Derivatives

A presentation by Vishal TrehanRoll No. 880506CBM DepartmentGuru Nanak Dev University

Derivatives

Derivative is a product whose value is derived from the value of one or more basic variables, called underlying assets. Those assets can 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 BondsShort-term debt securities such as T-

bills

Exchange Traded vs OTC Derivatives Market

• 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

5. The OTC contracts are generally not regulated by a regulatory authority and the exchange’s self –regulatory organisation, although they are affected indirectly by national legal systems, banking supervision and market surveillance.

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.

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 options) contracts on S&P CNX Nifty index w.e.f. January 1, 2008.

History of Exchange Traded Derivatives

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

Derivatives

Futures

Index Futur

es

Stock Futur

es

Options

Call Put

Forwards Swaps

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. 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 MarketsLack of centralisation of trading

• Illiquidity

• Counterparty risk

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

Futures•Trade on an organised stock exchange•Standardized contract terms hence more liquid.•Requires Margin Payments•Follows daily settlement.

Forwards•OTC in nature.•Customised contract terms hence less liquid•No margin payment •Settlement happens at the end of period.

FUTURES TERMINOLOGY

Spot price

Futures price

Contract cycle

Expiry date

Contract size

Initial margin

Marking-to-market

Maintenance margin

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

OPTION TERMINOLOGY

Index options

Stock options

Buyer of an option

Writer of an option

Option price/premium

Expiration date

Strike price

American options

European options

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 priceOut-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 Y-axis.

FUTURES PAYOFFS

PRICING FUTURES

where:F futures priceS spot index valuer cost of financingq expected dividend yieldT holding period

With expected dividendWithout dividend

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 futuresThe 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

Payoff profile for buyer of call options: Long callThe figure shows the profits/losses for the buyer of a three-month 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 anotherThe 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 ofthe 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 currentindex level.

Straddles

Rs. 4300

Buy Call & Put

When market is volatile

Pay-off of Straddle Strategy

Strike Price

Premium Paid

Buy Nifty Call 4300 98

Buy Nifty Put 4300 22

Nifty Lot Size = 50 Shares On settlement if Nifty touches

• 4500

• 4000

• 4250

Particulars 4500 4000 4250

Payoff of Nifty Call/Put

200 300 50

Total Premium (120) (120) (120)

Net Payoff 80 180 (70)

Lot Size 50 50 50

Profit/Loss(Net Payoff*Lot Size)

4000 9000 (3500)

Stranglers

For April 2007

Buy Call of 4400

Buy Put 4200

When market is volatile

Pay-off of Strangle Strategy

Strike Price Premium Paid

Buy Nifty Call

4400 120

Buy Nifty Put 4200 50

Nifty Lot Size = 50 Shares

On settlement if Nifty touches• 4600• 4000• 4300

Particulars 4600 4000 4300

Payoff Nifty Call/Put 200 200 Nil

Total Premium (170) (170) (170)

Net Payoff 30 30 (170)

Lot Size 50 50 50

Profit/Loss(Net Payoff*Lot Size)

1500 1500 (8500)