Derivatives and risk management Definition of derivative Derivative is a product whose value is derived from the value of one

e or more basic variables, called bases (underlying asset, index, or reference rate), in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. Forward A forward contract or simply a forward is a contract between two parties to buy or sell an asset at a certain future date for a certain price that is predecided on the date of the contract. Forward contracts are traded only in Over the Counter (OTC) market and not in stock exchanges. OTC market is a private market where individuals/institutions can trade through negotiations on a one to one basis. Salient features of Forward They are bilateral contracts and hence exposed to counter-party risk. Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality. The contract price is generally not available in public domain. On the expiration date, the contract has to be settled by delivery of the asset. If the party wishes to reverse the contract, it has to compulsorily go to the same counter-party, which often results in high prices being charged. Limitations of Forward Lack of centralization of trading, Illiquidity, and Counterparty risk

A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. But unlike forward contracts, the futures contracts are standardized and exchange traded. To facilitate liquidity in the futures contracts, the exchange specifies certain standard features of the contract. Standard features of future contract Quantity of the underlying Quality of the underlying The date and the month of delivery The units of price quotation and Location of settlement Distinction between forward and future Futures Trade on an organized exchange Standardized contract terms hence more liquid Requires margin payments Follows daily settlement Almost no counter party risk FUTURES TERMINOLOGY Spot price: The price at which an asset trades in the spot market. Futures price: The price at which the futures contract trades in the futures market. Expiry date: It is the date specified in the futures contract. This is the last day on which the contract will be traded, at the end of which it will cease to exist. Forward OTC in nature Customized contract terms No margin payment Settlement happens at end of period High counter party risk

 Contract size: The amount of asset that has to be delivered under one contract. Also called as lot size. Option An option is a derivative contract between a buyer and a seller, where one party (say First Party) gives to the other (say Second Party) the right, but not the obligation, to buy from (or sell to) the First Party the underlying asset on or before a specific day at an agreed-upon price. The right to buy or sell is held by the option buyer (also called the option holder); the party granting the right is the option seller or option writer. Unlike forwards and futures contracts, options require a cash payment (called the premium) upfront from the option buyer to the option seller. This payment is called option premium or option price. Options can be traded either on the stock exchange or in over the counter (OTC) markets. Type of option Call option: The buyer of call option has the right but not the obligation to buy the underlying asset at predetermined time for predetermined price. Where as the writer of the call option has the obligation to sell the underlying asset at predetermined time and predetermined price. Put option: The buyer of put option has the right but not the obligation to sell the underlying asset at predetermined time for predetermined price. Where as the writer of the put option has the obligation to buy the underlying asset at predetermined time and predetermined price. Option terminologies Buyer of an option: The buyer of an option is the one who by paying the option premium buys the right but not the obligation to exercise his option on the seller/writer.

 Writer of an option: The writer of a call/put option is the one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him. Option price/premium: Option price is the price which the option buyer pays to the option seller. It is also referred to as the option premium. Expiration date: The date specified in the options contract is known as the expiration date, the exercise date, the strike date or the maturity. Strike price: The price specified in the options contract is known as the strike price or the exercise price. American options: American options are options that can be exercised at any time up to the expiration date. Most exchange-traded options are American. European options: European options are options that can be exercised only on the expiration date itself. European options are easier to analyze than American options Moneyness of the optionIn the-money option: An in-the-money (ITM) option is an option that would lead to a positive cash flow to the holder if it were exercised immediately. A call option on the index is said to be in-the-money when the current index stands at a level higher than the strike price (i.e. spot price >strike price). If the index is much higher than the strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the strike price(i.e. spot price < strike price). At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cash flow if it were exercised immediately. An option on the index is at-the-money when the current index equals the strike price(i.e. spot price = strike price).

 Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to a negative cash flow if it were exercised immediately. A call option on the index is out-of-the-money when the current index stands at a level which is less than the strike price (i.e. spot price < strike price). If the index is much lower than the strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the index is above the strike price. STRATEGIES A straddle is a strategy that is accomplished by holding an equal number of puts and calls with the same strike price and expiration dates. Long Straddle - The long straddle is designed around the purchase of a put and a call at the exact same strike price and expiration date. The long straddle is meant to take advantage of the market price change by exploiting increased volatility. Regardless of which direction the market's price moves. Short Straddle - The short straddle requires the trader to sell both a put and a call option at the same strike price and expiration date. Strangle An options strategy where the investor holds a position in both a call and put with different strike prices but with the same maturity and underlying asset. s This option strategy is profitable only if there are large movements in the price of the underlying asset.