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Derivatives Jignesh Shah
Dhiren Prajapati
Kaustubh Parkar
Akash Jadhav
Deepali Jain
Rahul Gavali
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What will we look at?
Basic concepts of Derivatives
Futures
Options
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Derivatives
What is Derivatives?
Classification of Derivatives
Risk Associated with Derivatives
Participants of Derivatives
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A Derivative is a financial instrument which derives its valuefrom its underlying assets.
It does not have any value of its own
The underlying assets can be Futures, Equities, Index andCurrency
What is Derivatives?
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Futures
Options
Forward Contracts
Classification of Derivatives
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Definition
Futures :
Its a standardized agreement between buyer and seller, where theseller is obligated to deliver a specific assets to a buyer on thespecified date and buyer is obligated to pay the future priceprevailing in the exchange on the delivery of the asset.
Options :
An option is the right, but not the obligation to buy or sell theunderlying assets and other financial instrument at an agreed price,on or before a given expiry date.
Forward Contracts :
Its an agreement between two persons for purchase and sale ofcommodity or financial asset at specified price to be delivered atspecified future date.
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Risk Associated With Derivatives
Market Risk : It is price sensitive to fluctuation in interest rateand foreign exchange rate.
Liquidity Risk : Most derivatives are customized instrumenthence they have substantial liquidity risk.
Credit Risk : Derivatives are traded in over the counter marketwhich are subject to counter party default.
Hedging Risk : Hedge are used to reduce specific risk, it theanticipated risk do not develop it may limit the total return.
Regulatory Risk : The regulatory controls are some time toooppressive for market participants.
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Participants of Derivatives
Hedgers
Those who are interested in the underlying and want to hedge out theirrisk of price changes. For eg. farmers who sell future contracts for thecrops that guarantee a certain price. Also, hedging against an existingequity position with a view to earn on short term fluctuation while
keeping the original position as intact.
Speculators
Those who seek to make profit by predicting market movements andhave no interest in the underlying equity / commodity.
Strategist / Traders
With the help of cash and derivative products, large number ofstrategies are being formulated and traded.
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Futures
What is Futures?
Futures Vs Forwards
Characteristics of Futures
Types of Futures
Example
Margin Components Advantages
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What is futures ?
Definition:
A future contract is astandardisedcontract traded on anexchange, to buy or sell a certain underlying instrumentat a
certain date in thefuture,
at apre-setprice.
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Futures vs. Forwards
Standardized
Standard Lot size
Exchange Traded
Not Standardized
Odd lot size
Over the Counter(OTC)
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Some of the Exchanges
Chicago Mercantile Exchange (CME)
Chicago Board of Trade (CBOT)
New York Board of Trade (NYBOT)
New York Mercantile Exchange (NYMEX) National Stock Exchange (NSE)
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Characteristics
Standardisation
Pricing
Margin
Always traded on an Exchange
Settlement
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Standardisation
The contract usually specifies the following:
i. The underlying instrument
ii. Whether the settlement would be in cash or physical
iii. The amount and number of units of the underlying assets.
iv. Currency in which the future contract is quoted.
v. Date of delivery & month.
vi. Last date of delivery This varies from exchange toexchange.
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Types of Futures
Equity
Commodity
Index
Foreign Currency
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Example:
Spot price of Gold is $ 400.
Futures Price of Gold is $ 415 at the beginning of the day.
The movements over 3 days as shown below explains theconcept of Mark to Market:
Time period Gold Future Buyer's Cash Flow
1 $420.00 $5.002 $430.00 $10.003 $425.00 - $5.00
Net Cash Flow $10.00
Mark to Market
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Margin Components
Initial margin VAR technique
Maintenance margin minimum requirement
Margin Call -Variation margin
Additional margin market trends / volatility
Any credit balance in a margin account can be withdrawn.
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Reliance Future having lot size of 600 @ Rs. 1000/-= Rs. 600,000/-
Margin fixed by Exchange = 15% = Initial Margin
Amount deposited with Broker = Rs. 600,000/- *15% = Rs. 90,000/-
Maintenance margin = 50% of initial margin =
90,000/- * 50% = 45,000/-
Simple Illustration
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2nd day :
Next day, the rate of Reliance future is Rs. 950/-Mark to market: 600 lots @ Rs. 950/- = Rs. 570,000/-
Current Margin 90,000.00 15%Less : Notional loss 30,000.00 (600,000 570,000)
60,000.00 > 45,000
3rd day:
Next day, the rate of Reliance future is Rs. 900/-Mark to market: 600 lots @ Rs. 900/- = Rs. 540,000/-
Calculation :Current Margin 60,000.00Less : Notional loss 30,000.00 (570,000 540,000)
30,000.00 < 45,000
Required margin 90,000.00Variation Margin required (60,000.00) margin call
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Calculation:
Future Contract:
Date B / S Lot Multiplier Price Mark-to-market Comm. Fees
16th June Sell 10 * 10 * 3,514.60 = 351,460.00/- 25.00
30th June Buy 2 * 10 * 3,639.505 = 72,790.10/- 109.19
Cash Flow:
On 16th June: Commission fees: 25.00 is the cash flow generated on this day.
On 30th June: 72,790.10 - 70,292.00/- (2 lots * 10 * 3,514.60) = 2,498.10+ Commission Fees 109.10 = 2,607.2
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Options
What is Options?
Kinds of Options.
Types of Options.
Characteristics of Options.
Call Options
Put Options In / At / Out the Money Options
Benefits of Options Trading
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What is an options ?
Definition:
An option contract is a standardised contract traded
on an exchange, offering the right, but not theobligation, to buy or sell a certain underlyinginstrument at a pre-set price called the strike price.
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Kinds of Options
European Options:
These are exercised only on the maturity date. On theexpiry date, the option buyer's right to exercise the option(and the seller's obligation to perform) ends.
American Options:
These can be exercised at any time prior to or up to thematurity date.
This presentation presumes European options for ease ofcalculation.
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Types of Options
Equity
Commodity
Index
Foreign Currency
Future Contracts
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Characteristics
Standardisation
Premium
Call / Put option
Always traded on an Exchange
Settlement
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Standardisation
The contract usually specifies the following:
i. The underlying instrument
ii. Whether the settlement would be in cash or physical
iii. The amount and number of units of the underlying assets.
iv. Currency in which the option contract is quoted.
v. Date of delivery & month.
vi. Last date of delivery This varies from exchange toexchange.
C ll / P t O ti
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CALL OPTIONS
Buyer gets a RIGHT,
To BUY underlying shares at a price.
On or before a determined date.
PUT OPTIONS
Buyer gets a RIGHT,
To SELL underlying shares at a price.
On or before a determined date.
Call / Put Options
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BUY CALL:
Buyer gets right to BUY underlying at the strike price
BUY PUT:
Buyer gets right to SELL underlying at the strike price
SELL CALL:
Seller has an obligation to SELL the underlying at strike price
SELL PUT:
Seller has an obligation to BUY the underlying at strike price
Options-Positions
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In The Money
Concepts from the buyers perspective.
Option is said to be in the money when the option hasintrinsic value.
Call option is in the money when the Strike price is < Spot
price Put option is in the money when the strike price is > spot
price
Eg. Strike Price 250 Call option of Satyam Computers when
the Spot price is 300. The difference of Rs. 50 is said to be the intrinsic value of the
option.
Options- Spot & Strike price Relationship
Options S t & St ik i
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Out of The Money
Option is said to be out of money when it does not have anyintrinsic value
Call option is out of the money when the Strike price is > CMP
Put option is out of the money when the strike price is < CMP
Eg. Strike Price 350 Call option of Satyam Computers when the Spotprice is 300.
At The Money
Strike price = Spot Price
Options- Spot & Strike priceRelationship
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Call Option Buyer - Example
Mr. X holds a bullish view on Microsoft. Microsoft is trading on NASDAQ in the cash market at $ 100. Call option on Microsoft with 3 months maturity is available at various
strikes. Lets takes strike of $ 100. Mr. X Buys one call Options contract with 3 months maturity (Say one
contract has 100 underline shares). He Pays a premium, say @ $ 5 per share i.e. $ 500. He waits for 3 months. During this time Microsoft may go up, it may go down or it may
remain stable. If Microsoft remains same or goes down i.e. below $ 100, Mr.X will not
exercise his option and would loose the premium amount i.e. $ 500. Inother words, Mr. X lose is Capped at this value.
If the Microsoft rises above $ 105 (Strike Price of $ 100 + Premium of $5) Option would generate money for Mr. X
The Higher the Microsoft rises, the higher the profit to Mr. X. Hence the maximum profit potential of Mr. X is unlimited, While the
maximum lose is limited to premium paid ($ 500).
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Consider the Option on Microsoft, Which Mr. X had bought, Say
for Mr. Y. The Position of Call Option Seller i.e Mr. Y is exactly the
opposite of the Option Buyer i.e Mr. X.
Mr. Y collects the Premium amount of $ 500 from Mr. X.
If Microsoft falls below $ 100, Mr. Y pockets the premium
amount, which is the Maximum Profit he can make. However if the Stocks moves up Mr. Ys loss is unlimited which
is proportional to Mr. Xs gain.
Call Option Seller - Example
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Benefits of Option Trading
Leverage
Limited risk
No margin, only premium
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Futures - Advantages over Delivery Trading
You can take 4 5 times more than limits
Close positions anytime before expiry. On expiry day, exchangeautomatically closes out positions.
Keep your positions open up to 3 months
Profits / losses are paid / recovered on a daily basis
If you feel the market will be bearish, take short positions infutures, which is not possible in delivery based trading without
actual shares in demat.
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Intrinsic Value Difference between the Strike Price and Spot Price
Time Value - Theta
Time to expiry of the contract
As the expiry date comes nearer, the options premium decays
Volatility of underlying- Beta
Higher volatility of stock would attract higher premium
Premium in HINLEV (low beta) would be lesser than SATCOM(high beta) - other factors remaining same
Options- Pricing
Options Ri k
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BUYER of CALL / PUT options
Maximum loss : PREMIUM
Maximum Gain : UNLIMITED
SELLER of CALL / PUT options
Maximum loss : UNLIMITED
Maximum Gain : PREMIUM
Options-Risk
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Options-Exercise
Only In the Money (ITM) options are allowed to be exercised
Buyer/Holder receives the difference
Call Option: Spot price-Strike price
Put Option: Strike price-Spot price
Writer/Seller pays the difference
Call Option : Spot price-Strike price
Put option: Strike price-Spot price
All At the Money (ATM) and Out of the Money (OTM) contractsexpires worthless
Assigned to seller/writer who is Out of the Money (OTM)
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Options - Exercise v/s Square-off
EXERCISE SQUARE-OFF
Difference between Difference betweenSTRIKE PRICE and PREMIUM Amounts atCLOSING PRICE of the time of Square-off.
underlying on exercise day
EXERCISE can be done only by the BUYER.
SQUARE-OFF can be made by both BUYER & SELLER
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To sum up
Some of the key uses of options are
- Leverage
- Protecting the value of equity positions
- Limiting risk
- Alternative to direct investment in equitymarkets.
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How can you get the most out of
these instruments?
- Adopt the appropriate strategy that suits
- Your personal circumstances and
- Your market view
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Life is all about Choices,
Good or Bad; Right or Wrong;Your Destiny will unfold according to
the Choices you make
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Thank You
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