Derivatives

Derivatives are financial products whose

value is derived from the value of underlying.

Underlying can be shares, commodities,

bonds, currency, index, cost of living, weather, freight, electricity, LTC or any other thing.

DERIVATIVES
Derivatives

Forwards

Futures

Options

Swaps

FORWARD CONTRACT
An agreement to buy or sell something on a specified date for a specific price decided at the time of entering in to contract.

Features of a forward contract

Bilateral Contract Custom designed Counter party risk Settlement by delivery on expiry date Low liquidity Reversing trade is difficult

PROBLEMS OF FORWARD CONTRACT

Lack of centralization of trading
Illiquidity Counterparty risk risk of default

PAY OFF FOR BUYER AND SELLER

Long position position Short

FUTURES CONTRACT
A futures contract is a promise to buy or sell an asset/good at a certain time in the future for a certain price.

Features of futures contract

6

Traded on the Exchange Standardized contract No counter party risk High liquidity (any time it can be closed)

FUTURES TERMINOLOGIES

Spot price Futures price Contract cycle Expiry date Margin money Marking to market

Open interest Basis

FORWARD VS FUTURES
1. 2. 3. 4. 5.

Customized contract Traded off the Exchange

1. 2. 3. 4. 5.

Standardized contract On the Exchange

No margin money
Counter party risk Settlement on expiry

Margin money exists

No counter party risk Daily settlement & Final settlement

CASH MARKET MARKET

1.Actual assets are traded 2. One should have it to sell it 3. Settlement is immediate 4. No Margin money 5. Full payment 6. Actual delivery of assets
9

VS
1. 2. 3. 4. 5. 6.

FUTURES
Standardized contracts are traded Not necessary On expiry date or before There is margin money No Payment Actual delivery is not necessary

Positions in the Futures Market

Now
First Leg(1)

Before Expiry
Second Leg(2)

BUY (OPEN)

SELL (CLOSE)

SELL (OPEN)

BUY (CLOSE)

10

EXAMPLE
Days
1 2 3 4 5 6 7 8 9 10

11

Settlement price (RS.) 9500 9600 9550 9650 9700 9600 9800 9700 9850 9700

Transaction
Buy (Open)

Profit/Loss (Rs.)

Sell (Close)

+ 150

Sell (Open)

Buy (Close)

+ 100

PROCESS OF MARKING TO MARKET

Trade price Rs.6450

Day Daily settlement price 6500 6600 6800 6600 6700 Total P/L to the long +50 + 100 + 200 - 200 + 100 + 250 P/L to the short -50 -100 -200 +200 -100 - 250

1 2 3 4 5
12

FUTURES PRICE
FP is determined in the same way as cash market

13

prices on the basis of demand and supply (after all they are the same assets) Futures price are generally more than the cash price due to cost of carry Futures price converges with the spot price on expiry There is interrelationship between cash price and futures price Open-High-Low-Closing price-Volume-OI Settlement price-Daily-Final Change in price

CONVERGENCE OF FUTURES PRICE TO SPOT PRICE ON EXPIRY

14

ARBITRAGE
Actual futures price must be equal to theoretical futures price MIS-PRICING Futures price > Theoretical Futures price Futures price < Theoretical Futures price Arbitrage results in: Zero risk Zero investment Positive profit

15

EXAMPLE: COST OF CARRY

Cash Price Rs.100 Futures Price Rs.105 (6months to expiry) Interest cost Rs. 100 X 0.10 X 6/12 = 5 Futures Price = Cash Price + Cost of Carry 105 = 100 + 5

16

STRATEGY WHEN FUTURE PRICE IS RICH Buy in the spot market and sell in the futures market Cash Price=Rs.100 and FP =Rs.110

Transactions March 1, Sell August Futures contract @ Rs. 110 Borrow Rs. 100 at 10% p.a. for 6 months Buy the asset in the cash market

August 30, Deliver the goods in the futures market and Receive payment from the futures market Repay loan with interest (100 + 5) Arbitrage

Cash Flow (Rs.) ------+ 100 - 100 --------00 --------+ 110 - 105 ---------5.00 ----------

17

profit

STRATEGY WHEN FUTURE PRICE IS RICH Buy in the spot market and sell in the futures market

Transactions March 1, Sell August Futures contract @ Rs. 110 Borrow Rs. 100 at 10% p.a. for 6 months Buy the asset in the cash market

August 30, Buy August Futures @Rs. 200 Payoff from futures Sell the asset in the cash market @Rs.200 Repay the loan with interest Arbitrage
18

profit

Cash Flow (Rs.) ------+ 100 - 100 --------00 ---------90 +200 -105 ---------+5 -------------

REVERSE ARBITRAGE
When Futures price is poor compared to cash price Market information Cash price of the asset on march 1, Rs. 100 Per k.g. August Futures price Rs. 102 Per k.g. Interest rate 10 % p.a.

Theoretical futures price Rs. 100 + 5 = 105

19

STRATEGY WHEN FUTURE PRICE IS POOR

Buy in the futures and sell in the cash market Cash Flow March 1, (Rs.) Buy August Futures contract @ Rs. 102 ------per k.g. + 100 Borrow pepper & sell it in the cash market - 100 Invest the proceeds at 10 % p.a. --------00 --------August 30, + 105 Receive from the investment (100+5 ) - 102 Take delivery in futures market and pay Repay pepper to the lender ---------3.00 Arbitrage profit ---------Transactions

20

STRATEGY WHEN FUTURE PRICE IS POOR

Buy in the futures and sell in the cash market Transactions March 1, Buy August Futures contract @ Rs. 102 per k.g. Borrow pepper & sell it in the cash market Invest the proceeds at 10 % p.a. Cash Flow (Rs.) ------+ 100 - 100 --------00 --------+ 105 +48 -150 ---------3.00

August 30, Receive from the investment (100+5 ) Sell August Futures @150 Payoff from August Futures(150-102) Purchase the asset in the cash market and 21 return

Types of traders/Uses of forward contract

Hedgers- Hedging Speculators- Speculation
Arbitrageurs -Arbitrage

22

Hedging
Trading the forward/futures contract for the purpose of

reducing or controlling the price risk is called hedging.

Hedger must have position in both cash and derivative

markets.

Hedging also reduces the potential gains Hedging involves taking a position in the derivatives

contract that is opposite in the cash market

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Speculation
Bull

Buy the futures when you are expecting

an increase in price

Bear Sell futures when you are expecting a

decrease in price

BULLISH VIEW LONG STOCK FUTURES

May 3, 2012 Infosys cash market price Rs.2295

Infosys May Rs.2298

Infosys June Rs.2300 1 contract of 100 shares Buy price Rs. 2300 Contract value Rs.230,000 Initial margin 20% - Rs. 46,000 Final settlement price Rs. 2400 Contract value Rs. 240,000 Profit or gain Rs. 10000 ROI 10000/46000 = 22% for 2 months or 130 % per annum !!!
25

BEARISH VIEW SHORT STOCK FUTURES

May 3, 2012 Infosys cash market price Rs.2300 Infosys May Rs.2296 Infosys June Rs.2300 Market lot 100 shares Sale price Rs. 2300 Contract value Rs.230,000 Initial margin 20% - Rs. 46,000 Final settlement price Rs. 2000 Contract value Rs. 200,000 Profit or gain Rs. 30,000 ROI 30000/46000 = 65% for 2 months or 391 % per annum 26 !!!

Settlement of Futures Contract

1. Physical delivery on expiry 2. Offsetting at any time before

expiry
3. Cash delivery at expiry
27

Mechanics of Trading Futures

1. Signing an agreement and opening a derivative

trading account
2. Depositing the margin money 3.

Placing the order & taking long or short position

4. Reversing the trade or giving or taking delivery 5. Settlement of the transaction

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Trading shares and Trading futures

1.Security Trading a/c the with CM broker 2.Demat a/c is a must 3.Becomes SH of the Company 4.Receives div, notices to AGM etc 5.Must buy before selling 6.Minimum lot is one share 7.Maturity period is not there
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1.Futures Trading a/c with derivative broker 2. Not Necessary 3. Does not become 4. Does not receive 5. Not necessary 6. Market lot is specified 7. There is maturity or expiry date.

Futures Vs Options
1.Linear pay off 2.Both long and short are at risk 3.Price of the asset is determined by the market forces 4.Buyer and seller need not pay premium 5.Both the parties must deposit margin money 6.Maximum loss to both buyer and seller ins unlimited 7.Futures do not have different strike prices 1.Non linear payoff 2. Only short is at risk 3.Price of the option is determined by market forces 4. Buyer must pay the premium to the seller 5.Only the seller must pay the margin money 6.Maximum loss to the buyer is limited to the premium paid. 7.Options are available at different strike prices.

30

OPTIONS: MEANING

An option is a legal contract which gives the holder the right to buy or sell a specific amount of underlying asset at a fixed price within a specified period of time.
31

POINTS TO REMEMBER
1. 2. 3. 4. 5.

6.
7.

Legal Contract Buyer and Seller of the option contract Option Exchange OTC Buyer has a right to buy / sell the asset Seller has the obligation to buy / sell Buyer must pay the premium to the seller Contract should be completed within or on expiry of the contract

32

OPTIONS : TYPES
Options

Call Option

Put Option

Buyer

Seller

Buyer

Seller

33

OPTIONS TERMINOLOGY
1. 2. 3. 4.

5.
6. 7.

8.

Call Option Put Option American Option European Option Option Premium Strike/Exercise Price Expiry date Exercise date

9. Option holder 10. Option seller/writer 11. Option series 12. In the money option 13. At the money option 14. Out of the money option 15. Deep ITM and OTM 16. Open interest 17. Assignment

34

OPTION POSITIONS

Buy call

Buy put

Write call

Write put

35

PROFITABILITY OF OPTIONS S=Stock price & x= exercise price

Price Call Option Put Option

S>X
S=X

In the Money
At the Money Out of the Money

Out of the Money

At the Money In the Money

S<X
36

EXERCISE FOR OTM, ITM & ATM

Stock Price (S) Strike Price (X) Condition Status for Status for s call put

270 300

360 360

360
400 450

360
360 360

500
37

360

EXERCISE FOR OTM, ITM & ATM

Stock Price (S) Strike Price (X) Condition Status for Status for call put

270 300

360 360

S<X S<X

OTM OTM

ITM ITM

360
400 450

360
360 360

S=X
S>X S>X

ATM
ITM ITM

ATM
OTM OTM

500
38

360

S>X

ITM

OTM

ATTITUDES OF BUYERS & SELLERS

1. 2. 3. 4.

Call Option Buyer Bullish Call Option Seller Bearish Put Option Buyer Bearish Put Option Seller Bullish

39

OPTIONS TO OPTION HOLDERS (BUYERS)

1.
2. 3.

Do nothing till expiry day

Close out the position by reversing the trade Exercise the option if it is American type

40

Asset: Nifty-CE-4880-July
Asset: Nifty-CE-4800-July Option type: European

Strike price : 4800

Market lot : 50 times index Option premium : Rs. 50 X 96= 4800

Nifty at expiry : 5200

Gross profit : 50 X400 = 20000 Less Premium : Rs. 4800 Brokerage (App.) Rs. 200 Net gain Rs. 15000
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ROI : 15000 / 4800 =312.50% for 2 months or 1875% P.A

Nifty-PE-4880-July
Asset: Nifty-PE-4880-July Option type: European Strike price : 4880 Market lot : 50 times index Option premium : Rs. 50 X 96 = 4800 Nifty at expiry : 4480 Gross profit : 50 X 400 = 20,000 Less Premium : Rs. 4800 Brokerage (App.) Rs. 200 Net gain Rs. 15,000 ROI : 15,000 /4800 = 312.50% for 2 months or 1875% P.A

42

OPTIONS PAYOFF
Call option buyer (Long Call)
Stock Price Strike Price 500 525 550 575 600 625 650 600 600 600 600 600 600 600 Premium P/L to the buyer 25 25 25 25 25 25 25

675 700
43

600 600

25 25

OPTIONS PAYOFF
Call option buyer (Long Call)
Stock Price Strike Price 500 525 550 575 600 625 650 600 600 600 600 600 600 600
(in Rs.)

Premium P/L to the buyer 25 -25 25 25 25 25 25 25 -25 -25 -25 -25 00 25

675 700
44

600 600

25 25

50 75

OPTIONS PAYOFF
Call option Buyer (Long Call)

45

OPTIONS PAYOFF
Call option Seller (Short Call)
Stock Price 500 525 550 575 600 625 650 Strike Price 600 600 600 600 600 600 600 Premium 25 25 25 25 25 25 25 P/L to the seller

675 700
46

600 600

25 25

OPTIONS PAYOFF
Call option Seller (Short Call)
Stock Price 500 525 550 575 600 625 650 Strike Price 600 600 600 600 600 600 600 Premium 25 25 25 25 25 25 25
(Rs.)

P/L to the seller 25 25 25 25 25 00 -25

675 700
47

600 600

25 25

-50 -75

OPTIONS PAYOFF
Call option Seller (Short Call)

48

Options Payoff
Put option buyer (Long Put) (in Rs.)
Stock Price Strike Price 500 525 550 575 600 625 650 600 600 600 600 600 600 600 Premium P/L to the buyer 25 25 25 25 25 25 25

675 700
49

600 600

25 25

OPTIONS PAYOFF
Put option buyer (Long Put)
Stock Price Strike Price 500 525 550 575 600 625 650 600 600 600 600 600 600 600 Premium P/L to the buyer 25 75 25 25 25 25 25 25 50 25 00 -25 -25 -25

675 700
50

600 600

25 25

-25 -25

OPTIONS PAYOFF
Put option buyer (Long Put)

51

OPTIONS PAYOFF
Put option writer (Short Put)
Stock Price Strike Price 500 525 550 575 600 625 650 600 600 600 600 600 600 600 Premium P/L to the buyer 25 25 25 25 25 25 25

675 700
52

600 600

25 25

OPTIONS PAYOFF
Put option writer (Short Put)
Stock Price Strike Price 500 525 550 575 600 625 650 600 600 600 600 600 600 600 Premium P/L to the buyer 25 -75 25 25 25 25 25 25 -50 -25 00 25 25 25

675 700
53

600 600

25 25

25 25

OPTIONS PAYOFF
Put option writer (Short Put)

54

INDEX OPTIONS
Nifty

Contract specifications Contract size : 50 Nifty Style : European Price band : Not Applicable Trading cycle : 3 months, 3 contracts Near, Next and Far month New contract: Next day of the expiry date Expiry date: Last Thursday of the 3rd month Settlement : Cash Settlement on T+1 basis
55

Stock options
Asset: Suzlon-CE-June-30 Option type: European Strike price : 20 Market lot : 8000 shares Option premium : Rs. 2 X 8000 = 16000 Suzlon at expiry : 30 Gross profit : 10 X8000 = 80,000 Less Premium : Rs. 16,000 Brokerage (App.) Rs. 200 Net gain Rs. 64,000 ROI : 64000 / 16000 =400%p.m

Stock option
Asset: P E- Suzlon- June Option type: European Strike price : 20 Market lot : 8000 shares Option premium : Rs. 2 X 8000 = 16000 Suzlon at expiry : 15 Gross profit : 5 X8000 = 40,000 Less Premium : Rs. 16,000 Brokerage (App.) Rs. 200 Net gain Rs. 24,000 ROI : 24000 / 16000 =150%p.m

Introduction to swaps
Swaps are private agreements between 2 parties to exchange cash

flows in the future according to prearranged formula.

Started from early 1980s In 1984 ONGC entered in to swap with consortium of foreign banks to

hedge interest rate risk (foreign jurisdiction).

RBI permitted swaps in 1995on a case by case basis.

RBI permitted banks to enter in to swap and report such deals from

1999 In 2005 finance minister allowed the swap contract by amending SCRA in parliament.
58

Types of Swaps
Commodity swap Equity swap

Interest rate swap

Currency swap Credit default swap
59

COMMODITY SWAP
Market Price

FARMER
Rs. 120 If the price is Rs.150

USER
If the price is Rs. 60

FARMER -150 +120 - 30

60

USER + 150 -120 + 30

FARMER -60 +120 + 60

USER +60 -120 - 60

EQUITY SWAP

Variable return Equity Invt.

A (Equity)
Fixed return (10%)

B( Debt)

Debt Invt.

Position of variable return payer and fixed return payer When the variable return is 40% and -10% Receives in cash market Pays under swap Receives under swap A +40% -40% +10% B +10% -10% +40% A -10% +10% +10% B +10% -10% -10%

Net cash flow

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+10%

+40%

+10%

-10%

Introduction to Interest Rate Swap

Definition: A contract which involves two counter parties to exchange

over an agreed period, two streams of interest payments, each based on a different kind of interest rate, for a particular notional amount.
Contract between two parties Notional principal amount One party pays fixed rate and receives floating rate The other party pays floating rate and receives fixed rate Fixed rate remains the same and floating rate changes Interest amount is exchanged for several future dates
62

Fixed or Floating Rate?

Borrow at Fixed Rate

Borrow at Floating Rate

Risk of fall in interest rate

Benefit if interest rate rises

Risk of rise in interest rate

Benefit from fall in Interest rate

Low risk if the interest rates are near the bottom of a cycle

Low risk if the Interest rates are At the top of a cycle

63

Interest Rate Swap

A borrowed at fixed rate and B at floating rate

-7 %

MIBOR

A
7%

B
A - 7% Fixed + 7% Fixed - MIBOR
- MIBOR

-MIBOR

B - MIBOR + MIBOR - 7 % Fixed

-7%

64

Transformation of assets and liabilities

IRS can be used to transform
1.

Fixed rate loan in to floating rate loan

2.
3. 4.
65

Floating rate loan in to fixed rate loan

Fixed rate investments in to floating rate investments Floating rate investments in to fixed rate investments

Transforming Floating Rate Loan in to Fixed Rate Loan

The company must enter in to swap as a floating rate payer
Floating rate loan Pays fixed rate under swap

Company X

Company Y

Receives floating rate under swap

After the swap cash flows are as below 1. Pays floating rate under loan contract 2. Receives floating rate under swap contract 3. Pays fixed rate under swap contract The above 3 cash flows net out as a floating rate loan 66

Transforming fixed rate loan in to floating rate loan

The company must enter in to swap as a floating rate payer
Pays floating under swap 10% under loan Company X Company Y

Receives fixed 10% under swap

After the swap cash flows are as below 1. Pays fixed rate under loan contract 2. Receives fixed rate under swap contract 3. Pays floating rate under swap contract The above 3 cash flows net out as a floating rate loan 67

Transforming floating rate investment in to fixed rate investment

The company must enter in to swap as a floating rate payer After the swap cash flows are as below

1. 2. 3.

Receives floating rate for its investments

Receives fixed rate under swap contract Pays floating rate under swap contract

68

The above 3 cash flows net out as fixed rate investments

Comparative advantage argument

AAA wants to borrow floating & BBB wants to borrow fixed rate funds AAA has comparative advantage in fixed rate market because it need to pay

2.5% less than BBB

BBB has comparative advantage in floating rate market because it need to pay

0.5% more than AAA

AAA wants floating but borrows fixed and transforms fixed loan in to floating

through swap
BBB wants fixed but borrows floating and converts floating in to fixed

through swap

Rates quoted to them by their banks are: Fixed Floating AAA

69

10% 12.50%

MIBOR+0.50% MIBOR+1.00%

BBB

Example Comparative Advantage

Libor

AAA 10.50%

BBB

Fixed 10%

Libor+1.00%

70

Cash Flows to Parties

Cash flows
Payment under loan

AAA
-10%

BBB
-LIBOR+1.00%

Receipt under swap Payment under swap Net payment after swap Net cost before swap

+10.50% -LIBOR -LIBOR-0.50% -LIBOR+0.50%

+LIBOR -10.50% -11.50% -12.50%

71

Currency Swap
A currency swap is an agreement between

two parties to exchange payments or receipts in one currency for payments or receipts in another currency.
In an IRS the principal is not exchanged In a currency swap the principal is exchanged

at the beginning and the end of the life of the swap

72

Mechanics of currency swap

A (Borrows USD) Pays $ principal B (Borrows GBP) Receives $ principal

Receives GBP principal

Pays GBP interest Receives $ interest

Pays GBP principal

Receives GBP interest Pays $ interest

Receives $ principal
Pays GBP principal Transforms $ loan in to GBP loan 73

Pays $ principal
Receives GBP principal Transforms GBP loan in to $ loan

What happens in a currency swaps Near value date Periodic intervals $ principal

Sterling principal

Exchange of principal at on agreed rate of exchange

GBP Interest

$ Interest

GBP Interest

$ Interest

GBP Interest
GBP Interest

$ Interest
$ Interest

Far value date

Exchange of interest payment at previously agreed rate of interest

GBP Principal

$ Principal

TIME
74 Re-exchange of principal at same rate of exchange as for the original exchange at the near value date

Currency swap( with no exchange of principal at the near value date)

Party A
SWAP term begins Euro Interest Euro Interest

Party B
$ Interest $ Interest

Euro Interest

$ Interest $ Interest $ Interest $ Principal

Euro Interest Euro Interest Euro Principal Maturity TIME Euro principal
75

Exchange of interest payment on specified amount of principal $ principal

Exchange of principal at an agreed rate of exchange

Credit default swaps

1. 2. 3.

4.
5. 6. 7. 8. 9.
7610.

Bilateral contract CPB and CPS CPB pays fixed periodic payment to CPS Protection against adverse credit event. Buyer has aright to sell the bond for face value when the credit event occurs. Payment is expressed as annualized basis point on notional principal. Third party and specific obligation Ref entity and ref obligation. Credit event triggers the obligation (Bankruptcy, Rating downgrade, Obligation default etc.) CDS can be settled in cash or physical based on formula agreed. CDS spread is the % p.a. of notional principal paid for the protection In credit market, banks quote two way price on CDS (250-260 bps)

Credit default swaps

Premium (periodic) X bps per annum.

CPB

Zero
Cr Event payment (CEP)

No credit event Credit event

CPS

CEP = Par value recovery value Ref entity/ obligation

CASH SETTLEMENT BASIS

77