DERIVATIVES

Definition of Derivatives.
 Derivatives
are securities whose value is
derived from the underlying security.

 Examples of security: Such as bonds,

stocks, currencies, commodities, an index
or temperature.
 Types of Derivatives.
 Forward
 Future
 Options
 Warrants

Necessity of Derivatives
 Counterparty
 Common Asset
 Market
 Contractual Agreement
 Markets
 CBOE-Chicago Board Options Exchange,
 CBOT-Chicago Board of Trade, USA
 LIFFE-London international financial
futures Exchanges (LIFFE).
 BOX - Boston Options Exchange
 EDX London - London's Equity Derivatives
Exchange, UK
Forward Contracts
 Forward Contracts
 Definition:-Aforward contract is an
agreement between two parties to buy or
sell an asset at a pre-agreed future point
in time.

 The owner of a forward contract has the

obligation to buy the underlying asset at a
fixed date in the future for a fixed price.
 They are traded on, over the counter .
 Example of how the payoff of a
forward contract works
 “A” enters a forward contract to buys a house
from “B” $1,04,000 on 1.1.2005
 Situation 1: On 1.1.2006, if the value of the
house is $1,10,000, (spot price)
“A” will gain $6000 and “B” will loose $ - 6,000.
 Situation 2: On 1.1.2006, if the value of the
house is $ 1,00,000, (spot price)
“A” will loose $ -4000 and “B” will gain $4000.
 Example of How Forward Prices Should Be
Agreed Upon Considering the Time value
 On 1.1.2005, the value of the house is
$1,00,000.
 If B sold on 1.1.2005, & deposited in bank, he
would earn at least 4% p.a. (i.e.$1,04,000)
 If A takes a loan and buys the above house on
1.1.2005 he will have to at least pay 4% interest
to the bank.
 Hence it would be ideal for A & B to enter into a
one year’s forward contract (expire date
1.1.2006) for at least $1,04,000
FUTURE CONTRACTS
 Future Contracts
 Definition: Future contract is an obligation to buy or sell a specific quantity
and quality of a commodity or security at a certain price on a specified
future date.

 They are standardized, and exchange traded

 Some futures contracts may call for physical delivery of the asset, while
most are settled in cash.

 Example:-
 Commodities markets farmers often sell futures contracts for the crops and
livestock they produce to guarantee a certain price, making it easier for them to
plan. Similarly, livestock producers often purchase futures to cover their feed
costs, so that they can plan on a fixed cost for feed.

 In modern (financial) markets, "producers" of interest rate swaps or equity

derivative products will use financial futures or equity index futures to reduce or
remove the risk on the swap.
 Futures Trade Process Flow

Traders on
Seller A - A’s Broker Calls Traders Exchange find X
Calls Broker
Who wants on Exchange Co. Share
to sell X buyers
Co.Shares

Exchange
Orders get Exchanged

Buyer B Traders on
B’s Calls Traders
who wants Calls Broker On Exchange Exchange find
to buy X Broker X Co. Share
Co. Shares Sellers
 Specification
on a Future Contract
Futures contracts ensure their liquidity by being highly standardized, usually by
specifying:
 The underlying. This can be anything from a barrel of sweet crude oil to a short term
interest rate.
 The type of settlement, either cash settlement or physical settlement.
 The amount and units of the underlying asset per contract. This can be the notional
amount of bonds, a fixed number of barrels of oil, units of foreign currency, the
notional amount of the deposit over which the short term interest rate is traded, etc.
 The currency in which the futures contract is quoted.
 The grade of the deliverable. In the case of bonds, this specifies which bonds can be
delivered. In the case of physical commodities, this specifies not only the quality of
the underlying goods but also the manner and location of delivery. For example, the
NYMEX Light Sweet Crude Oil contract specifies the acceptable sulfur content and API
specific gravity, as well as the location where delivery must be made.
 The delivery month.
 The last trading date.
 Margin percentage are specified.
 Other details such as the commodity tick, the minimum permissible price fluctuation.
 Types of Future Contracts
There are many different kinds of futures contract, reflecting the
many different kinds of tradable assets of which they are
derivatives.

 Foreign exchange market

 Bond market

 Money market

 Equity index market

 Soft Commodities market

 Who trades futures?
 Hedgers:-Hedgers, who have an interest in the underlying
commodity and are seeking to hedge out the risk of price changes

 Speculators:-Speculators, who seek to make a profit by predicting

market moves and buying a commodity "on paper" for which they
have no practical use.

 Arbitragers also trade in future, if they feel that the instrument in

over priced, they would buy in Spot and sell in futures or if they feel
that the instrument is under priced , they would sell in Spot and buy
in futures.

 Hedgers typically include producers and consumers of a commodity.

 Margin on Future Contracts
 Although the value of a contract at time of trading should be zero, its price constantly
fluctuates. This renders the owner liable to adverse changes in value, and creates a
credit risk to the exchange, who always acts as counterparty. To minimize this risk, the
exchange demands that contract owners post a form of collateral, in the US formally
called performance bond, but commonly known as margin.

 Initial Margin: While entering into a trade the investor pays an upfront some
percentage of the total contract value as an initial margin money.

 Variation Margin: The cash transfer that takes place after each trading day (and
sometimes intraday) in most futures markets to mark long and short positions to the
market. Most contracts are settled daily by the payment of variation margin from the
party who has lost money that day to the party who has made money.

 Example: If each point in the price of a contract is worth $1,000, and the futures price
goes up by 1/2 point during a session, the short will pay the long $500 per contract in
variation margin.

 Margin requirements are waived or reduced in some cases for hedgers who have
physical ownership of the covered commodity or traders who have offsetting contracts
balancing the position.
 Future v/s Forward Contract
Future Forward
Exchange traded Over the counter
Standard contract Customized contract
Margins May not require
margins
Daily Settlement End of the period
settlement
Liquid Illiquid

No counter party risk Counter party risk

Options Contracts
 Options - Definition.
 An option is a type of derivative where the
buyer has the right, but not the obligation,
to buy (call option) or sell (put option) a
commodity or financial asset at a specified
price (the strike price) during a specified
period of time in future.
 Features of an option contract.
 Unit of Trading: One option contract gives right over a fixed quantity of the
underlying asset, eg. one individual equity option gives right over 1000
shares (in the UK). It is 100 shares in the USA.

 Expiration: The rights conferred upon the owner of an option are only valid
for a certain period (until expiration) - after this expiry date they are not
legitimate.

 Writer: The option seller is also known as the option writer.

 Strike / Exercise Price: The price of which the option holder has the right to
buy (or sell) the underlying asset. Most exercise prices gravitate around the
current price of the underlying asset.

 Premium: The amount paid by the option buyer to the option writer for the
right. Premium is determined by a intrinsic value and time value
 Option Exercise Style
 American option: Can be exercised at any time for both
stock & indices
 European option: Can only be exercised on the expiry
date for the underline stock or indices
 Capped-style Option:
The term "capped-style option" means an option
contract that is automatically exercised when the cap
price is reached. If this does not occur prior to
expiration, it can be exercised ,(relating to the cutoff
time for exercise instructions and to the rules of the
clearing corporation), only on its expiration date.
 Bermuda Option: A type of option that can only be
exercised on predetermined dates, usually every month.
 Call Options
 An option contract that gives its holder the
right (but not the obligation) to buy a
specified number of shares of the
underlying stock at a given strike price, on
or before the expiration date of the
contract is known as call option.
 CALL OPTION STRATERGY
CALL OPTION (BUY)

Long (Right) Short (Obliged)

Advantage if Price goes up Disadvantage if price goes down

Price goes up-Profits unlimited Price goes up-Losses are unlimited

If Price falls /remain same If Price falls /remain same
losses limited to premium paid profits are limited to premium received
 Put Options
 An option contract that gives its holder the
right (but not the obligation) to sell a
specified number of shares of the
underlying stock at a given strike price, on
or before the expiration date of the
contract is known as put option
 PUT OPTION STRATERGY
PUT OPTION (SELL)

Long (Right) Short (Obliged)

Advantage if price goes down Disadvantage if price rises

Price goes down-profits unlimited Price goes down - losses are unlimited
If Price rises /remain same If Price rises /remain same
losses limited to premium paid profits are limited to premium received
 Equity options.
 Equityoptions:-Exchange traded equity
options are "physical delivery" options. It
gives the owner the right to receive
physical delivery (if it is a call), or to make
physical delivery (if it is a put), of
underlying shares when the option is
exercised.
 Equity Option Trading Example
 Equity options allow you to take advantage of
share price movements by allowing you to gain
exposure, to larger amounts of shares for less
initial cash outlay than would be possible when
trading the actual shares.
 If you buy an equity option, you get the right -
without the obligation - to buy or sell the
underlying shares at a fixed price by an
appointed time.
 If the market moves in your favour, you gain; if
you get it wrong, all you lose is the price you
paid for the option (premium).
 Intrinsic Value
 In options terminology, intrinsic value is the positive
difference between the current price for the underlying
and the strike price of an option. For a call option the
strike price has to be under the price of the underlying;
for a put option the strike price has to be over the price
of the underlying. If an option has intrinsic value, it is
also referred to as in-the-money, if it has no intrinsic
value, it is referred to as out-of-the-money.

 For example, if the strike price for a call option is USD 1

and the price of the underlying is USD 1.20, then the
option has an intrinsic value of USD 0.20. Options are
usually sold for their intrinsic value plus their time value
 In the Money Option
 An in-the-money call option is described as a call
whose strike (exercise) price is lower than the
present price of the underlying. An in-the-money
put is a put whose strike (exercise) price is
higher than the present price of the underlying,
i.e. an option which could be exercised
immediately for a cash credit should the option
buyer wish to exercise the option.
 Example for ITM option
 In our Microsoft example, an in-the-money call option would be any listed
call option with a strike price below $65.00 (the price of the stock). So, the
MSFT January 60 call option would be an example of an in-the-money call.
The reason is that at any time prior to the expiration date, you could
exercise the option and profit from the difference in value: in this case
$5.00 ($65.00 stock price - $60.00 call option strike price = $5.00 of
intrinsic value). In other words, the option is $5.00 “in-the-money.”
Using our Microsoft example, an in-the-money put option would be any
listed put option with a strike price above $65.00 (the price of the stock).
The MSFT January 70 put option would be an example of an in-the-money
put.
It is in-the-money because at any time prior to the expiration date, you
could exercise the option and profit from the difference in value: in this
case $5.00 ($70.00 put option strike price - $65.00 stock price = $5.00 of
intrinsic value. In other words, the option is $5.00 “in-the-money.”
In-the-money option examples
MSFT CALLS STOCK = $65.00
Strike Price Option Price Status Intrinsic Value
50 15.10 ITM 15.00
55 10.30 ITM 10.00

60 5.70 ITM 5.00

65 1.50 ATM 0
70 0.75 OTM 0

75 0.35 OTM 0
80 0.15 OTM 0

MSFT PUTS STOCK = $65.00

Strike Price Option Price Status Intrinsic Value
50 0.10 OTM 0

55 0.30 OTM 0
60 0.70 OTM 0

65 1.50 ATM 0

70 5.70 ITM 5.00

75 10.30 ITM 10.00
80 15.10 ITM 15.00
 Out of-the-money option
 An out-of-the-money call is described as a
call whose exercise price (strike price) is
higher than the present price of the
underlying.

There is no intrinsic value in an out-of-

the-money call because the option’s strike
price is higher than the current stock
price.
 Example for OTM option
 For example, if you chose to exercise the MSFT January 70 call while the
stock was trading at $65.00, you would essentially be choosing to buy the
stock for $70.00 when the stock is trading at $65.00 in the open market.
This action would result in a $5.00 loss. Obviously, you wouldn’t do that.
An out-of-the-money put has an exercise price that is lower than the
present price of the underlying.

There is no intrinsic value in an out-of-the-money put because the option’s

strike price is lower than the current stock price. For example, if you chose
to exercise the MSFT January 60 put while the stock was trading at$65.00,
you would be choosing to sell the stock at $60.00 when the stock is trading
at $65.00 in the open market. This action would result in a $5.00 loss.
Obviously, you would not want to do that.
Out-of-the-money option examples
MSFT CALLS STOCK = $65.00
Strike Price Option Price Status Intrinsic Value
50 15.10 ITM 15.00
55 10.30 ITM 10.00
60 5.70 ITM 5.00
65 1.50 ATM 0
70 0.75 OTM 0
75 0.35 OTM 0
80 0.15 OTM 0

MSFT PUTS STOCK = $65.00

Strike Price Option Price Status Intrinsic Value
50 0.10 OTM 0
55 0.30 OTM 0
60 0.70 OTM 0

65 1.50 ATM 0

70 5.70 ITM 5.00

75 10.30 ITM 10.00
80 15.10 ITM 15.00
 At-the-money-option
 An at-the- money option (ATM) option is
an option that would lead to a zero cash
flow if it were exercised immediately. An
option on the index is at the money when
the current index equals the strike price.
(i.e. spot price=strike price).
 Example for ATM option
 An at-the-money option is described as an
option whose exercise or strike price is
approximately equal to the present price of the
underlying stock.

For instance, if Microsoft (MSFT) was trading at

$65.00, then the January $65.00 call would an
example of an at-the-money call option.
Similarly, the January $65.00 put would be an
example of an at-the-money put option.
 Difference between Futures &
Options.
Future
Obligation to the buyer &
seller to honor the contract.
Aside from commissions, an
investor can enter into a
futures contract with no
upfront cost.
Are more risky for those
investors new to the market
Options
Gives the buyer the right,
but not the obligation to buy
(or sell)
Premium upfront (cost) is
the maximum that a
purchaser of an option can
lose.
Are less risky, since the
holder has the option not to
exercise.
Warrants Contracts
 Warrants
 It is a part of the derivatives family as their
value depends on the value of an underlying
security. As such, the warrant investor gains
economic exposure to this underlying security
without actually owning it.
 A warrant is the right (but not the obligation) to
buy or sell an underlying financial instrument at
a specific price (strike price or exercise price)
until a specific time (expiration date).
 Types of Warrants
 Equity Warrants : Equity warrants can be call and put
warrants.
 Call warrants give you the right to buy the underlying
securities or if your prediction is that an underlying
asset is going to rise in value, then you will want to
buy a call warrant. This gives you the right to buy the
underlying asset at a certain price (the strike price).
 Put warrants give you the right to sell the underlying
securities or if your expectation is that that the
underlying security is going to fall in value then you
will want to buy a put warrant. This will give you the
right to sell the underlying security at the agreed
strike price.
 Difference between warrants &
options
Warrants Options

Normally issued by the Available at the exchange.

company.
Terms of issue are variable, Terms are standardized by
depending upon issuer. exchange.

Normal life time is 3months Life time is Spot upto 5

to 15 years years
Cannot be short sold Can be short sold

Conversion ratio is decided Each contract is of 1000

by the issuer shares
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