Introducing Financial Derivatives

by
Vipul Mehta
Financial Markets
 Financial Markets
 Money market
 Call money market
 Transactions mainly between banks
 High value transactions
 Transactions over the telephone
 Transactions for a maximum of one fortnight
 Banks allowed to participate as provider and user of the funds
 Other participants to participate as provider of the funds
Financial Markets
 Financial Markets
 Money market
 Call money market
 Gilt-edged securities market (G-secs)
 Capital market
 Primary market
 Secondary market/stock market
 Wholesale Debt Market (WDM)
 Foreign Currency Markets
 Currency Derivatives
 Traders in Derivatives Market
 Hedger
 Speculator
 Arbitrageur
The Stock Market
 Financial market for buying/selling of stocks
 Major Stock Exchanges in India
 NSE
 BSE
 Trading segments at BSE and NSE
 Capital market (spot market)
 Derivatives market
 Stock and index derivatives segment
Financial Derivatives
 Forwards
 Futures
 Options
 Swaps
 Currency Derivatives
 Credit Derivatives
Derivatives Markets
 OTC Market for Derivatives
 Private negotiation between buyer and seller
 Risks involved:
 Counterparty default risk
 Transaction risk
 Systematic risk
 Prominent OTC derivatives:
 Forwards
 SWAPs
 Credit Derivatives
 Clearing House to prevent counterparty default risk
Derivatives Markets
 Exchange Traded Derivatives
 Counterparty default risk removed due to presence of exchange
 Exchange decides terms of the contract:
 Underlying assets to be traded
 Margin requirements
 Type of derivatives offered (futures/options etc.)
 Settlement of transactions
 Lot size
 Key exchange traded derivatives
 Stock futures/options
 Index futures/options
 Currency futures/options
 Commodity futures
Derivatives Transactions
 Forward Transactions
 Features
 Underlying asset – mutually decided
 Exercise price – mutually decided
 Duration and value date – mutually decided
 Margin – To be deposited with the OTC exchange, settled on mark-to-
market basis
 Settlement – delivery on value date
 Square-up – take permission of the same party
 Position
 Customised
 No expiration – must be settled
Derivatives Transactions
 Futures Transactions
 Features
 Underlying asset
 Exercise price
 Duration and value date
 Margin
 Settlement
 Square-up
 Position
 Standardised
 No expiration
Futures v. Forward Contracts
Derivatives Transactions
 Option Contracts
 Features of an option transaction:
 Strike price/Exercise price
 Duration/Strike date/Exercise date
 Premium
 Call option v. Put option
 American v. European option
 Expiration of the option
 Margin deposit
 Status of option contract
Derivatives Transactions
 Option Contracts
 Parties involved:
 Buyer/Holder of the option (with all the rights and no obligation)
 Seller/Writer of the option (with all the obligation and no rights)
 Exchange regulates the following:
 Underlying asset
 Lot size
 Strike date/expiration date
 Margins
Derivatives Transactions
 Option Contracts
 Option status:
 In-the-money
 At-the-money
 Out-of-the-money
 Payoff from option contract
 Intrinsic value
 Time value
 Other terminology
 Open interest
 Squaring-up
Derivatives Transactions
 Option Contracts
 Factors affecting Price of Option
 Volatility
 Expiration date
 Strike price
 Market trends
 Dividend
 Interest rate
 Other systematic factors
Derivatives Transactions
 Futures Transactions
 Margins
 Initial margin
 Mark-to-margin
Derivatives Transactions
 Index-based Derivatives
 Index futures
 Features of index futures
 Absolute derivative product
 A tool for hedging the risk
 Settlement by differences
 Based on widely accepted index
 Regulated by stock exchange
 Margin deposit
 Open interest
Derivatives Transactions
 Index-based Derivatives
 Index options
 Same as option contracts

 SWAP
 Foreign exchange Swap
 Interest Rate Swap (Plain Vanilla Swap)
 Cross Currency Swap (Total Loan Swap)