DERIVATIVE

Derivative is a financial contract; its value is dependent upon value of some other
item called underlying assets. The underlying assets could be a stock ( for example
futures on Infosys), currencies( Dollar Futures),stock index, Futures on BSE Sensex
, physical commodity ( oil Futures), interest banking instruments ( T- bill futures)
or even weather.

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FRA &
SWAPS
OPTIONS
FUTURES
Forwards
Futures
Options
Swaps
Forward Rate Agreement (FRA)
FRA is a forward contract to buy or sell on a specified future date, at a
predetermined rate

Settlement of FRA
Actual Borrowing/Investment does not take place in FRA. Instead FRA is
considered to be a bet on LIBOR. The one who wins the bets gets an amount
equal to present value of the Rupee difference between Actual LIBOR and FRA
rate.

Pricing and Arbitrage
The pricing of FRA is set in such a way that there is no scope for arbitrage.




FINANCIAL SWAPS
A Financial swap is a portfolio of forward contract. Here cash flows are
exchanged periodically according to a pre-defined formula. In an interest rate
swap one party agrees to pay fixed interest and other party pays floating interest
on notional principal.

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Financial Swaps comes in various flavors





Motives of Financial Swap
a) Swaps designed to reduce the effective cost of preferred funding
b) Swaps to convert the nature of funding
c) Swap based on comparative advantage theory
D) Overnight index swap (OIS)


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Plain Vanilla
swap
This involves swapping fixed versus floating payments based on a notional
principal with netting features.
Currency
Swap
The two legs of theswap are in different currencies and based on initial
exchange rate principal amounts are fixed.howerver periodic interest
payment are without netting.
Equity Swap
One leg has to be return on equity stock or index and other leg
could befixed interest or floating interest, or return on other
equity.
Commodity
Swap
One leg would be the market price of commodity and other
would be a fixed price. The quantity shall be notional and there
is netting feature.
Pricing and valuation of swap
Swap price refers to the rate applicable for the fixed legs of the swap.
The price of the swap is set in such manner that Value of Swap is NIL to begin with.
V
fixed
=V
floating
V
swap=
V
floating -
V
fixed
V
fixed= PV
of the coupon and redemption discounted at market rate
V
floating= on[RESET DATE]=Par Value
Periodic swap price =

Where d=

R= Periodic LIBOR
Valuation of Currency Swap takes place along the same lines as a normal swap. We just have to
convert one leg into another using exchange rate on the date of valuation.
Overnight Index Swap is a fixed floating swap where the floating leg is based on MIBOR
compounded daily.


FUTURES
Future are derivative instruments which involve a Standardized Contract to
Buy/Sell a certain amount of the underlying asset at an agreed upon price called
future price.

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Below are the things standardized is future contract-:


Margin Maintenance
Long Position : If a person buys or holds an asset , he is said to be in a Long Position . When trading in
long position contract should be bought , upside betting
Short Position : If a person sells an asset , he is said to be in a Short Position. When trading in short
position contract should be sold , downside betting.
Going Long/Short in futures implies contracting to buy/sell. If there is an adverse price movement there
is a possibility of default on the part of the trader. To mitigate the same , the clearing house requires
every futures trader to make a security deposit called Initial margin.
This margin balance may fluctuate due to the marketing to market feature. There is a minimum margin
requirement called maintenance margin. If the margin balance on a particular day goes below the
maintenance margin , the customer has to bring in an amount called variation margin to achieve the
initial margin , also any amount over and above the initial margin is allowed to be withdrawn.
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life.
Underlying
Lot size
Quality Expiry date
Tick size

Note
The minimum movement in future price is called ONE TICK , thus if the quotation is in four decimal
places , one tick = 0.0001.


OPEN INTEREST
Open interest denotes number of contracts not yet squared off. When a new series is opened (
month end Friday) , fresh positions are entered and open interest rises.
Buy Signal- Rise in future price
Sell Signal- Fall in future price

Relation between spot price and futures price
Future price are priced as per the Cost of carry model which is based on the prevention of
arbitrage principal.
As per the model
Theoretical F=S+C
Where,
S= Spot Price
C= Cost of carry= Interest saved + storage cost saved-convenience yield foregone
In some cases , the cost of carry model is applied in a continuous framework i.e. , when interest
rates and dividend yield are continuously compounded , we have
F=S x e(r-d)t

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In Case of Futures on Stock , Dividend Information will be given.
Dividend Yield Share price
Dividend Rate- Face value
Dividend stated P.a/ Annualized Apply time factor

Take a lot size to be 100 if not given , however for nifty futures, lot size would be 50

Stock future Arbitrage
If the cost of carry model does not holds good ( actual F not = theoretical F ), there is a clear cut
arbitrage opportunity .
Whatever be the type of arbitrage , profit will be equal to the amount of mispricing.
CONCEPT OF ARBITRAGE UNDER FUTURE MARKET :

Case Valuation Borrow/Invest Cash Market Future Market
Actual Future Value > Fair Future Value Overvalued Borrow Buy Sell
Actual Future Value < Fair Future Value Undervalued Invest Sell Buy
* here we are assuming that arbitrageur holds one share .

Stock index futures
These are futures on well publish index like NIFTY futures , IT index futures ,
Bank Nifty futures.



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Beta management using stock index futures
No. of NIFTY FUTURES Contracts(N)=

Where ,
V
p
= Value of portfolio

T
=Target

p
= Beta of existing portfolio
F= Futures price
M= Multiple/lot size

f
= of hedging tools

Hedging through currency future
In order to hedge a transaction exposure i.e. a known foreign currency payable/receivable , we
can use futures cover. This may be compared with the forward cover or no cover. Futures cover
is imperfect due to basis risk i.e. (S-F) will keep on changing.
Foreign currency receivable
Buy Home Currency (Rupees) Future
No. of Contracts =



On the day of lifting the hedge rupee futures are squared off resulting in profit or loss in FC
Foreign currency payable -Vice versa
Speculation through futures
OUTRIGHT Trading 1) Buy futures on a currency in case of bullish price belief.
2) Sell futures on the currency in case of bearish price belief
You are always a student, never a master. You have to keep moving forward.
SPREAD Trading
It involves simultaneously selling and buying futures. It is non directional and less risky. It is a
bet on the spread i.e. the gap between the futures bought and futures sold.
Inter commodity spread involves buying and selling futures on the same commodity for
different maturities
Intra commodity spread involves buying and selling futures on different commodities for the
same maturity

OBTAINING COMPLETE HEDGE WITH THE HELP OF INDEX FUTURES AND BETA

How to Hedge:
First Decide on Position to be taken:
If you are short on any Security-To Hedge You should go Long in Index [Sensex or Nifty]
If you are long on any Security- To Hedge You should go Short in Index [Sensex or Nifty]
Decide on Value to be Hedged:
Extent of Hedging or Total Value to be hedged or Value of Perfect Hedge = Beta of the Stock Value
of Transaction or Value of Exposure or Current Value of Portfolio

OBTAINING PARTIAL HEDGE WITH THE HELP OF INDEX FUTURES AND BETA

Partial Hedge = Beta of the Stock X Value of Transaction or Value Of Exposure or Current Value Of
Portfolio X % which is to be hedged %Which is to be hedged


My interest is in the future because I am going to spend the rest of my life there.



OPTIONS
An option is a derivative contract which involves a Right but not an obligation to buy or sell the
underlying asset at an agreed upon price called the strike price or exercise price (E). The option
holder (buyer) has to pay the option premium to the option writer (seller) i.e. the price of the
option
Since option is derivative ; the premium derives its value from the value of underlying asset.
Every option gives the option holder either the right to buy or to sell , if the option holder buys
or sells the underlying asset then it is said that the option is exercised or else it is said to have
lapsed.

Option Buyer VS Option Seller

American option can be exercised on or before maturity
European option can be exercised only on maturity

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admit it, correct it, and learn from it--immediately.

Enoys a right
Pays initial premium
Pay - off cannot be negative
Long on volatility
Suffers time decay
Long C
+
Suffers an obligation
Receives initial premium
Pay off cannot be positive
Short on volatility
Enjoys time decay


Short C
-




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to believe. The more goals you set - the more goals you get.

Put Option
Call Option
Call
Option
Right to
Buy
Right to
Sell
Pay
Premium
Put
Option
Duty to Sell
Duty to
Buy
Receive
Premium
Value of an Option
The amount of Premium payable for a option is said to be value.
Option Premium is the component of two parts: Intrinsic Value + Time Value of Money i.e. OP =
IV + TVM
Intrinsic Value
It can never be negative (always equal to or greater than zero).
Intrinsic Value of Call Option= Maximum of (0, Current Market Price-Exercise Price);
Intrinsic Value of Put Option=Maximum of (0, Exercise Price-Current Market Price).
Time Value of Option:
Time Value of Option is the amount by which the option price exceeds the Intrinsic Value. i.e.
TVM=OP-IV
On the expiration date, the time value of option is zero and the premium is entirely
represented by the Intrinsic Value.
Factors Affecting the Value of an Option


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Current Stock Price
(S)
Strike price or
Exercise price (E)
Time to Expiry (t)
Risk Free Rate of
Interest (r)
Volatility of
underlying price
Hedging through Options
When buying option contract is hedged, it not only will hedge against adverse movement but it
will also allow the hedger to enjoy the favorable movement. The charge of this movement
however will be the option premium.
In case of hedging by Option selling is theoretically bad , it does not protect us from adverse
movement nor let us enjoy the favorable movement. However there will be a benefit to the
extent of premium received.
Speculation Through Options Option contracts like other derivatives can be used to make
profits in case of a particular price belief.

Three Strategies for Speculation through Option Contract are :-




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confidence.
Synthetic
Strategies
Combines Stock with Option to result in a new option
a) Protective Put
b) Covered call writing
Combination
Strategy
Combines Call and Put to Exploit Volatile & Non Volatile Price Belief
a) Volatile Price Belief
b) Non Volatile Price Belief
Spread
Strategies
Simultaneous Buying and Selling Option, resulting in Limited Profit/Loss
a) Butterfly Spread
b) Bull and Bear Spread
Valuation of Options
Option Price = Intrinsic Price + Time Value
PUT- CALL PARITY
This is a general relationship between Value of Call and Value of Put provided it has the same
exercise price and same maturity.
P
0
+ S
0 =
C
0
+ PV of E



Where Portfolio X Protective Put Portfolio Y Fiduciary call
P
0
= Put price
S
0
= Stock Price
C
0
= Call price
E= Strike Price
To prevent arbitrage
Cost of Protective Put = Cost of Fiduciary Call

Binomial Mode
The binomial mode breaks down the time to expiration into the potentiality a very large
number of time intervals, or steps. A tree of stock prices is initially