DERIVATIVES

Introduction
 Topics to be covered
• Derivatives
• Types of traders
• Leverage
• Financial engineering
 Derivatives
• A derivative is a financial instrument whose value derives
from the value of something else.
• Question: Is a barrel of oil a derivative?
• Consider an agreement/contract between A and B:
If the price of a oil in one year is greater than Rs
50 per barrel, A will pay B Rs.10.
If the price of a oil in one year is less than Rs.50, B will pay A
rs.10.
• Question: Is this agreement a derivative?
 Derivatives
Why might A and B make such an agreement?
1. To hedge or reduce risk.
Suppose A is an oil producer and B is a
refinery.
A will earn Rs.10 if the price of oil goes down.
B will earn Rs.10 if the price of oil goes up.
2. To speculate on the price of oil.
 Derivatives
• A derivative is a financial instrument whose
value derives from the value of something
else, generally called the underlying(s).
• Underlying: a barrel of oil, a financial asset, an
interest rate, the temperature at a specified
location.
 Derivatives
Derivative
Derivative security
Derivative asset
Derivative instrument
Derivative product

Underlying(s)
 Derivatives
Example Underlying
Stock option, such as option on A stock, such as the stock of
the stock of RELIANCE RELIANCE
Stock index option, such as an A portfolio of stocks, such as the
option on the S&P NIFTY 50 portfolio of stocks comprising the
S&P NIFTY 50
Treasury bill futures contract A Treasury bill

Foreign currency forward contract A foreign currency

Gold futures contract Gold

Futures option on gold A gold futures contract

Weather derivative Snowfall at a specified site

 Derivative markets

• Have a long history.

• Futures markets: date back to the Middle
Ages.
• Options markets: date back to 17th century
Holland.
• Last 35 years: extraordinary growth
worldwide.
• Today: derivatives are used to manage risk
exposures in interest rates, currencies,
commodities, equity markets, the weather.
Derivative markets

The over-the-counter (OTC) market

The exchanges
 Derivatives
• Basic instruments:
– Forward contracts
– Options
• Hybrid instruments:
– Futures contracts
– Swaps
 Derivatives
• Derivatives are contracts, agreements
between two parties: a buyer and a seller.

Buyer Seller
 Forward contract
• A forward contract is an agreement between
two parties, a buyer and a seller, to exchange
an asset at a later date for a price agreed to in
advance, when the contract is first entered
into.
• We call this price the delivery price.
• Trades in the OTC market.
 Futures contract
• A futures contract is an agreement between
two parties, a buyer and a seller, to exchange
an asset at a later date for a price agreed to in
advance, when the contract is first entered
into.
• We call this price the futures price.
• Trades on a futures exchange.
DIFFERENCE BETWEEN FUTURES AND
FORWARDS
BASIS FOR COMPARISON FORWARD CONTRACT FUTURES CONTRACT

Forward Contract is an agreement A contract in which the parties agree to

between parties to buy and sell the exchange the asset for cash at a fixed
Meaning
underlying asset at a specified date and price and at a future specified date, is
agreed rate in future. known as future contract.

What is it? It is a tailor made contract. It is a standardized contract.

Over the counter, i.e. there is no

Traded on Organized stock exchange.
secondary market.
Settlement On maturity date. On a daily basis.
Risk High Low
As they are private agreement, the
Default No such probability.
chances of default are relatively high.

Size of contract Depends on the contract terms. Fixed

Collateral Not required Initial margin required.

Maturity As per the terms of contract. Predetermined date

Regulation Self regulated By stock exchange

Liquidity Low High
 Options
• An option gives the buyer the right, but not
the obligation, to buy/sell the underlying at a
later date for a price agreed to in advance,
when the contract is first entered into.
• We call this price the strike/exercise price.
• The option buyer pays the seller a sum of
money called the option price or premium.
• Trades OTC or on an exchange.
 Types of options
• Call option: an option to buy the underlying at
the strike price
• Put option: an option to sell the underlying at
the strike price
 Pricing derivatives
• All current methods of pricing derivatives
utilize the notion of arbitrage.
• Arbitrage: a trading strategy that has some
probability of making profits without any risk
of loss.
• Arbitrage pricing methods derive the prices of
derivatives from conditions that preclude
arbitrage opportunities.
 Uses of derivatives
• Derivatives can be used by individuals,
corporations, financial institutions, and
governments to reduce a risk exposure or to
increase a risk exposure.
 Traders of derivatives
• Hedgers
• Speculators
• Arbitrageurs
 Example
• But the same result could be achieved in another way: an
equity swap denominated in USD

Price performance of INFOSIS

shares in USD
Fund Swap
manager dealer
Interest in USD
 Preferred derivatives

Type of Risk Preferred

Derivative
Foreign exchange Forward contracts
risk
Interest rate risk Swaps

Commodity price Futures contracts

risk
Stock market risk Options
 Leverage
• Leverage is the ability to
control large dollar amounts of
an underlying asset with a
comparatively small amount of
capital.
• As a result, small price changes
can lead to large gains or
losses.
• Leverage makes derivatives:
– Powerful and efficient
– Potentially dangerous
 Leveraging with futures
• A speculator believes interest rates are going to fall.
• To realize a gain, she might:
– Buy bonds worth, say, Rs.10 crs.
– Buy Treasury bond futures for the purchase of Rs.10 crs of Treasury
bonds.
• To buy the bonds, she needs Rs.10crs.
• To buy the Treasury bond futures, she needs initial margin of
about Rs.800000.
• She gains the same exposure in both cases. That is, she
stands to realize an equivalent gain/loss should interest rates
fall/rise.
 Leveraging with options
• It is march 2017 now.
• The price of RELIANCE is Rs.1230.
• A april 2017 call option on RELIANCE SHARES with a 1260
strike price is selling for Rs.10 .
• A speculator thinks the stock price will rise.
• To make a profit, the speculator might:
– Buy, say, 1000 shares of Nortel stock for Rs.1230 the amount to be
paid will Rs.1230000.00
– Buy 2 options (lot size of 500shares contracts) for Rs10, (the total
premium paid will Rs.10000 roughly for the price of 9 shares).
 Leveraging with options

• Suppose the speculator is right . The stock

price of RELIANCE goes up and closes on
expiring date at Rs.1310..

By buying the stock (9 shares) . The profit will be

((1310-1230)*9.= Rs.10210.
By buying the options (2 lots. i.e total 1000
shares) the profit will be=== ((1310-
1280)*1000)-(10*1000)=20000
 Leveraging with options
• Suppose the speculator is wrong . The stock price
of RELIANCE falls and closes on expiring date at
Rs.1200..

By buying the stock (9 shares) . The profit will be

((1200-1230)*9.= -270(loss)
By buying the options (2 lots. i.e total 1000 shares)
the profit will be=== ((1230-1280)*1000)-
(10*1000)=10000 only and not 80*1000. it will be
only the premuim paid
 Thank you
Hope you understood derivatives
 swaps
• Swaps are forms of derivatives. Swaps in
simple terms can be explained as transaction
to exchange one thing for another or BARTER.
• Types of swaps
• Interest rate swaps,currency swaps, basis
swap, overnight index swaps(OIS).
 swaps
• Interest rate swaps: where cash flows at fixed
rate of interest are exchanged for those
reference to floating rate
• Currency swaps::where the cash flows in one
currency are exchanged for cash flows in
another currency.
• Basis swaps:: where cash flows on both legs of
the swaps are referred to different floating
rates.
 Interest rate swaps
• Contractual agreement to exchange a series of
cash flows.
• One leg of cash flow is based on fixed interest
rate
• Other leg is based on floating rate over a period
of time.
• There is no exchange of principle. It is only
notional.
• Example of interest rate swaps is OIS. Which is
very popular among banks
 Currency swaps
• Currency swaps is conceptually similar to interest
rate swaps. The main difference are;;
• Each interest rate is in different currency.
• The notional amount is now replaced by two
principal amounts– one in each currency.
• The principal amounts are typically exchanged at
the start of swaps, then re exchanged at
maturity.
• The different kinds of currency swaps are
• Principal +interest swaps--- covers both
 Basis swaps

• Basis swap could be an interest rate swap or a currency

swap where both legs are based on floating rate for e.g.
• 6 months USD LIBOR against 3 months USD LIBOR
• 6 months JPY LIBOR against 6 months USD LIBOR
• 6 months MIFOR against 6 USD LIBOR
• Most commonly used used when::
• Liabilities are tied to floating rate intex
• Financial assests are tied to another floating rate index.
 Pricing of interest rate swaps
• An interest rate swaps is simply an exchange of
fixed rate bond for a floating rate Bond or vice
versa
• First step in pricing an IRS consists in finding the
present value of the cash flow of these two bonds.
• Net present value of the cash flows of these two
bonds should be equal to start with.
• Rate will be base rate for pricing the swaps on
which mark up may be made to offer it to the
market.
 Types of interest rate swaps
• Plain vanilla swap
• A Basis swap
• Amortizing swap
• Step up swap
• Extendable swap
• Delayed rate swap
• Differential swap: combination of interest rate
swap and currency swap
RBI GUIDELINES SAILENT FEATURES
• Scheduled commercial bank, pDs, and all India
financial institutions can undertake IRS
• The can offers these products to their
corporates for hedging
• They should have sufficient skills and
infrastructure
• No restriction on tenor
• Should maintain adequate capital for FRA and
IRS
 RBI guidelines

• Transaction for hedging and market making

purpose should be recorded separately
• They had use standard ISDA documentation
and should have proper board approved
counterparty limit.
• Should report deals on fortnightly basis to RBI
• capital adequacy should be calculated as per
RBI guidelines.
 THANKS YOU
• SWAPS ARE ONE WAY CAN BE CALLED
BARTER SYSTEM.
 Options
• An option is a contract which give thebuyer
(holder) the right but not the obligation yo
buy or sell specified quantity of the underlying
assests.
• Underlying can be commodities, equity,
currency, bonds, index
 Important terminology in options
• Underlying
• Option premium
• Strike price or exercise price
• Expiration date
• Open interest
• Option holder
• Option seller
• Option class
• Option series: an option series consists of all
the options of a given class with same
expiration date and strike price
 European and american style of
options
• An American style option is the one, which
can be exercised by the buyer on or before the
expiration date.
• The European kind of option is the one , which
can exercised by the buyer on the expiration
day one, and not any time before that.
 OPTION DIFFERENCE

CALL OPTIONS PUT OPTIONS

OPTION BUYER OR Buys the right to buy the Buy the right to sell the
OPTION HOLDER underlying asset at underlying asset the
specified price specified price

Has the obligation to sell

OPTION SELLER OR the underlying asset (to Has the obligation to buy
OPTION WRITER the option holder) at the the underlying asset ( from
specified price the option holder ) at the
specified price
 OTHER OPTION TERMINOLOGIES
CALL OPTIONS PUT OPTIONS

IN THE MONEY strike price < spot price of strike price >spot price of
underlying underlying

AT THE MONEY strike price = spot price of strike price = spot price of
underlying underlying

OUT OF THE MONEY strike price > spot price of strike price < spot price of
underlying underlying
 TYPES OF OPTIONS
• Covered and naked call: writer writes a call on
reliance and at the same time holds the shares
of reliance so that if the call is excercised by
the buyer he can deliver the stock
• Intrinsic value of the option:: mean spot price
– strike price. For call option. For put option
will be strike price – spot price.
• This factor affects the price of option
premium
 Quantifiable factors

• Underlying stock price

• The strike price of the option
• The volatility of the underlying stock
• The time to expiration
• The risk free interest
• NON QUANITIFIABLE FACTORS
• Market participants varying the estimates of
the underlying assets future volatility
 NON QUANTIFIABLE FACTORS
• Indiviuals~ varying estimates of future
performance of the underlying asset based on
fundamental or technical analysis
• The effect of supply and demand
• The depth of market for the option
• Different pricing options
• Two important pricing formula:
• Black and scholes module
• Binominal model
 Option greeks

• Delta: depends are price change of the underlying:::

change in option/ price change of the underlying
• Gamma; measure the estimated change in the delta of
an option for a change in the price of the underlying
• Vega: measure the estimated change in the option
price for the change in the volatility of the underlying.
• Theta : measures the estimated change in the option
price for a change in the time to option expiry
• RHO: measure the estimated change in the option
price for a change in the risk free interest rates.
 Thank you
• Some types of trading strategies' of options in
the next class. Please feel free to ask quires. I
shall be able to clarify the same.