Derivatives

A presentation by Vishal Trehan Roll No. 880506 CBM Department Guru Nanak Dev University

Derivatives

D e ri ti va ve i s a p ro d u ct w h o se va l e i d e ri d fro m th e va l e u s ve u o f o n e o r m o re b a si va ri b l s, ca l e d c a e l u n d e rl n g a sse ts. T h o se a sse ts ca n yi be These underlying assets are of various categories like Stocks(Equity) Agri Commodities including grains, coffee beans, etc. Precious metals like gold and silver. Foreign exchange rate Bonds Short-term debt securities such as T-bills

E xch a n g e Tra d e d vs O TC D e ri ti s M a rke t va ve As the word suggests, derivatives that trade on an exchange are called exchange traded derivatives, where as privately negotiated derivative contracts are called OTC contracts. The former have rigid structures compared to the latter.

OTC derivatives markets have the following features compared to exchange traded derivatives : 1.The management of counter-party risk is decentralized and located within individual institutions. 2.There are no formal centralized limits on individual positions, leverage, or margining 3.There are no formal rules for risk and burden sharing, 4. There are no formal rules or mechanisms for ensuring market stability and integrity, and for safeguarding the collective interests of market participants, and The OTC contracts are generally not regulated by a regulatory authority and the exchanges self regulatory organisation, although they are affected indirectly by national legal systems, banking supervision and market surveillance.

5.

Features of Exchage Traded Derivatives

Centralization of Trading No counter party risk Standardization of contracts Liquidity Mark to Market (MTM) margining system Squared off in cash on expiration. Three series trade at any point in time. Contract expires on last Thursday of the month

H i ry o f E xch a n g e Tra d e d D e ri ti s sto va ve

The National Stock Exchange of India Limited (NSE) commenced trading in derivatives with the launch of index futures on June 12, 2000. The futures contracts are based on the popular benchmark S&P CNX Nifty Index. The Exchange introduced trading in Index Options (also based on Nifty) on June 4, 2001. NSE also became the first exchange to launch trading in options on individual securities from July 2, 2001. Futures on individual securities were introduced on November 9, 2001. Futures and Options on individual securities are available on 224 securities stipulated by SEBI. The Exchange provides trading in other indices i.e. CNX-IT, BANK NIFTY, CNX NIFTY JUNIOR, CNX 100 and NIFTY MIDCAP 50 indices. The Exchange is now introducing mini derivative (futures and

PARTICIPANTS
Speculators - willing to take on risk in pursuit of profit. Hedgers - transfer risk by taking a position in the Derivatives Market.

Arbitrageurs - aim to make a risk less profit by taking advantage of price differentials and thus bring about an alignment in prices by participating in two markets simultaneously

Types of derivatives

Forward Contract

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

Salient Features :

1.They are bilateral Contracts and hence exposed to counter party risk. 2.Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality. 3. 3. The contract price is generally not available in public domain 4. On the expiration date, the contract has to be settled by delivery of the asset. 5. If the party wishes to reverse the contract, it has to compulsorily go to the same counter-party, which often results in high prices being charged.

Limitations of Forward Markets

Lack of centralisation of trading I l q u i i l i d ty C o u n te rp a rty ri sk

Futures Contract
Futures markets were designed to solve the problems that exist in forward markets. A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. But unlike forward contracts, the futures contracts are standardized and exchange traded.

Salient Features Obligation to buy or sell Stated quantity At a specific price Stated date (Expiration Date) Marked to Market on a daily basis

Distinction between futures and forwards

To understand all these terms we will use NIFTY.

OPTIONS

An Options contract confers the right but not the obligation to buy (call option) or sell (put option) a specified underlying instrument or asset at a specified price the Strike or Exercised price up until or an specified future date the Expiry date.

The Price is called Premium and is paid by buyer of the option to the seller or writer of the option.

Types of option Call Option Put option

To understand these lets check Nifty and Reliance

Call Option

In-the-Money (ITM) Strike price < Spot price(current price) At-the-Money (ATM) Strike price = Spot price Out-of-the-Money (OTM) Strike price >Spot price

Put Option

In-the-Money (ITM) Strike price > Spot price

At-the-Money (ATM) Strike price = Spot price

Out-of-the-Money (OTM) Strike price < Spot price

What is payoff ?
A

payoff is the likely profit/loss that would accrue to a market participant with change in the price of the underlying asset. This is generally depicted in the form of payoff diagrams which show the price of the underlying asset on theX-axis and the profits/losses on the Yaxis.

FUTURES PAYOFFS

PRICING FUTURES
Without dividend With expected dividend

where: F S r q T

futures price spot index value cost of financing expected dividend yield holding period

Example: Security XYZ Ltd trades in the spot market at Rs. 1150. Money can be invested at 11% p.a. The fair value of a one-month futures contract on XYZ is calculated as follows

Payoff for buyer of futures: Long futures

The figure shows the profits/losses for a long futures position. The investor bought futures when the index was at 2220. If the index goes up, his futures position starts making profit. If the index falls, his futures position starts showing losses.

Payoff for seller of futures: Short futures

The figure shows the profits/losses for a short futures position. The investor sold futures when the index was at 2220. If the index goes down, his futures position starts making profit. If the index rises, his futures position starts showing losses

OPTIONS PAYOFFS

Long call

The figure shows the profits/losses for the buyer of a threemonth Nifty 2250 call option. As can be seen, as the spot Nifty rises, the call option is in-the-money. If upon expiration, Nifty closes above the strike of 2250, the buyer would exercise his option and profit to the extent of the difference between the Nifty-close and the strike price. The profits possible on this option are potentially unlimited. However if Nifty falls below the strike of 2250, he lets the option expire. His losses are limited to the extent of the premium he paid for buying the option.

Payoff profile for writer of call options: Short call

Payoff profile for buyer of put options: Long put

Payoff profile for writer of put options: Short put

PRICING OPTIONS

N(d1) is called the delta of the option

Bull spreads - Buy a call and sell another

The buyer of a bull spread buys a call with an exercise price below the current index level and sells a call option with an exercise price above the current index level.

Payoff for a bull spread created using call options

Bear spreads - sell a call and buy another

In a bear spread, the strike price of the option purchased is greater than the strike price of the option sold. The buyer of a bear spread buys a call with an exercise price above the current index level and sells a call option with an exercise price below the

Straddles

Rs. 4300 Buy Call & Put

When market is volatile

Pay-off of Straddle Strategy

Strike Price Premium Paid Buy Nifty Call Buy Nifty Put 4300 4300 98 22
Nifty Lot Size = 50 Shares

On settlement if Nifty touches 4500 4000 4250

Particulars

4500

4000 300 (120) 180 50 9000

4250 50 (120) (70) 50 (3500)

Payoff of Nifty Call/Put 200 Total Premium Net Payoff Lot Size (120) 80 50

Profit/Loss 4000 (Net Payoff*Lot Size)

Stranglers

For April 2007

Buy Call of 4400 Buy Put 4200

When market is volatile

Pay-off of Strangle Strategy

Strike Price Buy Nifty Call 4400 Buy Nifty Put 4200 Premium Paid 120 50

Nifty Lot Size = 50 Shares On settlement if Nifty touches 4600 4000 4300

Particulars Payoff Nifty Call/Put Total Premium Net Payoff Lot Size Profit/Loss (Net Payoff*Lot Size)

4600 200 (170) 30 50 1500

4000 200 (170) 30 50 1500

4300 Nil (170) (170) 50 (8500)