Basics of Derivatives

Financial
Derivatives
Meaning of Derivatives
• Derivatives: Derivatives are instruments which
include a Security derived from a debt
instrument share, loan, risk instrument or
contract for differences of any other form of
security
• A contract that derives its value from the
price/index of prices of underlying securities.
Derivatives (Definition)
• A financial instrument whose characteristics and value
depend upon the characteristics and value of an
underlying asset, typically a commodity, bond, equity or
currency.
• Examples of derivatives include futures and options.
Advanced investors sometimes purchase or sell
derivatives to manage the risk associated with the
underlying security, to protect against fluctuations in
value, or to profit from periods of inactivity or decline.
These techniques can be quite complicated and quite
risky.
Features of derivatives
• Underlying - the rates or prices that relate to the asset or
liability underlying the derivative instrument
• Notional amount - the number of units or quantity that are
specified in the derivative instrument
• Minimal initial investment - a derivative requires little or
no initial investment because it is an investment in a change
in value rather than an investment in the actual asset or
liability
• No required delivery- generally the parties to the
contract, the counterparties, are not required to actually
deliver an asset that is associated with the underlying
Types of Derivatives
Derivatives
Financial derivatives Commodities derivatives
Simple /basic Complex

derivatives derivatives
Swaps Exotic
Warrants &
Forward Future Options
convertible
contracts contracts contracts s
Advantages of Derivative Market
• Diversion of speculative instinct from the cash
market to derivatives.
• Increased hedge for investors in cash markets.
• Reduced risk of holding underlying assets.
• Lower transaction costs.
• Enhance price discovery process.
• Increase liquidity of investors and growth of
saving flowing into these markets.
• It increased in volume of transaction.
Forward Contract
• A forward contract is an agreement to buy and
sell an asset on a specified date for a specified
price. One of the parties of contract assume
long position and agrees to buy the underlying
assets on a certain specified future date, on a
certain specified price.
Features of forward contract
• Bilateral contracts
• Custom designed
• Long and short position
• Delivery price
• Synthetic assets
Limitations of forward contract
• 1. Forward markets are afflicted by several problems
• 2. Lack of centralization of trading
• 3. Liquidity and Counterparty risk.
• 4. The basic problem in the first two is that they
have too much flexibility and generality.
• 5. Counterparty risk arises from the possibility of
default by any one party to the transaction. When
one of the two sides to the transaction declares
bankruptcy, the other suffers.
Future contracts
• Future contract is an agreement between two
parties to buy or sell an asset at a certain time
in the future, at a certain price. But unlike
forward contract, futures contract are
standardized and stock ex-changed traded.
Continue.,,….,,
• The standardized items in a futures contract
are:
1. Quantity of the underlying,
2. Quality of the underlying,
3. The date/month of delivery,
4. The units of price quotation and minimum
price change and
5. Location of settlement.
Distinction between futures and forward
S.no. Future Contract S.no. Forward Contract
1 Traded on an organized stock 1 Over the Counter (OTC) in

nature exchange
2 Standardized contract terms, hence, 2 Customized contract

terms, hence, more liquid.
less liquid.
3 No margin payment 3 Requires margin payments
4 Settlement happens at the end of the 4 daily settlement period

Follows
Over The Counter(OTC) Trading
• In general, the reason for which a stock is traded over-
the-counter is usually because the company is small,
making it unable to meet exchange listing
requirements.
• Also known as "unlisted stock", these securities are
traded by broker-dealers who negotiate directly with
one another over computer networks and by phone.
• OTC stocks are generally unlisted stocks which trade
on the Over the Counter Bulletin Board (OTCBB)
Important terms in future contract
• Spot price: The price at which an instrument/asset
trades in the spot market.
• Future Price: The price at which the futures contract
trade in the future market.
• Contract cycle: The period over which a contract trades.
The index futures contract typically have one month,
two months and three months expiry cycles that expire
on the last Thursday of the month.
• Expiry date: It is the date specified in the futures
contract. This is the last day on which the contract will
be traded, at the end of which it will cease to exist.
Continue…,,,,
• Contract size: The amount of asset that has to be delivered under one
contract.
• Basis: Basis is defined as the future price minus the spot price. There will
be different basis for each delivery month for each contract. In the a
normal market, basis will be positive. This reflects that futures prices
normally exceed spot prices.
• Cost of Carry: The relationship between futures prices and spot prices
can be summarized in terms of the cost of carry.
• Initial Margin: The amount that must be deposited in the margin account
at the time a futures contract is first entered into is the initial margin.
Pay off for futures
• A pay off is the likely profit/loss that would
accrue to a market participant with change in
the price of the underlying asset.
• Futures contracts have linear pay off.
• Linear pay off: “ losses as well as profits for
both the buyer and the seller of futures are
unlimited”
Pay off for Buyer of Futures: (Long Future)
• The pay offs for a person who buys a futures

contract is similar to the pay off for a person who
holds an asset. He has a potentially unlimited
upside as well as downside.
• e.g. Take the case of a speculator who sells a two
month Nifty index futures contact when the Nifty
stands at 1220. the underlying asset in this case is
the nifty portfolio. When the index moves down
the short futures position starts making profits and
when the index moves up it starts making losses.
Pay off for Seller Futures (short future)
• The pay off for a person who sells a futures
contract is similar to the pay off for a person
who shorts an asset. he has potentially
unlimited upside as well as downside.
Types of futures contract
Futures contracts are divided into various categories which are as under:
Interest rate futures : future contract by which lenders and borrowers

commit themselves to the interest rates at which they will lend or
borrow specified sums on a specified future date. Firms that may
suffer losses due to fluctuations in interest rates (such as banks,
brokerage houses, insurance companies) use these contracts to hedge
(reduce risk). Speculators use these contracts to bet on lower or higher
market interest rates in the future. These contract are traded on
financial futures and options exchanges, and their value rises and falls
in an inverse proportion to the rise and fall in market interest rates.
• Foreign currencies futures: These financial futures, as the name
indicate, trade in foreign currencies, thus, also known as
exchange rate futures. These contracts have a directly
corresponding to spot market, known as inter bank foreign
exchange, and also have a parallel inter bank forward market.
• Stock index futures: Agreements to buy or sell a standardized
value of a stock index, on a future date at a specified price, such
as trading New York Stock Exchange composite index on the
New York Futures Exchange (NYFE). As an investment instrument
it combines features of securities trading based on stock indices
with the features of commodity futures trading. It allows
investors to speculate on the entire stock market's performance,
short sell (see short sale) an index with a futures contract, or to
hedge a long position against a decline in value.
• Bond index future: Like stock index futures, these
futures contracts are also based on particular
bond indices, i.e.., indices of bond prices. As we
know that prices of debt instruments are
inversely related to interest rate, so the bond
index is also related inversely to them.
• Cost of living index futures: This is also known as
inflation futures. These futures contracts are
based on a specific cost of living index. For
example, consumer price index, wholesale price
index, etc. it can be used to hedge against
unanticipated inflation which cannot be avoided.
OPTIONS
• Meaning of option: An option is the right, but not
the obligation to buy or sell something on a
specified date at a specified price. In the securities
market, an option is a contract between two
parties to buy or sell of shares at a later date for
an agreed price.
• Types of Options: 1. Call option: A call option is a
contract giving the right to buy the shares.
2. Put option is a contract giving the right to sell
the shares.
Warrants and convertibles
• Convertibles and warrants are securities offered by companies
to attract investors and raise finance.
• Convertibles are long-term securities which can be changed
into another type of security, such as common stock.
Convertibles include bonds and preferred shares, but most
commonly take the form of bonds.
• Warrants are also long-term securities but are generally
shorter-term than convertibles. They grant investors the right to
purchase shares at a fixed price (known as the "exercise price")
for a predetermined amount of time, often several years.
Warrants are often tied to bonds or preferred stock, but can also
be issued independently.
SWAPS
• Swaps are private agreements between two parties to
exchange cash flows in the future according to a
prearranged formula. They can be regarded as portfolios
of forward contracts.
• Commonly two kind of swaps• Interest rate swaps:
These entail swapping only the interest related cash flows
between the parties in the same currency.
Currency swaps: These entail swapping both principal and
interest between the parties, with the cash flows in one
direction being in a different currency than those in the
opposite direction.
Exotics
• Exotics derivatives have been described as
non-standard derivatives. There is no
boundary for designing the non-standard
financial derivatives, and hence, they are
sometimes termed as exotic option or exotic.
• For example: compound options, basket
options, index currency option notes(ICON)
etc.
Critique of derivatives
• Speculative and gambling motives
• Increase in risk
• Instability of the financial system
• Price stability
• Displacement effect
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Basics of Derivatives

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Financial

Financial derivatives Commodities derivatives

Simple /basic Complex

1 Traded on an organized stock 1 Over the Counter (OTC) in

2 Standardized contract terms, hence, 2 Customized contract

3 No margin payment 3 Requires margin payments

4 Settlement happens at the end of the 4 daily settlement period

• The pay offs for a person who buys a futures

Interest rate futures : future contract by which lenders and borrowers

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