FINANCIAL DERIVATIVES

WHAT ARE DERIVATIVES

Derivative is a financial instrument whose price is dependent upon or derived from one or more underlying is called derivatives.

When price of underlying changes value of derivative also changes.

Derivative is not a product . It is a contract which derives value from underlying.

ExampleValue of sbin future contract derive the value of underlying assets i.e. sbin equity.

Economic benefit of Derivatives

Reduce risk

Low transaction cost

Portfolio management

Enhance liquidity

Type of derivatives

Derivatives

forward

Futures

Options

Call options

Put options

Swaps

Currency rate

swapsInterests

rate swaps

Forward

Forward is a contract between two parties to buy or sell an assets on a pre-specified future date at a pre specified price.

Forward contract settlement comes on a pre-specified future date.

This is traded only in over the counter market.

This is customized contract.

Counterparty risk

No money involve at imitation of contract.

Liquidity risk

Future

Future Buyer

Clearing house

Future seller

Future contract is an agreement between two parties to buy or sell an assets at a certain time in the future at a certain price .

This is standardized exchange traded contract.

Standardisations--Quantity of underlying-Central clearing facility-Delivery Dates-Price quotes

It is traded on an organised exchange.

Indian equity market concern , NSE is having the most developed equity derivatives market . They have launched 3 month series for future contract cycle i.e. Current month, next month and far month.

Expiry date – usually last Thursday of every month or previous day if Thursday is public holiday.

comparison Forward FutureTraded on organized exchange

No Yes

Standardized contract No YesInvolve clearing house No YesRequired margin payment and daily settlements

No Yes

Market are transparent No YesMarked to market daily No YesClosed prior to delivery No YesProfit and losses realized daily

No yes

Options An option is contract between two party , where one party gives

to other the right , but not obligations, to buy from (or sell to) the first party the underlying assets on or before specific day at an agreed price.

In return for giving the right , the party collect the payment from the other party the payment collected is called premium or price of option.

Swaps

Swaps are private agreements between two parties to exchange cash flow in the future according to a pre-agreed price.

Interest rate swap- interest related cash flow between the parties in the same currency.

Currency swaps- Under this consider different currency.

Traders in Derivative

market

Type

of

trade

r Hedger

SpeculatorAribitrageu

r

Arbitrageur

A person who enter into transactions in two or more market to take an advantage of the discrepancies between prices in these markets.

Arbitrage involve making profit from relative mispricing. Arbitrageurs also help to make market liquid , ensure accurate

and uniform pricing, and enhance price stability. They help in bringing about price uniformity and discovery.

Some basic Terminology

Long position – Buyer (+)

Short position – Seller (-)

Spot Price - price of the asset in the spot market (market price)

Forward price – price of the asset at the delivery date.

Contract size - The amount of the asset that has to be delivered under one contract. All future are sold in multiples of lots which is decided by the exchange board. Contd….

Contract Cycle – period for which contract trades. Strike price – The agreed price of the deal is called the strike

price. Daily price range(DPR)-we can trade with in this limit. Beyond

this limit if we initiate order than trade will not go in to the market.

Open Interest(OI)- The number of outstanding contract. Strike Price (Exercise price) (X)– The fixed price at which the

underlying assets can be purchased. Only short can default in option. Option price – The amount per share that an option buyer pay to

seller.

OPTION

An option is an derivative financial instrument that specifies a contract between two parties for future transaction on an assets at a reference price.

The buyer of an option gain the right but not to obligation, to engage in that transaction, while the seller incurs the corresponding obligation to full fill the transaction

Summary of option

Option give the right not the obligation. Right for specified time period. Option con be exchange traded derivatives or even over the

counter derivatives. Option can be cash settled or settled by physical delivery. Option in India are cash settled

OPTION

Option

CallCACBCE

PutPAPBPE

Type of option

Call option- An option Which gives a right to buy the underlying assets at a strike price.

Put option –An option which gives a right to sell the underlying assets at a strike price.

Style of option -American option – An option can expire on or before the

expiry date.European option – An option can expire only on expiry date.Bermuda option – An option can exercise at the date and certain specified dates that occur between the purchase date and date of expiration.

Type of option

In the money (ITM)

At the money (ATM)

Out of the money (OTM)

Call option buying (bullish about underlying )

Expect stock price to go

up hence he buy

Stock

Call option on stock

Call option selling (Bearish about the underlying)

Expect stock price to go down

hence he buy

Sell Stock

Sell Call option on stock

Put option buying (Bearish about underlying stock)

Expect stock price to go down

hence he buy

Sell Stock

buy put option on stock

Put option selling(bullish about underlying stock)

Expect stock price to go

up hence he sell

Buy Stock

Sell put option on

stock

Important notes

Both call and put option buyers are buying the right i.e. they are transferring their risk to seller of the option.

For this transfer of risk to the sellers, buyer have to compensate by paying option premium.

Option premium is also known as price of option, cost or value of the option.

Option pricing

Component of option pricing

Intrinsic value

Time value (volatility, time to expiry and rate of

interest)

Pricing and valuation of the contact

CE PESPOT Positive NegativeSTRIKE Negative PositiveVOLITALITY Positive PositiveTIME TO EXPIRATION Negative NegativeRATE OF INTEREST Positive Negative

Basic option Strategy

Covered call Protective put Bull spread Bear spread Butterfly Condor Calendar Diagonal Straddle Strangle

Greeks

Greeks

Delta Gamma

Vega

theta

rho

THANKS BY ANKUR