DERIVATIVES

Innovation of derivatives have redefined and revolutionised the landscape of financial

industry across the world and derivatives have earned a well-deserved and extremely
significant place among all the financial products. Derivatives are risk management tool that
help in effective management of risk by various stakeholders. Derivatives provide an
opportunity to transfer risk, from the one who wish to avoid it; to one, who wish to accept it.
India’s experience with the launch of equity derivatives market has been extremely
encouraging and successful. The derivatives turnover on the NSE has surpassed the equity
market turnover. Significantly, its growth in the recent years has surpassed the growth of its
counterpart globally.
Derivatives are
 Risk management tools
 Instruments of hedging
 Successful innovations in capital, money & forex markets
But Warren Buffet refereed to Derivatives as financial weapons of mass destruction
Definition
Derivatives are financial instruments whose value depends on the value of other, more basic
underlying variables.
Derivatives are financial contracts that derive their value from the price movements of these
underlying assets.
[(ac)] “derivative” includes— (A) 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; (B) a contract which derives its value from the prices, or index of prices, of
underlying securities;]
Derivatives are financial instruments whose value depends on the value of other, more
basic underlying variables.
The underlying can be…
• Physical Commodities: Wheat, Coffee
• Financial Assets : Currencies, Stocks, Bonds
• Financial Prices : Interest rates, Stock indices
• Other Derivatives : Weather Derivatives
Participants in Derivatives Market
Hedgers:
Hedgers use derivatives markets to mitigate or eliminate the risk associated with price of an
asset. Through hedging, they protect their assets by entering into an exact opposite trade in
the derivative market. Hedging helps to counterbalance the risks involved in investing in
assets such as stocks, bonds, commodities, or currencies.
Speculators
Speculators are traders who make speculations about market price movements and enter into
derivatives contracts based on these speculations. Speculators have a high-risk appetite and
are highly driven by the urge to make higher returns. They provide liquidity in the market
contributes to making the market more vibrant.
Arbitrageurs
Arbitrageurs seek to profit from price differences between different markets for the same
asset.
Their behaviour is guided by the desire to take advantage of a discrepancy between prices of
more or less the same assets or competing assets in different markets. They utilize the low-
risk market imperfections to make profits. They simultaneously buy low-priced securities in
one market and sell them at a higher price in another market.
Margin traders
In finance terms, margin is the collateral deposited by an investor with their broker or the
exchange in order to borrow money to leverage their investment power.
Margin trading refers to the trading technique where the investors only pay a fraction of the
total amount payable initially. A small fraction of the total amount payable is as a deposit,
known as the margin balance. Using margin trading, investors can make more significant
trades than what their financial capacity can afford. Margin trading is a technique that is
distinctive to the derivatives market. Examples of margin traders include day traders and
position traders.
Derivative Products
• FORWARDS
• FUTURES
• OPTIONS
• SWAPS
Forwards:
Forwards are non-standardized contracts between two parties to buy or sell an asset at a
specified future time at a price agreed today.
A highly customized agreement which obligates purchaser to buy, seller to sell a specified
asset on a specified date at a specified price (the forward price / today’s pre-agreed price) at a
specified location.
The party agreeing to
BUY asset in the future ……… the long
SELL asset in the future .…….. the short
Features of Forward Contract:
 Physical delivery of the underlying is a must
 Privately Negotiated agreement
 Costs nothing to enter into the agreement
 Credit risk is two sided – Parties may default on the deal
 Not enforceable – wagering agreements.
Features
1. It is an agreement between the two counter parties in which one is buyer and other is
seller.
2. All the terms are mutually agreed upon by the counterparties at the time of the
formation of the forward contract.
3. It specifies a quantity and type of the asset (commodity or security)-to be sold and
purchased.
4. It specifies the future date at which the delivery and payment are to be made.
5. It specifies a price at which the payment is to be made by the seller to the buyer; the
price is determined presently to be paid in future.
6. It obligates the seller to deliver the asset and also obligates the buyer to buy the asset
7. No money changes hands until the delivery date reaches, except for a small service
fee, if there is.
Futures:
Futures are exchange-traded forwards. Futures are exchange-traded standard contracts for a
pre-determined asset to be delivered at a pre-agreed point in the future at a price agreed
today.
The buyer makes margin payments reflecting the value of the transaction. The buyer is said to
have gone long and the seller to have gone short. Counterparties can exit a commitment by
taking an equal but offsetting position with the exchange, so that the net position is nil and
the only delivery will be a cash flow for profit or loss. Futures coverage includes currencies,
bonds, agricultural and other commodities such as silver.
The exchange standardizes the terms of contacts:
• Asset grade
• Contract size
• Delivery location
• Delivery months
• Minimum price movements
• Daily price limits
• Positions limits
• Standardization enables a futures contract to trade on an exchange like a security.
Margins
• Types:
• Initial Margin
• Maintenance Margin
• Purpose:
• To minimize counterparty default
Options:
Exchange-traded options are standardized contracts whereby one party has a right to purchase
something at a pre agreed strike price at some point in the future, The right, however, is not
an obligation as the buyer can allow the contract to expire and walk away. The cost of buying
an option is the seller’s premium which the buyer must pay to obtain the option right
An option is a contract that gives its owner the right, but not the obligation to buy (Call)
or sell (put) a specific underlying instrument at a specific price – the strike or exercise
price –up until or on a specific future / expiry date.
Options Terminology
Parties to an option contract
Option buyer
 Option seller / Option writer
Maturity Date / Expiry Date
The date on which the option contract expires. Exchange traded options have standardized
maturity dates
• Call option Call - Buy
• Put option Put - Sell
Call option
Call option
The buyer the right but not the obligation of buying the asset at the strike price before the
expiration date of the contract.
Put Option
The buyer a right, not an obligation to sell the asset at the strike price before the expiration
date of the contract.
• Call -A buyer of a call option has the right but not the obligation to buy the asset at
the strike price (price paid) at a future date. A seller has the obligation to sell the asset
at the strike price if the buyer exercises the option.
• Put - A buyer of a put option has the right, but not the obligation, to sell the asset at
the strike price at a future date. A seller has the obligation to repurchase the asset at
the strike price if the buyer exercises the option.
Strike Price / Exercise Price)
The price specified in the option contract at which the option buyer can purchase the asset
(call) or sell the asset (put).
PREMIUM :
The buyer has the right but not the obligation to buy. For this asymmetry of privilege, the
buyer is expected to pay option price – option premium to the seller/writer
Components of Premium of an Option
Premium =Intrinsic Value + Time value
Intrinsic Value = Underlying price – Strike Price
Time Value = Premium – Intrinsic Value
Moneyness of Option
• In the money - positive cash flow
Call: market price > exercise price
Put: exercise price > market price
• At the money - zero cash flow
 • Out of the money - negative cash flow
Call: market price < exercise price
Put: exercise price < market price
Option - Types
American option
An option that can be exercised at any time. In India all stock options are trading under
American.
European option
An option that can be exercised only on the expiry date
Vanilla options are the simplest and most basic options without exotic characteristics.
Two types of vanilla options: call options and put options
They are widely used by investors and traders to hedge against or speculate on the future
price movements of underlying assets such as stocks, bonds, currencies, and commodities.
Exotic options
are more complex variations of the simple vanilla options, in terms of expiration dates,
exercise prices, payoffs, and underlying assets.
Exotic options usually trade in the over-the-counter(OTC) market.
 Commodity options
 Futures Options
 Stock options
 Foreign Currency Options:
 Bond options
 Currency options
 Index Options
 Leaps Options - Long Term Equity Anticipated Securities
 Stock Index options
 Interest Rate Options
 Options on futures
Swaps
A swap is an agreement between two or more parties to exchange stream of cash flows over a
period of time in the future. The parties that agree to the swap are known as counter parties.
The two commonly used swaps are:
i Swaps are over the counter (OTC) contracts that are between businesses or financial
institutions and are customised to satisfy the demands of both parties.
 Swaps are not traded on exchanges like options and futures, and are usually not opted for by
individuals as they involve a high risk of counterparty default.
• Interest rate swaps which entail swapping only the interest related cash flows between
the parties in the same currency, and
• Currency swaps: These entail swapping both principal and interest between the
parties, with the cash flows in one direction being in a different currency than the cash
flows in the opposite direction.
• Credit Default Swap (CDS)
• Commodity Swaps
• Debt-Equity Swaps
Credit Derivatives
Credit derivatives (CDs) are a type of derivatives instrument that allows the transfer of credit
risk from a lender to a third party against payment of a premium.
Types of Credit Derivatives
Credit default swaps
Collateralized Debt Obligations (CDO)
Total Return Swaps
Credit- linked notes
Distinction between Futures and Options

Particulars Futures Options

Options contracts are standardised agreements that

Futures contracts are agreements to let investors trade an underlying asset at a
transact in an underlying asset at a specified price before a particular date (the
specified price at a later date. Both the options' expiration date). There are two different
Meaning buyer and the seller are required to finish types of options: call and put. While the buyer of a
the deal on that day. Investors can buy and put option has the right to sell the security, the
sell futures on an exchange. Futures are buyer of a call option has the right (but not the
typical contracts. obligation) to acquire the underlying asset at a
fixed price prior to the option's expiration date.

Although it lessens the likelihood of suffering a

Gain or It might experience countless gains and
possible loss, it might still bring you endless profit
Loss losses.
and loss.
Particulars Futures Options

Risk They are exposed to greater risks. The limited risk applies to them.

The buyer is required to purchase the item In this, neither the buyer nor the contract's
Obligation
on the specified future date. execution are required.

In an options contract, the buyer is expected to pay

a premium. The premium payment gives the
There is no entry fee when entering a
option buyer the choice to decide not to acquire
Payment in futures contract. However, the buyer is
the asset at a later time if it starts to lose its appeal.
Advance eventually obligated to pay the agreed-
It should be noted that the premium paid is the
upon price for the item.
amount the options contract holder is intended to
lose if he decides not to purchase the asset.

The buyer of an option may exercise it at any time

Execution A futures contract is put into effect on the
before the expiration date. As a result, a person is
of a predetermined date. The buyer purchases
willing to purchase the asset anytime the
Contract the underlying asset on this specific day.
circumstances look favourable.

Difference between Forward and Future Contracts

Characteristics Forward Contract Future Contract

A future contract is a
Form A forward contract is a tailor-made contract.
standardized contract.

Settlement Done on the maturity date. Done on a daily basis

The chances of default are comparatively higher There is no such

Default than the futures contract as the forward contract is a probability in a future
private agreement. contract.

Risk The risk is high. The risk is low.

Characteristics Forward Contract Future Contract

The initial margin is

Collateral It is not required.
required.

Size of the The size of the contract

The size depends on the contract terms.
contract is fixed.

It is done over the counter, and there is no Traded on the organized

Trades
secondary market. stock exchange.

Liquidity It is low. It is high.

Regulated by the stock

Regulation It is self-regulated.
exchange.

Maturity As per the terms in the contract. On the Prescribed date.

Functions of Derivative Markets

Derivatives were invented to fulfill the need of hedging against the price risk. It enables transfer
of risk from those wanting to avoid it to those who are willing to assume it. Besides hedging,
derivatives perform many other important functions

Enable Price Discovery

Derivatives and derivative market increase the competitiveness of the market as it encourages a
greater number of participants with varying objectives of hedging, speculation, and arbitraging.
Active participation by large number of buyers and sellers ensures fair price. The derivative
markets, therefore, facilitate price discovery of assets due to increased participants, increased

Provide leveraging

Taking position in derivatives involves only fractional outlay of capital when compared with the
position in the underlying asset in the spot market. Derivatives, as products, and their markets
provide such exit route by letting him first enter into a contract and then permitting him to
neutralize position by booking an opposite contract at a later date. This magnifies the profit
manifolds with the same resource base. This also helps build volumes of trace, further helping the
price discovery process.

Facilitate Transfer of Risk

Hedgers amongst themselves could eliminate risk if two parties face risk from opposite movement
of price. When speculators enter the market, they discharge an important function and help
transfer of risk from those wanting to eliminate to those wanting to assume risk.
Other Benefits.

Efficient portfolio management. The function of leveraging and risk transfer helps in

Better diversification - fund allocation to derivatives assets.

Better risk return trade off - Derivatives provide a much wider menu to portfolio managers

The transaction costs are likely to be lower with derivative markets

Efficient allocation of resources

Faster and efficient dissemination of information also help in removing price disparities across
geographies.

Derivatives can be extremely useful in smoothening out the seasonal variations in the prices of the
underlying assets.

Derivatives can help curb hoarding by continuous trading and increasing participation