1. Introduction To Derivatives Prepared and Presented B Kiran Shinde

2. Derivatives Some say the world will end infire, Some say in iceFire and Ice Poem by RobertFrost (18741963) This is what the Derivative world is. 3. 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 4. What is Derivatives? A derivative can be defined as a financial instrument whose valuedepends on (or derives from) the values of other, more basic underlyingvariables. -John C. Hull A derivative is simply a financial instrument (or even more simply anagreement between two people) which has a value determined by theprice of something else. -Robert L. McDonald The Securities Contracts (Regulation) Act, 1956 defines "derivatives" toinclude:1. A security derived from a debt instrument, share, loan whether securedor unsecured, risk instrument, or contract for differences or any otherform of security.2. A contract which derives its value from the prices, or index of prices,of underlying securities. 5. ContIn simple words, Derivative is Financial instrument whose price is dependentupon or derived from the value of underlying assets.The underlying not necessarily has to be an asset. It could be any otherrandom/uncertain event like temperature/weather etc. The most common underlying assets includes: Stock, Bonds, Commodities Currencies, Interest rates Derivatives cannot exist without the underlying Derivatives do not convey any ownership in the underlying Settlement : Cash settled or delivery of underlying Physical Delivery : Exchange money and goods on final settlement Cash : Settle profit / loss on final settlementOrigin of derivatives - Protection of Farmers Interest 6. Derivatives in India In India, derivatives markets have been functioning since thenineteenth century with organized trading in cotton throughthe establishment of the Cotton Trade Association in 1875. Derivatives, as exchange traded financial instruments wereintroduced in India in June 2000. (Nifty 50 index futurescontract) 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 inNovember,2001 In 1999, the Securities Contracts (Regulation) Act of 1956, orSC(R)A, was amended so that derivatives could be declaredas securities. The Act considers derivatives on equities to be legal andvalid, but only if they are traded on exchanges. 7. Milestones in the development of Indian derivative market November 18, 1996L.C. Gupta Committee set up to draft a policyframework for introducing derivatives May 11, 1998L.C. Gupta committee submits its reporton the policy framework May 25, 2000SEBI allows exchanges to trade in indexfutures June 12, 2000 Trading on Nifty futures commences onthe NSE June 4, 2001 Trading for Nifty options commences on theNSE July 2, 2001 Trading on Stock options commences on theNSE November 9, 2001 Trading on Stock futures commences on theNSE August 29, 2008Currency derivatives trading commences on theNSE 8. Derivatives Markets Exchange Traded Contracts Over The Counter Market 9. Market ParticipantsHedgerHedgers face risk associated with the price of an asset. Theyuse futures or options markets to reduce or eliminate this riskSpeculatorsSpeculators wish to bet on future movements in the price of anasset. Derivatives can give them an extra leverage to enhancetheir returnsArbitrageurs Arbitragers work at making profits by taking advantage ofdiscrepancy between prices of the same product acrossdifferent markets 10. Basic purpose of derivatives In derivatives transactions, one partys loss is alwaysanother partys gain.The main purpose of derivatives is to transfer riskfrom one person or firm to another, that is, to provideinsurance. If a farmer before planting can guarantee a certainprice he will receive, he is more likely to plant Derivatives improve overall performance of theeconomy Thus, the basic purpose of derivatives is to transferthe price risk (inherent in fluctuations of the assetprices) from one party to another; they facilitate theallocation of risk to those who are willing to take it. 11. Example of Derivatives a reimbursement program for college credit.Consider that if your firm reimburses 100% ofcosts for an A, 75% of costs for a B, 50% for aC and 0% for anything less. Your right to claim this reimbursement, then istied to the grade you earn. The value of thatreimbursement plan, therefore, is derived fromthe grade you earn. 12. 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 out4. 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 specific condition or event (e.g. the underlying reaching a specific price level) 13. Types of Financial Derivative There is no definitive list of derivative productsand the types of derivative products that can bedeveloped are limited by human imagination only.However the most common financial derivativescan be classified as1. Forwards2. Futures3. Options 14. Forwards A forward contract is an agreement between two parties 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 issaid to have the long position. The party that agrees to sell the asset in the future is saidto have the short position. The specified future date for the exchange is known asthe delivery (maturity) date. 15. Forwards An example 11th August 2012 Mr. Tushar wants to buy 20 grm Gold, but his wife sayshe should buy Gold only on the occasion of Diwali (on11th November, 2012-Dhantreys) Worried about price fluctuations Jeweler thinks Prices of gold are very high currentlyand 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 16. Transaction Mr. Tushar and Jeweler enter into a contract on 11th August 2012Mr. Tushar JewelerWill buy 20 grm. Gold Will sell 20 grm. goldWill Pay Rs. 30,000 per 10grmWill receive Rs. 30,000 per 10grmDate of settlement : 11th Nov, 2012 This is a Forward contract,trade happens today, settlement in future Jewelers OBLIGATION is to give Gold and Mr. Tushars OBLIGATION is to pay 17. ContractTerms : Underlying: Gold Contract Date : August 11, 2012 Contract Price : Rs. 30,000 per 10 grm Quantity: 20 grm. Settlement date: November 11, 2012 By entering into the contract on August 11, 2012 what have the two parties done? Locked in a future price of Rs. 30,000/- per 10grm. 18. Settlement On November 11, 2012 : Mr. Tushar buys 20 grm Gold from Jeweler Jeweler Recieves Rs. 60,000 The contract entered on Aug 11, 2012 is settled. Price of Gold quoting in the spot market(underlying price) is Rs. 28000/- per 10 grm. 19. Cash Settlement On Nov11, 2012 : 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 20. Pay Off Pay Off = ST K (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 be bought/sold 21. Forward Contract PayoffK 22. 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 afinancial 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 ofthe contract regardless of whether the other party fails. 23. Futures .exchange traded forwards1. Exchange Traded (transperancy)2. Standardised contracts (reduce complexity)3. Counter - Party Risk is absent (settlement is guaranteed by a Clearing Corporation) 24. Futures terminology Spot price : Price at which asset trades in the spot market Futures :Price at which Futures contracts trade in thefutures 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 isdetermined by cost of carry.Forfinancial assets it is interest cost. 25. Contract Life Cycle - exampleFutures contracts in NIFTY on Feb 2012: Any given time upto 3months duration contracts.Contract Month Expiry/settlement dateFeb 2012 25th FebMarch 201225th MarchApril 201229th April*Expiry last Thursday of the monthYou are on Feb 10.You have a Near Month, Middle Month and Far Month contractsto choose from. 26. Steps in trading Futures Pay Initial Margin Buy or Sell Futures Daily Mark to Market Settlement 27. Initial Margin (IM)Stock (ABC Ltd.) Futures (ABC Ltd. Futures)Rs. 500Rs. 510Buy 1000 sharesBuy 1000 FuturesValue = Rs. 5,00,000 Value = Rs. 5,10,000Pay Rs. 5,00,000 Pay IM = Rs. 51,000After 10 days :Rs. 600Rs. 610RETURN = 20% RETURN = 196% 28. Pricing of Futures Futures price = Spot Price + Cost of carry Cost of carry = interest rate* At expiry : Futures price = Spot price*for financial futures 29. Pricing - FuturesFeb 10, you have Rs. 100.How much will it become on March 10.Depends on how much interest you can earnIf it is 12% p.a., then after 1 month Rs. 100 will become =Rs. 101F =S+ Int.Rs. 101 =Rs. 100+ Re. 1 30. Points to remember. Long Buy (going long) [Bullish view] Short Sell (going short) [Bearish view] Squaring off (turn around trades) opposite transaction to the previous one Buy low, sell high - gives a profit Sell high, buy low - also gives a profit Sell low, buy high gives a loss Buy high, sell low also gives a loss 31. Daily Mark to Market Settlement Futures contractsDateSpot Price of Mr. Raju Buys MTM Gain Mr. Ajay Sells MTM Gain Remarks :ABC Ltd. :ABC Ltd./ Loss ABC Ltd. / Loss Gainer receivesFutures @Futures @ MTM amount fromOct 1, 2008the loser on a daily11:00 amRs. 510Rs. 510 basisRs. 490Oct 1, 2008Ajay Pays Rs. 2 toRs. 500 Rs. 512 + Rs. 2Rs. 512- Rs. 23:30 pmRaju Ajay Pays Rs. 8 toOct 2, 2008Rs. 510 Rs. 520 + Rs. 8Rs. 520- Rs. 8Raju3:30 pm Raju Pays Rs. 10 toOct 3, 2008Rs. 495 Rs. 510 - Rs. 10 Rs. 510+ Rs. 10 Ajay3:30 pmOct 4, 2008Ajay Pays Rs. 5 to3:30 pm Rs. 505 Rs. 515 + Rs. 5Rs. 515- Rs. 5Raju Ajay Pays Rs. 10 toOct 5, 2008Rs. 515 Rs. 525 +Rs. 10Rs. 525- Rs. 10 Raju3:30 pm 32. Futures Payoff A payoff is the likely profit or loss that would accrue 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 33. Payoff diagram for futures P R O F Rs. 50 I T S0Rs. 250Rs. 300 Rs. 500 L O Buy RELIANCE S S FUTURES @ Rs. 250 E S Sell @ Rs. 300 Linear Pay Off 34. Payoff diagram for futures P R O F I T SRs. 200 Rs. 250 L O S S Sell RELIANCE E FUTURES @ Rs. 250 S Buy @ Rs. 200 Linear Pay Off 35. Final Settlement convergence of Futures to Spot No Arbitrage Principle FuturesPriceOn the final settlement day/ expiry day, the FuturesSpot Price contract is settled at the underlying closing price (spot price)Time Cash Settlement (a) 36. DISTINCTIONS BETWEEN FUTURES& FORWARDSForwardsFutures Traded in dispersed Traded in centralizedinterbank market 24 hr a day. exchanges during specifiedLacks price transparencytrading hours. Exhibits pricetransparency. Transactions are customizedand flexible to meet Transactions are highlycustomers preferences.standardized to promotetrading and liquidity. 37. DISTINCTIONS BETWEEN FUTURES & FORWARDS Forwards Futures Counter party risk is variable Being one of the two parties,the clearing housestandardizes the counterpartyrisk of all contracts. No cash flows take place On a daily basis, cash mayuntil the final maturity of the flow in or out of the margincontract. account, which is marked tomarket. 38. OptionsExample :- TATA is launching a car Nano 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? o A 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? 39. 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 40. 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 to exist after expiry 41. OptionsCalls give the buyer the right but not the obligation to buy.Puts give the buyer the right, but not the obligation to sell. CALL OPTIONS : Gives the buyer of the Call Optionthe RIGHT to buy at the STRIKE PRICE CALL OPTIONS : The Seller of the Call Option has tomeet his OBLIGATION of selling when the buyerEXERCISES his right The Buyer retains the RIGHT to Exercise or notExercise 42. Call Option Exercise Point :U > SP Break Even point : U = SP + Premium Net profit :U > SP + Premium 43. Call OptionDecember 15,Underlying Price Strike PricePremiumRs. 100 Rs. 80Rs. 30December 28,Underlying Price can be above, at or below Strike PriceRs. 112Rs. 80Rs. 75At which underlying price Buyer will exercise the Option ? 44. 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 45. Call Option The Buyer of an Options needs to pay to the Seller 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. 46. 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) 47. Classification of Options Type Call or Put Exercise style EUROPEAN is an option that can be exercised onlyon its expiration date AMERICAN is an option that can be exercised anytime up until and including its expiration date Settlement Cash or physical 48. CALLS & PUTS RIGHTS AND OBLIGATIONRIGHTCALLS Buyer Buy at the strike price at expiry OBLIGATIONSeller Sell at the strike price at expiry RIGHTPUTSBuyerSell at the strike price at expiry OBLIGATIONSeller Buy at the strike price at expiry 49. BUYER OF AN OPTIONPAYSPREMIUMPREMIUM IS THE MAXIMUM LOSS THE BUYER CAN SUFFERSELLER OF AN OPTIONRECEIVESPREMIUMPREMIUM IS THE MAXIMUM PROFIT THE SELLER CAN MAKEAPPLICABLE FOR BOTH CALLS AND PUTS 50. Intrinsic valuePrice of an option is called PremiumPremium = Intrinsic value + time valueIntrinsic value is the amount the contract is inthe money e.g. Spot = 1000, Strike Price = 990 March CallPremium = Rs 15 (Intrinsic value = Rs. 10, timevalue = 5) 51. 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 TV Longer the expiry more the TV, on expiry TV is 0 52. Options Payoff Optional characteristics of options results in a nonlinear payoff for options. Non linear payoffs provideflexibility to create combinations Losses of the buyer is limited to the premium paid andprofits are unlimited For writers/sellers losses are unlimited and profitslimited to the premium received 53. Options PayoffsPayoff profile of buyer of asset: Long assetPayoff for investor who went Long Nifty at 2220 54. Payoff profile for seller of asset:Short assetPayoff for investor who went Short Nifty at2220 55. Payoff profile for buyer of calloptions: Long callPayoff for the buyer of a three month calloption with a strike of 2250 bought at apremium of 86.60 56. Payoff profile for writer of calloptions: Short callPayoff for the writer of a three month calloption with a strike of 2250 sold at a premiumof 86.60. 57. Payoff profile for buyer of put options:Long putPayoff for the buyer of a three month putoption with a strike of 2250 bought at apremium of 61.70. 58. Payoff profile for writer of put options:Short putPayoff for the writer of a three month putoption with a strike of 2250 sold at a premiumof 61.70 59. THE PAY OFF DIAG. - OPTIONS PROFITS AND LOSSES ON CALLS AND PUTS Security ACC PROFITSPROFITSCALLS PUTS 100100 20 20120 80 LOSSES LOSSES 60. Any Questions?Now we have some Questions. 61. Spot value of NIFTY is 2240. An investor buys a oneMonth 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 62. A call option that is out-of-the-money or at-the-moneyhas ________.only time value only intrinsic face value no valuevalue 63. A put option is in-the-money if the price ofthe underlying asset is __________ thestrike price. Above Below Equal to Between the premium and strike price 64. Spot value of NIFTY is 2230. An investor buys a oneMonth NIFTY 2245 call option for a premium of Rs.5.After One month the spot value of NIFTY is 2250. TheOption is _________. In the money At the money Above the money Out of the money 65. 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 forthe buyer of the option?Rs. 2148Rs. 2196Rs. 2204Rs. 2194 66. Thank You !!