum= Volatility per trading day*(number of trading day pa)

Function N(x) is the cumulative probability distribution function for a standardized normal distribution= expected volatility on stock also called implied volatilityFor dividend paying stocks, we make changes in BSM Model where s*=s-present value of dividends, instead of So in BSM formula we will use s*

Insurance against the price fallHave a OTM or ATM long put along with buying position on a stockIn order to save himself from unexpected volatility when investors are short on a stock, investor for hedging take OTM long call ultimately deriving the payoff of long put

Covered Call is taken when investor is neutral to moderately bullish on stock while Covered put is taken when investor is pessimistic on a stock but not expecting much movement

Long combo or zero cost derivative is taken when investor is bullish on movementCombination of OTM long call+ OTM short putIf taken at a same strike price it leads to payoff of a long forward contract

Expecting high volatility in any sideCombination of long call+ long put at the same strike priceCombination of long call+ long put at the same strike priceCombination of OTM long call+ OTM long put

Adopt by the investor when are expecting not much movement in market. Gain premium by the silent movement in the market as long position holder does not exercise the contractCombination of short call+ short put at same strike price in short straddleCombination of OTM short call+ OTM short put in short strangle

Use when investor is moderately bullishCombination of ITM long call+ OTM short call or lower strike price OTM long put+ higher strike price OTM short putObjective is to minimize the initial cost( initial premium) through short call or short put but that reduce the upside unlimited profit to limited profit

Combination of ITM long put+ OTM short put or OTM long call+ ITM short call

Conservatively bearish on the market

Taken when investor is expecting very little movement in the stock/index. Investor is looking to gain from low volatility at low cost.Long butterfly spread= 1 ITM long call+ 2 ATM short call+ 1 OTM long callLong Condor=1 ITM long call+ 1 short call (lower middle)+ 1 short call ( higher middle) + 1 OTM long call

Strategy for volatile marketShort butterfly spread= 1 ITM short call+ 2 ATM long call+ 1 OTM short callLong Condor=1 ITM short call+ 1 long call (lower middle)+ 1 long call ( higher middle) + 1 OTM short call

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

ABFixed 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

The only Rupee exchanged between the parties are the net interest payment, not the notional principle amount.In the given eg A pays LIBOR/2*50crs to B once every six months. Say LIBOR=5% then A pays be 5%/2*50crs= 1.25crs B pays A 12%/2*50crs=3crsIf interest rates decline fixed rate payer is at a loss, If interest rates rise variable rate payer is at a loss and vice versa

There are four types of basic currency swaps:fixed for fixed.fixed for floating.floating for fixed.floating for floating. Typically, the Notional Principal is exchanged at the swaps initiation and termination dates.

An agreement to pay 1% on a Japanese Yen principal of 1,040,000,000 and receive 5% on a US dollar principal of $10,000,000 every year for 3 years.

At initiation

Party AAParty B$10,000,0001,040,000,000 At each annual settlement date:Party AParty B$500,00010,400,000 At maturity: Party A Party B$10,000,0001,040,000,000

Tenor is three years. NP1 = 1,040,000,000 yen, and r1 = 1% fixed in yen. NP2 = $10,000,000, and r2 = 6 month $-LIBOR (floating). Settlement dates are every 6 months, beginning 6 months hence.

On the origination date, 6 month LIBOR is 5.5%.

Assume that subsequently, 6 mo. LIBOR is:Time6 mo. LIBOR0.55.25%1.05.50%1.56.00%2.06.20%2.5 6.44%

6-month Fixed rate Floating ratetime LIBOR Payment Payment0.05.50% $10MM 1,040MM0.55.25% 5.2MM $275,0001.05.50% 5.2MM $262,50011.56.00% 5.2MM $275,0002.06.20% 5.2MM $300,0002.5 6.44% 5.2MM $310,0003.0 ---- 5.2MM $322,000 1,040MM $10MM

Credit derivatives are derivative instruments that seek to trade in credit risks. Basically there are 3 types of Credit derivative instruments:- a. Credit Default Swap b. Credit Spread Option c. Credit linked Notes

Credit default swaps allow one party to "buy" protection from another party for losses that might be incurred as a result of default by a specified reference credit (or credits).

The "buyer" of protection pays a premium for the protection, and the "seller" of protection agrees to make a payment to compensate the buyer for losses incurred upon the occurrence of any one of several specified "credit events."

Suppose Bank A buys a bond which issued by a Steel Company. To hedge the default of Steel Company: Bank A buys a credit default swap from Insurance Company C. Bank A pays a fixed periodic payments to C, in exchange for default protection.

A credit spread option grants the buyer the right, but not the obligation, to purchase a bond during a specified future exercise period at the contemporaneous market price and to receive an amount equal to the price implied by a strike spread stated in the contract.

Credit Spread is the different between the yield on the borrowers debt (loan or bond) and the yield on the referenced benchmark such as U. S. Treasury debt of the same maturity. An investor may purchase from an insurer an option to sell a bond at a particular spread above LIBOR Credit spread. If the spread is higher on the exercise date, then the option will be exercised. Otherwise it will lapse.

A credit-linked note (CLN) is essentially a funded CDS, which transfers credit risk from the note issuer to the investor.

The issuer receives the issue price for each CLN from the investor and invests this in low-risk collateral. If a credit event is declared, the issuer sells the collateral and keeps the difference between the face value and market value of the reference entitys debt.

If we refer to the Steel company case again.

Bank A would extend a $1 million loan to the Steel Company.

At same time Bank A issues to institutional investors an equal principal amount of a credit-linked note, whose value is tied to the value of the loan.

If a credit event occurs, Bank As repayment obligation on the note will decrease by just enough to offset its loss on the loan.

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