By, Animesh Verma - 04 Meet Buch 18 Mrinal Banerji - 21 Pradyumna Swain 27 Rittvik Agarwal 32 Satwik Kabisatpathy - 41

Derivatives
A security whose price is dependent upon or derived from one or more

underlying assets

The derivative itself is merely a contract between two or more parties.

It derives its value from the prices, or index of prices, of underlying securities bonds, commodities, currencies, interest rates and market indexes

The most common underlying assets include stocks,

Derivatives are generally used as an instrument to hedge risk

Futures Contract
Futures Contract means a legally binding agreement

to buy or sell the underlying security on a future date at a price agreed today
Contracts in terms of quantity, quality (in case of

commodities), delivery time and place for settlement on any date in future
Expires on a pre-specified date which is called the

expiry date of the contract

The price of the underlying instrument, in whatever

form, is paid before control of the instrument changes

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Forward Contract
Forward is a non-standardized contract between two

parties to buy or sell an asset at a specified future time at a price agreed upon today
Forward contracts are very similar to futures

contracts, except they are not exchange-traded, or defined on standardized assets and they are traded over the counter
Futures are margined, while forwards are not .Thus

futures have significantly less credit risk, and have different funding.

SWAP
Traditionally, the exchange of one security for another

to change the maturity (bonds), quality of issues (stocks or bonds), or because investment objectives have changed
The benefits in question depend on the type of

financial instruments involved

If firms in separate countries have comparative

advantages on interest rates, then a swap could benefit both firms

Options
Options Contract is a type of Derivatives Contract which

gives the buyer/holder of the contract the right (but not the obligation) to buy/sell the underlying asset at a predetermined price within or at end of a specified period
The buyer / holder of the option purchases the right from

the seller/writer for a consideration which is called the premium

The seller/writer of an option is obligated to settle the

option as per the terms of the contract when the buyer/holder exercises his right
An Option to buy is called Call option and option to sell is

called Put option

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Types Of Options
On the basis of payoff structures Call option A call gives the holder the right to buy an asset at a certain price within a specific period of time. Put option A put gives the holder the right to sell an asset at a certain price within a specific period of time.

Types Of Options
On the basis of exercise options American options Can be exercised at any time between the date of purchase and the expiration date. Mostly American options are exercised at the time of maturity. But when the underlying makes cash payments during the life of option, early exercise can be worthwhile.

European options Can only be exercised at the end of their lives

Types Of Options
On the basis of versatility Vanilla Option A normal option with no special or unusual features Exotic Option A type of option that differs from common American or European options in terms of the underlying asset or the calculation of how or when the investor receives a certain payoff.

Foreign exchange derivatives

A foreign exchange derivative is a financial derivative whose

payoff depends on the foreign exchange rate(s) of two (or more) currencies. These instruments are commonly used for currency speculation and arbitrage or for hedging foreign exchange risk. Instruments: Currency Options Currency Futures Currency Swap Forward

Currency Swap
Currency Swap is an agreement between two parties of two

countries for exchanging of principle and interest of loan at its present value. This swap is very useful for controlling foreign exchange risk. Interest rate swap is different from currency swap, because in interest rate swap, we just exchange the interest from fixed to floating rates but in currency swap, we both principle and interest of loan is exchanged from one party to another party for mutual benefits. Structure: Exchange only the principal with the counterparty at a specified point in the future at a rate agreed now. Equivalent to forward or future contract Commonly used for longer term Also called FX- Swap

Currency Swap
Combine the exchange of loan principal with an interest rate

swap As each party effectively borrows on the other's behalf, this type of swap is also known as a back-to-back loan
Swap only interest payment cash flows on loans of the same

size and term Ex: Exchange of fixed-rate US dollar interest payments for floating-rate interest payments in Euro Also called as cross currency swap

Example 1
Suppose one USA company wants to start his factory in

India. For this it gets $10 billion dollar in the form of loan from USA market and Exchanges this amount from India company B. Now company A has Indian currency for doing business in India and company B which is Indian company has USA currency and it can get Forex earning. It means that both are benefited with single deal of currency swap.

Example 2
Suppose a U.S. MNC wants to finance a 10,000,000

expansion of a British plant. l) They could borrow dollars in the U.S. where they are well known and exchange for dollars for pounds. 2) They could borrow pounds in the international bond market, but pay a premium since they are not as well known abroad.

Example Contd
If they can find a British MNC with a mirror image

financing need they may both benefit from a swap. If the spot exchange rate is S0($/) = $1.60/, the U.S. firm needs to find a British firm wanting to finance dollar borrowing in the amount of $16,000,000.

Example 2 Contd
Interest rate for Borrowing Dollar Firm A (Subsidiary of US based in UK) Firm B (Subsidiary of UK Based in US) 6 Interest rate for Borrowing Euro 9

Currency Futures
Currency Futures is a standardised foreign exchange derivative

contract traded on a recognized stock exchange to buy or sell one currency against another on a specified future date, at a price specified on the date of contract, but does not include a forward contract.
Currency Futures are permitted in US Dollar Indian Rupee

(USD INR), Euro Rupee (EUR INR), Great Britain Pound Indian Rupee (GBP INR) and Japanese Yen Indian Rupee (JPY INR).

Settlement in future contract

Time Monday Morning Action Investor buys SFr future contract that matures in 2 days. Price is $0.75. Cash Flow None

Close of the day

Future price rises to $0.755. Position is marked to market. Future price drops to $0.752 Position is marked to market

Investor receives 125,000*(0.755-0.75)= $625 Investor pays 125,000*(0.755-0.752) =$375 1)Investor pays 125,000*(0.7520.74)=$1500 2) Investor pays $92,500 @0.74

Tuesday close

Wednesday close Future price drops to $0.74. 1) Contract is marked to market. 2) Investor takes delivery of SFr 125,000.

Advantages of Currency Futures

Low Commission

Cut Out the Middleman

Standardised Lot Size Low Transaction Cost

Almost Instantaneous Transactions

Low Margins, High Leverage Online Access No Insider Trading

Currency Option
A currency option is a contract that allows the buyer the right

but not the obligation to buy or sell the underlying at a stated date and at a stated price. A call option gives the right to buy and put option gives the right to sell. In every currency transaction, one currency is bought and another sold.
Options are either call or put options

Strike Price Terminology

The type of option and the relationship between the spot price of the underlying asset and the strike price of the option determine whether an option is in-the-money, at-the-money or out-of-the-money. Exercising an in-the-money call or in-the-money put will result in a payoff. Neither a call nor put that is at-the-money will produce a payoff.
Call Option
In-the-Money At-the-Money Out-of-the-Money Spot > Strike Spot = Strike Spot < Strike

Put Option
Spot < Strike Spot = Strike Spot > Strike

Buying a call Option

US Importer has Euro 62,500 payment to make to a

German exporter in 60 days. The importer purchased a call option to have it delivered at a specific strike rate on due date. Option premium= $0.02/Euro Strike price= $1.25 Total option premium paid by Importer= $1250 1) On Due date Euro rises; Spot rate = $1.30 Option is In the Money; Importers profit=62,500*0.05=$3125 Net profit= 3125-1250= $1875 2) On Due date Euro declines; Spot rate= $1.20 Option is Out of Money; So the importer would let the option expire & purchase in the spot market.

Buying a Put option

Strike Price= $1.25 Option Premium= $0.02

On Due date Euro rises; Spot rate = $1.30 Option is Out of Money; So the Investor would let the option expire & sell in the spot market. 2) On Due date Euro declines; Spot rate= $1.20 Option is In the Money; Investors profit=62,500*0.05=$3125 Net profit= 3125-1250= $1875
1)

What is Equity Derivative ?

a financial instrument referencing an underlying

equity asset or other variable, from which the financial instruments price or value is derived, entered into by the parties for a purpose

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 The Financial instrument

OTC derivatives Structured products

: Swap, Forward, Option

: Note, Certificate, Warrant, Fund unit

Exchange traded products : Future, option, one of

the structured products

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 The underlying equity asset

share or a basket of shares

ONGC, RIL, TCS, Infosys etc.

an index or basket of indices

NIFTY, Mini NIFTY, Bank NIFTY etc.

a variable linked to these

DVRs

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 Price of the financial instrument

the change in the price level of the underlying asset over a

period of time
the relative price level of different underlying assets over a

period of time
the total return on single or multiple underlying assets over a

period of time Different Formulae

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 Purpose of parties to enter

monetizing an existing shareholding
a corporate finance strategy

building up a stake prior to a M&A

hedging

tax advantage

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Types of Traders
Hedgers Traders who want to avoid an exposure to adverse movements in the price of an asset

Eg; Consider an investor, in September, owns 500 ITC shares. Current share price = Rs.260. The investor is concerned that the share price may decline sharply in the current month and wants protection. The investor could buy September put option to sell 500 shares for a strike price of Rs.255. Assuming the lot size to be 100 shares per lot and quoted option price be Rs.4, the total cost of hedging strategy would be 5x4x100 = Rs.2000. Ensured value of holding : Rs.255x500 2000 = Rs.125500

 Speculators
Traders who wish to take a position in the market

by betting that the price of the equity will go up or go down.

Eg; Investor has Rs.130000.
Strategy Rs.250 Rs.275

Buy shares
Buy call options

-5000
130000

7500
487500

Terminology

Expiration date Strike prices Option series Intrinsic value

Call option : max (S-X,0) Put option :max (X-S,0)

Flex option : Traders on the floor agree to nonstandard terms Position limits : maximum number of option contracts that a

trader can hold on one side of the market Exercise limits : maximum number of the contracts that can be exercised by any individual Basis risk : (Spot price of the underlying asset) (Future price of the underlying asset)

 Option and future clearing corporations It guarantees that option/future writers will fulfill their obligations under the terms of the contract

Commodity Derivatives Defined

Derivative contracts where underlying assets are

commodities. If the underlying asset of the derivative contract is

Precious metals (e.g Gold, Silver etc) Other metals (e.g tin, copper, lead etc) Agro products (e.g coffee, wheat , pepper & cotton) Energy products (e.g crude oil)

then the derivative is known as commodity derivative.

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Why one trades in commodities ??

A potato producer could purchase potato futures on a

commodity exchange to lock in a price for a sale of a specified amount of potato at a future date, while at the same time a speculator could buy and sell potato futures with the hope of profiting from future changes in potato prices.

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Commodity Derivatives- History

Trading in such derivatives started so as to protect the farmers from the

risk of the value of their crop going below the cost price of their produce. The first 'futures' contracts can be traced to the Yodoya rice market in Osaka, Japan around 1650. The first organized exchange, the Chicago Board of Trade(CBOT) with standardized contracts on various commodities was established in 1848. In 1874, the Chicago produce exchange which is now the Chicago Mercantile Exchange(CME) was established. CBOT & CME are the two largest exchanges in the world. People speculate in the direction of prices hoping to gain if the price movement is in their favour. Derivatives trading started in oilseeds in Bombay (1900), raw jute and jute goods in Calcutta (1912), wheat in Hajipur (1913) and in Bullion in Bombay (1920)

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The Indian Context

A revolution in Commodity derivatives and risk

management Commodity options banned in India between 1952 and 2002 Commodity market began from 2003 onwards Almost all stock exchanges have commodity market segments apart from 3 national level electronic exchanges. Almost Eighty commodities are in the list now

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After Independence
The Parliament passed Forward Contracts (Regulation) Act, 1952 The Act envisages three-tier regulation: The Exchange which organizes forward trading in commodities can regulate trading on a day-to-day basis; the Forward Markets Commission provides regulatory oversight under the powers delegated to it by the central Government, and the Central Government - Department of Consumer Affairs, Ministry of Consumer Affairs, Food and Public Distribution is the ultimate regulatory authority. In 1960s, following several years of severe draughts that forced

many farmers to default on forward contracts (and even caused some suicides), forward trading was banned in many commodities considered primary or essential.

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Policy Shift Kabra Committee

Government set up a Committee

in 1993 to examine the role of futures trading. The Kabra Committee recommended allowing futures trading in 17 commodity groups.

It recommended certain

amendments to Forward Contracts (Regulation) Act 1952, particularly allowing options trading in goods and registration of brokers with Forward Markets Commission.

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After Effect
The Government accepted

most of these recommendations and futures trading was permitted in all recommended commodities. Derivatives do perform a role in risk management led the government to change its stance. Liberalization facilitates market forces to act freely The next decade is being touted as the decade of commodities.
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Comm. Exchange Hierarchy (India)

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Example
On June 8 a company knows that it will need to

purchase 20,000 barrels of crude oil at some time in October or November. Oil future contracts are traded for delivery on NYMEX every month, and the contract size is 1000 barrels. The company therefore takes a long position in 20 contracts and decides to use the December position. The futures price on June 8 us $18.00 per barrel. The company finds that it is ready to purchase the crude oil on November 10. It therefore closes out its futures contract on that date. The spot price & future price on November 10 are $20.00 per barrel & $19.10 per barrel.

Example continued
Thus the gain on the futures contract is 19.10 -18.00 =

$1.10 per barrel. The effective price paid is the final spot price less the gain on the futures or 20.00 1.10 = $18.90 Thus the total price received = 18.90 * 20,000 = $378,000

Bond Derivatives
Bond futures

Bond options

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Bond Futures
An agreement whereby the short position agrees to deliver pre-

specified bonds to the long at a set price and within a certain time window. "standardized".

Its typically traded on an exchange and the underlying bond is

Futures price is set in such a way that no cash changes hands when a

contract is entered into.

Bond futures are often very liquid instruments, which gives the user the

certainty that he can establish and unwind positions easily and cheaply. protection against movements in the cash market for government bonds by taking an opposite position in the futures market.

The contract is used for hedging, speculation, and arbitrage by

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Bond Options
An option to buy or sell a bond at a certain price on or before the

option expiry date.

These instruments are typically traded OTC. European bond option: at a certain date in future for a

predetermined price. predetermined price.

American bond option: on or before a certain date in future for a Generally, one buys a call option on the bond if one believes that

interest rates will fall, causing an increase in bond prices. Likewise, one buys the put option if one believes that the opposite will be the case.

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Bond Option (contd..)

A call bond option hedges that the value of a bond will increase at a

future date.

If the price > strike price => bond option is valued at a premium
If the price < strike price => bond option is valued at a discount

The exact opposite would be true for a put bond option.

Why It Matters:
Bond options provide investors with a tool for hedging interest rate fluctuations. For instance, an investor who believes that interest rates are going to drop in the future may purchase a call bond option on an underlying bond for which the yield is higher than the current interest rate level.

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Number of ETD traded worldwide

Source: World Federation of Exchanges

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Growth rate by product type

Equity derivatives:

14% growth Interest rate derivatives: Continued to grow in 2011 (+9%) Did not recoup from their highest level reached in 2007 Currency derivatives: Highest growth rate across all products in 2011 (+24%). Overcame the commodity derivatives market in terms of number of traded contracts as of 2011 Commodity derivatives: 34% decrease in volumes on mainland Chinese exchanges caused a global 6% decrease in commodity derivatives in 2011 +24% when excluding mainland Chinese exchanges
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Growth rate by region

25 billion Exchange Traded Derivatives (ETD) contracts

13 billion options and 12 billion futures

+12% in 2011 (+26% in 2010)

Higher growth rate than on cash markets

Asia-Pacific growth rate was lower (+10%) than in Americas and EAME (+13%) Growth rate of Indian market is 32%

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Facts about Indian derivative market

Korea accounted for 42% of derivatives traded across the Asia-Pacific

region in the first half of 2011, while those changing hands in Indian exchanges accounted for 32 %, the association said. Chinas exchanges made up 16 %
Growing demand for commodity futures contracts in China and India

will help the worlds biggest consumers of raw materials to eventually overtake Korea as the regions top derivatives exchange
Contracts traded on the four Indian derivatives exchanges more than

doubled to 1.36 billion in the first half of 2010, compared with 542.4 million a year earlier, according to the associations data
The growth in the currency derivative market was primarily driven by

currency options being traded on NSE. 24% growth rate of which 18% came from NSE

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Source: World Federation of Exchanges

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Source: World Federation of Exchanges

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Source: World Federation of Exchanges

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Thank You.

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