Introduction to Derivatives

What is a Derivative Security?

A Derivative Security is a security whose
value depends on the values of other, more basic
underlying variables.
Example:
An Indian exporter is likely to receive USD 1000
after one month goes to a bank and contracts to
sell the USD money for Rs.41 per USD.
This contract is an example of derivative
contract where the underlying is the foreign
currency (USD)
2

Derivatives Markets
Two types:
Exchange traded
Over-the-counter (OTC)

Exchange traded
Traditionally exchanges have used the open-outcry
system, but increasingly they are switching to
electronic trading.
Contracts are standard, so there is virtually no credit
risk
Example:
Futures, Options
3

Derivatives Markets contd.

Over-the-counter (OTC)
A computer- and telephone-linked network of
dealers at financial institutions, corporations, and
fund managers
Financial institutions often act as market makers.
Contracts can be non-standard and there is some
amount of credit risk
Example:
Swaps, Forward Rate Agreement, Exotic options

Advantages of OTC & Exchanged

Traded market
Advantage of OTC market:
In OTC market participants are free to
undertake any mutually attractive deal.

Advantage of Exchange traded market:

In OTC market there is a small risk that the
contract will not be honored, which is
eliminated in exchange traded market.
Secondary trading in the security is possible.

Types of Derivatives

Forward Contracts
Futures Contracts
Swaps
Options

Forward Contract
A forward contract is an agreement to buy or
sell an asset at a certain future time for a certain
price.
It can be contrasted with a spot contract, which
is an agreement to buy or sell an asset today.
The contract is between two financial
institutions or between a financial institution
and one of its corporate clients.
It is not traded on an exchange.
Forward contracts are particularly popular on
currencies and interest rates.
7

Terminology
Long position agrees to buy the underlying
asset on a certain specified future date for a
certain specified price.
Short position is the other party and agrees to
sell that asset on same future date for the same
price.

The specified price in a forward contract is

referred to as the delivery price.
8

Example of Forward Contract

Suppose on April 01,2007 the treasurer of
an export company in India knows that it
will receive USD 1 million in 6
months (i.e. on October 01,2007) and
wants to become indifferent against
exchange rate moves.
He can undertake currency forward contract
with a bank now to sell USD 1 million in 6
months at a particular INR/USD forward rate.
9

Spot and Future Quotes for

INR/USD (Not Actual Values)
Spot
6 month
Forward

Bid Price
41.85
42.80

Offer Price
42.10
43.15

INR/USD means Rs. per USD

Bid price at which one is prepared to buy
Ask price at which one is prepared to sell
These quotes are for inter-bank transactions, for retail investors spread
(difference between bid and ask) is more

10

Payoffs From Long Forward

Contracts
Payoff from
Long Position

K
Price of Underlying
at Maturity, ST

The payoff from a long position in a forward contract on one

unit of an asset = ST K (K = delivery price, ST = Price of
the underlying security at maturity )
11

Payoffs From Short Forward

Contracts
Payoff from
Short Position

Price of Underlying
at Maturity, ST
K

The payoff from a short position in a forward contract on one

unit of an asset = K ST (K = delivery price, ST = Price of the
underlying security at maturity )
12

Futures Contract

Agreement (obligation) to buy or sell

an asset for a certain price at a certain

time
Similar to forward contract but futures
contracts are traded on an exchange

13

Examples of Futures Contracts

NIFTY Futures as on 29-May 2007

Symbol

Expiry Date

No of
Contracts
Traded

Last Traded
Price

Open
Interest

Value of
Underlying

NIFTY

31-May-07

375902

4294.55

20340250

4290.9

NIFTY

28-Jun-07

186386

4285.95

15260600

4290.9

NIFTY

26-Jul-07

1720

4283.7

265400

4290.9

One contract has lot size of 50 units

Hence, 1 point change in underlying results in change
of Rs.50 for 1 contract
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Options

A call option is an option to buy a certain

asset by a certain date for a certain price.
A put option is an option to sell a certain
asset by a certain date for a certain price.

The price of the contract is known as

strike price/exercise price.
The date in the contract is known as
expiration date/maturity.

15

Options contd.
An American option can be exercised at any

time during its life.

An European option can be exercised only at
maturity.

The terms American or European do not refer to the

location of the option.

Examples:

Index options traded in NSE are of European type

Stock options traded in NSE are of American type
16

Difference Between Options and

Forward/Futures Contracts
The holder of the option is not obliged to
honor the contract, whereas the holder of
Forward/Futures Contract is obliged to
buy or sell the underlying asset.
It costs nothing to enter into Forward/
Futures Contracts, but for buying
options, upfront payment is required.
17

Example of European Long Call

Option
Suppose an investor purchases 1 NIFTY-May4000-Call at premium 45
One contract consists 50 index share.
The contract is cash settled.

If at the end of this option life NIFTY value is

more than 4000
He exercises the option and receives the amount by
which NIFTY exceeds 4000 for one index share times
Rs. 50.
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Example of European Long Call

Option contd.
Suppose the final day value of NIFTY is 4100.
By exercising he gets (4100 4000) = 100 per index
share or Rs. 50X100 = Rs. 5,000 for one contract

However, if the final day value is below 4000

He will not exercise the option.

For this privilege, he pays a fee of Rs.2250

(Rs.45 a share for 50 shares).

19

Example of American Option Long

Call
Suppose an investor purchases 1 Reliance-May-1590Call at premium Rs.55.
Lot size is 150
The contract is cash settled

This contract allows him to buy 150 shares of

Reliance at Rs.1590 per share at any time
between the current date and the option expiry
date of May.

If the price goes above Rs. 1590 he can exercise the

option.
20

Example of American Option Long

Call contd.
Suppose the price goes to 1650 and he exercises the
option.
This is equivalent to buying the option @ 1590 and
selling it @ 1650.
He will get Rs. (1650 1590) = Rs. 60 per share or Rs. 60 * 150
= Rs. 9,000 for one contract

If the price remains below Rs. 1590 over the life of the
option.
He will not exercise the option.

For this privilege, he pays a fee of Rs.8250 (Rs.55 a share

for 150 shares).
21

Example of American Option

Short Call
Suppose an investor writes/shorts 1 Reliance-May1590-Call at premium Rs. 55.
Lot size is 150
The contract is cash settled

This contract gives an obligation on him to sell

150 shares of Reliance at Rs.1590 per share at
any time between the current date and the
option expiry date of May.

If the price goes above Rs. 1590 long position holder will
exercise the option.
22

Example of American Option Long

Call contd.
Suppose the price goes to 1650 and long position
holder exercises the option.
For short position holder this is equivalent to selling
the option @ 1590 after buying it @ 1650.
He will make loss Rs. (1650 1590) = 60 per share or RS. 60*
150 = Rs. 9,000 for one contract
However, he receives a fee of Rs.8250 (Rs.55 a share for 150
shares) from long position holder.

However, if the price remains below 1590 over the life of

the option
Long position will not exercise the option.
The entire fee of Rs.8250 (Rs.55 a share for 150 shares) is the
profit of short position holder.
23

Payoff Diagram Long Call

Payoff from
Long Call

-C

ST

The payoff from a long position in a call option

= Max (ST K, 0) - C (K = Strike price, ST = Price of the
underlying security at maturity, C = Call option premium )

24

Payoff Diagram Short Call

Payoff from
Short Call

ST

The payoff from a short position in a call option

= Max (ST K, 0)+ C = Min (K - ST, 0)+ C (K = Strike price,
ST = Price of the underlying security at maturity, C = Call
option premium )

25

Payoff Diagram Long Put

Payoff from
Long Put

K
-P

ST

The payoff from a long position in a put option

= Max (K ST, 0) - P (K = Strike price, ST = Price of the
underlying security at maturity, P = Put option premium )

26

Payoff Diagram Short Put

Payoff from
Short Put

P
K

ST

The payoff from a short position in a put option

= Max (K ST, 0)+P = Min (ST K, 0) + P (K = Strike
price, ST = Price of the underlying security at maturity, P =
Put option premium )

27

Payoff diagram Combined

Payoff from
Long Call

Payoff from
Long Put

ST

ST

Payoff from
Short Put

Payoff from
Short Call

K
ST

ST

28

Types of Traders

Hedgers
Speculators
Arbitrageurs

29

Hedging
Hedgers are essentially spot market players.
Hedgers are interested in reducing price risk (that they already
face in the spot market) with derivative contracts and options.

Forward contracts are designed to neutralize risk by fixing the price

that hedger will pay or receive for the underlying asset.
Future contracts can be used to undertake minimum variation
hedging.
Option strategy enables the hedger to insure itself against adverse
exchange rate movements while still benefiting from favorable
movements.

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Hedging Using Forward Contracts

Suppose that it is June 16, 2007, and ImportCo, a
company based in the United States, knows that it will
pay 10 million on September 16,2007, for goods it has
purchased from a British supplier.
The USD-GBP exchange rate quotes made by a financial
institution are known.
ImportCo can hedge its foreign exchange risk by buying
pounds (GBP) from the financial institution in the threemonth forward market at 1.4407.
This would have the effect of fixing the price to be paid to the
British exporter at $14,407,000.
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Hedging Using Forward Contracts

contd.
Consider next another U.S. company, which we
will refer to as ExportCo, that is exporting goods
to the United Kingdom and on July 16, 2007,
knows that it will receive 30 million three
months later.

ExportCo can hedge its foreign exchange risk by

selling 30 million in the three month forward
market at an exchange rate of 1.4402.
This would have the effect of locking in the U.S.
dollars to be realized from the sterling receipts at
$43,206,000.
32

Hedging Using Forward Contracts

Some Issues
There is no assurance that the outcome with hedging will
be better than the outcome without hedging.
For ImportCo.:
If the exchange rate is 1.4000 on September 16 and the company
has not hedged, the 10 million that it has to pay will cost
$14,000,000, which is less than $14,407,000.
If the exchange rate is 1.5000, the 10 million will cost
$15,000,000.

For ExportCo. the outcomes are reverse:

If the exchange rate on October 16 proves to be less than 1.4402,
hedging would give better result.
If the rate is greater than 1.4402, it will be pleased that it had not
hedged.
33

Hedging Using Options

Consider an investor who in May 2007 owns
1,500 Reliance shares
The current share price is Rs.1750 per share

The investor is concerned that the share price

may decline sharply in the next two months and
wants protection.
The investor could buy 10 July put option
contracts with a strike price of Rs.1750 on NSE.
This would give the investor the right to sell 1,500
shares for Rs.1750 per share.
34

Hedging Using Options contd.

If the quoted option price is Rs.25, each option
contract would cost 150 x Rs. 25 = Rs. 3750, and
the total cost of the hedging strategy would be 10
x RS. 3750 = Rs. 37,500

The strategy costs Rs. 37,500 but guarantees

that the shares can be sold for at least Rs.
1750 per share during the life of the
option.
35

Hedging Using Options contd.

If the market price of Reliance falls below Rs.
1750, the options can be exercised so that Rs.
26,25,000 is realized for the entire holding.
When the cost of the options is taken into account, the
amount realized is Rs.25,87,500

If the market price stays above Rs. 1750, the

options are not exercised and expire worthless.
However, in this case the value of the holding is
always above 26,25,000 (or above 25,87,500 if
the cost of the options is taken into account).
36

Speculation
Speculators wish to take a position in the
market either by betting that the price will go
up or down.
Futures and options can be used for speculation
When a speculator uses futures then the
potential gain or loss is high.
When a speculator uses options, speculators
loss is limited to the amount paid for the option.
37

Speculation Using Future Contracts

Consider that a trader fancies his chances in
predicting the market trend. So instead of buying
different stocks, he buys NIFTY Futures.
On May 1, 2007, he buys 50 NIFTY May
futures @ 4000 on expectations that the index
will rise in future. On May 22, 2007, the NIFTY
rises to 4200 and at that time he sells an equal
number of contracts to close out his position.
38

Speculation Using Future Contracts

contd.
Selling Price : 4200*50
= Rs 210,000
Less: Purchase Cost: 4000*50 = Rs 200,000
Net gain
Rs 10,000
The trader has made a profit of Rs 10,000 by
taking a long position on NIFTY May Futures.
However, if the NIFTY had fallen he would have
made a loss.
Similarly, if he would have been bearish he
could have sold NIFTY futures and made a profit
from a falling market.
39

Speculation Using Options

Suppose that it is October and a speculator considers
that Cisco is likely to increase in value over the
next two months.
The stock price is currently $20, and a two-month call option
with a $25 strike price is currently selling for $1.

The speculator is willing to invest $4,000.

It has two alternatives
The first alternative involves the purchase of 200 shares
The second involves the purchase of 4,000 call options (i.e., 20
call option contracts)

Suppose that the speculator's hunch is correct and the

price of Cisco's shares rises to $35 by December.
40

Speculation Using Options contd.

The first alternative of buying the stock yields a profit of
200 x ($35 - $20) = $3,000
However, the second alternative is far more
profitable.
A call option on Cisco with a strike price of $25 gives a
payoff of $10, because it enables something worth $35 to
be bought for $25.
The total payoff from the 4,000 options that are purchased
under the second alternative is:
4,000 x $10 = $40,000
Subtracting the original cost of the options yields a net profit of
$40,000 - $4,000 = $36,000

The options strategy is, therefore, 12 times as profitable

as the strategy of buying the stock.
41

Speculation Using Option contd.

Options also give rise to a greater potential
loss.
Suppose the stock price falls to $15 by
December
The first alternative of buying stock yields a
loss of 200 x ($20-$15) = $1,000.
Because the call options expire without being
exercised, the options strategy would lead to a
loss of $4,000the original amount paid for
the options.
42

Arbitrageurs
Arbitrage involves locking in a riskless profit by
simultaneously entering into transactions in two
markets.
Example:
Consider a stock that is traded in both New York and London.
Suppose that the stock price is $172 in New York and 100
in London at a time when the exchange rate is $1.7500
per pound.
An arbitrageur could simultaneously buy 100 shares of the stock
in New York and sell them in London
He will obtain a risk-free profit of:
100*($1.75*100 $172) or $300 in the absence of transactions
costs.
43

Mechanism of Futures Markets

Delivery of Futures Contract

Most of the future contracts do not lead
to delivery.
Most traders choose to close out their
positions.

45

Closing Out Positions

Closing out a position means entering into the
opposite type of trade from the original
one
Example:
Long position holder in August cotton futures can
close out his position anytime before August by selling
the same contract on cotton
The total gain or loss is the difference in August
cotton future price between the start day and the
closing out day.
46

Convergence of Futures to Spot

Futures
Price

Spot Price
Futures
Price

Spot Price

Time

Time

47

Trading Margin Operation

Margin account
Initial margin
Marking to market
Maintenance margin
Margin Call
Variation margin

48

Trading Margin Operation

Consider an investor who contacts his or her
broker/member on Monday, May 7, 2007, to
buy two July 2007 Reliance futures
contracts on the NSE.
Current futures price is Rs.1750 per share.
Since the contract size is 150 shares, the
investor has contracted to buy a total of 300
shares at this price.

The broker will require the investor to deposit

funds in what is termed a margin account.
49

Trading Margin Operation

The amount that must be deposited at the time
the contract is first entered into is known as the
initial margin.
This is determined by the broker.
Suppose, for previous example this is Rs.20,000 per
contract, or Rs.40,000 in total

At the end of each trading day, the margin

account is adjusted to reflect the investor's gain
or loss.
This is known as marking the account to market.
50

Trading Margin Operation

The investor is entitled to withdraw any
balance in the margin account in excess of
the initial margin.
To ensure that the balance in the margin
account is above a minimum level, a
maintenance margin is set.
This is somewhat lower than the initial margin

51

Trading Margin Operation

If the balance in the margin account falls below
the maintenance margin, the investor receives a
margin call.
Investor is requested to top up the margin account to
the initial margin level within a very short period of
time.

The extra funds deposited are known as a

variation margin.
If the investor does not provide the variation
margin, the broker closes out the position by selling
the contract.
52

Trading Margin Operation

If by the end of June 5 the futures price dropped from Rs.1750 to
Rs.1740
The investor has a loss of Rs.3000 (= 300 * Rs.10), because the 300
shares of September, which the investor contracted to buy at Rs.1750,
can now be sold for only Rs1740.
The balance in the margin account would therefore be reduced by
Rs.3000 to Rs.37,000

Similarly, if the price of September shares rose to Rs.1755 by the end

of the first day
The balance in the margin account would be increased by Rs.1500 to
Rs.41,500.

When there is a decrease in the futures price so that the margin

account of an investor with a long position is reduced by Rs.3,000,
the investor's broker has to pay the exchange Rs.3,000 and the
exchange passes the money on to the broker of an investor with a
short position.

53

Trading Margin Operation

Date

Futures Price

Daily Gain (loss)

Cumulative Gain
(Loss)

Margin Account
Balance

Margin Call

Cumulative
Margin Call

7-May

1,750.00

40,000.00

8-May

1,740.00

(3,000.00)

(3,000.00)

37,000.00

0.00

0.00

9-May

1,735.00

(1,500.00)

(4,500.00)

35,500.00

0.00

0.00

10-May

1,728.00

(2,100.00)

(6,600.00)

33,400.00

0.00

0.00

11-May

1,709.00

(5,700.00)

(12,300.00)

27,700.00

12,300.00

12,300.00

14-May

1,697.00

(3,600.00)

(15,900.00)

36,400.00

0.00

12,300.00

15-May

1,724.00

8,100.00

(7,800.00)

44,500.00

0.00

12,300.00

16-May

1,733.00

2,700.00

(5,100.00)

47,200.00

0.00

12,300.00

17-May

1,741.00

2,400.00

(2,700.00)

49,600.00

0.00

12,300.00

18-May

1,746.00

1,500.00

(1,200.00)

51,100.00

0.00

12,300.00

21-May

1,698.00

(14,400.00)

(15,600.00)

36,700.00

0.00

12,300.00

22-May

1,705.00

2,100.00

(13,500.00)

38,800.00

0.00

12,300.00

23-May

1,714.00

2,700.00

(10,800.00)

41,500.00

0.00

12,300.00

24-May

1,703.00

(3,300.00)

(14,100.00)

38,200.00

0.00

12,300.00

25-May

1,722.00

5,700.00

(8,400.00)

43,900.00

0.00

12,300.00

28-May

1,662.00

(18,000.00)

(26,400.00)

25,900.00

14,100.00

26,400.00

29-May

1,671.00

2,700.00

(23,700.00)

42,700.00

0.00

26,400.00

30-May

1,680.00

2,700.00

(21,000.00)

45,400.00

0.00

26,400.00

54

Trading Margin Operation

On May 11 the balance in the margin account falls Rs.2300 below
the maintenance margin level.
This drop triggers a margin call from the broker for additional
Rs.12,300.
It is assumed that the investor does in fact provide this margin by the
close of trading on May 11.

On May 28 the balance in the margin account again falls below the
maintenance margin level.
A margin call for Rs.14,100 is sent out
The investor provides this margin by the close of trading on May 28.

On May 30 the investor decides to close out the position by selling

two contracts.
The futures price on that day is Rs.1680, and the investor has a
cumulative loss of Rs.21000.

The investor has excess margin on May 15-18, 23, 25, 29-30.

55

Some more Terminology

Open Interest: the total number of contracts
outstanding
equal to number of long positions or number of short
positions
Settlement Price: the price just before the final bell
each day
used for the daily settlement process (daily gains and
losses and margin requirements)
Volume of Trading: the number of trades in 1 day
When a new trade is completed what are the possible
effects on the open interest?
Can the volume of trading in a day be greater than the
open interest?
56

Examples of Patterns of Future

Prices
Normal Market: The futures price of gold on
the New York Mercantile Exchange and the
futures price of wheat on the Chicago Board of
Trade increase as the time to maturity increases.
This is known as a normal market.
Inverted Market: The futures price of SugarWorld is a decreasing function of maturity. This
is known as an inverted market.
57

Cash Settlement
Some financial futures, such as those on stock indices,
are settled in cash
This is because it is inconvenient or impossible to deliver the
underlying asset

When a contract is settled in cash, it is marked to market

at the end of the last trading day and all positions are
declared closed.
The settlement price on the last trading day is the
closing spot price of the underlying asset.
This ensures that the futures price converges to the spot price

Example: All futures traded at NSE are settled in cash.

58