Dhaval Sanghavi (MMS)

Pratik Mistry (PG FS)

Forwards

Futures

Options

Swaps

Forwards

Futures

Options

Swaps

What are Derivatives ?

• Equities (most common in Indian markets)

• Commodities (the oldest form of derivatives)

• Currencies (forex rates)

• Interest rates

• Debt instruments (bonds, T – Bills)

• Traded on stock/derivative exchange

• Derivative Exchange/Segment - Self-Regulatory Organization (SRO)

• SEBI - oversight regulator.

• Clearing & settlement is done through a Clearing House

• Entities to trading system

Trading memberClearing member Trading member – Clearing memberSelf clearing member

Participants

Hedgers Hedgers Speculators

Speculators

Arbitrageurs Arbitrageurs

TYPES

FORWARDS FUTURES

OPTIONS SWAPS

A Forward contract is an agreement to buy or sell an asset on a specified date for a specific price.

Forwards

At start

Rs 10,40,000Omkar

Buy

Ashika(Initial price-10,00,000) Sell

Buy

Sell

Omkar Ashika(Market valuation-11,00,000)

Rs 10,40,000

At end of 1 year

Bank deposit @ 4%

How prices are agreed upon

Omkar

Buy

Rs 10,40,000

Sell

Ashika

Rs.10,00,000

•A future contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price.

•They are standard and highly liquid.

Futures

ExampleRahul purchases following two lots of Nifty Futures Contracts on 4th Sept. 2000:

Initial Margin is 6%, Amount of Margin -Rs 16,050 (50 Units per Contract on the NSE).

October 2000 Series 1 Contract @ Rs. 2,500

November 2000 Series 1 Contract @ Rs. 2,850

Futures payoff

Futures Terminology

• Spot Price (S)

• Futures price (F)

• Contract cycle

• Basis

• Futures Payoff

• Cost of carry

• Contract Size

• Open Interest• Normal

Backwardation

• Contango

• Initial margin

• Mark to Market (MTM) marginExample Romit buys Nifty futures at 1300 Day Closing MTM a/cOne 1310 +10Two 1305 -05Three 1315 +10Total +15 

• Maintenance Margin 

i. Futures price spot price during the delivery Period:

•Sell a futures contract•Buy the asset•Make delivery

ii. Futures price spot price during the delivery period : Companies will acquire the asset.

Convergence of Future price to spot price

Delivery period – Future price = Spot price

June 300 (spot price)

September 350 (future price)

SeptemberSpot price < 350

Later SeptemberFuture price

Now

Future price and Expected Future spot Price

SeptemberSpot price > 350

SeptemberFuture price

OR

Commodity-Corn

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

American option

Exercise before maturity

European option

Exercise only on maturity

Options

Options Terminology

• Index options

• Stock Options

• Option buyer

• Option seller

• Option premium

• Strike Price

• Expiration Date

• Open Interest

• A call option is a contract giving the buyer the right, but not the obligation, to buy an underlying (a stock or index) at a specific price on or before a certain date.

Call Options

Eg:Spot price: Rs 1000Strike price = Rs 975Option premium= Rs 50Maturity: 3 months

Case I : Spot price < Strike price (Rs 950) (Rs 975)

Case II : Spot price > Strike price (Rs 1025) (Rs 975)

CALL OPTION

CALL OPTION

Spot price 950 975 990 1050

Exercised No No Yes Yes

Buyer -50 -50 -35 25

Writer 50 50 35 -25

Call option pay-off

BEP0-50

50

1025975

BEP= Strike price + Premium

• A put option is a contract giving the buyer the right, but not the obligation, to sell an underlying (a stock or index) at a specific price on or before a certain date.

Put Options

Eg:Spot price: Rs 1000Strike price = Rs 975Option premium= Rs 50Maturity: 3 months

Case I : Spot price < Strike price (Rs 950) (Rs 975)

Case II : Spot price > Strike price (Rs 1025) (Rs 975)

PUT OPTION

PUT OPTION

Spot price 950 900 1000 1050

Exercised Yes Yes No No

Buyer -25 +25 -50 -50

Writer +25 -25 +50 +50

Put option pay-off

BEP

0-50

50

925 975

BEP= Strike price - Premium

Moneyness of an option

Call Option

S>X In the MoneyS=X At the moneyS<X Out of the Money

Put Option

S>X Out of the moneyS=X At the moneyS<X In the money

Pricing of options

Call option

Put option

INTRINSIC VALUE TIME VALUE

= 1000-950= Rs.50

= 950 – 1000= Rs.0

Case I - current stock price = Rs 1000Strike price = Rs 950

option premium = Rs 110

Call option : 110 – 50 = Rs 60

Put option : 110 – 0 = Rs 110

• Swaps are agreements between two parties to exchange assets or sets of financial obligations or a series of cash flows for a specified period of time at predetermined intervals.

• They are customized transactions

• They are not traded on organized secondary market

•Swaps are largely unregulated

Swaps

Types of Swap

•Fixed for Fixed currency Swap

•Interest rate Swap

•Equity Swap

Fixed for Fixed Currency Swap

•BB can borrow in USA @ 9% and in Australia @ 8%

•AA can borrow in Australia @ 7% and in USA @ 10%

•BB & AA wants to do business in each others country

•AA needs USD 1 million & BB needs AUD 2 million

•Both parties will buy fund in local currency.

•USA rate : 9%•Australia rate: 7%•Swap period: 5 yrs

Fixed for Fixed Currency Swap

•AA borrows AUD 2 million from Australian bank @ 7% (AUD 1,40,000)

•BB borrows USD 1 million from USA bank @ 9% (USD 90,000)

AA & BB Swap their currency

•AA gets USD 1 million , agreeing to pay BB @ 10%

•BB gets AUD 2 million, agreeing to pay AA @ 8%

•Now AA owes BB 1,00,000 & BB owes AA 1,60,000

•USA rate : 9%•Australia rate: 7%•Swap period: 5 yrs

Fixed for Fixed Currency Swap

•AA pays Australian bank 1,40,000 @ 7% and gets 1,60,000 from BB to whom he lend it @ 8% (Gain of 20,000)

•BB pays USA bank 90,000 @ 9% and gets 1,00,000 from AA to whom he lend it @ 10% (Gain of 10,000)

•After 5 yrs they will reverse the Swap

•USA rate : 9%•Australia rate: 7%•Swap period: 5 yrs