Derivatives Market

Introduction

Exposure to risk due to fluctuations in prices of

commodities, interest rates, foreign exchange rates, etc.
Organizations were not able to estimate their costs and
revenues
Derivatives helps control the price volatility
Impact of fluctuations can be minimized by locking-in
asset prices with the help of derivatives productions
A substance that can be made from another substance
Merriam Webster Dictionary
Eg. Curd is a derivate product derived from Milk
The performance of derivatives depends on the
movement in the prices of the underlying assets

Derivatives

A derivative is a financial instrument

whose value is derived from the value
of another asset, which is known as the
underlying.

When the price of the underlying

changes, the value of the derivative also
changes.
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Derivatives

A Derivative is not a product. It is a

contract that derives its value from
changes in the price of the underlying.

Example : The value of a gold futures

contract is derived from the value of the
underlying asset i.e. Gold.

Elements of Derivatives
Contracts
It is a legally binding contract
There are two parties
There is an underlying asset
Future date
Future price

Origination of Derivatives
Markets

Traced back to Agriculture markets In traditional market products

were brought and kept in the market the potential buyers would
negotiate the price
Problem: Farmers failed to fetch expected prices and also there was
no availability of storage facilities
Derivatives originated in Chicago Chicago Board of Trade (CBOT)
was established in 1848 to bring farmers and merchants together
Initially its main task was to standardize the quantities and qualities
of the grains that were traded
Within a few years the first futures-type contract was developed. It
was known as a to-arrive contract
Speculators soon became interested in the contract and found trading
the contract to be an attractive alternative to trading the grain itself
A rival futures exchange, the Chicago Mercantile Exchange (CME),
was established in 1919

Types of Underlying Assets

Financial
Equity Based
Individual Stock (Tata Motors, Infosys, etc,)
Indices (Sensex, Nifty, etc.)

Debt Based
Interest Rates (Libor, T-Bill Rates, etc,)
Credit (Bonds, Loan Receivables, etc.)

Others
Currency (Dollars, GBP, Euro, etc.)
Weather (Temperature, Rainfall Index, etc.)
Emissions (Carbon Credits)

Non-Financial
Agricultural
Cereals, Pulses, Fruits, Vegetables, etc.

Non-Agricultural
Metals, Dairy Products, Animal Products, Energy Products

Electronic Markets

Traditionally derivatives exchanges have used what is

known as the open outcry system
This involves traders physically meeting on the floor of
the exchange, shouting, and using a complicated set of
hand signals to indicate the trades they would like to
carry out
Exchanges are increasingly replacing the open outcry
system by electronic trading
This involves traders entering their desired trades at a
key board and a computer being used to match buyers
and sellers
The open outcry system has its advocates, but, as time
passes, it is becoming less and less common
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OTC Markets

The over-the-counter market is an important alternative to

exchanges and measured in terms of the total volume of trading,
has become much larger than the exchange-traded market
It is a telephone- and computer-linked network of dealers
Trades are done over the phone and are usually between two
financial institutions or between a financial institution and one of
its clients
A key advantage of the over-the-counter market is that the
terms of a contract do not have to be those specified by an
exchange
Market participants are free to negotiate any mutually attractive
deal
A disadvantage is that there is usually some credit risk in an
over-the-counter trade

Participants
HEDGERS
Someone who faces risk associated with
price movement of an asset and who uses
derivatives as means of reducing risk
They provide economic balance to the
market

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Participants
SPECULATORS
A trader who enters the futures market for
pursuit of profits, accepting risk in the
endeavor
They provide liquidity and depth to the
market

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Participants
ARBITRAGEUR
A
person who simultaneously enters into
transactions in two or more markets to take
advantage of the discrepancies between prices
in these markets
It involves making profits from relative mispricing
They help to make markets liquid, ensure
accurate & uniform pricing and enhance price
stability
They help in bringing about price uniformity and
discovery
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Economic benefits of
Derivatives

Enhances the price discovery process

Reduces risks - Transfer risks
Witnesses higher trading volumes, because
participation by more players
More controlled environment
Acts as a catalyst for new entrepreneurial activity
Increase savings and investment in the long run
Lower transaction costs
Enhances liquidity of the underlying asset
Provides signals of market movements
Facilitates financial markets integration

of

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Types of Derivatives
Forward
Futures
Options
Swaps

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Features of Forward
Contract

They are bilateral contracts and hence exposed to

counter-party risk
Each contract is custom designed, and hence is unique
in terms of contract size, expiration date and the asset
type and quality
The contract price is generally not available in public
domain
The contract has to be settled by delivery of the asset
on expiration date
In case the party wishes to reverse the contract, it has
to compulsorily go to the same counter party, which
being in a monopoly situation can command the price it
wants
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Example of Forward
Contract

If a farmer plans to grow 100 bushels of wheat nextyear,

he could sell the wheat for whatever the price is when he
harvests it, or he could lock in a price now by selling a
forward contract that obligates him to sell 500 bushels of
wheat to, say, Kellogg after the harvest for a fixed price.
By locking in the price now, he eliminates the risk of
falling wheat prices. On the other hand, if prices rise
later, hewill get only what his contract entitles to.
In case of Kellogg, they might want to purchase a
forward contract to lock in prices and control the costs.
However, they might end up overpaying or (hopefully)
underpaying for the wheat depending on themarket
pricewhen they take delivery of the wheat.

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Futures Contract

A futures contract is an agreement between

two parties a buyer and a seller to buy or
sell something at a future date
The contact trades on a futures exchange and
is subject to a daily settlement procedure
Future contracts evolved out of forward
contracts and possess many of the same
characteristics
Unlike forward contracts, futures contracts
trade on organized exchanges, called future
markets
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Features of Futures
Contract
There is an agreement
Agreement is to buy or sell the underlying
asset

The transaction takes place on a

predetermined future date
The price at which the transaction will take
place is also predetermined
They are standardized contracts

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Example of Futures
Contract

A has bought 1 lot (250 shares) of Reliance July Future @ Rs

700 mean in theory?
It means that the person has agreed to buy 250 shares of
Reliance Industries on 28th July 2016 (the expiration date) at
Rs 700 per share
Here, The underlying is the shares of Reliance Industries; The
quantity is 1 lot, i.e. 250 shares; The expiry date is 28th July
2016 (last Thursday of July)
The pre-determined price is Rs 700 (and is called the Strike
Price)
If the actual price of Reliance is Rs 800 on the settlement day
(26th July), the person buys 250 shares at the contracted price
of Rs 700 and may sell it at the prevailing market price of Rs
800 thereby gaining Rs 100 per share (Rs 25,000 in total)
On the other hand if the price falls to 650 he loses Rs 50 per
share (Rs 12,500 in total) as he has to buy at Rs 700 but the
prevailing market price is Rs 650

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Payoffs of Futures Contract

Long Position

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Payoffs of Futures Contract

Short Position

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Options

Futures contract is an obligation to deliver or purchase a

specific commodity as a predetermined time & price
An option is a derivative financial instrument that specifies a
contract between two parties for a future transaction on an
asset at a predetermined time & price
The buyer of the option gains the right, but not the obligation,
to engage in that transaction, while the seller incurs the
corresponding obligation to fulfill the transaction.
Only the purchaser (long position) of the contract gets the
option. The seller (short position) has to obligation to buy/sell
if the option is exercised
Call option gives the holder the right to buy the underlying
asset by a certain date for a certain price
Put option gives the holder the right to sell the underlying
asset by a certain date for a certain price

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Options - Terminologies

Put Option: A contract in which option buyer has right to sell

underlying asset at the exercise price
Call Option: A contract in which option buyer has right to buy
underlying asset at the exercise price
Option Buyer/Holder: A person who buys an option to either
buy (call option) or sell (put option) underlying asset
Option Seller/Writer: A person who sells/writes a call or a put
option to option buyer. He/she has the obligation to buy (in
case of put option wrote) or to sell (in case of put option
wrote), if the holder of option decides to exercise his option
Exercise/Strike Price: It is the pre-decided price at which option
buyer is eligible to buy or sell the underlying asset
Expiration/Maturity date: Last day on which option can be
either exercised or lapsed
Exercise Date: The date on which the option is actually
exercised
Option Premium/Price: Price paid by option buyer to the option

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Options - Terminologies

In-the-Money (ITM): An option is ITM, when exercising option

is favorable
In case of Call option, when ruling spot price (S) exceeds
Exercise Price (X), the option is ITM i.e. S >X
In case of Put option, when ruling spot price (S) is less than
Exercise Price (X), the option is ITM i.e. S<X
Out-of-the-Money (OTM): When exercising of option is not
favorable
In case of Call option, S<X and in case of Put Option, S >X
At-the-Money (ATM): When exercising option is neither
favorable nor unfavorable
IN case of both call and put option S=X
Intrinsic Value (IV): Amount by which an option is ITM
IV of call option (IVc)=Current price of underlying asset(S)Exercise Price(X)=S-X
IV of put option (IVp)=Exercise Price(X)-Current price of
underlying asset(S)=X-S

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Options - Terminologies

Option Class: All listed options of particular type (i.e. put or call) on a
particular underlying asset (Eg. All put or call options on S&P CNX Index)
Option Series: All the options of a given class having same Expiration
Date and Exercise Price. (Eg. OPTIDX NIFTY 29JUL 2010 PE 5400 is an
option series which includes all S&P CNX Nifty Put Options that are
traded with Exercie Price of 5400 and expiry 29 July 2010
Open Interest: The total number of options contracts outstanding in the
market at any given point in time
Futures Option: An option contract in which underlying asset is a futures
contract
Covered Call: When an option writer writes a call option which is covered
by a position in underlying asset, it is referred to as covered call
Eg. An option writer writes a call option on shares of ABS Ltd while
holder the shares of ABS Ltd, if the option buyer exercises the option,
the writer will be in a position to delivery the underlying
Naked Call: Involves writing a call option without holder the underlying

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Options Types
On the basis of timing of Exercisability:
American options: Can be exercised at any time up to the
expiration date
European options: Can be exercised only on the expiration
date itself
A Bermuda (Mid Atlantic) option:
Has several potential
exercise dates over the life of the contract (monthly,
quarterly, etc) commonly used in interest rate and foreign
exchange markets
On the basis of way they are traded:
OTC Options
Exchange Traded Options
On the basis of underlying:
Commodities
Equities and Indices based on equities

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Moneyness of Options
Moneyness of an option illustrates the
relationship between the spot price and the
exercise price of the option
It explains how the option holder would
benefit if the holder exercises the option
Three types of moneyness of options are:

ITM
ATM
OTM

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Moneyness of Options
Call Option

Put Option

Cash Flows if
Exercised

ITM

S >X

S<X

Positive

ATM

S=X

S=X

Nil

OTM

S<X

S >X

Negative

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Option Payoffs
The option has non-linear payoffs
The loss of the option buyer is limited to the
extent of premium paid and profit potential
is unlimited
For option writer, the profit is limited to
extent of premium received and loss
potentially unlimited
Call option Buyer; Call option Writer; Put
option Buyer; Put Option Writer

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Option Premium

Options are uneven contracts that give right to one i.e.

option buyer, while bind the other party i.e. option writer
The option writer gets bound to the contract for a
consideration (price) option price or premium
Option buyer/holder has to pay a price for acquiring this
right to buy or sell the underlying assets on pre-agreed
terms and the price of this right without obligation is
Option Price
Option premium is paid by Option buyer for both call as
well as Put Option to the option writer
It is a cash outflow for option buyer and inflow for writer
It will reduce the profit of buyer and reduce the loss of
writer

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Factors affecting Option

Premium

Quantifiable Factors

Spot price of Underlying

Exercise Price
Volatility of Underlying Assets
Time to Expiration
Risk-Free Interest Rate

Non-Quantifiable Factors
Participants perception about future volatility in
prices of underlying assets
Effect of demand-supply situation of underlying both
in derivatives and cash segment
Trading volume in the market
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What are SWAPS?

In a swap, two counter parties agree to

enter into a contractual agreement wherein
they agree to exchange cash flows at
periodic intervals.

Most swaps are traded Over The Counter.

Some are also traded on futures exchange

market.