Derivatives & Options

Derivatives and Options
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By:Akshaya Srinivasan
Batch:ISAS 2012-13
Institute: IIRM

Derivatives
 A financial contract of pre-determined duration, whose value is
derived from the value of an underlying asset
 Securities
 commodities
 bullion
 precious metals
 currency
 livestock
 index such as interest rates, exchange rates
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What do derivatives do?
 Derivatives attempt either to minimize the loss arising from adverse
price movements of the underlying asset
 Or maximize the profits arising out of favorable price fluctuation.
Since derivatives derive their value from the underlying asset they
are called as derivatives.
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Types of Derivatives
(Based On: Underlying Asset)
 Based on the underlying assets derivatives are
classified into.
 Financial Derivatives (UA: Fin asset)
 Commodity Derivatives (UA: gold etc)
 Index Derivative (BSE sensex)
 Weather elements Green house gasses etc)

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Types of Derivatives
(Based On: Transaction)
 Over The Counter. (O.T.C.)
 Involves a buyer and seller and the transaction is
generally facilitated by a bank.

 Exchange traded.
 Involves agents of buyers and sellers who are
registered with the exchange which facilitates the
transaction.
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How are derivatives used?
 Derivatives are basically risk shifting instruments. Hedging is the most
important aspect of derivatives and also their basic economic
purpose
 Derivatives can be compared to an insurance policy. As one pays
premium in advance to an insurance company in protection against
a specific event, the derivative products have a payoff contingent
upon the occurrence of some event for which he pays premium in
advance.
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What is Risk?
 The concept of risk is simple. It is the potential for
change in the price or value of some asset or
commodity. The meaning of risk is not restricted
just to the potential for loss. There is upside risk and
there is downside risk as well.
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What is a Hedge
 To Be cautious or to protect against loss.
 In financial parlance, hedging is the act of reducing
uncertainty about future price movements in a
commodity, financial security or foreign currency .
 Thus a hedge is a way of insuring an investment
against risk.
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Derivative Instruments.
 Forward contracts
 Futures
 Commodity
 Financial (Stock index, interest rate & currency )
 Options
 Put
 Call
 Swaps.
 Interest Rate
 Currency
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Forward Contracts.
 A one to one bipartite contract, which is to be performed in
future at the terms decided today.
 Eg: Jay and Viru enter into a contract to trade in one stock on
Infosys 3 months from today the date of the contract @ a price
of Rs4675/-
 Note: Product ,Price ,Quantity & Time have been determined in
advance by both the parties.
 Delivery and payments will take place as per the terms of this
contract on the designated date and place. This is a simple
example of forward contract.
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Risks in a forward contract
 Liquidity risk: these contracts a bi-party and not traded on the
exchange.
 Default risk/credit risk/counter party risk.
 Say Jay owned one share of Infosys and the price went up to
4750/- three months hence, he profits by defaulting the
contract and selling the stock at the market.
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Futures.
 Future contracts are organized/standardized
contracts in terms of quantity, quality, delivery time
and place for settlement on any date in future. These
contracts are traded on exchanges.
 These markets are very liquid
 In these markets, clearing corporation/house
becomes the counter-party to all the trades or
provides the unconditional guarantee for the
settlement of trades i.e. assumes the financial integrity
of the whole system. In other words, we may say that
the credit risk of the transactions is eliminated by the
exchange through the clearing corporation/house.
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The key elements of a futures contract are:
 Futures price
 Settlement or Delivery Date
 Underlying Asset/Stock.
Key elements of a future
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Positions in a futures
contract
 Long - this is when a person buys a futures
contract, and agrees to receive delivery at a
future date.
 Short - this is when a person sells a futures
contract, and agrees to make delivery.

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How does one make money
in a futures contract?
 The long makes money when the underlying assets
price rises above the futures price.
 The short makes money when the underlying
asset’s price falls below the futures price.
 Concept of initial margin
 Degree of Leverage = 1/margin rate.
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Options
 An option is a contract giving the buyer the right,
but not the obligation, to buy or sell an underlying
asset at a specific price on or before a certain date.
 An option is a security, just like a stock or bond, and
is a binding contract with strictly defined terms and
properties.
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Options Lingo
 Underlying: This is the specific security / asset on
which an options contract is based.
 Option Premium: Premium is the price paid by the
buyer to the seller to acquire the right to buy or
sell. It is the total cost of an option. It is the
difference between the higher price paid for a
security and the security's face amount at issue.
The premium of an option is basically the sum of
the option's intrinsic and time value.
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 Strike Price or Exercise Price :price of an option is
the specified/ pre-determined price of the
underlying asset at which the same can be
bought or sold if the option buyer exercises his
right to buy/ sell on or before the expiration day.
 Expiration date: The date on which the option
expires is known as Expiration Date
 Exercise: An action by an option holder taking
advantage of a favourable market situation
.’Trade in’ the option for stock.
Options Lingo (Contd.)
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 Exercise Date: is the date on which the option is
actually exercised.
 European style of options: The European kind of
option is the one which can be exercised by the
buyer on the expiration day only & not anytime
before that.
 American style of options: An American style
option is the one which can be exercised by the
buyer on or before the expiration date, i.e.
anytime between the day of purchase of the
option and the day of its expiry.
Options Lingo (Contd.)
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 Asian style of options: these are in-between
European and American. An Asian option's
payoff depends on the average price of the
underlying asset over a certain period of time.
 Option Holder
 Option seller/ writer
 Call option: An option contract giving the owner
the right to buy a specified amount of an
underlying security at a specified price within a
specified time.
 Put Option: An option contract giving the owner
the right to sell a specified amount of an
underlying security at a specified price within a
specified time

Options Lingo (Contd.)
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 In-the-money: For a call option, in-the-money is when
the option's strike price is below the market price of
the underlying stock. For a put option, in the money is
when the strike price is above the market price of the
underlying stock. In other words, this is when the
stock option is worth money and can be turned
around and exercised for a profit.
 Intrinsic Value: The intrinsic value of an option is
defined as the amount by which an option is in-the-
money, or the immediate exercise value of the option
when the underlying position is marked-to-market.
 For a call option: Intrinsic Value = Spot Price - Strike
Price
 For a put option: Intrinsic Value = Strike Price - Spot
Price

Options Lingo (Contd.)
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Positions
 Long Position: The term used when a person owns a security or
commodity and wants to sell. If a person is long in a security then
he wants it to go up in price.
 Short position: The term used to describe the selling of a security,
commodity, or currency. The investor's sales exceed holdings
because they believe the price will fall.
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Summary
 The profit and loss profile for a short put option is the
mirror image of the long put option. The maximum
profit from this position is the option price. The
theoretical maximum loss can be substantial should
the price of the underlying asset fall.
 Buying calls or selling puts allows investor to gain if
the price of the underlying asset rises; and selling
calls and buying puts allows the investors to gain if
the price of the underlying asset falls.
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Long Call
Short Put
Long Put
Short Call
Price rises
Price Falls
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Stock Index Option
 Trading in options whose underlying instrument is
the stock index.
 Here if the option is exercised, the exchange
assigned option writer pays cash to the options
buyer. There is no delivery of any stock.
 Dollar Value of the underlying index = Cash index
value * Contract multiple.
 The contract multiple for the S&P100 is $100. So, for
eg, if the cash index value for the S&P is 720,then
dollar value will be $72,000
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Swaps
 An agreement between two parties to exchange
one set of cash flows for another.
 In essence it is a portfolio of forward contracts.
 While a forward contract involves one exchange
at a specific future date, a swap contract entitles
multiple exchanges over a period of time.
 The most popular swaps are interest rate swaps
and currency swaps.
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Interest Rate Swap
A
B
Fixed Rate of 12%
LIBOR
‘A’ is the fixed rate receiver and variable rate payer.
‘B’ is the variable rate receiver and fixed rate payer.
Rs50,00,00,000.00 – Notional Principle
Counter Party
Counter Party
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 The only Rupee exchanged between the parties are
the net interest payment, not the notional principle
amount.
 In the given eg A pays LIBOR/2*50crs to B once every six
months. Say LIBOR=5% then A pays be 5%/2*50crs=
1.25crs
 B pays A 12%/2*50crs=3crs
 The value of the swap will fluctuate with market interest
rates.
 If interest rates decline fixed rate payer is at a loss, If
interest rates rise variable rate payer is at a loss.
Conversely if rates rise fixed rate payer profits and
floating rate payer looses.
Interest Rate Swap
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How Swaps work in real
life
Maruti
BOA
BOT
LIBOR +3/8%
10.5%
Fixed
LIBOR +3/8%

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Thank you
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