Ntroduction to Derivatives

7/30/2019 Ntroduction to Derivatives

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Derivatives in general refer to contracts that derive fromanother - whose value depends on another contract orasset. Derivatives are essentially devised as a hedgingdevice to insulate a business from risks over which a

business has no or little control, but in practice, they arealso used as yield-kickers.

Where there are risks, there are derivatives to strip therisk and transfer it. As derivatives are essentially devicesof transferring risks, their types and applications differ

based on the type of risk facing a business. Take, forinstance, the following sources of risk and the derivativesto protect a business against such risks:


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Interest rate risk:

Banks and financial institutions face the risk of changes in interest rates. If a

bank has liabilities carrying floating costs and assets having fixed rates, it faces

the risk of an adverse movement, that is, a decline in interest rates. This risk

can be sheltered by writing an interest rate swap - that is, swapping the floating

rate for fixed rates. Associated with interest rate movements is the basis risk, that is risk of

unpredicted changes in the basis on which interest rates float. Let us say, a

business has loans which are floating with reference to the LIBOR or

EURIBOR, whereas the assets of the business are floating with reference to US

treasuries. To cushion against this risk, the business may like to swap the basis

by entering into a basis swap.

Foreign exchange risk:

If a business has assets or liabilities denominated in foreign currency, there is a

risk of adverse changes in exchange rates. This risk is sheltered by foreign

exchange futures or forward covers.


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Commodity risks: A business having any position on commodities faces risk of changes in

commodity prices. Such risks are also sheltered by futures and forwards incommodities.

Risk on capital market instruments:

If someone holds equity shares, there is a risk that prices of equity shareswill move up or down. To manage this risk, there are various futures andoptions available.

Credit risk: Yet another risk in all financial transactions is credit risk. Credit derivatives

are used to hedge against credit risk.

Weather risk: Even something like risk of changes in weather is hedged and transferred.

There is a variety of weather derivatives, that is, instruments that pay offbased on weather changes.


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A derivative is a financial instrument that derives its value from an

underlying asset. This underlying asset can be stocks, bonds,currency, commodities, metals and even intangible, pseudo assetslike stock indices.

Derivatives can be of different types like futures, options, swaps,caps, floor, collars etc.

The most popular derivative instruments are futures and options. There are newer derivatives that are becoming popular like weather

derivatives and natural calamity derivatives. These are used as ahedge against any untoward happenings because of natural causes.

derives its value from an asset:

What the phrase means is that the derivative on its own does nothave any value. It is considered important because of the importance of the

underlying. When we say an Infosys future or an Infosys option,these carry a value only because of the value of Infosys.


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.Derivatives

ComplexBasic

CommoditiesFinancials

Forwards

Futures Options

Warrants&

Convertibles

SwapsExotic(Non-

standard)


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Financial derivatives are instruments thatderive their value from financial assets.

These assets can be stocks, bonds, currencyetc.

These derivatives can be forward rateagreements, futures, options swaps etc. Asstated earlier, the most traded instruments

are futures and options.


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Derivatives will find use for the following set of people:

1. Speculators: An investor who is willing to take a risk bytaking futures position with the expectation to make

profits.

Usually trade in futures market to earn profit on the basisof difference in spot and future prices of the underlyingasset

Can be classified in 3 categories: fundamental analyst,

technical analyst, & local speculator For example, if you will the stock price of Reliance is

expected to go up to Rs.400 in 1 month, one can buy a 1month future of Reliance at Rs 350 and make profits


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2. Hedgers: People who buy or sell to minimize theirlosses.

Use the futures markets for avoiding exposure toadverse movements in the price of the asset.

Hedging strategy can be undertaken in all marketslike futures, forwards, options, swap, etc with adifferent modus operandi.

For example, an importer has to pay US $ to buy

goods and rupee is expected to fall to Rs 50 /$ fromRs 48/$, then the importer can minimize his losses by

buying a currency future at Rs 49/$


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3.Arbitrageurs: People who buy or sell to makemoney on price differentials in different markets.

Tries to earn riskless profits from discrepanciesbetween futures and spot prices and among different

future prices Arbitrage trading helps to make market liquid, ensue

accurate pricing and enhance price stability.

It involves making profits from relative mis-pricing

For example, a futures price is simply the currentprice plus the interest cost. If there is any change inthe interest, it presents an arbitrage opportunity.


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By Speculator

Perception

Short Call

BearishBullish

Long Call Long PutShort Put


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By Hedger: If in Cash Market, Long Security

That means, bearish in derivatives market i.e.Long Put And Short Call

If in Cash Market, Short Security

That means bullish in derivatives market i.e.Long Call And Short Put


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Derivatives have been a recent development in the Indian financial markets. Butthere have been derivatives in the commodities market.

There is Cotton and Oilseed futures in Mumbai, Soya futures in Bhopal, Pepper

futures in Cochin, Coffee futures in Bangalore etc.

But the players in these markets are restricted to big farmers and industries, who

need these as an input to protect themselves from the vagaries of agriculture sector. Globally too, the first derivatives started with the commodities, way back in 1894.

Financial derivatives are a relatively late development, coming into existence only

in the 1970s. The first exchange where derivatives were traded is the Chicago

Board of Trade (CBOT).

In India, the first derivatives were introduced by National Stock Exchange (NSE) in

June 2000. The first derivatives were index futures. The index used was Nifty.

Option trading was started in June 2001, for index as well as stocks. In November

2001, futures on stocks were allowed.

Currently, there are 30 stocks on which derivative trading is allowed.


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Insurance is nothing but transfer of risk. An insurance company sells you risk

cover and buys your risk and you sell your risk and buy a risk cover. The riskinvolved in life insurance is the death of the policyholder.

The insurance companies bet on your surviving and hence agree to sell a riskcover for some premium.

There is a transfer of risk here for a financial cost, i.e. the premium.

In this sense, a derivative instrument can be compared to insurance, as there isa transfer of risk at a financial cost.

Derivatives also work well on the concept of mutual insurance. In mutual insurance, two people having opposite risks can enter into a contract

and reduce their risk.

The most classic example is that of an importer and exporter. An importer buysgoods from country A and has to pay in dollars in 3 months. An exporter sells

goods to country A and has to receive payment in dollars in 3 months. In caseof an importer, the risk is of exchange rate moving up. In case of an exporter,the risk is of exchange rate moving down. They can cover each others risk byentering into a forward rate after 3 months.


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Futures

Forwards

Options Swap


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The following are the basic types of derivatives:

Forwards: A forward is a contract to buy a thing or security at a prefixed future date.

The typical usage of a forward would be something like this: a business having itsassets in a local currency has taken a loan repayable in a foreign currency 6 monthshence. There is an exchange rate risk here: if the local currency suffers against theforeign currency, the business has to write a loss. To cover against this risk, thebusiness enters into a forward contract - that is, it agrees today to buy the foreign

currency 6 months hence at prices prevailing today, against a pre-fixed premium.Obviously, if the perceptions of the seller and the buyer as to future prices of theforeign currency differ, both will strike what they perceive is a win-win deal.

Forwards are also quite common in commodities, and can be used either forspeculation or for hedging. Say, XYZ has an order to ship 10000 tons of steel 6months hence at a prefixed price of say USD 1000 per ton. And XYZ expects theprice of steel to go up. So, to hedge against the price risk, XYZ enters into a

forward purchase agreement, for 10000 tons 6 months hence. XYZ's position isnow fully hedged: if the price of steel goes up as expected, XYZ will either claim adelivery from the forward seller, or a net settlement. If the price comes down, XYZwill be obliged to settle by making a payment for the price difference to theforward seller, but will be fully offset by the pre-fixed price it gets from its ownforward sale contract.


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A forward rate agreement is one in which a buyerand a seller enter into a contract at a specifiedquantity of an asset at a specified price on aspecified date.

An example for this is the exporters getting into

forward rate agreements on currencies withbanks. But there is always a risk of one of the parties

defaulting. The buyer may not pay up or theseller may not be able to deliver.

There may not be any redressal for theaggrieved party as this is a negotiated contractbetween two parties.


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A future is similar to a forward rate agreement,except that it is not a negotiated contracted but astandard instrument.

A future is a contract to buy or sell an asset at aspecified future date at a specified price.

These contracts are traded on the stockexchanges and it can change many hands beforefinal settlement is made.

The advantage of a future is that it eliminatescounterparty risk. Since there is an exchangeinvolved in between, and the exchangeguarantees each trade, the buyer or seller doesnot get affected with the opposite partydefaulting.


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There are two kinds of futures traded in themarket- index futures and stock futures.

There are three types of futures, based on thetenure. They are 1, 2 or 3 month future. Theyare also known as near and far futuresdepending on the tenure.


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Futures Forwards

Futures are traded on astock Exchange Futures are contracts

having standard terms andconditions

No default risk as the

exchange provides acounter guarantee Exit route is provided

because of high liquidity onthe stock exchange

Highly regulated withstrong margining andsurveillance systems

Forwards are nontradable, negotiatedinstruments

Forwards are contractscustomized by the buyerand seller

High risk of default byeither party No exit route for these

contracts No such systems are

present in a forward

market.


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Spot Price: The current market price of thescrip/index

Future Price: The price at which the futurescontract trades in the futures

market Tenure: The period for which the future is

traded Expiry date: The date on which the futures

contract will be settled Basis : The difference between the spot price

and the future price


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As seen earlier, futures are derivative instruments whereone can take a position for an asset to be delivered at afuture date. But there is also an obligation as the seller hasto make delivery and buyer has to take delivery.

Options are one better than futures. In option, as thename indicates, gives one party the option to take or makedelivery. But this option is given to only one party in thetransaction while the other party has an obligation to takeor make delivery.

The asset can be a stock, bond, index, currency or acommodity

But since the other party has an obligation and a riskassociated with making good the obligation, he receives apayment for that. This payment is called as premium


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The party that had the option or the right to buy/sell enjoys low risk. The cost ofthis low risk is the premium amount that is paid to the other party.

Thus option is a derivative that gives one party a right and the other party anobligation to buy /sell at a specified price for a specified quantity.

The buyer of the right is called the option holder.

The seller of the right (and buyer of the obligation) is called the option writer.

The cost of this transaction is the premium. For example, a railway ticket is an option in daily life. Using the ticket, a passenger

has an option to travel. In case he decides not to travel, he can cancel the ticket andget a refund. But he has to pay a cancellation fee, which is analogous to thepremium paid in an option contract. The railways, on the other hand, have anobligation to carry the passenger if he decides to travel and refund his money if hedecides not to travel. In case the passenger decides to travel, the railways get theticket fare. In case he does not, they get the cancellation fee. The passenger on theother hand, by booking a ticket, has hedged his position in case he has to travel asanticipated. In case the travel does not materialize, he can get out of the position bycanceling the ticket at a cost, which is the cancellation fee.


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Call option Put option


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The money made in an option is called as the option pay off. There can be twopay off for options, for put and call option

Call option:

A call option gives the holder a right to buy shares.

The option holder will make money if the spot price is higher than the strikeprice.

The pay off assumes that the option holder will buy at the strike price and sellimmediately at the spot price. But if the spot price is lower than the strike, theoption holder can simply ignore the option.

It will be cheaper to buy from the market. The option holder loss is to theextent of premium he has paid. But if the spot price increases dramatically thenhe can make wind fall profits.

Thus the profits for an option holder in a call option is unlimited while lossesare capped to the extent of the premium.

Conversely, for the writer, the maximum profit he can make is the premiumamount. But the losses he can make are unlimited.


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Put option

The put option gives the right to sell. The option holder will make money if the spot price islower than the strike price.

The pay off assumes that the option holder will buy at spot price and sell at the strike price

But if the spot price is higher than the strike, the option holder can simply ignore the option.It will be beneficial to sell to the market. The option holder loss is to the extent of premiumhe has paid. But if the spot prices falls dramatically then he can make wind fall profits.

Thus the profits for an option holder in a put option is unlimited while losses are capped to

the extent of the premium. This is a theoretical fallacy as the maximum fall a stock can have is till zero, and hence the

profit of a option holder in a put option is capped.

Conversely, the maximum profit that an option writer can make in this case is the premiumamount.

But in the above pay off, we had ignored certain costs like premium and brokerage. These arealso important, especially the premium.

So, in a call option for the option holder to make money, the spot price has to be more thanthe strike price plus the premium amount.

If the spot is more than the strike price but less than the sum of strike price and premium, theoption holder can minimize losses but cannot make profits by exercising the option.

Similarly, for a put option, the option holder makes money if spot is less than the strike priceless the premium amount.

If the spot is less than the strike price but more than the strike price less premium, the optionholder can minimize losses but cannot make profits by exercising the option.


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If the spot is more than the strike price but lessthan the sum of strike price and premium, theoption holder can minimize losses but cannotmake profits by exercising the option.

Similarly, for a put option, the option holdermakes money if spot is less than the strike priceless the premium amount.

If the spot is less than the strike price but more

than the strike price less premium, the optionholder can minimize losses but cannot makeprofits by exercising the option.


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These are universal terminologies and mean the same everywhere.a. Option holder : The buyer of the option who gets the rightb. Option writer : The seller of the option who carries the obligationc. Premium: The consideration paid by the buyer for the rightd. Exercise price: The price at which the option holder has the right to buy or

sell. It is also called as the strike price.

e. Call option: The option that gives the holder a right to buyf. Put option : The option that gives the holder a right to sellg. Tenure: The period for which the option is issuedh. Expiration date: The date on which the option is to be settledi. American option: These are options that can be exercised at any point till the

expiration datej. European option: These are options that can be exercised only on the

expiration datek. Covered option: An option that an option writer sells when he has the

underlying shares with him.


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l.Naked option: An option that an option writersells when he does not have the underlyingshares with him

m.In the money: An option is in the money if theoption holder is making a profit if the option wasexercised immediately

n. Out of money: An option is in the money if theoption holder is making a loss if the option wasexercised immediately

o. At the money: An option is in the money if theoption holder evens out if the option wasexercised immediately


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Swaps are arrangements between twocounterparts to exchange cash flows overtime two basic types areinterest-rate swapscurrency swaps.


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In a swap, both the parties exchangerecurring payments with the idea ofexchanging one stream of payments foranother.

A typical usage is a swap of fixed interestrates with floating rates, or rates floating withreference to one basis to another basis.

In credit derivatives market, there are swaps

based on the total return from a particularcredit asset against total return on areference asset.


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Currency swaps are swaps of obligations to paycash flows in one currency for obligations to payin another currency Uses:

1. To convert a loan in one currency into a loan inanother currency

2. To convert an investment in one currency intoan investment in another currency

3. To take the advantage of lower interest rate on a

loan4. To take the advantage of higher interest rate on

an investment


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A swap in which one party agrees to pay tothe another party cash flow a equal tointerest at a floating rate on a notionalprincipal for the number of years . To the

same time another party agrees to pay to thefirst party cash flows equal to interest at afixed rate of interest on the same notionalprinciple for the same period of time.


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Caps, floors and collars are essentially options designed to shift the riskof an upward and/or downward movement in variables such as interestrates. These are normally linked to a notional amount and a referencerate.

For example, if some one wants to transfer the risk of interest ratesgoing up, one will enter into a cap on a notional amount of say, USD 100million, with the interest rate of 5.5%. Now if the interest rate increasesto 6%, the cap holder will be able to claim a settlement from the cap

seller, for the differential rate of 0.5% on the notional amount. If theinterest does not go up, or rather declines, the option holder would havepaid the premium, and there is no settlement.

On the other hand, if some one expects the interest rate to go downwhich spells a risk to him, he would enter into a floor, which would allowhim to claim a settlement if the interest rate falls below a particularstrike rate.

Interest rate collar is the fixation of both a cap and floor, so that thepayment will be triggered if the rate goes above the collar and below thefloor.


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A swaption is an option on a swap. Theoption provides the holder with the right toenter into a swap at a specified future date atspecified terms. This derivative has

characteristics of an option and a swap.


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A return from a contract or investment is said to be symmetricwhen it can either give a profit or incur a loss. Returns from forwards and futures are symmetrical: if you enter

into a forward at a particular price, the price might either go upor come down, and so, you might either make a profit or a loss.

However, options have an asymmetric return profile: an option isan option with one party. The option will be exercised only whenthe purchaser of the option is in-the-money. Therefore, the onlyloss in an option is the cost of writing and carrying the option.Hence, options have an asymmetric return profile.

On the other hand, the option-seller only makes returns by wayof fees or premium for selling the option, against which he takesthe risk of being out-of-money. If the option is not exercised, hemakes his fees, but if the option is exercised, he might losesubstantially.


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The system allows the trading members toenter orders with various conditions attachedto them as per their requirements

These conditions are broadly divided in to

following categories-

Time conditions

Price conditions

other conditions .


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Day Order Good Till cancelled(GTC)

Good Till Days/Date(GTD)

Immediate or cancelled(IOC)


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Stop Loss


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Market Price Trigger Price

Limit Price

Pro

CLI

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