FINANCIAL

DERIVATIVES
The last three decades have been characterized by :
(1) Globalization of financial markets
(2) Massive increase in the volumes of trade in various markets
(3) Tremendous increase in the volatility of financial markets
currency markets, equity markets, debt markets as well as
commodity markets
(4) Emergence of exotic financial and commodity related
products
(5) Extensive use of technology in the process of trading and
regulation of markets
As a result, understanding the nature of financial products
and functioning of markets has become essential
A British speaker addressing a group of
professors raised the following question:

WHAT IS THE BEST EXAMPLE OF

GLOBALIZATION?

ANY ANSWERS?
 HIS ANSWER:

Princess Diana's death.

HOW COME?
 An English princess with an Egyptian lover, crashes in
a French tunnel sitting in a German car, with a Dutch
engine driven by a Belgian who was drunk on Scottish
whisky, followed closely by Italian photographers, on
Japanese motorcycles; she was treated by an American
doctor using Brazilian medicines.
The speaker was using Bill Gates' technology, and the
participants saw it through a Japanese multimedia
projector, that uses Taiwanese chips and a Korean lens,
assembled by workers from Bangladesh, in a Singapore
plant. The audience was a group of professors,
educated in USA, UK, India and France.

That, ladies and gentlemen, is Globalization

John Bowen quoted in Technology and Global Financial
Markets- A Marriage Made in Heaven or a Witches Brew?
.. I will never forget the day in 1982 when the news
screens issued a warning that their news carrier service was
not updating. American systems transmitted carrier down
across their screens. At that time Britain was at war with
Argentina and had a number of aircraft carriers involved in
the South Atlantic. The sterling trader in our office saw this
message and incorrectly took it to mean that one of these
vast ships had been sunk. Sell! sell! sell! he cried and
rapidly sold 200 million pound sterling before discovering it
had nothing to do with the navy.
One wonders whether the resulting losses to the bank might
have been enough to finance a new aircraft carrier!
 Derivatives have been around for centuries
332 BC Greece: Thales of Miletus first option idea
The earliest known options trade dates from 4th century BC. Thales of
Miletus speculated that the year's olive harvest would be especially
bountiful, and put a deposit on every olive press in his region of Greece.

This gave him the right to use the olive press if he wanted to after the
harvest. The harvest was huge, demand for olive presses skyrocketed,
and Thales sold his rights, or options, at substantial profit.

1636 : Options on Tulips

1859 CBOT: First agricultural derivatives contract

The modern history of stock options trading begins with the 1973
establishment of the Chicago Board Options Exchange (CBOE) and the
development of the Black-Scholes option pricing model.
 Confusion about
D(erivatives)
D are financial weapons of mass destruction (Buffet)
ncrease financial stability ; the more the better (Greenspan)

D offer high leverage and cheap transaction costs (Financial

Notional values are not meaningful measures (FED)

D make full disclosure even more difficult (World Bank)

OTC regulation would stifle market creativity (SEC)

D can avoid prudential safeguards, manipulate accounting, bu

Markets, not regulators should focus on risk managem

D are hugely profitable ; but each winner finds a dumb loos

D are used by only 5% of large banks (Econom
 Derivative Products
OTC Derivative Markets Exchange Traded Derivatives
$128 trn notional $29 trn notional
$ 5 trn market value $700 trn turnover US: 35%
EU: 34%
JP Morgan Chase Chicago 28% Asia: 25%
$ 27 trn Eurex
14% Euronext
Non-Financials SGX
70% $ 20 trn BM&F
62%
KSE/KOFEX

(relative size may be misleading)

40% annual growth rates
Interest Interest
FX G-Debt
Equity Key Driving Factors
Equity-Index
Com Capital flows
Stocks
Credit Leverage
Com
Other Risk Management
FX
Liquidity
Transaction Costs

Sources: BIS (June 2002) ; FIBV (Dec 2001)

 Evolution of Derivatives in India
OTC Exchange traded
1980s Currency June 2000 Equity Index
Forwards futures
1997 Long term FC June 2001 Equity Index
Rupee swaps options
July 1999 Interest July 2001 Stock Options
rate swaps and FRAs November 2001 Stock
July 2003 FC-Rupee futures
options June 2003 Interest rate
futures
Aug 2008 Dollar-Rupee
futures start trading
Jan 2010 Yen, Pound, Euro
futures introduced

Exchange traded currency options will start trading soon.

The Nature of Derivatives

A derivative is an instrument whose

value depends on the values of other
more basic underlying variables
 The Nature of Derivatives
Each derivative product has an underlying
associated with it.
The value of the derivative depends on, among other
things, the value of the underlying
The underlying can be
1. Physical commodities: Coffee, Crude oil, Wheat etc.
2. Financial assets: Currencies, Stocks, Bonds, etc.
3. Financial Prices: Interest rates, stock prices, stock index
4. Weather derivatives, emission derivatives
5. Derivatives on derivatives swaptions, captions, compound
options option on option
 Examples of Derivatives
Forward-like Derivatives
Forward contracts, Futures, FRAs, Swaps
Forex forwards and futures, stock futures, stock index futures, coffee
futures, crude oil futures, interest rate futures, interest rate swaps,
currency swaps etc.

Option Products
Stock options, currency options, index options, commodity options,
interest rate options, Interest rate caps & floors, bond options

Compound Derivatives
Options on futures, options on swaps (swaptions), captions, options on
options
 Structured Products

Combinations of plain derivatives; products with

customized payment patterns;
Exotic Products

Barrier options; Balloon options; Fade-in and Fade-

out options; Basket options and a whole barrel of
custom-made exotic products
 Derivatives Markets
Exchange Traded
standard products
trading floor or computer trading
virtually no credit risk
clearinghouse party to each contract
margins, daily mark-to-market
Over-the-Counter (OTC)
non-standard, customized products
telephone market/also via computerized
trading systems
some credit risk
 How are Derivatives Used?
To hedge price risk and other risks
To reflect a view on the future direction of the
market price of a commodity or financial instrument
or even relative price of two commodities or
instruments
To lock in an arbitrage profit
To change the nature of a liability
To change the nature of an investment without
incurring the costs of selling one portfolio and
buying another
 Forward Contracts
A forward contract is an agreement to buy or
sell an asset at a certain time in the future for a
certain price (the delivery or contract price)
An OTC product tailor-made to the needs of
contracting parties
Usually settled by delivery of the underlying but
cash settled in some cases e.g. Non-
deliverable forwards in some currencies.
The two parties to the contract bear each others
credit risk.
 How a Forward Contract Works
The delivery price is usually chosen so that
the initial value of the contract is zero. No
money changes hands when contract is first
negotiated and it is settled at maturity
Physical delivery or cash settlement
Some credit enhancement device may be
used e.g. compensating balances, letters of
credit etc.
Usually standard documentation is employed.
The Value of a Forward Contract
A forward contract starts out as a zero value
contract i.e. neither party pays the other
anything up-front. It develops plus/minus
value as market rates move.
A seasoned contract would generally have
a non-zero value, positive or negative. If the
contract is to be cancelled this amount must
be settled between the contracting parties
Marking-to-market a forward contract
means carrying it at its current market value
On January 1, 2013 I had entered into a contract with State
Bank of India that on July 3, I will purchase 250000 US dollars
at an exchange rate of Rs.53.50 per dollar from SBI.
Today, the dollar is trading at 50.50 and SBI is quoting a rate of
52.15 for delivery of dollars on July 3.
I want to sell my forward contract to buy dollars on July 3. How
much will you pay me/want to be paid by me?
 FUTURES CONTRACTS
A futures contract, like a forward contract is an
agreement between two parties to exchange one asset for
another, at a specified date in the future.
Terms of the contract fixed upfront.
However, there are a number of significant differences.
These relate to contractual features, market
organisation, kinds of participants in the markets,
profile of gains and losses.
 Major Features of Futures Contracts
Organised Exchanges not OTC markets.
Standardisation : Amount of asset, expiry dates,
deliverable grades etc.
Clearing House: A party to all contracts. Guarantees
performance. Mitigates/Eliminates Credit Risk
Margins : Initial, Variation, Maintenance
Marking to Market : Daily settlement of gains & losses.
Actual Delivery Is Rare : Futures used for hedging or
speculation not for acquiring the underlying asset
INITIAL MARGIN, VARIATION MARGIN,
MAINTENANCE MARGIN

Initial margin : When position is opened

Variation Margin: Settlement of daily gains and losses
Maintenance Margin : Minimum balance in margin
account
Margin Call
Position Liquidated if Margin Call not Honoured
within Specified Time.
Protects clearing house; enhances financial integrity.
 System of Margins
Regulators specify minimum margins between
clearing members and clearinghouse.
Margins at other levels negotiated
Margins can be deposited in cash or specified
securities such as T-bills. Interest on securities
continues to accrue to owner. Margin is a
performance bond.
Levels of margins may be changed if volatility
increases.
 CLEARING
HOUSE

CLEARING CLEARING
MEMBER A MEMBER B

NON-CLEARING
MEMBER CUSTOMER
CUSTOMER NON-CLEARING
MEMBER

CUSTOMER CUSTOMER
 TYPES OF ORDERS IN FUTURES
MARKETS
Market Orders : Execute at best available price
Limit Orders: Sell above or buy below stated limits
Market If Touched or MIT Orders: Become market orders
If price touches a trigger
Stop-Loss Orders : Sell if price falls below a limit; buy if it
rises above a limit. Used to limit losses on existing positions
Stop Limit Orders : Stop loss plus limit
Time of Day Orders, Day Orders, Good Till Canceled
 PARTICIPANTS IN THE FUTURES
MARKETS
Floor Brokers: Trade on others account.
Pure brokers.
Floor Traders: Trade on own account
Dual Traders: Trade on own account as well
as act as brokers for customers.
Some exchanges may not permit dual
traders
Both hedgers and speculators participate.
 OPTIONS
Option to buy or sell the underlying asset
Right, not obligation
Call option: right to buy the U/L asset
Put option: right to sell the U/L asset
Buyer = holder = long position (option to
exercise)
Seller = writer = short position
 OPTIONS

A call option is A put option is

an option to buy an option to sell
a certain asset a certain asset
on or by a on or by a
certain date for certain date for
a certain price a certain price
(the strike price (the strike price
or exercise or exercise
price) price)
 OPTIONS
The call option buyer has the right to buy the underlying
asset but not the obligation; he can let his option lapse. The
option seller also called the option writer has the
obligation to deliver the asset if the buyer chooses to buy i.e.
exercise his option.
The put option buyer has the right to sell the underlying
asset but not the obligation; he can let his option lapse. The
option seller writer has the obligation to take delivery of the
asset if the buyer chooses to exercise his option.
For this one-sided privilege the option buyer must pay a
premium to the option writer up-front. The premium is non-
refundable whether or not the option buyer exercises the
option.
 OPTIONS
Relevant features of an option
The underlying
The strike or exercise price
Time to maturity
Premium
Type of option
The last of these has to do with timing of exercise
 TYPES OF OPTIONS
Timing of Exercise
European Options : Can be exercised by the holder only
on maturity date
American Options : Can be exercised at any time between
contract date and expiry date.
Bermudan Options : Can be exercised at discrete finite
number of times during option life (e.g. every Friday)
Path Dependent and Path Independent Options
Payoff depends only on the price of underlying at the time
of exercise
Payoff may depend upon the price of the underlying at
other points in time during the life of the option
 Options Terminology
Option Premium (Option Price, Option Value):
The fee that the option buyer must pay the
option writer up-front. Non-refundable.
Intrinsic Value of the Option: The intrinsic
value of an option is the gain to the holder on
immediate exercise. Strictly applies only to
American options.
Time Value of the Option: The difference
between the value of an option at any time and
its intrinsic value at the time is called the time
value of the option.
 Options Terminology
A call option is said to be at-the-money (ATM) if
Current Spot Price (St ) = Strike Price (X),
in-the-money (ITM) if St > X and out-of-the-
money (OTM) if St < X
A put option is said to be ATM if St = X,
ITM if St < X and OTM if St > X
In the money options have positive intrinsic
value; at-the-money and out-of-the money
options have zero intrinsic value.
 EQUITY DERIVATIVES
STOCK INDEX FUTURES BSE100, NIFTY50
STOCK INDEX OPTIONS SENSEX, NIFTY50
SECTORAL INDEX OPTIONS*
INDIVIDUAL STOCK OPTIONS
SINGLE STOCK FUTURES*
OPTIONS ON INDEX FUTURES*
 BSE 30 SENSEX AND NIFTY FUTURES
CONTRACT SPECIFICATIONS
SENSEX NIFTY

UNDERLYING BSE 30 SENSEX S&P CNX NIFTY

CONTRACT SIZE 50 INDEX 50 INDEX
CONTRACT
MONTHS NEAREST 3 NEAREST 3
TICK VALUE 0.1 POINT 0.05 POINT
LAST TRADING
DAY LAST LAST
THURSDAY THURSDAY
OF CONTRACT OF CONTRACT
MONTH MONTH
NIFTY FUTURES QUOTES
MARCH 24, 2011
RELIANCE STOCK FUTURES QUOTES
MARCH 25, 2011
MCX COMMODITY FUTURES QUOTES 24/3/2011
SYMBOL EXP DATE OPTION STRIKE HIGH LOW PREV CL. LAST NO. OF TURNOVER
CONTRACTS (RS.LAKH)

INFOS 28APR CE 3300.0 51.65 23.00 16.50 51.40 141 587.76

YSTCH 2011 0
INFOS 28APR PE 3000.0 60.10 32.00 78.00 37.45 129 490.57
YSTCH 2011 0
INFOS 28APR CE 3100.0 145.00 70.00 60.00 137.30 85 339.90
YSTCH 2011 0
INFOS 28APR CE 3350.0 35.05 26.85 173.40 35.05 54 228.36
YSTCH 2011 0
INFOS 28APR PE 3100.0 94.00 56.00 245.00 65.00 55 217.93
YSTCH 2011 0
INFOS 28APR CE 3000.0 224.60 110.05 105.00 211.00 52 204.88
YSTCH 2011 0
INFOS 31MAR PE 2800.0 1.10 0.60 1.50 0.60 58 203.06
YSTCH 2011 0
INFOS 28APR PE 2900.0 28.00 18.45 42.75 22.00 46 168.07
YSTCH 2011 0
2950.0
INFOS 28APR PE 43.75 22.00 61.00 22.00 38 141.61
0
YSTCH 2011
INFOS 31MAR 2950.0
CE 225.00 120.00 76.05 225.00 32 124.70
YSTCH 2011 0

INFOSYS STOCK OPTION QUOTES (NSE 25 MARCH)

 APPLICATIONS OF INDEX FUTURES
Cash-Futures Arbitrage Yield Enhancement
Hedging a Portfolio against Decline- Portfolio
Insurance
Locking in Acquisition Cost of Stocks
Hedging Underwriting Commitments
Betting on Aggregate Market Movements
Index Put Replication for Portfolio Insurance
 ARBITRGE EXAMPLE
You hold a portfolio worth Rs.40 lakhs.
NIFTY cash index 1100; 2-month futures 1110
Can borrow/invest money at 1% per month
Cash market transaction cost 0.4% roundtrip
Fair price : 1100(1+0.01-0.004)2 = 1122.02
Do reverse cash-and-carry. Sell cash, buy
futures.
2 months later, close out futures position, buy
back portfolio
 Hedging Example
A fund manager holds a
diversified portfolio of stocks
worth 50 crores
Cash Index is 1160. Fears fall in
the market
Sells stock index futures
Futures price is 1150
Hedging Example (Contd.)

Each contract is worth Rs.115000

Portfolio beta is 1.5
Sells 6522 contracts
2 months later Nifty falls by 20%
Futures price falls by 15%
Portfolio loses 25%. Net result?
 YIELD ENHANCEMENT
A fund manger has $10m to invest. S&P 500 spot index
at 340; Near month futures 342; Expected Div. Yield 4%;
T-bill yield 8% (BEY); Futures price should be 343.40.
Futures underpriced
Alternative 1: Hold stocks portfolio worth $10m
Alternative 2 : Hold T-bills and go long in futures
$10,000,000/(342500) 58 contracts
Alternative scenarios: I : Market up by 10% S&P 500 up
to 374; II Market unchanged S&P 500 at 340
III Market down by 10% to 306
 YIELD ENHANCEMENT
I II III
Stocks 11,100,000 10,000,000 9,100,000
Cash+Fut. 10,000,000 10,000,000 10,000,000
+200,000 +200,000 +200,000
(Interest on T-bills)
+928,000 -58,000 -1,044,000
(Gain on Fut.) (Loss on Fut.) (Loss on Fut.)
_______________ _____________ _____________
11,128,000 10,142,000 9,156,000
YIELD ENHANCEMENT : CAVEATS
Transactions costs (Brokerage, bid-offer spreads
etc.) ignored
Mark-to-market cashflows ignored
If fund manager tries to acquire stocks after
liquidating futures position, execution risk arises.
T-bills+Futures outperforms stocks if futures
sufficiently underpriced;
Stocks+ Short Futures will outperform T-bills if
futures sufficiently overpriced
 HEDGING WITH INDEX FUTURES
A portfolio manager has $50m invested in a
portfolio that mimics the S&P 500 index.
It is January, spot index is 360, March futures
trading at 365, basis is 5. Manager sells futures.
(50,000,000)/(500365) 274 contracts
March 10: Market down by 15%. Spot index 306,
March futures 312, basis 6. Manager lifts hedge by
buying 274 contracts. Loss on portfolio 15% of
$50m = $7.5m; Gain on Futures :
(365-312)(500)(274) = $7.261m. Net loss: $240,000
HEDGING WITH INDEX FUTURES
Caveats:
Transaction costs ignored; Mark-to-market
ignored
Basis risk : Futures and cash market do not
move in tandem, basis changes. When spot index
fell 15%, futures price fell 14.52%. If the manager
had shorted (15/14.52)(274) = 283 contracts, hedge
would have been almost perfect.
Choice of underlying, choice of contract maturity,
choice of hedge ratio- dimensions of hedging
decision
 LOCKING IN STOCK PRICES
It is now February 10. You expect a subscription of
Rs.50 crores to come by May 30 to a new equity
scheme. You will invest in a portfolio of FMCG stocks
which has a beta of 1.25.
Spot nifty is at 1100 and futures are :
March: 1150 April: 1165 May: 1200 June: 1275
Buy index futures; Basis is positive, long hedge, buy
far contracts i.e. June
Buy [(500,000,000)/(127550)](1.25) = 9804
contracts
 LOCKING IN STOCK PRICES
By May 30, spot Nifty has risen to 1240 and June
futures to 1325. Due to a friendly budget FMCG
stocks have risen by 20%. The target portfolio now
costs 60 crores, a loss of 10 crores. Futures gain is
(50)(50)(9804) = 24510000
Beta captured systematic risk but not industry/firm
specific risk. FMCG stocks rose more than the
market. Sector-specific index futures would have
worked better.
 HEDGING AN UNDERWRITING
COMMITMENT
April 5. GI Corp underwrites $200m issue of XYZ
Co. at $50 per share. Current price is $52.
XYZs beta estimated to be 1.2.
S&P 500 spot index 360. June futures 355.
Target: Hedge 50% of the underwriting commitment
Sell S&P 500 futures.
No.of contracts = [100,000,000/(500355)](1.2) = 676
 HEDGING AN UNDERWRITING
COMMITMENT
April 7. Issue is 40% subscribed at $50.50
Underwriting opportunity loss on 40%
subscription =$(80m/50)(1.5)=$2.4m
S&P 500 June futures trading at 346.
Buy back 0.4(676) = 270 contracts.
Gain on futures: (270)(5009) = $ 1,215,000
April 9. Market trading begins. Price settles at $47.
June Futures at 330
 HEDGING AN UNDERWRITING
COMMITMENT
Opportunity loss = (120m/50)(5.0) = 12m
Buy back remaining 406 futures contracts.
Gain on futures = (406)(500)(25) = $5,075,000
Hedge Efficiency = (1.215m+5.075m)/(0.5)(14.4m)
= 87.4%
GUARANTEED EQUITY FUNDS: AN
APPLICATION OF INDEX OPTIONS
The Product: A retail product for small investors.
A typical example:
Return: 1.33 times the % rise in FTSE 100 over a
specific period; Period: 1/6/2000 1/6/2005
Settlement Price: Average of daily closing over final
six months
Guarantee: 100% of investment returned if FTSE 100
falls over the period. No management fee.
 GUARANTEED EQUITY FUNDS
Two ways to structure the product:
(1) Purchase a 5-year zero-coupon bond with face
value equal to amount invested plus a five year at-
the-money call option on FTSE 100 for an amount
equal to 1.33 times the investment
(2) Buy a well diversified equity portfolio, plus a 5-
year at-the-money put option for an amount equal
to the investment plus a 5-year at-the-money call
for an amount equal to 0.33 times the investment.
Option premiums financed by dividends on the
portfolio.
 GUARANTEED EQUITY FUNDS
Suppose 5-year zero-coupon yield is 8.5%
At-the-money call premium is 20% of face amount.
For every 100 invested:
5-year zero with face value 100 : 67.28
Call on face amount 133.33 : 26.67
Total : 93.95
6.05 left to cover transaction costs, management fees
etc.
GUARANTEED EQUITY FUNDS
As interest rates fall, zeros become more expensive.
Options also become cheaper but zeros rise faster than
option premia fall. Participation rates have to be
reduced say from 1.33 times to 1.25 times rise in the
index.

OTHER APPLICATIONS
Portfolio Insurance with Index Puts
Other trading strategies to speculate on price
movements and volatility changes
EQUITY COLLAR
EQUITY COLLAR

1) You already hold stocks but you want to limit

downside (buy a put) but you are also willing to limit
the upside if you can earn some cash today (by
selling an option - a call)

COLLAR = long stock + long put (K1)

+ short call (K2)
K2 > K 1
Equity Collar Payoffs

ST < K1 K1 ST K2 S T > K2

Long Shares ST ST ST

Long Put (K1) K1 - ST 0 0

Short Call (K2) 0 0 -(ST - K2)

Gross Payoff K1 ST K2

Net Profit(1) K1 - (P -C) ST - (P - C) K2 - (P- C)

Note : 1. Net Profit = Gross Payoff (P-C)