INDUSTRIAL SECURITIES

MARKET.
OPTIONS, FUTURES, AND
OTHER DERIVATIVES
DERIVATIVES

A derivative= A financial instrument

Forward, futures, options and swaps

markets

Hedgers, speculators, and arbitrageurs

 Speculators take positions with a view to gain
if the prices move in the direction they have
bet on.

Hedgers use derivatives to protect their other

positions.

Arbitrageurs make use of market mispricings

to make risk-less profits.
A derivative can be define as a financial
instrument whose value depends on (or
derives from) the values of other, more basic,
underlying variables.

Very often the variables underlying derivatives

are the prices of traded assets. However,
derivatives can be dependent on almost any
variable.
Over-the-counter 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.
History of derivatives exchange
A derivatives exchange is a market where individuals trade
standardized contracts that have been defined by the exchange.
The 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.
The first futures-type contract 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.
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.
 Trades in the over- the-counter market are
typically much larger than trades in the exchange-
traded market.
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.
Forward contracts
Forward contract is relatively a simple derivative.
It is an agreement to buy or sell an asset at a
certain future time for a certain price.

It can be contrasted with a spot contract, which is

an agreement to buy or sell an asset today.
A forward contract is traded in the over-the-
counter marketusually between two financial
institutions or between a financial institution and
one of its clients.
Forward contracts
One of the parties to a forward contract assumes a
long position and agrees to buy the underlying asset
on a certain specified future date for a certain
specified price.
The other party assumes a short position and agrees
to sell the asset on the same date for the same price.
Forward contracts on foreign exchange are very
popular, and can be used to hedge foreign
currency risk.
 It would receive a payment of $1 million in six months time, it
cannot be sure as to what would be the Rupee value of this $1
million after six months.
Assuming that the current rate is Rs 43/$, the value as per current
rate would be Rs 43 million.
Now suppose the actual forex rate after six months is Rs 37/$ and
hence the company receives Rs 37 million which is less by almost
14% that the current value. In the reverse scenario of rupee
depreciating vis--vis the dollar, a rate of Rs 45/$ would lead to a
gain of Rs 2 million
Forwards contract
It may enter into an agreement to sell $1 mn after 6
months at a rate of Rs 43/$. Note that it satisfies all the
conditions of a forward contract. One pre-requisite of a
forward contract is that there should be another party
which is willing to take a reverse position.

An importer who purchases goods and hence makes

payment in dollars might need to hedge his currency risk
by being the other side of this contract.
 However, forward contracts are exposed to
counterparty risk as the other party might fail
to fulfill its obligation later on.
Also, it has liquidity risk as it is difficult to get
a counterparty for the same quantity of
underlying and with the same time horizon.
Further, the contract is settled by the actual
delivery of the underlying asset.
Futures contracts
A futures contract is an agreement between
two parties to buy or sell an asset at a certain
time in the future for a certain price.
Unlike forward
. contracts, futures contracts are
normally traded on an exchange.
To make trading possible, the exchange specifies
certain standardized features of the contract.
The Derivatives market in India commenced in June 2000
when the first index future contracts were introduced.
"marking to market"
The futures exchange requires both parties to put up an initial amount of cash
(performance bond), the margin.
Margins, sometimes set as a percentage of the value of the futures contract,

the product is marked to market on a daily basis whereby the difference between
the prior agreed-upon price and the actual daily futures price is settled on a daily
basis.

This is sometimes known as the variation margin where the futures exchange will
draw money out of the losing party's margin account and put it into the other
party's thus ensuring that the correct daily loss or profit is reflected in the
respective account.

If the margin account goes below a certain value set by the Exchange, then a
margin call is made and the account owner must replenish the margin account.
This process is known as "marking to market".
Reliance Future contract.
I have bought 1 lot (250 shares) of Reliance July Future @ Rs 700 dated
26th July 2012 means
The underlying is the shares of Reliance Industries
The quantity is 1 lot, i.e. 250 shares
The expiry date is 26th July 2012 (last Thursday of July), and
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.
Forwards v/s futures
Forward contracts are very similar to futures contracts, except they are not
exchange-traded, or defined on standardized assets.

Forwards also typically have no interim partial settlements or "true-ups" in

margin requirements like futuressuch that the parties do not exchange
additional property securing the party at gain and the entire unrealized gain
or loss builds up while the contract is open.
Options
Is a contract which gives the buyer (the
owner) the right, but not the obligation, to buy
or sell an underlying asset or instrument at a
specified strike price on or before a specified
date.
The buyer pays a premium to the seller for this
right.
The seller has the corresponding obligation
to fulfill the transactionthat is to sell or buy
if the buyer (owner) "exercises" the option.
Options

Options are traded both on exchanges and in the

over-the-counter market.
There are two types of option:

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.
Options
The price in the contract is known as the exercise
price or strike price.
The date in the contract is known as the
expiration date or maturity.
American options can be exercised at any time up
to the expiration date.
European options can be exercised only on the
expiration date itself.
Most of the options that are traded on exchanges
are American.
There are four types of participants in
options markets:
1. Buyers of calls
2. Seller of calls
3. Buyer of puts
4. Seller of puts
Swaps

A Swap is a simultaneous buying and selling of the

same security or obligation.

The best-known Swap occurs when two parties

exchange interest payments based on an identical
principal amount, called the "notional principal
amount."
 A swap is a derivative contract through which two
parties exchange financial instruments.
These instruments can be almost anything, but most swaps
involve cash flows based on a notional principal
amount that both parties agree to.
One cash flow is generally fixed, while the other is variable,
that is, based on a benchmark interest rate, floating
currency exchange rate or index price.

The most common kind of swap is an interest rate swap.

Swaps do not trade on exchanges, and retail investors do
not generally engage in swaps. Rather, swaps are
over-the-counter contracts between businesses or financial
institutions.
Interest Rate Swaps

In an interest rate swap, the parties exchange

cash flows based on a notional principal
amount (this amount is not actually
exchanged) in order to hedge against interest
rate risk or to speculate.
 Think of an interest rate Swap as follows: Party
A holds a 10-year $10,000 home equity loan that
has a fixed interest rate of 7 percent, and Party
B holds a 10-year $10,000 home equity loan that
has an adjustable interest rate that will change
over the "life" of the mortgage. If Party A and
Party B were to exchange interest rate payments
on their otherwise identical mortgages, they
would have engaged in an interest rate Swap.
 Interest rate swaps occur generally in three scenarios.
Exchanges of a fixed rate for a floating rate,
a floating rate for a fixed rate, or
a floating rate for a floating rate.

Today, Swaps involve exchanges other than interest

rates, such as mortgages, currencies, and "cross-
national" arrangements.
Swaps may involve cross-currency payments (U.S.
Dollars vs. Mexican Pesos) and crossmarket payments,
e.g., U.S. short-term rates vs. U.K. short-term rates.
For example
ABC Co. has just issued $1 million in five-year bonds with a variable
annual interest rate defined as the London Interbank Offered Rate
(LIBOR) plus 1.3% (or 130 basis points).
LIBOR is at 1.7%, low for its historical range, so ABC management is
anxious about an interest rate rise.
They find another company, XYZ Inc., that is willing to pay ABC an
annual rate of LIBOR plus 1.3% on a notional principal of $1 million for
5 years. In other words, XYZ will fund ABC's interest payments on its
latest bond issue.
In exchange, ABC pays XYZ a fixed annual rate of 6% on a notional
value of $1 million for five years.
ABC benefits from the swap if rates rise significantly over the next five
years. XYZ benefits if rates fall, stay flat or rise only gradually.
LIBOR rises at 0.75bps/year
LIBOR rises at 200bps/year
Other Swaps
Commodity swaps
Commodity swaps involve the exchange of a floating commodity
price, such as the Brent Crude spot price, for a set price over an
agreed-upon period. As this example suggests, commodity swaps
most commonly involve crude oil.

Currency swaps
In a currency swap, the parties exchange interest and principal
payments on debt denominated in different currencies. Unlike in an
interest rate swap, the principal is not a notional amount, but is
exchanged along with interest obligations. Currency swaps can take
place between countries: China has entered into a swap with
Argentina, helping the latter stabilize its foreign reserves, and a
number of other countries.
 Debt-equity swaps
A debt-equity swap involves the exchange of debt
for equity; in the case of a publicly traded company,
this would mean bonds for stocks. It is a way for
companies to refinance their debt.

Total return swaps

In a total return swap, the total return from an asset
is exchanged for a fixed interest rate. This gives the
party paying the fixed rate exposure to the
underlying asseta stock or an index for example
without having to expend the capital to hold it
Warrants

A derivative security that gives the holder the

right to purchase securities (usually equity)
from the issuer at a specific price within a
certain time frame.

Warrants are often included in a new debt

issue as a "sweetener" to entice investors.
 Warrant
The price at which the underlying security can be bought or sold is
referred to as the exercise price or strike price.
An American warrant can be exercised at any time on or before the
expiration date, while European warrants can only be exercised on the
expiration date.
Warrants that confer the right to buy a security are known as call
warrants; those that confer the right to sell are known as put warrants.
Warrants do not pay dividends or come with voting rights. Investors
are attracted to warrants as a means of leveraging their positions in a
security, hedging against downside (for example, by combining a put
warrant with a long position in the underlying stock) or exploiting
arbitrage opportunities.
Warrants are no longer very common in the U.S., but are heavily
traded in Hong Kong, Germany and other countries.
 For example, if Company XYZ issues bonds with
warrants attached, each bondholder might get a
$1,000 face-value bond and the right to purchase
100 shares of Company XYZ stock at $20 per
share over the next five years. Warrants usually
permit the holder to purchase common stock of
the issuer, but sometimes they allow the
purchaser to buy the stock or bonds of another
entity (such as a subsidiary or even a third party).
Warrants v/s options
Warrants are generally issued by the company itself,
not a third party, and they are traded over-the-
counter more often than on an exchange. Investors
cannot write warrants like they can options.

Unlike options (with the exception of employee stock

options), warrants are dilutive: when an investor
exercises her warrant, she receives newly issued
stock, rather than already-outstanding stock.

Warrants tend to have much longer periods between

issue and expiration than options, of years rather
than months.
Types
Traditional: in conjunction with stock(equity)
Wedding warrant: not detachable
Naked warrant: only equity without bond/preferred
Covered : are issued by financial institutions rather
than companies,
no new stock is issued when covered warrants are
exercised.
The underlying securities are not limited to equity, as with
other types of warrants, but may be currencies,
commodities or any number of other financial instruments.

Trading warrant: listed on the exchange

Types of traders

Hedgers use derivatives to reduce the risk that

they face from potential future movements in a
market variable.
Speculators use them to bet on the future
direction of a market variable.
Arbitrageurs take offsetting positions in two or
more instruments to lock in a profit.