DERIVATIVES

A derivative is a financial instrument, which derives its value from an underlying asset. The
value of a derivative is nothing without value of its underlying asset. Derivatives do not have
physical existence but emerge out of contract between two parties. For example, a derivative/
security is issued, whose value is defined based on price of rice in the market. As price of rice
increases or decreases, the value of derivative also goes up and down. If the asset (rice)
underlying this derivative is removed, the value of derivative will become zero because this
security has no value on its own.
The underlying asset can be a commodity, currency, interest rate et cetera.
Derivatives are very similar to insurance. Insurance protects against specific risks such as
accidents, fire, floods, droughts etc. derivatives take care of market risks emanating from
volatility in interest rates, currency rates, share prices etc. derivatives help in redistribution of
risk from one party to the other.
Economic benefits of derivatives:
Derivatives reduce risk and therefore increase the willingness of investor to invest his
money in the financial or commodity market but still remain risk averse.
Derivatives increase the liquidity of underlying asset or financial market.
The cost of trading a real or financial asset like shares, bonds, commodities etc is larger
than the cost of trading in derivatives. By trading in derivatives, the total cost of
transaction for an investor goes down.
Derivatives provide an opportunity to create an optimum portfolio by adjusting risk ad
return characteristic of the portfolio. They help in shifting the risk from those who
have it but dont want it to those who have the appetite and are willing to take it. 3 types
of risks which can be adjusted through derivatives are- Market Risk, Interest Rate Risk
and Exchange Rate Risk.
Market risk- also called as systematic risk, market risk is the risk of the whole
market going down or moving up. Market risk cannot be diversified because it
affects the entire market. It can only be shifted from one person to the other.
Interest rate Risk- This risk is related to fixed income securities like Bonds and
debentures. This risk arises when interest rate on such securities goes up or
down, affecting the market value of such securities.
Exchange rate risk- wherever foreign currency is involved, it gives rise to
exchange rate risk in terms of fluctuation in exchange rate of currencies.

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Traders in a derivative market:
Hedger- a hedger is a person who faces certain risk associated with price movement of
an asset and uses a derivative to reduce that risk. This is done by taking a position
opposite to movement of the underlying asset. For example, if A feels that his asset X is
going to lose value in the near future, he can hedge by buying a derivative whose value
moves opposite to movement of the underlying asset. So, if value of X goes down, value
of derivative will go up by the same or more proportion, hedging the risk for A.
Speculator- Speculators are people interested in taking risk and making money out of
higher risk transactions. They are not risk averse investors. Speculators are the people
interested in taking risks that hedgers wish to transfer.
Arbitrageur- whenever there is a discrepancy in price of the same asset in different
markets, arbitrageurs simultaneously enter into transactions in 2 or more markets and
take advantage of the discrepancy by buying and selling the same asset simultaneously
in different markets.
Kinds of Derivatives- Derivatives can be of the following kinds:
Forwards
Futures
Options
Swaps


Forwards and Futures:
Example- Person A wants to have carrots every month. But he expects prices of carrots
to rise in the future. He will ask person B to supply him x carrots at the price of Rs y
every month. B expects prices of carrots to fall. He will agree to Supply x carrots for Rs
y every month. This agreement is a Forward/ Future
Thus, a forward is a customized contract between two entities where settlement takes
place on a specified date in the future at todays pre agreed price.
Future is structurally similar to a forward contract. The only difference is that forward
contracts are dealt in Over The Counter (OTC) market whereas Futures are
standardized contracts dealt over stock exchange.

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Forwards Futures

Over the counter Exchange traded

Customized Standardized

Less liquidity More liquidity

Credit default risk in high Credit guarantee as they are

because one of the parties traded on the stock exchange
may default if the contract
turns unfavorable

Paid at settlement date- the Marked to market- this means

derivative is not tradable. that value of derivative changes
Settlement between parties everyday according to value of
takes place at the end of the underlying asset. An investor
commitment period. can trade the derivative on the
stock exchange.

Terminology in futures contract:
Long- a party is said to be long on an instrument when he or she purchases that particular
instrument. By instrument is meant the derivative (future) being talked about.
Short- opposite of long, a party is said to be short when he or she sells a contract, which he
does not currently own. Short position indicates an over-sold position.
Spot price- the price at which an asset trades in the spot market is called spot price. Also called
as cash price or current price.
Futures price- the price at which the future contract trades in the futures market.
Expiry date- the last day on which the contract will be traded, at the end of which it will cease
to exist.
Margin- the amount of money deposited by both buyers and sellers of futures contracts to
ensure performance of terms of the contract is called margin money. Margin reduces the risk of
default by either counter party.
Basis- the difference between spot price and futures price of an asset is called as basis. As a
contract approaches maturity, the basis reduces and becomes zero on the date of maturity
because the future price and spot price become the same on date of maturity.

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Spread- A spread is the difference between 2 futures prices. The futures involved may be intra
commodity or inter commodity. Intra commodity futures happen when the same underlying
good with different expiration dates has different futures prices.


Pricing of futures contract depends on the following variables:
Price of underlying asset in the market
Rate of return expected from investment in the asset
Risk free rate of interest

Question: The current value of a share in robotronics is Rs 12.50 (So). One year riskless rate is 6%
(r). What is the price of a 2 year forward contract on robotronics stock.
1. 1 year forward contract is being sold for Rs 16 in the market. Outline an Investment
strategy that can take advantage of the opportunity this presents.

Ans:
So = Rs 12.50; r = 6%; k = 2; we have to find Fk
The formula for no arbitrage forward pricing is So Fk (1 +r) k = 0 or Fk = So(1 +r) k
Thus, Rs 12.5 Fk (1 + 0.06) -2 = 0
12.5 (1 + 0.06) 2 = Fk ;
Fk = 14.045

If Fk = Rs 16 in the market, the investor can short (agreement to sell) forward contract to sell @
Rs 16 one year from now. At the same time, she can borrow Rs 12.50 @ 6% from the market to
purchase one robotronics stock. One year from now, she can sell forward contract at Rs 16 and pay
back the lender by using Rs 14.045, making a profit of
Rs 16 Rs 14.045 = Rs 1.955. this will continue till So (1 + r)k = Fk


Question: Current NIFTY is 1800 and minimum lot is 100. Risk free rate is 8% and futures period
is 3 months. What is the fair value of 3 months NIFTY futures?

Ans: Fk = So(1 +r) k

So = 1800 (spot price)

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r = 8%
k = 3 months or 3/12 years

Fk = 1800(1+ 0.08)3/12 (to solve this using normal calculator, instead of using time k in decimals,
we divide r to make it equal to rate of interest for a quarter. Here, the rate of interest for a quarter
would be 2%. Therefore, the formula becomes 1800(1+ 0.02)1 . solving this, we get 1836 as the
value of future contract)

Fk = 1836.36 (fair value of 3 month future. Since minimum lot of NIFTY stock is 100, the fair
value comes to 1836.36*100 = 183636)

Currency Future:

When the actual price of dollar is Rupees 65/ dollar, Mr X will be able to buy $1000 by paying
62000 rupees but he can sell his 1000 USD in the market at 65000 rupees, thus making a profit
of 3000
Similarly, in case of actual price being 60/ dollar, he will be in a loss.

NOTE: Market for currency futures in India commenced in august 2008.

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OPTIONS:

An Option is a contract, which offers the buyer of the contract (long position) the right, but not
the obligation, to buy (call) or sell (put) a security or other financial asset at an agreed-upon
price (strike price) during a certain period of time or on a specific date (exercise date). The
seller of the Option gets premium for selling his right to take decision. There is no premium
involved in forwards and futures but Option contracts have premium paid to the seller of
Option contract. Futures contract have symmetric risk profile for both buyer and seller of the
contract whereas options have an asymmetric risk profile.
Writer of an option is the person who creates an option and floats it in the market for people to
buy the option. Writer is the person who gets premium for selling his right to decide on the
future date about buying/ selling of the option. Writer of a call option is bearish and writer of a
put option is bullish.
Popular models to determine value of an option- Black Scholes Option pricing model; Binomial
Model.
Stock based option trading was allowed by SEBI in 2002.
3 things to be understood:
Buyer of contract versus seller of contract. The buyer of contract is in long position
while the seller is in short position.
Right to buy the asset or security (Call option)- belongs to the buyer of the contract
Right to sell the underlying asset or security (Put option)- belongs to the buyer of the
contract

Call Option Payoff- A call option is a right to buy the underlying asset at a future date at a
predetermined price. As the holder of option contract has a right to buy the asset at a future date, he
will exercise this right only in case of profits from the exercise. Therefore, his losses are limited to
premium paid to the seller of contract. In the diagram below, premium is not included. Therefore, the
holder of option contract cannot have any loss from the contract while his profits can be unlimited.

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Put Option Payoff- A put option is the right to sell the underlying asset at a future date at a
predetermined price. As the holder of option contract has a right to sell the asset at a future date, he
will exercise this right only in case of profits from the exercise. Profit in case of a put contract is
maximum in a situation when the price of the underlying asset is 0 as in that case, the option holder
can buy the asset for 0 from the market and sell it to the other party under contract at pre-
determined selling price.

European vs. American Option:
American-style Options can be exercised at any time up to and including the expiry date
European-style contracts can only be exercised on the expiry date

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Important Terms in Option Contracts:
1. Option Premium- In options, the buyer of the option has to buy the right from the seller by
paying an option premium. The premium is a one time non-refundable amount for availing the
right.
2. Expiration date- the last date when the option can be exercised is called expiration date. In case
of American options, the right can be exercised even before the last date.
3. Strike Price- the specified price at which the option can be exercised is known as the strike
price. The actual price of the underlying asset may be different from the strike price of the
option contract.
Relationship Call Option (right to buy) Put option (right to sell)
Actual Price > strike price In the money (exercise) Out of money (do not exercise)
AP = SP At the money At the money
AP < SP Out of the money In the money

Currency Options:

Strike price is the price at which option contract can be exercised at a future date. Option
buyer will gain because he can buy Pound at a call price of $1.820 from the other party and sell
the same in the market at $1.920, making a profit.



Example of Call and Put options:

Call:
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An investor buys a call option to buy 100 forcemotors shares at a price of Rs 300 on october 1, 2016.
The current price is Rs 250 per share and premium charged by writer/seller of the contract is Rs 25
per share. Thus, the total premium to be paid by the buyer to writer is Rs 2500. If the market price of
force motors goes up to Rs 400, the investor will exercise his right by paying Rs 300 *100 (30,000)
and selling the shares in the market at price of Rs 400. The net gain to the investor in this case would
be (40,000 30,000 2500) = 7500.
The buyer of option contract will not exercise the contract if price of shares at the date of expiration is
less than Rs 300.

Put:
An investor buys a put option to sell 100 forcemotors shares at a price of Rs 300 on october 1, 2016.
The current price is Rs 350 per share and premium charged by writer/seller of the contract is Rs 25
per share. Thus, the total premium to be paid by the buyer of contract to writer is Rs 2500. If the
market price of force motors goes down to Rs 200, the investor will exercise his right by buying the
shares from the market for Rs 200 *100 (20,000) and selling the shares to the writer of option
contract at price of Rs 300. The net gain to the investor in this case would be (30,000 20,000 2500)
= 7500.


Option Spreads:
The risk profile of option buyer and seller is different. While Option buyer is exposed to limited losses
but unlimited profits, option seller is exposed to limited profits but unlimited losses. To limit this
profit and loss profile for both buyer and seller, a spread is created. An option spread involves taking a
position in 2 or more options of the same type. For example, buying a call and selling another call with
different strike price or different expiration dates is termed as spread. There are 3 types of spreads-
Vertical spread, horizontal spread and diagonal spread.

Vertical spread- In a vertical spread, the investor involves in simultaneous buying and selling of
options of the same instrument but with different exercise price/ Strike price. Vertical spreads are
also called price spreads.

Horizontal spread- in a horizontal spread, the instruments purchased and sold have the same strike
price but different expiry dates.

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Diagonal spread- combines features of both vertical and horizontal spread. Both the expiration date
and strike price are different in a diagonal spread.

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SWAPS:
A swap is an agreement between two parties in which they agree to exchange their respective
cash flows. The parties to a swap contract are called as counter parties. In a swap, one party
agrees to exchange his set of pre-determined cash flows with pre-determined set of cash flows
of the other party.
In a currency swap, 2 currencies are exchanged in the beginning and again at maturity the
currencies are re-exchanged.




Currency Swap:

Currency Swap involves exchanging principal and fixed interest payments on a loan in one currency
for principal and fixed interest payments on a similar loan in another currency.
Parties to a swap exchange principal amount at the beginning as well as end of the swap.

For example, Company A, a US firm and company B, a European firm enter into a 5 year $50 million
swap agreement. The exchange rate at the time of agreement is $1.25 per Euro.
First, the firms will exchange principals. So, company A pays $50 million to B and company B pays 40
million euros (1$ = 0.80 euros) to A. This satisfies each companys need for funds.
The parties will exchange interest at regular intervals. Because company A has exchanged dollars for
Euros, it would pay interest in Euros based on Euro interest rate. Similarly, company B will pay
interest in dollars.
Dollar denominated interest rate is 8.25% and Euro denominated interest rate is 3.5%.
Therefore, company A pays 3.5% interest on 40 million euros i.e. 1.4 million euros. Company B pays
8.25% interest on 50 million Dollars i.e. 4.125 million USD.
If the exchange rate at the end of the year is $1.4 per euro, Company As payment would be (1.4
million *1.4) 1.96 million USD and Company Bs payment would be 4.125 million USD. Netting the
amount, company B will pay 2.165 million USD to A
At the end of 5 years, both companies would swap their principals. Principal amount is unaffected by
the exchange rate at the end of the period.

Interest rate swaps (IRS):

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An interest rate swap is an exchange of interest flows on an underlying asset or liability. In an interest
rate swap, there is a shift of basis of interest rate calculation, from fixed rate to floating rate or vice
versa. The cash flows representing the interest payments during the swap period are exchanged
accordingly.

Example:
Fixed rate Floating rate
Company A 10% LIBOR + 0.80
Company B 8.85% LIBOR + 0.30

Company B enjoys lower borrowing cost in both markets but Company A has relatively lower cost in
floating rate market.
In this case, Company A will borrow at floating rate from the market and lend to B at LIBOR. This will
provide an advantage of 0.30 % to B and a loss of 0.80% to A.
Company B will borrow at a fixed rate interest of 8.85% and lend to A at 9%. This way, company A will
save 1% on its borrowing through B and company B will gain 0.15%.
Total gain to both parties due to the agreement of swap:
A- 1% -0.80% = 0.20%
B- 0.3% + 0.15% = 0.45%
















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Questions:
1. The price of equity shares of Onida limited in rupees 30. The risk free rate is 12% p.a. an
investor wants to enter into a
a. 1 year and
b. 6 months forward contract.
Find out the forward price in both cases.

2. The debentures of ABC ltd. are currently selling at Rupees 930 per debenture. The 4
months future contract on this debenture is available at Rupees 945. Should the investor
buy this future if the risk free rate of interest is 6%?

3. The share of ABC ltd is currently traded at rupees 47. An investor buys a call option for a
strike price of 50 and premium of 5. Under what circumstances does the investor make
profit?

4. Deeksha has bought a 3-month call option on SBI limiteds share with an exercise price of
Rs 50, at a premium of Rs 4. She has also bought a put option on the same share at an
exercise price of Rs 40, at a premium of Rs 1.50. SBIs share is currently selling for Rs 45.
What will be deekshas position after 3 months, if the share price turns out to be Rs 50 or
Rs 30?

Answer:
Total premium paid = Rs 5.50

When share price is Rs 50-
She will not exercise call option because there will be no profit no loss for exercising the
option. Thus loss on call option = Rs 4 (premium)
She will also not exercise put option because actual price>strike price/ exercise price

Total loss = 5.50

When share price is Rs 30-
She will not exercise call option
Profit on put option = Rs (40-30) = Rs 10

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Total profit = Rs 10 Rs 5.50 = Rs 4.50
5. Person A buys a call option of IBM with an exercise price of Rs 195 selling for a premium of
Rs 3.65. At the time of expiration of the option, the actual price of the share is Rs 197. Find
out the profit or loss for person A for exercising the option contract?

Answer:
Value at expiration = stock price exercise price = 197 195 = Rs 2
Loss on account of premium paid = Rs 3.65
Total loss to A in the call option = Rs 3.65 Rs 2 = Rs 1.65


6. Person A buys a put option of IBM with an exercise price of Rs 195 selling for a premium of
Rs 5. At the time of expiration of the option, the actual price of the share is Rs 188. Find out
the profit or loss for person A for exercising the option contract?

Answer:
Value at expiration = exercise price stock price = 195 188 = Rs 7
Profit to A = Rs 7 Rs 5 = Rs 2 per share

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