1. What is Derivatives?

We are living in the globalization era; we are highly susceptible to risk. But
however Humans are Risk averse. This risk-averse characteristic of human
beings has brought about growth in derivatives.
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Most Complex of all the instruments.

Derivatives are double-edged swords

No Independent value.
Contract, Value is derived from the asset(Share,commodity,Currency,Stock
market index)
Change in the price of the Asset will have a influence over the derivatives.
E.g. Gold futures

For Understanding,
Take Sugarcane, the price will go up or down depends on the many
factors. It may be of either natural (calamities) or artificial (man made)
If the Prices of the commodity increase (heavy Storm hit in USA),
The Farmer will benefit provided there are no intermediate like broker.
If the Prices of the commodity decrease (Production increased multifold in
USA because of Green revolution in CANADA),
The Farmer will be badly affected.
To nullify this, the farmer is selling his harvest at a future date by entering
into a forward, or futures, contract. This is just an agreement between the
Famer and the buyer.
Similarly the Buyer will also have dealing with the Product based industry,
here its sugarcane industry. In this case both the farmer and the sugar cane
industry will get benefitted with the assured amount and also price of the
essential commodity will be stabilized. Apart from mitigating the risk this has
the capacity to keep the price stable.
2. History
-

Several centuries ago Greece and Rome, hedging device for price
fluctuation in commodity.
To ensure supply of food grains to the masses.
Commodity futures and options have had a lively existence for several
centuries.
Organized commodity exchange Japan 1700.
Formal commodity exchange USA Chicago board of Trade 1848.
Financial derivatives - post-1970 period.
Basic difference financial and commodity underlying instrument.
Underlying instrument
a. Financial - treasuries, bonds, stocks, stock index, foreign
exchange, and currency.

b. Commodity - wheat, cotton, pepper, turmeric, corn, oats,

soybeans etc
-

The currency futures traded on the IMM were the British pound, the
Canadian dollar, the Japanese yen, the Swiss franc, the German mark, the
Australian dollar, and the euro-dollar.

The value of underlying instruments - USD 16 trillion (more than Rs. 50

lakh crore)
Twice the size of USA GDP and Thrice the size of NYSC stocks

3. What is the economic benefit in this?

-

Reduce risk
Enhance liquidity of the underlying asset
Lower transaction costs
Enhance price discovery process
Portfolio Management
Provide signals of market movements
Facilitates financial markets integration

4. Why financial derivatives?

Everywhere in this world, there are two kinds of people
- Ready to take risk / dont want to
- World is a playing field, If you looking for more returns then you should
have a guts take risk.
- In this the risk is shifted from those who dont want to those who have
the appetite and are willing to take it
- There are three types of Risk
a. Market risk
- Securities prices goes up or down
b. Interest rate risk
- Treasury bills, Government securities, bonds
fluctuates
c. Exchange rate risk - Imports and Exports decides
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Types of Financial derivatives

a. Forwards
b. Futures
c. Options
d. Warrant
e. Swaption
f. Swaps

Forwards:
-

Settlement on a specific day, price determined today.

Over the counter.

Buyer Long Position.
Seller Short position.
Delivery date, price, and quantity, are negotiated bilaterally.
Exposed to Counterparty Risk.
Delivery on expiry date.
Mitigating Exchange rate fluctuations (e.g. exporter and Reporter.)

Futures:
-

Exchange traded contracts,

Standardized specifications
a. Quantity
b. Quality ( Not required in Financial derivatives)
c. Date of Delivery
d. Price Quotation
e. Settlement area
Differences
Futures
Exchange traded
Standardized
Transparent
More Liquid, Price Discovery
Single Delivery date
Profit & Loss Daily basis
Safety against
House
Regulator

Risks

Clearing

Forwards
OTC
All terms are negotiated
Not Transparent
Illiquid
Range of Delivery date
Profit & Loss At the time of
maturity
No Safety against Risks
No Regulator

Futures Trading Strategies:

-

Based on the expectations how the market will move.

a. Bullish: The investor anticipates a price rise.
b. Bearish: The investor anticipates a price decline.
c. Volatile: The investor anticipates a significant and rapid movement
either in the market or scrip but he is not clear of the direction of
the movement.
d. Neutral: The investor believes that market will not move
significantly in any direction. It is opposite of the volatile view

Different Strategies
a. Hedging strategies
b. Speculative trading strategies
c. Arbitrage strategies

Hedging strategies
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Future contract available in S&P CNX Nifty and the BSE Sensex
Reducing the volatility by reducing the Risk
Helps locks existing returns and doesnt mean maximisation of return.
Beta: How much the market is Volatile with respect to market Index
Four Strategies:
a. Long stock, short index futures
b. Short stock, long index futures
c. Hedging a portfolio with short index futures
d. Hedging with long index futures

Long stock, short index futures

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If the Inverster feels the Stock is intrinsically undervalued

Example1:
Holds posiyion from Sep1 to Sep25
Beta =1.2
Stock value = 2lakh
Index (Say Nifty)=1000
Trading value = 1,020
Sep21, the Nifty crashed because of Terrorist attck on WTO.
His Net gain = (1000*1020)-(200000*1.2) = 4000
Example2:
Reliance Shares:200/Share
No of Shares:1000
Nifty:300

Trading Value:992
Reliance Share dropped by 5% and Nifty dropped by 4%
Reliance Loss = 200000-190000=10000
Nifty Gain=297600-285696=11904
Net Gain=1904

Short Stock , Long Index futures:

-

Stock was intrinsicaly over valued

Reliance Shares:200/Share
No of Shares:1000
Nifty:300
Trading Value:992
Reliance Share increased by 5% and Nifty increased by 4%
Reliance loss = 210000-200000=10000
Nifty gain=298790-297600=11904
Net Gain=1904

Hedging a portfolio with Short Index futures:

-

Stock price will fall in near future.

Budget related volatility
Volatility increases one week before and two weeks after the Budget.
Portpolio of 5 shares ,value=190000
Beta=0.95
Nifty=200
Trading Value=1,125
March-5 ,
Portfolio came down to 155000
Loss o=190000-155000=35000
The nifty decreases to 963
Gain (200*1125)-(200*963)=225000-192600=32,400
Overall Loss=35,000-32,400=2,600

Hedging with Long Index Futures

- Person has funds are anticipate funds in near future.
- Equity research and Portfolio are time consuming.
- Index may rise due to mutual funds
The Risk can be hedged by buying index futures.
- Covert the indiex holding into share holding slowly.
Strategies for speculations
- Two ways
a. Long Index Futures
b. Short Index Futures
Long Index Futures
-

Speculator thinks index will go up

Buy index futures

Short Index Futures

-

Speculator thinks index will go down

Sells index futures

Factors affecting Future prices:

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Spot Price Goods price on Immediate Delivery

Basis Current Cash price - Future price , At maturity - Zero
Spread Difference between two Futures
a. Inter Commodity Spread Gold and Silver
b. Intra Commodity spread Two Futures Gold delivered at two pints in
time.
Expected Future spot price
Cost of storage
Future Price = Spot Price + Carry costs (Storage, Transportation)

Options:
-

It gives the holder the option to buy or sell.

The holder has the right and not the Obligation
In futures & Forwards, commit to buy, but Option Right to buy or sell.
Styles
a. European Style Only on Expiry date

b. American Style Any time before

Types
a. Call Option
b. Put Option
Call Option:

Right to Buy

Example
1.
2.
3.
4.

Shares: 100 Reliance Shares

Current Price: 250/Share
Offered Price: 300/Share
Premium price: 25/Share

Total Premium amount: 25*100 = 2500

Total contract price: 300*100 = 30000
If the market price is 400/Share, he exercises his power by paying
30000 to seller and sells the same in market for 40000.
Net profit to Buyer: 40000-(25000+2500) = 12500
If the market price is 200/Share, he wont buy the shares and loses it
premium alone say 2500.
Net profit to Buyer: Loss of 2500.
Put Option:
Right to sell

Example
1.
2.
3.
4.

Shares: 100 Reliance Shares

Current Price: 250/Share
Offered Price: 300/Share
Premium price: 25/Share

Total Premium amount: 25*100 = 2500

Total contract price: 300*100 = 30000
If the market price is 200/Share, he exercises his power by selling his
shares to buyer for a rate of 30000.
Net profit to Share holder: 30000-(25000+2500) = 2500

If the market price is 400/Share, he wont sell his shares and loses it
premium alone say 2500.
Net profit to Share holder: 40000 - (25000+2500) =12500

5. Traders in Derivative Market

a. Hedger
- offset the risk.
b. Speculator - buy and sell derivatives to make profit and reduce
risk.
c. Arbitrageur - Transaction in two or more market.
Uses:
a.
b.
c.
d.

Bear risk
Provide liquidity
Maintain price stability
Hedging