DERIVATIVES

CONCEPT OF DERIVATIVES-INTRODUCTION

DERIVATIVE
A product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index or reference rate ), in a contractual manner. The underlying asset can be equity , forex commodity or any other asset.
In the Indian context the securities contracts (Regulation)Act, 1956(SC(R)A) defines Derivative to include :

A security derived from a debt instrument ,share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security. A contract which derives its value from the prices, or index of prices, of underlying securities.

TYPES OF DERIVATIVES
 Forwards

A forward contract is customized contract between two entities, where settlement takes place on a specific date in the future at todays pre-agreed price. Futures An agreement between two parties to buy or sell an asset at a certain time in the future at a certain price . Futures contacts are special types of forward contracts in the contracts in the sense that the former are standardized exchange-traded contracts. Options Options are of two types calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not obligation to sell a given quantity of the underlying asset at a given price on or before a given date.

Operators in the derivatives market

Hedgers - Operators, who want to transfer a risk component of their portfolio. Speculators - Operators, who intentionally take the risk from hedgers in pursuit of profit. Arbitrageurs - Operators who operate in the different markets simultaneously, in pursuit of profit and eliminate mis-pricing.

OPTION TRADING
OPTION CONTRACTS SETLLEMENT PRICING OF OPTION FUTURES

WHAT IS AN OPTION?
Definition: a type of contract between two investors where one grants the other the right to buy or sell a specific asset in the future the option buyer is buying the right to buy or sell the underlying asset at some future date the option writer is selling the right to buy or sell the underlying asset at some future date

TYPES OF OPTION CONTRACTS

Options are of two types Calls and Puts Call options give the buyer the right but not the obligation to buy a given quantity of the underlying asset , at a given price on or before a given future date. Put options give the buyer the right , but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date. Long=Buy= Holder Short=Sell=Writer C= Current Price of the Call E=Exercise Price=Strike Price So=The current price of the share S1=The stock price at the expiration date of the call.

CALL OPTIONS
WHAT IS A CALL OPTION CONTRACT? DEFINITION: a legal contract that specifies four conditions FOUR CONDITIONS the company whose shares can be bought the number of shares that can be bought the purchase price for the shares known as the exercise or strike price the date when the right expires

Role of Exchange
exchanges created the Options Clearing Corporation (CCC) to facilitate trading a standardized contract (100 shares/contract) OCC helps buyers and writers to close out a position

PUT OPTIONS
WHAT IS A PUT OPTION CONTRACT? DEFINITION: a legal contract that specifies four conditions
the company whose shares can be sold the number of shares that can be sold the selling price for those shares known as the exercise or strike price the date the right expires

Call Option

Put Option

Option Buyer

Buys the right to buy the underlying asset at the Strike Price

Buys the right to sell the underlying asset at the Strike Price

Option Seller

Has the obligation to sell the underlying asset to the option holder at the Strike Price

Has the obligation to buy the underlying asset from the option holder at the Strike Price

Illustration on Call Option

An investor buys one European Call option on one share of Reliance Petroleum at a premium of Rs.2 per share on 31 July. The strike price is Rs.60 and the contract matures on 30 September. It may be clear form the graph that even in the worst case scenario, the investor would only lose a maximum of Rs.2 per share which he/she had paid for the premium. The upside to it has an unlimited profits opportunity.

On the other hand the seller of the call option has a payoff chart completely reverse of the call options buyer. The maximum loss that he can have is unlimited though a profit of Rs.2 per share would be made on the premium payment by the buyer.

Illustration on Put Options

An investor buys one European Put Option on one share of Reliance Petroleum at a premium of Rs. 2 per share on 31 July. The strike price is Rs.60 and the contract matures on 30 September. The adjoining graph shows the fluctuations of net profit with a change in the spot price.

OPTION TERMINOLOGY (For The Equity Markets) Options

Options are instruments whereby the right is given by the option seller to the option buyer to buy or sell a specific asset at a specific price on or before a specific date. Option Seller - One who gives/writes the option. He has an obligation to perform, in case option buyer desires to exercise his option. Option Buyer - One who buys the option. He has the right to exercise the option but no obligation. Call Option - Option to buy. Put Option - Option to sell. American Option - An option which can be exercised anytime on or before the expiry date. Strike Price/ Exercise Price - Price at which the option is to be exercised. Expiration Date - Date on which the option expires. European Option - An option which can be exercised only on expiry date. Exercise Date - Date on which the option gets exercised by the option holder/buyer. Option Premium - The price paid by the option buyer to the option seller for granting the option.

Basis: Basis is usually defined as the spot price minus the future price

Terminology - contd.
Spot Price: The price at which an asset trades in the spot market. Future Price:The price at which the futures contract trades in the futures market. Option Price:Option price is the price which the option buyer pays to the option seller. Exercise Price: The price specified in the options contract is known as the strike price or the exercise price.

LONG CALL POSITION ON ACC Strike price 140 Premium 5 5 Spot Price Buy Future Buy Put Synthetic Long Call Buy Call 120 -20 15 -5 -5 125 -15 10 -5 -5 130 -10 5 -5 -5 135 -5 0 -5 -5 140 0 -5 -5 -5 145 5 -5 0 0 150 10 -5 5 5 155 15 -5 10 10 160 20 -5 15 15 165 25 -5 20 20 170 30 -5 25 25 175 35 -5 30 30 180 40 -5 35 35 185 45 -5 40 40 190 50 -5 45 45 195 55 -5 50 50 200 60 -5 55 55 205 65 -5 60 60 210 70 -5 65 65

LONG CALL POSITION ON ACC

Buy Call
70 60 50 40 30 20 10 0 -10

15 5

17 5

Sp ot Pr ic

20 5

12 5

14 5

19 5

13 5

16 5

18 5

Short Call Position ON ACC Strike price 140 Premium 5 5 Spot Price Short Future Synthetic Short Call Short Call Sell Put 120 20 5 5 -15 125 15 5 5 -10 130 10 5 5 -5 135 5 5 5 0 140 0 5 5 5 145 -5 0 0 5 150 -10 -5 -5 5 155 -15 -10 -10 5 160 -20 -15 -15 5 165 -25 -20 -20 5 170 -30 -25 -25 5 175 -35 -30 -30 5 180 -40 -35 -35 5 185 -45 -40 -40 5 190 -50 -45 -45 5 195 -55 -50 -50 5 200 -60 -55 -55 5 205 -65 -60 -60 5 210 -70 -65 -65 5

Short Call Position ON ACC

Sell Call
10 0 -10 -20 -30 -40 -50 -60 -70

Sell Call

LONG PUT POSITION ON ACC Strike price 140 Premium 5 5 Synthetic Long Put uy Call B Spot Price Short Future Buy Put 120 20 15 15 -5 125 15 10 10 -5 130 10 5 5 -5 135 5 0 0 -5 140 0 -5 -5 -5 145 -5 -5 -5 0 150 -10 -5 -5 5 155 -15 -5 -5 10 160 -20 -5 -5 15 165 -25 -5 -5 20 170 -30 -5 -5 25 175 -35 -5 -5 30 180 -40 -5 -5 35 185 -45 -5 -5 40 190 -50 -5 -5 45 195 -55 -5 -5 50 200 -60 -5 -5 55 205 -65 -5 -5 60 210 -70 -5 -5 65

Sp o
10 20 15

-10 -5 0 5

tP ric e 5 5 5 5 5 5 18 19 20 5 5 5 12 13 14 15 16 17

Buy Put

Buy Put

SHORT PUT POSITION ON ACC Strike price 140 Premium 5 5 Spot Price Long Future Short Put SyntheticShort Put Short Ca ll 120 -20 -15 -15 5 125 -15 -10 -10 5 130 -10 -5 -5 5 135 -5 0 0 5 140 0 5 5 5 145 5 5 5 0 150 10 5 5 -5 155 15 5 5 -10 160 20 5 5 -15 165 25 5 5 -20 170 30 5 5 -25 175 35 5 5 -30 180 40 5 5 -35 185 45 5 5 -40 190 50 5 5 -45 195 55 5 5 -50 200 60 5 5 -55 205 65 5 5 -60 210 70 5 5 -65

-20 10 -5 0 5

-10

-15

Sp ot Pr ic e 12 5 13 5 14 5 15 5 16 5 17 5 18 5 19 5 20 5

Short Put

Short Put

Life of an option
The life of an option is limited: it has an expiration date. After the expiration date all the rights and obligations conferred by the option are null and void. The option holder can exercise the option, i.e. declare he or she wants to use the right to buy (or to sell) conferred by the option.

OPTION TRADING
FEATURES OF OPTION TRADING
a new set of options is created every 3 months new options expire in roughly 9 months long term options (LEAPS) may expire in up to 2 years some flexible options exist (FLEX) once listed, the option remains until expiration date

OPTION TRADING
Basic option contracts that are available to investors are the call and put options. When an investor expects the share price to increase in the near future, a trading position could be entered into to assure the investor a minimum return from the expected rise. The strategy that the investor would enter into will be to do for a long call or a short put. A long call gives the buyer the right to buy the share at a predetermined price in the future. Since a bullish market expectation is there, the investor can protect against increased price, when prices go beyond the expectation, by buying now at a predetermined price. When the market becomes bullish in the future as anticipated, and share prices rise above the option strike price, the buyer can exercise the option and benefit from the long call trading strategy. However, even if the market prices do not rise beyond expectation, the investor who had entered into the derivative contract benefits since there is no obligation to buy the share. A short put is a position taken by the writer of a option contract to sell the shares in the future. In a bullish market, the market prices are expected to go up and when the expected prices are higher than the strike price, the writer of the put option gains by the amount of premium that has been received in the beginning. Without trading in the market the writer of the put contract makes a profit from the willingness to take the risk.

Futures
1. Concepts 2. Characteristics 3. Types

CONCEPT OF FUTURES
A futures contract is traded on a future exchange as a standardized contract, subject to the rules and regulations of the exchange. The futures contract relates to a given quantity of the underlying asset and only whole contract s can be traded, and the trading of fractional contracts are not allowed in future contracting. A futures contract is a financial security, issued by an organized exchange to buy or sell a commodity, security or currency at a pre-determined future date at a price agreed upon today. The agreed upon price is called the future s price. Future are exchange traded contract t sell or buy financial instruments or physical commodities for future delivery at aggrieved price. There is an agreement to buy or sell a specified quantity of financial instruments/commodity in a designated future month at a price agreed upon by the buyer and seller. The contracts have certain standardized specifications

CHARACTERISTICS of future contracts

1) There is only a small number of actively traded products with future contracts. The trading unit is large and indivisible. 2) Almost all of the open interest is concentrated in the nearby contract, which has a maturity of no more than 3 months. 3) The success ratio of new contracts is about 25% in world financial market. Sum new contracts succeed and then, which seem to have similar useful features, fail. 4) Futures are seldom used by farmers. Instead, they are forward contracts. The main users of agricultural futures are intermediaries in the marketing process. 5) There are both commercial and non-commercial users of futures contract in interest rates and foreign exchange. The commercial users are to a large extent dealers.

Contd.
6) The position of the commercials and dealers in interest rate futures are almost evenly divided between long and short positions. 7) The main use of futures by the commercial is to hedge corresponding cash and forward positions. 8) The positions of the non commercial are almost entirely speculative positions. 9) In foreign exchange futures, the positions of the commercials are unbalanced.

TYPES OF FUTURES CONTRACT

Futures contracts may be classified into two categories:  Commodity Futures: where the underlying is a commodity or a physical asset such as wheat, cotton, butter, eggs etc. Such contracts began trading on Chicago Board of Trade (CBOT) in 1860 s. In India too, futures on soybean, black pepper and spices have been trading for long.  Financial Futures: Where the underlying is a financial asset such as foreign exchange, interest rates, shares, treasury bill or stock index.

Standardized items in Futures

The standardized items in any futures contract are: a) Quantity of the underlying b) Quality of the underlying (not required in financial futures) c) The date and month of delivery d) The units of price quotation (not the price itself) and minimum change in price (tick size) e) Location of settlement

FUTURES VS. OPTIONS

An options agreement is a contract in which the writer of the option grants a buyer of the option the right to purchase from or sell to the writer a designated instrument at a specified price (or receive a cash settlement) within a specified period of time. In contrast, a futures contract is a firm legal commitment between a buyer and seller in which they agree to exchange something at a specified price at the end of a designated period of time. The buyer agrees to take delivery of something and the seller agrees to make delivery. 1. With futures, both parties are obligated to perform. With options only the seller (writer) is obligated to perform. 2. With options, the buyer pays the seller (writer) a premium. With futures, no premium is paid by either party. 3. With futures, the holder of the contract is exposed to the entire spectrum of downside risk and has the potential for all the upside return. With options, the buyer limits the downside risk to the option premium but retains the upside potential. 4. The parties to a futures contract must perform at the settlement date. They are not obligated to perform before that date. The buyer of an options contract can exercise any time prior to the expiration date.

DIFFERENCE BETWEEN FUTURES & OPTIONS

FUTURES Futures contract is an agreement to buy or sell specified quantity of the underlying assets at a price agreed upon by the buyer and seller, on or before a specified time. Both the buyer and seller are obliged to buy/sell the underlying asset. OPTIONS In options the buyer enjoys the right and not the obligation, to buy or sell the underlying asset.

Unlimited upside & downside for both buyer and seller.

Limited downside (to the extent of premium paid) for buyer and unlimited upside. For seller (writer) of the option, profits are limited whereas losses can be unlimited. Prices of options are however, affected by a)prices of the underlying asset, b)time remaining for expiry of the contract and c)volatility of the underlying asset.

Futures contracts prices are affected mainly by the prices of the underlying asset

Instruments
The following instruments are included in these two groups that make up Forwards: Foreign Exchange Forward contracts Forward Rate Agreements Forward Bonds Short-term interest rate futures Bond Futures Stock index futures Commodity futures contracts

Forward Vs Cash Transactions

We might expects any transaction that settles today to be a cash transaction and anything settling from tomorrow onward to be a Forward. Unfortunately, this is not always the case and depending on the underlying financial asset, a cash transaction can range from today for a money market transaction to several weeks, or longer in some securities markets. A forward transaction does not commence until the settlement day passes the cash settlement date. Eg.In foreign exchange market, a Forward is a transaction that settles after two business days. In the Indian Equity market minimum Forward we can have is 8 days.

Deriving the Forward Price

Calculating the forward price is the same as asking the question How much should I pay to buy something in the Future? A forward transaction can be replicated by purchasing the asset today and borrowing the money to finance it. The fair forward price indicates the price at which buyers and sellers are indifferent to buying and selling the underlying asset today or in the future,based on the current market cash price,cost of financing the asset and the expected return on the asset.

Deriving the Forward Price

The Fair forward price is given by the cash price plus the net cost of financing the asset over the term of the Forward contract. The interest cost tends to increase the forward price versus the cash price. Any cash return on the asset over the term of the forward contract tends to decrease the forward price versus the cash price.

Deriving the Forward Price

These general rules should apply to all forward prices on financial assets, regardless of whether it is an interest rate, foreign exchange or equity product, provided they operate in freely operating markets. It is worth noting that these relationships start to break down when we move away from financial assets, particularly to consumable commodities. This is so because the decision to have the physical commodity today or in the future also has to take into consideration when the commodity is required for consumption.

FORWARD
OTC in nature Customised contract terms hence
Less Liquid No Secondary market

Vs

FUTURE

No margin Payment Settlement happens at end of period

Trade on an organised exchange Standardised contract terms hence More liquid Secondary market Requires margin requirement Follows daily settlement

Valuation Differences between Forward & Futures

An OTC and a Futures contract with the same forward expiry date should have the same forward price. The differences between OTC and ET futures contracts arise from the fact that futures contracts are subject to daily mark-to-markets (the price is calculated based on the daily market price) and upfront initial margins.

Figure 6.4 - Synthetic forward purchase example

Current market rates :

Spot JPY/USD: 6 month JPY rate - % pa A/365 6 month USD rate - % pa A/360

103 2.50% 6.50%

Invest JPY at 2.5% for 6 mths Buy JPY 500m, sell USD 4.85M Spot JPY/USD

JPY Money Mkt

JPY/USD 6mths Forward at 100.99 Forward JPY/USD

Borrow USD at 6.5% for 6mths

USD Money Mkt

Cashflows Day 0 Spot FX : Buy JPY at 103 Day 2 Settle Spot FX Invest JPY at 2.5%pa Borrow USD at 6.5%pa Money market interest Currency Balances Effective Forward FX rate = =

JPY

USD

500,000,000 (500,000,000)

(4,854,369) 4,854,369

Day 182

6,164,384 506,164,384

(157,767) 5,012,136

506,164,384 / 5,012,136 100.99

The Role of Forward Market

A Forward is an obligation to buy or sell a financial instrument or physical commodity at some date in the future at an agreed price. For our purposes, forwards include over-thecounter(OTC) forward contracts and exchangetraded (ET) futures contracts. Forward contracts represent a starting point for all derivative valuation.

Forward Vs Cash Transactions

We might expects any transaction that settles today to be a cash transaction and anything settling from tomorrow onward to be a Forward. Unfortunately, this is not always the case and depending on the underlying financial asset, a cash transaction can range from today for a money market transaction to several weeks, or longer in some securities markets. A forward transaction does not commence until the settlement day passes the cash settlement date. Eg.In foreign exchange market, a Forward is a transaction that settles after two business days. In the Indian Equity market minimum Forward we can have is 8 days.

BADLA CONTRACT
Badla financing is carried out by two ways either by lending money or by lending shares for the short position. The badla money financier enters into contract on the badla financing day. The badla financier cannot use his position for earn higher badla charges in the next settlement period. The shares received from the seller have to be deposited in the clearinghouse fill the arrangement for the borrowed fund is complete. If the original buyer carries forward the position for four settlements the financier gets the principal only at the end of the fourth settlement. Badla provides the facility of borrowing and lending of shares and funds. Badla is a part of a cash market. The borrower of the shares pays a fee or Vyaj badla charges. Badla works without strong margin system results in many payment crises. Badla 1. Expiration date is not clear 2. Mixed up spot market and different expiration dates 3. Counterparty identity not known 4. Counterparty risk is present 5. Default premia charged for badla financing 6. Long and short position may not be equal Futures 1. Expiration date is known 2. Distinct spot market and different expiration dates 3. Clearing corporation is the counterparty 4. Counterparty risk is absent 5. Counterparty guarantee reduces the risk premia 6. Long and short are equal