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Basics on Derivatives
Introduction to Derivatives Derivatives! Well they are everywhere nowadays. Everybody wants to know about them, everybody wants to talk about them. This note seeks to provide an insight into the basics of derivatives - What are they? How are they used? and so on. A derivative is an instrument whose value is derived from the value of underlying, which can be equity/ stocks, commodities, currency, bonds, etc. Why are Derivatives Used? To manage Risk To speculate (taking a view on the future direction of the market) To change the nature of the liability &/or an investment Some common examples of derivative Forwards Futures Options Types of Traders Hedgers- Who seek to manage risk Speculators- who seek to profit by taking a view on future market direction Arbitrageur- who seeks to earn risk-free profits Forward & Futures Forward Contract Shyam wants to buy a TV, which costs Rs 10,000 but he has no cash to buy it immediately. He can only buy it 1 month from today when he gets his salary. He, however, fears that price of television might rise in the forthcoming budget which is due exactly 1 month from today.

So in order to protect himself from the rise in prices, Shyam enters into a contract with the TV Dealer which will enable him to buy the TV exactly 1 month from now, when he gets his salary for Rs 10,000. By entering into this contract Shyam has locked the current price of a TV for a forward contract. The dealer will deliver the TV to Shyam at the end of one month and Shyam in turn will pay cash to the TV Dealer on delivery. A forward contract is a customized contract between two parties, where settlement takes place on a specific date in future at a price agreed today Or It is an agreement to buy or sell an asset at a certain future time for certain pre-agreed price Future Contracts The above transaction becomes a future contract if the same happens through an intermediary. Therefore the differentiating factor in this contract is the terms of the contract and the existence of an intermediary which helps to do away with the risk of default by either of the parties involved in the transaction. Intermediary can be a Clearing House/ the exchange. Therefore a forward/ futures contract is an agreement To buy (long) or sell (short), An asset (underlying), At a predetermined price (forward/future price), On a specific date (maturity). Illustration I enter into a contract today: To buy 100 shares of Reliance At a price agreed now, say at Rs 720 per share One month from now

After 1 month, I would Make a profit if the spot price is more than the agreed Delivery Price (Rs 720 per share) Make a loss if the spot price is less than the agreed Delivery price ( Rs 720 per share) Difference between Forward and Future contracts

Contract Type Counter party Risk

Forward Customized (Negotiated) Exists (either parties to the contract can default)

Futures Standardized by the exchange Nil, as it gets transferred to Exchange/Clearing House High Transparent due to standardization and market reporting Reversed with any member of the exchange.

Liquidity Contract Price

Low Generally not available in public domain

Settlement of Contract

Reversed only with the same counter party with whom it was entered into.

Options Illustration An Oil Manufacture produces oil at a cost of $40 per barrel but he fears that the oil prices will go down in near future. In order to limit his losses he would want to lock in the sale price of the Oil manufactured by him. This manufacturer enters into a contract of selling the Oil at $40 per barrel to another party in near future. He incurs an expense of $2 per barrel to enter into this contract. This contract gives the manufacturer the right to sell Oil at an agreed price of $40 to another party if the oil prices go down in near future and forgo the cost of $2 per barrel. But if the Oil prices rise in near future contrary to his expectations, he always has an option of not executing this transaction and lose at the most $2 per barrel.

Therefore an Option is a contract which gives the buyer/ holder the right to buy (call option) or to sell (put option) a specified underlying asset at a certain price (strike) on or before a specified date (maturity)

To acquire this right, the buyer pays a premium to the seller/ writer of that right Parties to Options Transaction Buyer or holder of an option Seller or the writer of an option The clearing house (in case of exchange traded funds)

To begin, there are two kinds of options: Call Option and Put Option. Call Option: A Call Option is an option to buy a stock or any underlying at a specific price on or before certain date or in simple words it is the right to purchase a specified stock. Illustration: Mr. Kumar purchases a December call option at Rs 40 by paying a premium of Rs 15 That is, he has purchased the right to buy that share for Rs 40 in December. If the stock rises above Rs 55 (40+15) he will break even (neither gain nor make a loss) and he will start making a profit. Suppose the stock does not rise and instead falls he will choose not to exercise the option and forego the premium of Rs 15 which he has paid. Call Options-Long & Short Positions If you have a bullish view- i.e., when you expect price to rise, you take a long position by buying calls. If you have a bearish view- i.e., when you expect prices to fall, you take a short position by selling calls.

Put option: Put Options are options to sell a stock at a specific price on or before a certain date or in simple words it is the right to sell a specified stock. Illustration: Mr. Kumar is of the view that the a stock is overpriced and will fall in future, but he does not want to take the risk in the event of price falling so he buys a put option at Rs 70. By purchasing the put option Mr. Kumar has the right to sell the stock at Rs 70 but he has to pay a premium of Rs 15. So he will breakeven (neither gain nor make a loss) only after the stock falls below Rs 55 (70-15) and will start making profit if the stock falls below Rs 55. Put Options-Long & Short Positions If you have a bearish view- i.e., when you expect prices to fall, then you take a long position by buying Puts. If you have a bullish view- i.e., when you expect price to rise, then you take a short position by selling Puts.

Buying options is like buying insurance policies If one buys a car along with auto insurance, he pays an insurance premium and would therefore be protected if his car is damaged in an accident. If case of any mishap, he can use his policy to regain the insured value of the car. On the other hand if nothing happens and all goes well, the insurance cover is not used, the insurance company keeps your premium in return for taking on the risk. Moneyness of an Option In the Money- Profitable to exercise the option At the Money- No loss No Profit in exercising the option Out of the Money- Not profitable to exercise the option

Summing up - Options

OPTIONS If you expect a fall in price (Bearish) If you expect a rise in price (Bullish)

CALL OPTIONS Short Long

PUT OPTIONS Long Short

Exposures to Options

CALL OPTION BUYER

CALL OPTION WRITER (Seller)

Pays premium Right to exercise and buy the shares Profits from rising prices Limited gain losses, Potentially unlimited

Receives premium Obligation to sell shares if exercised Profits from falling prices or remaining neutral Potentially unlimited losses, limited gain

PUT OPTION BUYER

PUT OPTION WRITER (Seller)

Pays premium Right to exercise and sell shares Profits from falling prices Limited gain losses, Potentially unlimited

Receives premium Obligation to buy shares if exercised Profits from rising prices or remaining neutral Potentially unlimited losses, limited gain

Difference between Futures and options

Contract Obligation of Buyer & Seller

Options In case of options the buyer enjoys the right & not the obligation, to buy or sell the underlying asset.

Futures Both the buyer and seller are obligated to buy/sell the underlying asset.

An insight into Hedging and Short Selling Hedging: A strategy used to offset/ minimize market risk, whereby one position protects another. Therefore Long Hedge- To lock in a buying price Short Hedge- To lock in a selling price Derivatives instruments are used to minimize the downside risk on existing portfolio by entering into following transactions: Strategies Selling Index futures and calls Selling stock (that the fund owns) futures and calls Buy put option on index and stocks (that the fund owns)

Illustration Let the Spot price of XYZ stock be Rs 100 You enter into a contract to buy put option of XYZ stock at a strike price of Rs 100 by paying a premium of Re 1. If market goes down in the short term & XYZ stock declines to Rs 95 then on the holding side you will have a loss of Rs 5 per share However on the put option he has gross profit of Rs 5 per share and after deducting the premium for buying the put option you will make a net profit of Rs 4 on the put option side. So effectively your loss of Rs 5 per share (on holding side) is compensated to the extent of Rs 4 (on Option side) by buying the Put.

As a result the loss has been reduced or minimized by buying put options when the view on the stock is bearish or market is expected to go down in short term.

Net profit or loss if we buy put option in the above example= profit on put - loss on holding

= (strike price - current price-premium) - loss on holding = (100-95-1)-5 = 4-5 Loss= 1 So it is clear that by buying a put option the loss has been reduced to Re 1 per share which would have been Rs 5 per share had you not bought the put option. Short Selling: Short selling is the selling of a security that the seller doesn't own. More specifically, a short sale is the sale of a security that isn't owned by the seller, but that is promised to be delivered. The selling of a security that the seller does not own, or any sale that is completed by the delivery of a security borrowed by the seller. Short sellers assume that they will be able to buy the stock at a lower amount than the price at which they sold short. When an investor goes short, he is anticipating a decrease in share price. That is, short sellers make money if the stock goes down in price. Conversely, when an investor goes long on an investment, it means that he has bought a security believing its price will rise in the future. Therefore, Selling short is the opposite of going long. Strategies Selling any Index futures and calls Selling stock (that the fund does not own) futures and calls Buy put option on index and stocks (that the fund does not own)

Sell stock futures If you expect that market may go down which will drag down the price of XYZ stock then he can straight forward sell a future of stock XYZ. You enter into a contract to sell futures of XYZ at a strike price of Rs 100. Now if the price of XYZ stock goes down, you will cover the short position by buying the future at the lower price. The difference between the selling price and buying price will be the profit.

Glossary Bear market: A market in which prices are declining. Bull market: A market in which prices are rising. Clearinghouse: An organisation connected with futures exchange through which all contracts are reconciled, settled, guaranteed and later either offset or fulfilled through delivery or cash settlement. Its function is to manage the margin and delivery systems, as well as to guarantee performance of exchange traded contracts. Counterparty: The other party (buyer or seller) to a transaction. Counterparty risk: The risk the counterparty will not fulfill the terms of the contract. Also called default risk. Exercise: To implement the right under which the holder of an option is entitled to buy (in the case of a call) or sell (in the case of a put) the underlying security Mark-to-market: The daily adjustment of margin accounts to reflect profits and losses. Underlying: It is the specific security / asset on which any contract is based on. Option Premium: Premium is the price paid by the buyer to the seller to acquire the right to buy or sell Strike Price or Exercise Price: The strike or exercise price of an option is the specified/ predetermined 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. On Expiration date, either the option is exercised or it expires worthless. Option Holder: is the one who buys an option which can be a call or a put option. He enjoys the right to buy or sell the underlying asset at a specified price on or before specified time. His upside potential is unlimited while losses are limited to the Premium paid by him to the option writer. Option seller/ writer: is the one who is obligated to buy (in case of Put option) or to sell (in case of call option), the underlying asset in case the buyer of the option decides to exercise his option. His profits are limited to the premium received from the buyer while his downside is unlimited. Call Option - Option to buy. Put Option - Option to sell. Exercise Date - Date on which the option gets exercised by the option holder/buyer.

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