explained about the concept of derivatives.

1. Derivative
s
P.Harika

2. Derivatives(Introduction)
A derivative is a financial instrument, whose
value depends on the value of basic underlying
variable The value of derivative is linked to risk
or volatility in either financial asset, transaction,
market rate, or contingency, and creates a
product

3. T-
Stocks Bill Agro Commodities
Interest Underlying Precious Metals
Rates Assets
Index & Bonds
Crude Oil
Foreign Exchange Rate

4. Features of Derivatives
•Traded on exchange
• No compulsory physical trading of underlying assets All
transactions in derivatives take place in future specific date
•Hedging Device-Reduces risk
• Derivatives has low transaction cost
•Derivatives are often leveraged, such that a small movement in
the underlying value can cause a large difference in the value of
the derivative.

5. Forward
Types of Derivatives contract
Forward rate
agreements
Swaps
Over the
counter(OTC)
Options
Credit
Derivative
s
Futures
EXCHANGE
RELATED Stock options
Commodity
futures

6. Over-the-Counter Contracts:
OTC derivatives are contracts that are traded (and
privately negotiated) directly between two parties,
without going through an exchange or other
intermediary. Products such as swaps, forward rate
agreements and exotic options are almost always
traded in this way. The OTC derivatives market is
huge. According to the Bank for International
Settlements, the total outstanding notional amount is
USD 516 trillion (as of June 2007)

7. Forwards
 A forward contract is a customized contract
between two entities, where settlement takes
place as a specific date in the future at
predetermined price.
 Ex: On 10th Novem, Ram enters into an
agreement to buy 100 kgs of wheat on 1st
May at Rs.10000 from Shyam, a farmer. It is
a case of a forward contract where Ram has
to pay Rs.10000 on 1st May to Shyam and
Shyam has to supply 100 kgs of wheat. Ram
has taken a long position assuming the price
of the wheat will rise in the future six months .
Normally traded outside exchange.

8. Forward Pricing:
 Forward Price The forward price for a
contract is the delivery price that
would be applicable to the contract if
were negotiated today (i.e., it is the
delivery price that would make the
contract worth exactly zero)
 The forward price may be different for
contracts of different maturities

9. Forward Pricing:
 The Forward Price of Gold If the spot
price of gold is S and the forward price
for a contract deliverable in T years is
F , then
F = S (1+ r )t
 where r is the 1-year (domestic
currency) risk-free rate of interest.
 In our examples, S = 300, T = 1, and r
=0.05 so that
F = 300(1+0.05) = 315

10. Futures
 A financial contract obligating the buyer to purchase an asset,
(or the seller to sell an asset), such as a physical commodity
or a financial instrument, at a predetermined future date and
price.
 Futures contracts detail the quality and quantity of the
underlying asset; they are standardized to facilitate trading on
a futures exchange.
 Some futures contracts may call for physical delivery of the
asset, while others are settled in cash. The futures markets
are characterized by the ability to use very high leverage
relative to stock markets.
 Some of the most popular assets on which futures contracts
are available are equity stocks, indices, commodities and
currency.
 FC –commodity (OTC) Kissan co wants to procure 500 kg of
tomatoes after 3 months. Prevailing 1 kg @Rs 6. View of the
company– Expected to go up to Rs 8 per kg. View of the
farmer- Price @ Rs 5.50. So FC between Company &
Farmer.Agreed price @ Rs 6.50 . Delivery after 3 months.
Situation after 3 moths – Price may be same I.e @ Rs 6 or

11. Swaps
 Swaps are private agreement between two
parties to exchange cash flows in the future
according to a pre-arranged formula.
 They can be regarded as portfolio of forward
contracts.
 The two commonly used Swaps are-
 i) Interest Rate Swaps: - A interest rate swap
entails swapping only the interest related cash
flows between the parties in the same currency.
 ii) Currency Swaps: - A currency swap is a
foreign exchange agreement between two
parties to exchange a given amount of one
currency for another and after a specified period
of time, to give back the original amount
swapped.

12. OPTIONS
 “ An Options contract confers the right but not the
obligation to buy (call option) or sell (put option) a
specified underlying instrument or asset at a
specified price – the Strike or Exercised price up
until or an specified future date – the Expiry date. ”
The Price is called Premium and is paid by buyer
of the option to the seller or writer of the option.
 Types of option:
 Call Option
 Put option

13. Option Jargons
Infosys In-The-Money At-The-Money Out-The-Money
(2800) (ITM) (ATM) (OTM)
CALL S>K S=K S<K
2800 > 2700 2800 = 2800 2800 < 2900
PUT S<K S=K S>K
2800 < 2900 2800 = 2800 2800 > 2700
S = Spot price
K = Strike price

14. OPTION PREMIUM
INTRINSIC TIME VALUE
VALUE
Intrinsic Value : When option is in-the-money we have maximum
Intrinsic Value. If the option is out of the money or at the money its
Intrinsic Value is zero.
For a call option intrinsic value : Max (0, (St – K) )
and
For a put option intrinsic value : Max (0, (K - St ) )

15. Eg. Stock ONGC
TYPE PREM INTRI TIME
TYPE EXPIR CALL STRIK SPOT OF IUM SIC VALU
Y /PUT E OPTI VALU E
ON E
OPTS 25/6/2
TK 006 CA 1170 1200 ITM 37 (1200-
1170= 7
30)
OPTS 25/6/2 (1200-
TK 006 CA 1200 1200 ATM 24 1200=
0) 24
OPTS 25/6/2 (1200-
TK 006 CA 1230 1200 OTM 11 1230=
-30 or 11
0)

16. Terminology:
• Spot price- the price at which an assets trades in a spot
markets.
•Future price- the price at which the future contracts
trades in future markets.
•Strike price- the price specified in the option contract
•Expiry date- the date specified in future and option
contracts.
•Contract size- the amount of assets that has to be
delivered under one contract.
•Basis= Future price- Spot Price
•Initial Margin- the amount that must be deposited at the
future contract is first entered into.
•Marking to market
•Maintenance Margin- A set minimum margin per
outstanding future contract that a customer must maintain
in his margin account .

17. PARTICIPANTS
 Speculators - willing to take on risk in
pursuit of profit.
 Hedgers - transfer risk by taking a
position in the Derivatives Market.
 Arbitrageurs - aim to make a risk less
profit by taking advantage of price
differentials and thus bring about an
alignment in prices by participating in
two markets simultaneously.

18. Stock Index futures
 Stock Index futures have
revolutionized the art and science of
equity portfolio management as
practiced by:
◦ mutual funds
◦ pension plans
◦ endowments
◦ insurance company
◦ other money managers.

19. •A futures contract on a stock market index
represents the right and obligation to buy or
to sell a portfolio of stocks characterized by
the index.
Stock index futures are cash settled.
That is, there is no delivery of the underlying
stocks.
The contracts are marked to market daily.
On the last trading day, the futures price is set
equal to the spot index level and there is a
final mark to market cash flow.

20. An interest rate future is a financial derivative (a
futures contract) with an interest-bearing instrument
as the underlying asset.
Examples include Treasury-bill futures, Treasury-
bond futures and Eurodollar futures.
Interest rate futures are used to hedge against the
risk of that interest rates will move in an adverse
direction, causing a cost to the company.
For example, borrowers face the risk of interest rates
rising. Futures use the inverse relationship between
interest rates and bond prices to hedge against the
risk of rising interest rates. A borrower will enter to
sell a future today. Then if interest rates rise in the
future, the value of the future will fall (as it is linked to
the underlying asset, bond prices), and hence a profit
can be made when closing out of the future (i.e.
buying the future).