Financial Derivatives

Text Books
1.Hull, J. C., (2010). Options, Futures and other Derivatives.
2.Gupta, S.L.(2009). Financial Derivatives: Theory, Concepts and Problems.

Deepak Bansal
Unit-1: Financial
Derivatives
An Introduction to Financial Derivative
Markets; Past and Present,
Concept, Purpose and Types of Financial
Derivative Instruments; Forwards, Futures,
Options, Swaps, and
Other Derivatives; Weather Derivatives,
Energy Derivatives and Insurance Derivatives.
Hedgers, Arbitrageurs and Speculators.
Difference between Exchange Traded and OTC
Derivatives
Introduction
In business, decisions are made in the
presence of RISK.
A decision maker confront two types of risk:

Business
Risk
Financial
Risk
Business Risks
Uncertainty of future sales.

Cost of Inputs.
Financial Risks
Interestrates
Exchange rates
Stock prices
Commodity prices
 Our financial system is replete with
risk
It also provides a means of dealing

with risk in form of DERIVATIVES.

Derivatves
They are the financial instruments whose
returns are derived from those of other
financial instruments.
Their performance depends on how other

financial instruments performs.

Derivatives serve a valuable purpose in

providing a means of managing financial

risk.
 What is a Derivative?
The term Derivative stands for a contract whose
price is derived from or is dependent upon an
underlying asset.
The underlying asset could be a financial asset
such as currency, stock and market index, an
interest bearing security or a physical commodity.
As Derivatives are merely contracts between two
or more parties, anything like weather data or
amount of rain can be used as underlying assets.
Need for Derivatives
The derivatives market performs a number of
economic functions. They help in :
Transferring risks
Discovery of future as well as current prices
Catalyzing entrepreneurial activity
Increasing saving and investments in long run.
Derivatives
By using derivatives companies and
individuals can transfer, for a price, any
undesired risk to other parties.
The vast majority of derivatives, however
created in private transactions in over the
counter markets.
Derivative can be based on real assets, which
are physical assets and include agricultural
commodities, metals, and source of energy.
It also be based on financial assets which are
Stocks, Bons/Loans and currencies.
 Derivative Markets and
Instruments
What is an Instrument?

Instrument

An asset or an item of ownership A Liability or an item of ownership

Having a positive monetary value having a negative monetary value
Derivative Markets and
Instruments
A security is a tradable instrument
representing a claim on a group of assets.
We know that A contract is an enforceable

legal agreement.
For a asset transaction the required asset

be delivered immediately or shortly

thereafter.
Payment usually is made immediately or

sometime credit arrangements are made.

Derivative Markets and
Instruments
On the first basis the markets are known as
cash market or spot market. Where:
Sale is made

Payment is remitted

Goods or security is delivered

Derivative Markets and
Instruments
For other type of arrangements which allow
the buyer or seller to choose whether or not
to go through with the sale.

These type of arrangements are conducted

in derivatives market.
Derivative Markets and
Instruments
Derivatives markets are market for
contractual instrument whose performance
is determined by the way in which another
instrument or asset performs.
Like all other contracts they are also
agreements between two parties as a buyer
and a seller, with a price where the buyers
try to buy as cheaply as possible and sellers
try to sell as dearly as possible,
Derivative Markets and
Instruments
Various types of derivative contracts

OPTIONS,
OPTIONS, FORWARDS
FORWARDS
FUTURES
FUTURES AND
AND SWAPS
SWAPS
AND
AND RELATED
RELATED
DERIVATIVES
DERIVATIVES
Option (Introduction)
Contract between two parties a buyer and
a seller.
Gives the buyer the right but not the to

obligation, to purchase or sell something

at a later date at a price agreed upon
today
Buyer pays a sum of money called price or

premium
Seller stands ready to sell or buy
according to the terms and when the
buyer so desires.
Option (Introduction)
An option to buy something is referred to a
CALL
An option to sell something is called a
PUT.
Major options are for the purchase or sale of
financial assets such as stocks and bonds, but
there are also options on future contracts,
metals, and currencies and even loan
guarantees and insurance are forms of options.
Stock itself is equivalent to an option.
Forward Contracts
(Introduction)
Contract between two Parties to purchase or
sell something at a later date at a price
agreed upon today
The two parties in a forward contract incur

the obligation to ultimately buy and sell the

good
They trade strictly in an over the counter

market consisting of direct communication.

Futures Contracts
(Introduction)
Contract between two parties to buy or sell
something at a future date at a price agreed upon
today.
The contract trades on a future exchange and is
subject to a daily settlement procedure.
Unlike forward contracts however the future
contracts trade on organised exchanges.
The buyer of a future contract who has the
obligation to buy the good at the later date, can
sell the contract in future market, which relieves
him of the obligation. Likewise the seller can buy
the contract back relieving him of the obligation
to sell the good.
Swaps and other
Derivatives
A Swap is a contract in which two parties
agree to exchange cash flows.
The firm and the dealer in effect swap

cash flow streams. Depending on what

later happens to price or interest rates.
In this one party might gain at the

expense of others.
An option to enter into a swap is called

swaption.
Types of Derivatives Markets
Over-the-Counter derivatives :
Contracts that are traded between two parties directly
without going through an exchange
Forward and Swap Contracts are OTC derivatives

Exchange-traded derivatives :
Contracts that are traded in derivatives exchanges
 What is OTC (Over the
counter)??
Over the Counter (OTC) derivatives are those
which are privately traded between two parties and
involves no exchange or intermediary.

Non-standard products are traded in the so-called

over-the-counter (OTC) derivatives markets.

The Over the counter derivative market consists of

the investment banks and include clients like hedge
funds, commercial banks, government sponsored
enterprises etc.
Exchange Traded Derivatives
Market
A derivatives exchange is a market where
individuals trade standardized contracts that
have been defined by the exchange.

A derivatives exchange acts as an

intermediary to all related transactions, and
takes initial margin from both sides of the
trade to act as a guarantee.
 Participants in Derivative
markets
Hedgers use futures or options markets to reduce
or eliminate the risk associated with price of an
asset.

Speculators use futures and options contracts to

get extra leverage in betting on future movements
in the price of an asset.

Arbitrageurs are in business to take advantage of

a discrepancy between prices in two different
markets.
 Classification of
Derivatives
Future Contracts OTC (Over the
Forward Contracts counter ) trading
Options
Swaps Exchange Traded
Derivatives

OTC Exchange Traded

Rupee Interest Forward Rate Interest Rate futures
Rate Derivatives agreements, Interest
rate Swaps
Foreign Currency Forwards, Swaps, Currency Futures
Derivatives Options
Equity Derivatives Index Futures, Index
Options, Stock
futures, Stock
options
 Basic Terminologies
Spot Contract: An agreement to buy or sell an
asset today.
Spot Price: The price at which the asset changes
hands on the spot date.
Spot date: The normal settlement day for a
transaction done today.
Long position: The party agreeing to buy the
underlying asset in the future assumes a long
position.
Short position: The party agreeing to sell the asset
in the future assumes a short position
Delivery Price: The price agreed upon at the time
the contract is entered into.
 Forward Contract
Forward is a non-standardized contract between
two parties to buy or sell an asset at a specified
future time at a price agreed today.

For Example: If A has to buy a share 6 months

from now. and B has to sell a share worth Rs.100.
So they both agree to enter in a forward contract
of Rs. 104. A is at Long Position and B is at
Short Position Suppose after 6 months the price
of share is Rs.110. so, A overall gained Rs. 4 but
lost Rs. 6 while B made an overall profit of Rs. 6.
 Swap Contract
The derivative in which counterparties exchange
certain benefits of one party's financial
instrument for those of the other party's financial
instrument. The benefits in question depend on
the type of financial instruments involved. The
types of Swaps are:
Interest rate swaps
Currency swaps
Commodity swaps
Equity Swap
Credit default swaps
 Futures Contract
Futures contract is a standardized contract
between two parties to exchange a specified asset of
standardized quantity and quality for a price agreed
today (the futures price or the strike price) with
delivery occurring at a specified future date, the
delivery date.
Since such contract is traded through exchange, the
purpose of the futures exchange institution is to act
as intermediary and minimize the risk of default by
either party. Thus the exchange requires both parties
to put up an initial amount of cash, the margin.
 Concept of Margin
Since the futures price will generally change daily,
the difference in the prior agreed-upon price and
the daily futures price is settled daily also.

The exchange will draw money out of one party's

margin account and put it into the other's so that
each party has the appropriate daily loss or profit.

Thus on the delivery date, the amount exchanged is

not the specified price on the contract but the spot
value.
 Options
An option is a derivative financial instrument
that specifies a contract between two parties
for a future transaction on an asset at a
reference price.

The buyer of the option gains the right, but not

the obligation, to engage in that transaction,
while the seller incurs the corresponding
obligation to fulfill the transaction.
 Some Terminologies
Call Option: Right but not the obligation to buy
Put Option: Right but not the obligation to sell
Option Price: The amount per share that an option
buyer pays to the seller
Expiration Date: The day on which an option is no
longer valid
Strike Price: The reference price at which the
underlying may be traded
Long Position: Buyer of an option assumes long
position
Short Position: Seller of an option assumes short
position
Option Pay Of
 Option Styles
European option an option that may only be
exercised on expiration.

American option an option that may be

exercised on any trading day on or before
expiry.

Bermudan option an option that may be

exercised only on specified dates on or before
expiration.
Unit-2: Financial Forward and
Futures Contracts
Financial Forward Contracts; Concept Characteristics,
and Type of Financial Forward Contracts; Equity
Forward, Currency Forward, Bond and Interest Rate
Forward, Forward Rate Agreements.
Financial Future Contracts: Concept, Characteristics,
and Type of Financial Future Contracts; Stock Future,
Index Future, Currency Future, Interest Rate Future
and Commodity Future.
Future Market-Trading and Mechanism;
Future Pricing-Theories, Cost of Carry Model,
Valuation of Individual Contracts.
Financial Forward
Contracts
Forward contract is a simple form of financial
derivative instruments.
It is an agreement to buy or sell a specified
quantity of an asset at a certain future date for a
certain price agreed upon now.
No money changes at the time the deal is signed.
They are not traded on an exchange.
They are private contracts between two parties
which may be between financial institutions,
between a financial institution and one of its
corporate client etc.
 Most of the forward contracts are traded on
the over the counter market or by
telephones.
At the time the forward contract is written,

a specified price is fixed at which the asset

is purchased or sold. This specified price is
referred to as the delivery price.
Features of forward
contract
Classification of forward
contracts
Hedge contracts
Transferable specific delivery contracts
Non-transferable specific delivery contracts
Forward rate agreements
Range forwards
Financial Future Contracts
A futures contract is an agreement between
a buyer and a seller where the seller agrees
to deliver a specified quantity and grade of
a particular asset at a predetermined time
in futures at an agreed upon price through a
designated market (exchange) under
stringent financial safeguards.
For example, the S&P CNX NIFTY futures are

traded on national stock exchange (NSE).

 BSE website defines futures contract:
Futures are exchange traded contracts to sell or
buy financial instruments or physical commodities
for future delivery at an agreed price. There is an
agreement to buy or sell a specified quantity of
financial instrument/commodity in a designated
future month at a price agreed upon by the buyer
and the seller. The contracts have certain
standardized specifications.
Types of financial futures
contracts
Interest rate futures
Foreign currencies futures
Stock index futures
Bond index futures
Cost of living index futures
Operators/traders in futures
market
Hedgers
Speculators
Arbitrageurs
Spreaders
Functions of futures
market
Hedging
Price discovery
Financing function
Liquidity function
Price stabilization function
Disseminating information
Futures market trading
mechanism
Unit-3: Financial Option and
Swap Contracts
Financial Options; Concept, Characteristics and Types of
Financial Options; Stock Options, Index Options, Currency
Options, Commodity Options, Option on Futures, Interest
Rate Options.
Option Pricing Models-the Black-Scholes Option Pricing
Model, Binomial Option Pricing Model,
Trading with Option, Option Strategies; Straddle, Strangle,
Spreads. Option Greeks; Delta, Gamma, Theta, Vega, Rho.
Exotic Option; Types of Exotic Options; Bermuda Option,
Forward Start Option, Barrier Option, Chooser Option,
Compound Option, Basket Option, Binary Option, Look
Back Option, Asian Option.
Swaps; Concept, characteristics and Types of Swaps,
Unit-4: Regulatory Framework
for Derivatives
Regulation of Financial Derivatives in India;
Securities and Contracts (Regulation) Act,
Guidelines of SEBI and RBI