Lec 10

Derivatives
Topics
Derivatives: an introduction
Types of Derivatives
How are derivatives used?
Forwards
Future
Options
Swaps
Warrants and convertibles






Derivatives
A financial contract of pre-determined
duration, whose value is derived from
the value of an underlying asset
Securities
commodities
precious metals
currency
livestock
index such as interest rates, exchange
rates

What do derivatives do?
Derivatives attempt either to minimize
the loss arising from adverse price
movements of the underlying asset
Or maximize the profits arising out of
favorable price fluctuation. Since
derivatives derive their value from the
underlying asset they are called as
derivatives.

Types of Derivatives
(UA: Underlying Asset)

Based on the underlying assets
derivatives are classified into.
Financial Derivatives (UA: Fin asset)
Commodity Derivatives (UA: gold etc)
Index Derivative (BSE sensex)

How are derivatives used?
Derivatives are basically risk shifting
instruments. Hedging is the most
important aspect of derivatives and also
their basic economic purpose
Derivatives can be compared to an
insurance policy. As one pays premium
in advance to an insurance company in
protection against a specific event, the
derivative products have a payoff
contingent upon the occurrence of some
event for which he pays premium in
advance.

What is Risk?
The concept of risk is simple. It is the
potential for change in the price or
value of some asset or commodity.
The meaning of risk is not restricted
just to the potential for loss. There is
upside risk and there is downside risk
as well.

What is a Hedge
To Be cautious or to protect against
loss.
In financial parlance, hedging is the
act of reducing uncertainty about
future price movements in a
commodity, financial security or
foreign currency .
Thus a hedge is a way of insuring an
investment against risk.

Derivative Instruments.
Forward contracts
Futures
Commodity
Financial (Stock index, interest rate &
currency )
Options
Put
Call
Swaps.
Interest Rate
Currency

Forward Contracts.
A one to one bipartite contract, which is to be
performed in future at the terms decided
today.
Eg: Jay and Viru enter into a contract to trade
in one stock on Infosys 3 months from today
the date of the contract @ a price of Rs4675/-
Note: Product ,Price ,Quantity & Time have
been determined in advance by both the
parties.
Delivery and payments will take place as per
the terms of this contract on the designated
date and place. This is a simple example of
forward contract.

Risks in a forward contract
Liquidity risk: these contracts a bi
party and not traded on the exchange.
Default risk/credit risk/counter party
risk.
Say Jay owned one share of Infosys
and the price went up to 4750/- three
months hence, he profits by defaulting
the contract and selling the stock at
the market.

Futures
Future contracts are
organized/standardized contracts in terms
of quantity, quality, delivery time and place for
settlement on any date in future. These
contracts are traded on exchanges.
These markets are very liquid
In these markets, clearing corporation/house
becomes the counter-party to all the trades
or provides the unconditional guarantee for
the settlement of trades i.e. assumes the
financial integrity of the whole system.
In other words, we may say that the credit
risk of the transactions is eliminated by the
exchange through the clearing
corporation/house.

The key elements of a futures
contract are:

Futures price
Settlement or Delivery Date
Underlying (infosys stock)
Illustration.
Let us once again take the earlier
example where Jay and Viru entered
into a contract to buy and sell Infosys
shares. Now, assume that this
contract is taking place through the
exchange, traded on the exchange
and clearing corporation/house is the
counter-party to this, it would be called
a futures contract.

Positions in a futures contract
Long - this is when a person buys a
futures contract, and agrees to receive
delivery at a future date. Eg: Virus
position
Short - this is when a person sells a
futures contract, and agrees to make
delivery. Eg: Jays Position

How does one make money in a
futures contract?
The long makes money when the
underlying assets price rises above
the futures price.
The short makes money when the
underlying assets price falls below the
futures price.
Concept of initial margin

Options
An option is a contract giving the
buyer the right, but not the
obligation, to buy or sell an
underlying asset at a specific price
on or before a certain date.
An option is a security, just like a stock
or bond, and is a binding contract with
strictly defined terms and properties.

Options Lingo
Underlying: This is the specific security
/ asset on which an options contract is
based.
Option Premium: Premium is the price
paid by the buyer to the seller to acquire
the right to buy or sell.
It is the total cost of an option. It is the
difference between the higher price paid
for a security and the security's face
amount at issue. The premium of an
option is basically the sum of the option's
intrinsic and time value.

Strike Price or Exercise Price :price
of an option is the specified/ pre-
determined price of the underlying
asset at which the same can be
bought or sold if the option buyer
exercises his right to buy/ sell on or
before the expiration day.
Expiration date: The date on which
the option expires is known as
Expiration Date
Exercise: An action by an option
holder taking advantage of a
favourable market situation .Trade in
the option for stock.

Exercise Date: is the date on which
the option is actually exercised.
European style of options: The
European kind of option is the one
which can be exercised by the buyer
on the expiration day only & not
anytime before that.
American style of options: An
American style option is the one which
can be exercised by the buyer on or
before the expiration date, i.e. anytime
between the day of purchase of the
option and the day of its expiry.

Asian style of options: these are in-
between European and American. An Asian
option's payoff depends on the average price
of the underlying asset over a certain period
of time.
Option Holder
Option seller/ writer
Call option: An option contract giving the
owner the right to buy a specified amount of
an underlying security at a specified price
within a specified time.
Put Option: An option contract giving the
owner the right to sell a specified amount of
an underlying security at a specified price
within a specified time

In-the-money: For a call option, in-
the-money is when the option's strike
price is below the market price of the
underlying stock. For a put option, in
the money is when the strike price is
above the market price of the
underlying stock.
In other words, this is when the stock
option is worth money and can be
turned around and exercised for a
profit.

Intrinsic Value: The intrinsic value of an
option is defined as the amount by which
an option is in-the-money, or the
immediate exercise value of the option
when the underlying position is marked-
to-market.

For a call option: Intrinsic Value = Spot
Price - Strike Price

For a put option: Intrinsic Value =
Strike Price - Spot Price

Types of Options
Stock index options
Currency options
Future options