derivatives ppt
TRANSCRIPT
Derivatives
A presentation by Vishal TrehanRoll No. 880506CBM DepartmentGuru Nanak Dev University
Derivatives
Derivative is a product whose value is derived from the value of one or more basic variables, called underlying assets. Those assets can be
These underlying assets are of various categories
like
Stocks(Equity)Agri Commodities including grains,
coffee beans, etc.Precious metals like gold and silver.Foreign exchange rate BondsShort-term debt securities such as T-
bills
Exchange Traded vs OTC Derivatives Market
• As the word suggests, derivatives that trade on an exchange are called exchange traded derivatives, where as privately negotiated derivative contracts are called OTC contracts.
• The former have rigid structures compared to the latter.
OTC derivatives markets have the following features compared to exchange traded derivatives :
1. The management of counter-party risk is decentralized and located within individual institutions.
2. There are no formal centralized limits on individual positions, leverage, or margining
3. There are no formal rules for risk and burden sharing,
4. There are no formal rules or mechanisms for ensuring market stability and integrity, and for safeguarding the collective interests of market participants, and
5. The OTC contracts are generally not regulated by a regulatory authority and the exchange’s self –regulatory organisation, although they are affected indirectly by national legal systems, banking supervision and market surveillance.
Features of Exchage Traded Derivatives
Centralization of Trading
No counter party risk
Standardization of contracts
Liquidity
Mark to Market (MTM) margining system
Squared off in cash on expiration.
Three series trade at any point in time.
Contract expires on last Thursday of the
month.
The National Stock Exchange of India Limited (NSE) commenced trading in derivatives with the launch of index futures on June 12, 2000. The futures contracts are based on the popular benchmark S&P CNX Nifty Index.
The Exchange introduced trading in Index Options (also based on Nifty) on June 4, 2001. NSE also became the first exchange to launch trading in options on individual securities from July 2, 2001. Futures on individual securities were introduced on November 9, 2001. Futures and Options on individual securities are available on 224 securities stipulated by SEBI.
The Exchange provides trading in other indices i.e. CNX-IT, BANK NIFTY, CNX NIFTY JUNIOR, CNX 100 and NIFTY MIDCAP 50 indices. The Exchange is now introducing mini derivative (futures and options) contracts on S&P CNX Nifty index w.e.f. January 1, 2008.
History of Exchange Traded Derivatives
PARTICIPANTS
Speculators - willing to take on risk in pursuit of profit.
Hedgers - transfer risk by taking a position in the Derivatives Market.
Arbitrageurs - aim to make a risk less profit by taking advantage of price differentials and thus bring about an alignment in prices by participating in two markets simultaneously
Derivatives
Futures
Index Futur
es
Stock Futur
es
Options
Call Put
Forwards Swaps
Types of derivatives
Forward Contract“A Forward Contract is an agreement to buy or
sell an asset on a specified date for a specified price.
Salient Features :
1. They are bilateral Contracts and hence exposed to counter party risk.
2. Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality.
3. The contract price is generally not available in public domain
4. On the expiration date, the contract has to be settled by delivery of the asset.
5. If the party wishes to reverse the contract, it has to compulsorily go to the same counter-party, which often results in high prices being charged.
Limitations of Forward MarketsLack of centralisation of trading
• Illiquidity
• Counterparty risk
Futures Contract
Futures markets were designed to solve the problems that exist in forward markets. A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. But unlike forward contracts, the futures contracts are standardized and exchange traded.
Salient Features Obligation to buy or sell Stated quantity
At a specific price Stated date (Expiration Date) Marked to Market on a daily basis
Distinction between futures and forwards
Futures•Trade on an organised stock exchange•Standardized contract terms hence more liquid.•Requires Margin Payments•Follows daily settlement.
Forwards•OTC in nature.•Customised contract terms hence less liquid•No margin payment •Settlement happens at the end of period.
FUTURES TERMINOLOGY
Spot price
Futures price
Contract cycle
Expiry date
Contract size
Initial margin
Marking-to-market
Maintenance margin
To understand all these terms we will use NIFTY.
OPTIONS
“ An Options contract confers the right but not the obligation
to buy (call option) or sell (put option) a specified underlying
instrument or asset at a specified price – the Strike or Exercised
price up until or an specified future date – the Expiry date. ”
The Price is called Premium and is paid by buyer of the
option to the seller or writer of the option.”
Types of option
◦ Call Option
◦ Put option
OPTION TERMINOLOGY
Index options
Stock options
Buyer of an option
Writer of an option
Option price/premium
Expiration date
Strike price
American options
European options
To understand these lets check Nifty and Reliance
Call Option
In-the-Money (ITM)Strike price < Spot price(current
price)At-the-Money (ATM)
Strike price = Spot priceOut-of-the-Money (OTM)
Strike price >Spot price
Put Option
In-the-Money (ITM)Strike price > Spot price
At-the-Money (ATM)Strike price = Spot price
Out-of-the-Money (OTM)Strike price < Spot price
What is payoff ?A payoff is the likely profit/loss
that would accrue to a market participant with
change in the price of the underlying asset.
This is generally depicted in the form of payoff diagrams
which show the price of the underlying asset on theX-axis and the profits/losses on the Y-axis.
FUTURES PAYOFFS
PRICING FUTURES
where:F futures priceS spot index valuer cost of financingq expected dividend yieldT holding period
With expected dividendWithout dividend
Example: Security XYZ Ltd trades in the spot market at Rs. 1150. Money can be invested at 11% p.a. The fair value of a one-month futures contract on XYZ is calculated as follows
Payoff for buyer of futures: Long futures
The figure shows the profits/losses for a long futures position. The investor bought futures when the index was at 2220. If the index goes up, his futures position starts making profit. If the index falls, his futures position starts showing losses.
Payoff for seller of futures: Short futuresThe figure shows the profits/losses for a short futures position. The investor sold futures when the index was at 2220. If the index goes down, his futures position starts making profit. If the index rises, his futures position starts showing losses
OPTIONS PAYOFFS
Payoff profile for buyer of call options: Long callThe figure shows the profits/losses for the buyer of a three-month Nifty 2250 call option. As can be seen, as the spot Nifty rises, the call option is in-the-money. If upon expiration, Nifty closes above the strike of 2250, the buyer would exercise his option and profit to the extent of the difference between the Nifty-close and the strike price. The profits possible on this option are potentially unlimited. However if Nifty falls below the strike of 2250, he lets the option expire. His losses are limited to the extent of the premium he paid for buying the option.
Payoff profile for writer of call options: Short call
Payoff profile for buyer of put options: Long put
Payoff profile for writer of put options: Short put
PRICING OPTIONS
N(d1) is called the delta of the option
Bull spreads - Buy a call and sell anotherThe buyer of a bull spread buys a call with an exercise price
below the current index level and sells a call option with an
exercise price above the current index level.
Payoff for a bull spread created using call options
Bear spreads - sell a call and buy another
In a bear spread, the strike price ofthe option purchased is greater
than the strike price of the option sold.
The buyer of a bear spread buys a call with an exercise price
above the current index level and sells a call option with an
exercise price below the currentindex level.
Straddles
Rs. 4300
Buy Call & Put
When market is volatile
Pay-off of Straddle Strategy
Strike Price
Premium Paid
Buy Nifty Call 4300 98
Buy Nifty Put 4300 22
Nifty Lot Size = 50 Shares On settlement if Nifty touches
• 4500
• 4000
• 4250
Particulars 4500 4000 4250
Payoff of Nifty Call/Put
200 300 50
Total Premium (120) (120) (120)
Net Payoff 80 180 (70)
Lot Size 50 50 50
Profit/Loss(Net Payoff*Lot Size)
4000 9000 (3500)
Stranglers
For April 2007
Buy Call of 4400
Buy Put 4200
When market is volatile
Pay-off of Strangle Strategy
Strike Price Premium Paid
Buy Nifty Call
4400 120
Buy Nifty Put 4200 50
Nifty Lot Size = 50 Shares
On settlement if Nifty touches• 4600• 4000• 4300
Particulars 4600 4000 4300
Payoff Nifty Call/Put 200 200 Nil
Total Premium (170) (170) (170)
Net Payoff 30 30 (170)
Lot Size 50 50 50
Profit/Loss(Net Payoff*Lot Size)
1500 1500 (8500)