1. Derivatives
Roy Thomas

2. Meaning
 Financial instrument whose value is based on one or more
underlying assets.
 A contract between two parties that specifies conditions
under which payments are to be made between the parties.

3.  In other words, derivatives means a forward, future, option or
any other hybrid contract of pre-determined fixed duration,
linked for the purpose of contract, fulfillment to the value of a
specified real or financial asset or to an index of securities.
 It should be understood that derivatives themselves are not
to be considered investments since they are not an asset
class. They simply derive their values from assets such as
bonds, equities, currencies etc. and are used to either hedge
those assets or improve the returns on those assets.

4. Definition
 A security derived from a debt instrument, share, loan,
whether secured or unsecured, risk instrument or contract for
difference or any other form of security.
 A contract which derives it’s value from the prices, or index of
prices of underlying securities or stocks.

5. Usage of Derivatives
 Provide leverage (or gearing), such that a small movement in
the underlying value can cause a large difference in the value
of the derivative
 Speculate and make a profit if the value of the underlying
asset moves the way they expect.
 Obtain exposure to the underlying where it is not possible to
trade in the underlying.

6.  Hedge or mitigate risk in the underlying, by entering into a
derivative contract whose value moves in the opposite
direction to their underlying position and cancels part or all of
it out
 Create option ability where the value of the derivative is
linked to a specific condition or event.

7. Uses
Hedging.
Speculation.
Arbitrage.

8. Hedging
 Process of risk reduction.
 Uses derivatives to reduce the risk of price movement.
 The buying and selling of future contracts to offset the risks of
changing prices in the cash markets.
 Seek price protection by hedging the commodity.
 Could be framers, investors, producers, exporters etc…

9. Speculations
 Facilitating the marketing of commodities and trading in
financial instruments.
 It do not create risk; they assume it in the hope of making
profit.
 They not reduce risk; rather they buy and sell derivatives to
make profit.
 Ensure the stability of market.

10.  Help in price stability and ensure accurate pricing.
 Speculators fill the gap between the sale and purchase by
hedgers.
 Speculators add to market liquidity.
 Improve informational efficiency of market.

11. Arbitrage
 Involves in making profit from the difference in prices
prevailing in the two markets(cash market and derivative
market).
 Automatically adjusts the under pricing and over pricing in
cash market relative to the derivative market and vice versa.

12. Underlying Assets
Commodities.
Stocks.
Bonds.
Interest rates.
Currencies.

13. Derivatives Market
80.10%
0.60%
1.90%
17.30%
Product wise Breakdown of Derivatives Market, 2002
(Data released by the Bank of Settlement)
Intrest rate
Commodities
Equity
Foreign Exchange

15. 52%
31%
13%
4%
Product wise Turnover of F&O at NSE from 2000-2008
Index Futures
Stock Futures
Index Options
Stock Options

16. Types of Derivatives
Forwards
Futures
Options
Swaps

17. Forward Contracts
 One to one bi-partite contract
 To be performed in future at terms decided today.
 Offer flexibility to design the contract
 Suffer from poor liquidity and risk.

18. Future Contracts
 Every future contract is a forward contract.
 Legally binding agreement to buy or sell the underlying
security on a future date.
 Expires on a pre-specified date.

19. Forward vs. Future
Features Forward Contracts Future Contracts
Operational Mechanism Not traded on exchange Traded on Exchange
Contract Specifications Differs from trade to trade Standardized Contracts
Counterparty Risk Exists Exists, but assumed by
clearing house
Liquidation Profile Poor liquidity High liquidity
Price Discovery Poor Better

20. Trading in Future Contracts
Daily Margins
Maintenance Margins
Initial Margins

21. Financial Futures
 Financial future is a commitment to buy or sell, or a specified
future date, a standard quantity of the underlying instrument
at a future price determined in the present.
 No facility for the exchange of the underlying instrument.
 Means of Hedging
 Position in the future markets can be taken easily than the
positions in the underlying spot markets

22. Interest Rate Futures
 Commitments to borrow or deposit for a pre-determined
period from the date of the contract.
 Both borrowers and lenders can hypothetically determine the
interest rates for the future.
 To reduce risk

23. Stock Index Futures
 Built on any market index
 Stock index and futures are matched by compensatory cash
flows
 BSE Sensex and S&P Nifty
 To reduce stock market risk

24. Currency Futures
 Exchange of a standard amount of a particular currency on a
specific future date, at a fixed exchange rate.
 Have the advantage of tradability

25. Options
 Gives the buyer/holder the right to buy/sell the underlying
asset at a predetermined price with in or at the end of a
specified period.
 Purchases the right from the seller for a consideration called
“premium”.
 Types of Options.
 Call Options.
 Put Options.
 Writing Options.
 Exotic Options.

26. Call Options
 A call gives the holder the right, but not the obligation, to buy
the underlying instrument.
 Gives the investor a specific locked-in price for a future time.

27. Put Option
 A put option gives the holder the right, but not the
obligation, to sell the underlying instrument.
 Gives the investor a specific locked-in price to sell a contract
on a commodity or a financial instrument which is expected to
decrease its value.

28. Writing Options
 The seller of the option is also known as the writer
 The buyer of the option have a longer option position
 The writer of the option have a shorter option position
 On expiry of the option, the profit/loss is the exact mirror
image of the long option

29. Call Option
Premium
Received Strike Price
Buyer’s
Position
Writer’s
Position
Stock Price
Premium Paid
Profit/Loss
0
 The buyer of a call option has a loss potential limited to the
premium paid, but unlimited profit potential.
 The writer of a call has a maximum profit equal to the
premium received, but unlimited loss potential.

30. Stock Price
Premium Paid
Premium Received
Buyer’s Position
Writer’s Position
Profit/Loss
0
Put Option
 The buyer of the put option has a maximum loss equal to the
premium
 The maximum profit of the put buyer occurs at a share price
of zero

31. Exotic Options
 Different derivations of the basic options characteristics.
 Types
Lookback options
Asian options
Barrier options
Knock-in
Knock-out
Double barrier
Options on an options.

32. SWAPS
 It’s a spot purchase
 Simultaneous futures sale or a spot sale with a simultaneous
buy from the future market.
 An agreed exchange of future cash flows with spot cash flows.
 Types
 Equity Swaps
 Interest rate Swaps
 Currency Swaps

33. Equity Swaps
• Agreement to exchange the returns on a stock index portfolio
for a return of fixed interest payments
Return on BSE 100 Portfolio
Libor + 1%
Investor A
US Dollar DepositIndian Share Portfolio
Investor B

34. Interest Rate Swaps
 Enables exchange of fixed to floating rates of return.
Currency Swaps
 Enables exchange of currency between international market

35. News on Derivatives
On 15th November, 2007
Sebi board okays 7 new derivative products
Intended to expand the domestic market and make it
largely onshore and safe for investors.
Relate to mini-contracts on equity indices, options with
longer life/tenures, volatility index and F&O (futures &
options) contracts, options on futures, bond indices,
exchange traded currency (foreign exchange.

36. On 1st December, 2011
New Index Derivatives on NSE: CNX PSE and CNX
Infrastructure
CNX PSE
An opportunity to invest in "Navratna" Public Sector companies
through the use of derivatives
Comprises of 20 Public Sector companies which is a combination
of 16 Navaratna PSEs and 4 Miniratna PSEs of India

37. Features
Both Futures and Options are available for trading.
Companies only with positive net worth are part of the index.
Index is computed using free float market capitalization weighted
method
Contracts available are of maximum three months- the next
month, near month and the far month.

38. Advantages
Investors can easily take positions in stocks of 20 well known
public companies with the help of derivative products
Waiver of transaction charges till six months from the
commencement of trading.
They can be used for hedging and arbitrage purposes.

39. Snapshot of returns on CNX infrastructure Index since inception:

40.  CNX Infrastructure
 Allows you to invest in 25 well known infrastructure stocks
 Features
 Companies only with positive net worth are part of the index.
 Both Futures and Options are available for trading.
 Index is computed using free float market capitalization weighted
method.
 Contracts available are of maximum three months- the next
month, near month and the far month

41.  Advantages
 Investors can easily take positions in stocks of 25 well known
infrastructure stocks with the help of derivative products
 They can be used for hedging and arbitrage purposes.
 Waiver of transaction charges till six months from the commencement
of trading.

42. Snapshot of returns on CNX infrastructure Index since inception:

43. On July 28th, 2012
 New derivative product by BSE - Cash-Future Spread (CFS)
 Aimed at eliminating trade execution risk by offering interest rate type
of a product
 CFS is in operation from August 6 and is made available for all stocks in
BSE's derivative segment
 Cash futures arbitrage is a combination of a short/long position in an
asset such as a stock and its future contract, which seeks to exploit
pricing inefficiencies for the same underlying stock in the cash (or
spot) and futures markets in order to make risk-less profits.

44. Reference
 www.sebi.gov.in
 www.finance.mapsofworld.com
 www.hedgefund.com
 Dr. Inderpal Singh-Kalyani Publishers
 M. Ranganatham-Investment Analysis and Portfolio Management
 www.thehindubusinessline.com
 www.business-standard.com
 www.rediff.com
 www.kotaksecurities.com
 International Research Journal of Finance and Economics

45. Thank You.