Derivatives Derivative is a financial contract of pre-determined duration, whose value is derived from the value of an underlying asset. It includes.

DerivativesDerivatives

Derivative is a financial contract of Derivative is a financial contract of pre-determined duration, whose pre-determined duration, whose value is derived from the value of an value is derived from the value of an underlying asset.underlying asset. It includes Securities, commodities,bullion, It includes Securities, commodities,bullion,

currency, stock, index (interest rates,currency, stock, index (interest rates,

exchange rates, etc.)exchange rates, etc.)

What do derivatives do?What do derivatives do?

DerivativesDerivatives attempt either to attempt either to minimize minimize the lossthe loss arising from adverse price arising from adverse price movements of the underlying assetmovements of the underlying asset

Or Or maximize the profitsmaximize the profits arising out of arising out of favorable price fluctuation. favorable price fluctuation.

The name derivative signifies that the The name derivative signifies that the value is derived from an underlying value is derived from an underlying asset.asset.

Types of DerivativesTypes of Derivatives

Based on the Based on the underlying assetsunderlying assets derivatives are classified into.derivatives are classified into.Financial DerivativesFinancial DerivativesCommodity DerivativesCommodity DerivativesIndex DerivativeIndex Derivative (example:BSE sensex) (example:BSE sensex)

How are derivatives used?How are derivatives used?

Derivatives are Derivatives are risk shiftingrisk shifting instruments. instruments. Hedging is the most important aspect of Hedging is the most important aspect of derivatives.derivatives.Derivatives can be compared to an Derivatives can be compared to an insurance policy. insurance policy.

What is a What is a HedgeHedgeTo Be cautious or to protect against loss.To Be cautious or to protect against loss.

In finance, hedging is the act of reducing In finance, hedging is the act of reducing uncertainty about future price uncertainty about future price movements in financial security, a movements in financial security, a commodity or foreign currencycommodity or foreign currency . .

Thus a hedge is a way of insuring an Thus a hedge is a way of insuring an investment against risk. investment against risk.

Derivative Instruments.Derivative Instruments.Forward contractsForward contracts

FuturesFutures– CommodityCommodity– Financial (Stock index, interest rate & Financial (Stock index, interest rate &

currency )currency )

OptionsOptions– PutPut– CallCall

Swaps.Swaps. – Interest RateInterest Rate– CurrencyCurrency

Forward Contracts.Forward Contracts.It is a bipartite contract, which is to be It is a bipartite contract, which is to be performed in future at the terms decided today.performed in future at the terms decided today.

Example: Jay and Viru enter into a contract to Example: Jay and Viru enter into a contract to trade in 100 stocks of Infosys after 3 months trade in 100 stocks of Infosys after 3 months from today (the date of the contract) @ a price from today (the date of the contract) @ a price of Rs2800/-of Rs2800/-

Note: Here Product ,Price ,Quantity & Time Note: Here Product ,Price ,Quantity & Time have been decided in advance by both the have been decided in advance by both the parties.parties.

Delivery and payments will take place as per Delivery and payments will take place as per the terms of this contract on the designated the terms of this contract on the designated date and place. date and place.

Futures.Futures.These are standardized contracts. That is These are standardized contracts. That is quantity, quality, delivery time and place for quantity, quality, delivery time and place for settlement in future are pre-definedon any settlement in future are pre-definedon any date. date.

These contracts are traded on exchangesThese contracts are traded on exchanges..Future markets are very liquid Future markets are very liquid In these markets, clearing corporation or, the In these markets, clearing corporation or, the clearing house becomes the counter-party to all clearing house becomes the counter-party to all the trades. It provides the unconditional the trades. It provides the unconditional guarantee for the settlement of trades In other guarantee for the settlement of trades In other words, the credit risk of the transactions is words, the credit risk of the transactions is eliminated by the exchange through the eliminated by the exchange through the clearing corporation/house.clearing corporation/house.

Long and Short Positions in a Long and Short Positions in a futures contractfutures contract

LongLong - this is when a person buys a - this is when a person buys a futures contract, and agrees to futures contract, and agrees to receive delivery at a future date. Eg: receive delivery at a future date. Eg: Viru’s position Viru’s position

ShortShort - this is when a person sells a - this is when a person sells a futures contract, and agrees to make futures contract, and agrees to make delivery. Eg: Jay’s Positiondelivery. Eg: Jay’s Position

OptionsOptions

An option is An option is a contract giving the buyer the a contract giving the buyer the right, but not the obligation, to buy or sell right, but not the obligation, to buy or sell an underlying asset at a specific price on an underlying asset at a specific price on or before a certain dateor before a certain date..

An option is a security, just like a stock or bond, An option is a security, just like a stock or bond, and is a binding contract with strictly defined and is a binding contract with strictly defined terms and propertiesterms and properties. .

Strike Price or Exercise PriceStrike Price or Exercise Price

Price of an option is the specified/ pre-Price of an option is the specified/ pre-determined price of the underlying asset at determined price of the underlying asset at which the same can be bought or sold if the which the same can be bought or sold if the option buyer exercises his right to buy/ sell on option buyer exercises his right to buy/ sell on or before the expiration day.or before the expiration day.

Expiration dateExpiration date:: The date on which the The date on which the option expires is known as Expiration Dateoption expires is known as Expiration Date

Exercise:Exercise: An action by an option holder taking An action by an option holder taking advantage of a favourable market situationadvantage of a favourable market situation trade in the option for stock.trade in the option for stock.

Exercise Date:Exercise Date: is the date on which the option is the date on which the option is actually exercisedis actually exercised

AMERICAN & EUROPEAN OPTIONSAMERICAN & EUROPEAN OPTIONS

European style of options:European style of options: option which option which can be exercised by the buyer on the expiration can be exercised by the buyer on the expiration day only & not anytime before that.day only & not anytime before that.

American style of options:American style of options: option which option which can be exercised by the buyer on or before the can be exercised by the buyer on or before the expiration date, i.e. anytime between the day of expiration date, i.e. anytime between the day of purchase of the option and the day of its expirypurchase of the option and the day of its expiry.. Asian style of optionsAsian style of options: : these are in-between these are in-between European and American. An Asian option's payoff European and American. An Asian option's payoff depends on the average price of the underlying asset depends on the average price of the underlying asset over a certain period of time.over a certain period of time.

Call optionCall option: An option contract giving the : An option contract giving the owner the owner the right to buyright to buy a specified amount of a specified amount of an underlying security at a specified price an underlying security at a specified price within a specified time.within a specified time.

Put OptionPut Option: An option contract giving the : An option contract giving the owner the right to sell a specified amount of an owner the right to sell a specified amount of an underlying security at a specified price within a underlying security at a specified price within a specified timespecified time

In-the-money:In-the-money:

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

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

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

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

SwapsSwapsSwap is an agreement between two Swap is an agreement between two parties to exchange one set of cash parties to exchange one set of cash flows for another. In essence it is a flows for another. In essence it is a portfolio of forward contracts. portfolio of forward contracts. While a forward contract involves While a forward contract involves one exchange at a specific future one exchange at a specific future date, a swap contract entitles date, a swap contract entitles multiple exchanges over a period of multiple exchanges over a period of time. The most popular are time. The most popular are interest interest rate swaps and currency swaps.rate swaps and currency swaps.

Interest Rate SwapInterest Rate Swap

A B

Fixed Rate of 12%

LIBOR

‘A’ is the fixed rate receiver and variable rate payer.

‘B’ is the variable rate receiver and fixed rate payer.

Rs50,00,00,000.00 – Notional Principle

Counter Party

Counter Party