By:

Amit Mittal Nitin Mittal

Introduction to Derivatives
Derivatives are the financial instruments which derive

their value from the value of the underlying asset. The underlying asset can be equity, fixed income instruments, interest rates, foreign exchange or commodities. The price movements of derivative products are related to that of the underlying securities.

Various types of Derivatives

History of Derivatives
Chicago Board of Trade (CBOT) for derivatives trading,

became functional in 1848 and by 1865 futures contract in commodities started trading. In 1972 currency futures were introduced, followed by equity options in 1973. Year 1975 saw introduction to Interest Rate futures. Currency Swaps were introduced in 1981 and in 1982 Index futures, Interest Rate swaps and Currency Options were started. In 1983, Index Options and Options on futures were started.

Advantages of using Derivatives

Leveraged Positions
Lesser transaction costs Ease of creating positions Derivatives as Risk Management Products Derivatives as Trading Products

Structured or Over The Counter versus Exchange traded Derivatives

Exchange traded derivatives are standardized contracts

which can only be traded on a recognized exchange. The clearing house of the exchange provides the counterparty guarantee OTC derivatives on the other hand are customized contracts and the terms of the contract are flexible. There is no counterparty guarantee. The liquidity of an OTC derivative can be limited as it is a customized contract.

Derivatives to be discussed
Futures
Forwards Options

In simple terms, a futures contract is a contract that allows the counterparties to exchange the underlying assets in future at a price agreed upon today. Following are the features of a futures contractContract through an exchange To exchange obligations on a future date At a price decided today For a quantity / quality standardized by the exchange Settlement guaranteed by the clearing corporation of the exchange

Difference between forwards and futures

Forwards Futures Forwards Futures

Nature of the contract

Customized

Standardized

Counterparty Credit Risk

Liquidity Margins

Any entity Exists

Poor Not Required

Valuation

Not Done

Clearing house of exchange Assumed by the exchange Very High Received / Paid on daily basis Done on daily basis

Underlying
Contract Multiplier Tick size

Contract months
Expiry date Daily settlement price Final settlement price

Pricing of Futures Trading of futures Margins required for futures contracts Settlement of futures

Forward Contracts
Forward Contract is an OTC derivative product.

It is a contract between two parties, which enables the

buyer to lock a desired value of the underlying that will become applicable at some future date, now. There is no counterparty guarantee provided by any third party. Forward contracts unlike futures, are deliverable contracts (Though there are non-deliverable forward contracts also).

Different Types of Forward Contracts

Depending on the underlying asset, the most common types of forward contracts are:
Currency Forwards Interest Rate Forwards, and Commodity Forwards

Participants in Forward Contracts

Hedgers They participate in the forward market with a

view to protect or cover an existing exposure in the spot market. Speculators These dealers based on their opinion about the market movements take an exposure in the forward market with a view to make profits from the expected movement in the underlying element. Arbitrageurs These players neither hedge nor speculate. They try to take advantage of the price differences in the spot and forward markets.

Options
Options or option contracts are instruments
Right, but not the obligation, is given To buy or sell a specific asset At a specific price On or before a specified date Options can be exchange traded derivatives or even

over the counter derivatives.

Differences in equity shares and equity options

Option Terminologies
Strike Price or Exercise Price
Expiration Date Exercise Date Option Buyer Option Seller American option European option Option Premium

Option Classifications
Call Option : an option which gives a right to buy the

underlying asset at a strike price.

Put Option : an option which gives a right to sell the

underlying asset at strike price.

Call Option Buying

A Call option buyer basically is bullish about the underlying stock.

Put Option buying

A buyer of put option is bearish on underlying stock.

 Both the Call and Put option buyers are buying the

rights, that is they are transferring their risks to the sellers of the option. For this transfer of risk to the sellers, buyers have to compensate by paying Option Premium. Option premium is also known as Price of the option, Cost or Value of the option.

Option Selling: Motives for selling options

The seller is ready to assume the risk in option exercise. The incentives for the seller to assume that risk are two :
Option Premium This is the actual amount received by him for

selling an option to the buyer. The possibility of non-exercise of option In sellers view the possibility of option being exercised by the buyer may be low.

Factors influencing Option Pricing

Time to expiration greater the time to expiration,

higher the value of the options.

Volatility higher the volatility, higher the value of the

options.
Risk free Rate of Interest If interest rate goes up, calls

gain in value while puts lose value.

ITM, ATM, OTM Options

In the money
At the money Out of money

Intrinsic and Time value of the option

Intrinsic value is equal to the amount by which option

is in the money. Time value is the difference between market price of the option and intrinsic value.

Settlement of Options
Physical Delivery Cash settlement

Exercise of calls

Exercise of Puts

Pay off from a Long Call

Payoff from Short Call

Summary of basic option strategies

Thank You!