Introduction:

The past decade has witnessed the multiple growths in the volume of
international trade and business due to the wave of globalization and
liberalization all over the world. As a result, the demand for the international
money and financial instruments increased significantly at the global level. In
this respect, changes in the interest rates, exchange rates and stock market
prices at the different financial markets have increased the financial risk to
the corporate world. It is, therefore, to manage such risks. The new financial
instruments have been developed in the financial market, which are also
popularly known as financial derivatives.

The basic purpose of these instruments is to provide commitments to prices

for future dates for giving protection against adverse movements in future
prices, in order to reduce the extent of financial risks.

There are two markets in which derivatives are traded-

1. Exchange-Traded Market: A derivatives exchange is the market where

individuals can trade standardized contracts that have been defined by
the exchange. Initially its main task is to standardize the qualities and
quantities of the grain that were traded. Initial the future contract were
develop in the derivatives exchange in CBOE (the Chicago Board of
Exchange) it is known as to-arrive contract. Later on options are also
traded in that and became very popular contracts. Many other
exchanges throughout the world now trade futures and options.

Electronic market: Traditionally derivatives traders have used what is

known as the open outcry system. This involves traders physically
meeting on the floor of the exchange, shouting, and using a
complicated set

2. Over-The-Counter Markets- Not all trading is done on exchanges. The

over-the-counter market is an important alternative to exchange and,
measured in terms of the total volume of trading, has become much
larger than the exchange-traded market. It is a telephonic or computer
linked network of dealers who do not meet physically. Trades are done
over the phone. Telephonic conversations in over-the-counter market
are usually taped. If there is a dispute about what was the
conversation about the contract, the taped are replayed to resolve the
issue.

Definition of Financial Derivatives:

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Derivatives is an financial instruments which derived its value from the value
of the underlying asset. The underlying asset can be securities, commodities,
bullion, currency, livestock or anything else.

Features of Financial Derivatives:

Derivatives or derivatives securities are future contracts which are written

between two parties (counter parties) and the counter parties to such
contracts are those other than the original issuer (holder) of the underlying
asset. From this definition, the basic features of a derivative may be stated
as follows-

1. A derivative instrument relates to the future contract between two

parties.

2. The derivatives instruments have the value which derived from the
values which derived from the values of other underlying assets.

3. The counter parties have specified obligation under the derivative

contract.

4. The derivatives contracts can be undertaken directly between the two

parties or through the particular exchange like financial future
contracts.

5. The financial derivatives are carried-off-balance sheet.

6. In derivatives trading, the taking or making of delivery of underlying

assets is not involved, rather underlying transactions are mostly
settled by taking offsetting positions in the derivatives themselves.

7. It requires no initial net investment or an initial net investment that is

smaller than would be required for other types of contract.

8. Derivatives are also known as deferred delivery or deferred payment

instrument.

Trading in Derivatives market is a Zero Sum Game. Zero sum game means
profit of one is the loss of the same amount of the other party of the contract
(counter party). If we summed the profit and loss of the counter parties of a
contract we get zero hence it is called zero sum game.

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For Example- Suppose one party ready to purchase 100 bushel of wheat
under forward contract at the price of 1,400 per bushel after 3-months now if after 3-
months the price of the wheat fall down to 1,000 per bushel then the buyer will suffer the loss
of 40,000 (1,400-1,000=400 loss per bushel and for 100 bushel it will be 400*100=40,000). And on the
other hand the seller will get the profit of 40,000 (1,400-1,000=400 profit per bushel and for the 100
bushel it will be 400*100=40,000).

Types of Financial Derivatives:

The derivatives can be classified into different categories shown in the figure
below-

Derivatives

Financials Commodities

Basic Complex

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Forward Options Swaps
Exotics

Futures Warrants

&

Convertibles

Commodities Derivatives:

In commodity derivatives, the underlying instrument is a commodity which

may be what, cotton, pepper, gold, silver, copper etc.

Financial Derivatives:

In Financial derivative, the underlying instrument may be stocks, bonds,

foreign exchange, stock index, etc

The basic difference between these is the nature of the underlying

instrument or asset. It is to be notes that financial derivatives are
fairly standard and there are no quality issues whereas in
commodity derivatives, the quality may be the underlying matters.

Basic Financial Derivatives-

1. Forward Contracts: A forward contract is a simple customized contract

between two parties to buy or sell an asset at a certain time in the
future for a certain price. They are traded in the over-the-counter
market, usually between two financial institutions or between a
financial institution and one of its clients.

Basic Features of a Forward Contract-

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 (a) Forward contract are bilateral contracts, and hence they are
exposed to counter party risk.

(b)Each contract is custom designed and hence, is unique in term of

contract size, expiry date, the asset type, quality, etc.

(c) In forward contract, one of the parties takes a long position by

agreeing to buy the asset at a certain specified future date. The
other party assumes a short position by agreeing to sell the same
asset at the same date for the same specified price.

(d) A party with no obligation offsetting the forward contract is said to

have an open position. A party with a closed position is, sometimes,
called a hedger.

(e) The specified price in a forward contract is referred to as the

delivery price. The forward price for a particular forward contract at
a particular time is the delivery price it would apply only at the time
of entering into contract but as the time passes the forward price is
likely to change whereas the delivery price remains the same.

In brief, a forward contract is an agreement between the counter parties to

buy or sell a specified quantity of an asset at a specified price, with delivery
at a specified price (future) and place. These contracts are not standardized;
each one is usually being customized to its owner’s specifications.

2. Futures Contracts: Like a forward contract, a futures contract is an

agreement between two parties to buy or sell an asset at a certain time
in the future for a certain price. Unlike forward contracts, futures
contracts are normally traded on an exchange. To make trading
possible, the exchange specifies certain standardized features of the
contract. As the two parties to the contract do not necessarily know
each other, the contract will be honored.

3. Options: Options may be defined as a contract, between two parties

whereby one party obtains the right, but not the obligation, to buy or
sell a particular asset, at a specified price, on or before a specified date.
The person who acquires the right is known as the option buyer or
option holder, while the other person (who offers the right) is known as

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 option seller or option writer. The seller of the option for giving such
right to the buyer charges an amount which is known as the option
premium.

Option can be divided into two types:

(a) Calls,

(b)Puts.

A call option gives the holder the right to buy an asset at a specified
date for a specified price whereas in put option, the holder gets the right
to sell an asset at a specified price and time. The specified price in such
contract is known as the exercise date or the maturity date.

4. Swap: A swap is an agreement between two counter parties to

exchange one stream of cash flow into another stream of cash flow in
the future. Under the swap agreement, various terms like the dates
when the cash flows are to be paid, the currency in which to be paid
and the mode of payment are determined and finalized by the parties.

There are two most popular forms of swap contracts, i.e., interest rate
swaps and currency swaps. When there is an exchange or swapping
between two different interest rates like fixed and floating for the same
notional principle then it is called interest rate swap. And when there
is an exchange or swapping between two different currencies like US
dollar and Indian Rupee for the same notional principle then it is called
currency swap. There are various forms of swaps based upon these
two, but having different features in general.

Uses of Derivatives-

Derivatives are supposed to provide the following services:

1. One of the most important services provided by the derivatives is to

control, avoid, shift and manage efficiently different types of risks
through various strategies like hedging, arbitraging, spreading, etc.

2. They help in disseminating different information regarding the futures

markets trading of various commodities and securities to the society
which enable to discover or form suitable or correct equilibrium prices
in the markets.

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 3. In the derivatives trading no immediate full amount of the transaction
is required as a result large traders, speculators, arbitrageurs operates
in such markets.

4. It enhances the liquidity and reduces transaction costs in the market

for the underlying assets.

5. The derivatives trading encourage the competitive trading in the

markets, different risk taking preference of the market operators like
speculators, hedgers, traders, arbitrageurs, etc. resulting in increase in
trading volume in the country.

Participants of Derivatives Market-

Three broad categories of traders can be identified:

1. Hedgers- A hedge is a position taken in the markets for the purpose of

reducing exposure to one or more types of risk, A person who
undertakes such position is called as ‘hedger’. The hedging strategy
can be undertaken in all the markets like futures, forwards, options,
swap, etc. but their modus operandi will be different. Forward
agreements are designed to offset risk by fixing the price that the
hedger will pay or receive for the underlying asset. In case of option
strategy, it provides insurance and protects the investor against
adverse price movements. Similarly, in the futures market, the
investors may be benefited from favourable price movements.

2. Speculators- A speculator may be defined as an investor who is willing

to take a risk by taking position in the derivates market with the
expectation to earn profits. The speculator forecasts the future
economic conditions and decides which position (long or short) to be
taken that will yield a profit if the forecast is realized. Speculators can
be divided into different categories. For example, a speculator who
uses fundamental analysis of economic conditions of the market is
known as fundamental analyst whereas the one who uses to predict
futures prices on the basis of past movements in the prices of the
asset is known as technical analyst.

3. Arbitrageurs-Arbitrageurs are another important group of participants

in derivatives markets. Arbitrageur is a trader who attempts to make
risk less profit by entering simultaneously into two different markets.

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 In. other words, an arbitrageurs is a trader who earn profit due to the
difference in the price of an asset into two different market. For
example, suppose that at the expiration of the gold future contract, the
futures price is Rs. 5500 per 10 grams, but the sot price is Rs. 5480 per
10 grams. In this situation, an arbitrageur could purchase the gold for
Rs. 5480 and go short a futures contract that expires immediately, and
in this way making a profit of Rs. 20 per 10 grams by delivering the
gold for Rs. 5500 in the absence of transaction costs.

The arbitrage opportunities available in the different markets usually

do not last long because of heavy transactions by the arbitrageurs
where such opportunity arises and keep the price to the equilibrium
position.

Types of Traders and Types of Order:

There are two types of traders executing trades: Commission Brokers and
Locals. Commission brokers are following the instructions of their clients and
charge a commission for doing so; Locals are trading on their own account.

Orders-

1. Market Order: It is the simplest type of order placed by the broker. It is

the order which is place by the broker on the request of trader to carry
out the trade immediately at the best price available to the market.

2. Limit Order: A limit price is specified by the investor when the order is
placed with the brokers. If the order is to purchase shares, then the
broker is to execute the order only at a price that is less than or equal
to the limit price.

3. Stop Orders or Stop-Loss-Orders: A stop order are of two types: to buy

and to sell. A stop order to buy is usually placed by a trader who is
currently short the contract and desires to limit his losses should the
price start rising. Thus, stop orders to buy are placed at a specified
price that is above the current price, and they become market orders
when the future price is at or above the specified stop price. Stop order
to sell is placed at a specified price that is below the current futures
price.

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 4. Stop Limit Orders: The stop limit order is a type of order that is
designed to overcome the uncertainty of the execution price
associated with a stop order. With a stop limit order the investor
specified not one but two prices: a stop price and a limit price. Once
someone else trades the stock at a price that reaches or passes the
stop price, then a limit order is created at the limit price. Suppose that
at the time the market price is $35, a stop-limit order to buy is issued
with a stop price of $40 and a limit price of $41. As soon as there is a
bid or offer at $40, the stop-limit becomes a limit order at $41.

OPTION PRICING

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Introduction

The price of the option is that amount which is paid by the option buyer to
the option seller, which is known as premium. The premium on a particular
option is to some extent depending on the demand and supply of the
underlying asset of that option. The option price can be subdivided into two:
intrinsic value and time value. To deal in option market, it is important to
know how the options are priced or valued. There are two reasons for it. First
to see whether existing options premiums quoted in the market are correct,
and second, to identify profitable trading are arbitrage opportunities.

The Determinants of Option Prices-

Option pricing are depend on the following five factors:

1. Current price of the option.

2. Strike price of the option.
3. Time to expiration of the option.
4. Expected price volatility of the stock.
5. Risk free interest rate.

1. Current price of the underlying asset: The option price will change as
the stock price change. For example; for a call option the option price
increases as the stock price increases and visa-versa.
2. Strike price of the Option: In case of call, if strike price is lower then
the premium is higher and visa-versa.
3. Time to expiration of the option: The longer the time to expiration of
the option price. This is because as the time to maturity decreases, lesser
time remains for stock’s price to rise or fall, and therefore the probability
of a favourable price movement decreases.
4. Expected stock price volatility: Fluctuations in stock prices in future is a
major factor to influence the option price, because greater the expected
of the price of the stock the more an investor would be willing to pay for
the option, and more premium an option writer would demand for it due
to increased risk in the option contract.
5. Interest Rates: interest rates have the opposite impact on premiums.
At higher interest rates, options writers sacrifice considerable income by
holding stocks instead of bonds. As a result, they usually demand and get
higher premiums for writing options during times of high interest rates.

The impact of each of these factors depends on whether-

• The option is a put or a call and
• The option is an American option or a European option.

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A summary of the effect of each factors on put and call option price is
presented in table below-

Factors Effect on an increase of factor

on
Call Price Put Price
Current price of underlying stock Increase Decrease
Strike Price Decrease Increase
Time to expiration of option Increase Increase
Expected price volatility Increase Increase
Short-term interest rate Increase Decrease
Anticipated cash dividends decrease increase

The Black-Scholes Option Pricing Model-

The Black-Scholes (B-S) Option pricing model is probably the most commonly
used option pricing model in finance. It was initially developed in 1973 by
two academicians, Fisher Black and Myron Scholes and was designed to price
European options on non-dividend paying stocks. Later on other
academicians further modified the model to make it applicable to American
option, option on dividend-paying stock, etc.

Assumptions underlying Black-Scholes Model-

1. It is assumed that µ and σ are constant.

2. The short selling of securities is allowed.
3. There are no transaction costs or taxes.
4. Securities/stocks are perfectly divisible.
5. No dividends payments are made during the life of option.
6. There are no riskless arbitrage opportunities.
7. Investors can borrow or lend at the same risk free rate of interest and
it is same for all maturity.

The Black-Scholes Pricing Formula:

For Call,
C = S N(d1) – E e-rt N(d2)
For Put,
P = E e-rt N(-d2) – S N(-d1)

Where,
d1 = ln(S/E) + rt + 0.5 σ√t
σ√t
d2 = ln(S/E) + rt – 0.5 σ√t
σ√t
or d2 = d1 – σ√t

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 S = Spot price of underlying asset
σ = Volatility of the underlying asset
E = Strike price of the underlying asset
t = Time to maturity in years
r = risk free rate of interest
N = Normal distribution
e = Exponential
ln = Natural log

Delta Hedging (Δ):

Delta (Δ) is define as the rate of change of the option price with respect to
the change in the stock (underlying asset) price, all other things beings the
same,

Symbolically, Δ = ΔC/ΔS

Where ΔS is a small change in stock price and ΔC is the corresponding

changes in the call price.
Suppose that the delta of a call option on a stock is 0.6. This means that
when the stock price changes by a small amount, the option price changes
by about 60% of that amount.
For example: the stock price is 100 and the option price is 10. Consider
an investor who has sold 20 call option contracts that is option to buy 2,000
shares. The investor’s position could be hedged by buying 0.6 X 2,000 =
1,200 shares. The gain (loss) on the option position would then tend to be
offset by the loss (gain) on the stock position. Suppose the stock price goes
up by (producing a gain of 1,200 on the shares purchased), the option price
will tend to go up by 0.6 X 1 = 0.60 (producing a loss of 1,200 on the
option writter) and vica cersa. This is called delta neutral +1,200 – 1,200 =
0.

Theta (θ):
The theta (θ) of a portfolio of option is the rate of change of the value of the
portfolio with respect to the passage of time with all else remaining the
same. Theta is sometimes referred to as the time decay of the portfolio. The
theta of the European option on non-dividend paying stock is almost always
negative because as the time to maturity decreases, the option tends to
become less valuable.

Symbolically, θ = ΔC/ΔT or ΔP/ΔT

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Gamma (γ):
The Gamma (γ) of a portfolio of options on an underlying asset is the rate of
change of the portfolio’s delta with respect to the price of the underlying
asset. It is the second partial derivative of the portfolio with respect to asset
price.
If the gamma is small, delta changes slowly, and adjustments to keep a
portfolio delta neutral need to be made only relatively infrequently. However,
if gamma is large in absolute terms, delta is highly sensitive to the price of
the underlying asset. It is then quit risky to leave a delta-neutral portfolio
unchanged for any length of time.

Vega (ν):
Up to now we have implicitly assumed that the volatility of the asset
underlying a derivative is constant. In practice, volatilities change over time.
This means that the value of a derivative is liable to change because of
movements in volatility as well as because of changes in the asset price and
the passage of time.

The vega of a portfolio of derivatives, ν is the rate of change of the value of

the portfolio w.r.t the volatility of the underlying asset.

Symbolically, ν = ΔC/Δσ

If vega is high in absolute term, the portfolio’s value is very sensitive to small
changes in volatility. If vega is low in absolute term volatility changes have
relatively little impact on the value of the portfolio.

Rho (ρ):
The rho of a portfolio of options is the rate of change of the value of the
portfolio with respect to the interest rate.

Symbolically, ρ = ΔC/Δr

It measures the sensitivity of the value of a portfolio to interest rates.

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