 What is a derivative?

: a financial
product which has been derived
from another financial product or
commodity. Without the
underlying product or market, the
derivative would have no
independent existence. Common
types of derivatives are Forwards,
Swaps and Options.
 Derivatives have risen from the
need to manage the risk arising
from movements in markets
beyond our control, which may
severely impact the revenues and
costs of the firm
 Firms are exposed to several risks in the
ordinary course of operations and
borrowing funds

 For some risks, management can obtain

protection from an insurance company
(fire, loss of profit , loss of stock,
marine insurance)
 Similarly, there are capital market products
available to protect against certain risks.
Such risks include :
- Risks associated with a rise in the price of
commodity purchased as an input
- A decline in a commodity price of a
product the firm sells
- A rise in the cost of borrowing funds
- An adverse exchange rate movement.
- The instruments that can be used to provide
such protection are called derivative
instruments
 A Derivatives is any security whose
price is determined by the value of
another asset.
--- This asset is called the underlying
security , or simply , the “Underlying”

UNDERLIYING DERIVATIVE
PRICE CHANGE PRICE CHANGE
 TWO PURPOSES

SPECULATIO
HEDGING N
 FORWARDS
A contract to make or take delivery of product in future , at a
price set in present. Not standardised or regulated

FUTURES
Similar to Forwards . Stanardised , regulated and traded on
exchanges

OPTIONS
A contract giving the right ,but not the obligation,to buy or
sell a security for e.g Movie ticket

SWAPS
A contract to exchange stream of cash flows based on certain events
Intrest rates ,Currencies , Commodities prices, CREDIT DEFAULT
SWAPS
 A swap, a popular financing tool, is a contract
between two parties (counter parties) to
exchange two streams of payment for an agreed
period of time.
 Variants of swaps - interest rate, currency,
commodities, equity
 Financial swaps are a funding technique, which
permit a borrower to access one market and
then exchange the liability for another type of
liability. The global financial markets present
borrowers and investors with a wide variety of
financing and investment vehicles in terms of
currency and type of coupon - fixed or floating.
 It must be noted that swaps by themselves
are not a funding instrument; they are a
device to obtain the desired form of
financing indirectly. The borrower might
otherwise have found this too expensive or
even inaccessible.
 A SWAP transaction is one where
two or more parties exchange one
set of predetermined payments
for another

1 Interest payment SWAP

2 Currency SWAP
COMPANY FIXED FLOATING

A 7.5% MIBOR + 0 .5%

B 9% MIBOR + 3 .5%

A borrows Rs 10000 from a bank at floating rate

B borrows Rs 10000 from a bank at fixed rate

(1) A will pay B a fixed rate of 7%
(2) B will pay A a floating rate of MIBOR +.5%
To under stand the benefits from the swap
consider the net cash flows of A and B
PART SWAP OUT SWAP IN SWAP TOTAL
Y FLOWS FLOWS OUTFLOWS OUTFLOW
% ON LOAN
% FROM BANK
(%)
A -7 +(MIBOR+.5) -(MIBOR+.5) -7

B -(MIBOR+.5) +7 -9% -(MIBOR+2.5)

( 1) For A, a fixed rate obligation at 7% ( this
is better than 7.5% which a would have
paid if it would have directly taken a fixed
loan.
A Gains .5%

(2) For B , a floating rate obligation at MIBOR

+2.5% (this is better than MIBOR + 3.5% )
B Gains 1%
 Lowering financing cost: use comparative
advantage
 Hedge exposure to interest rate risks
 Restructuring the debt in the balance sheet
 Swaps are privately negotiated products.
However, parties with low credit rating have
difficulty in entering the swap market.
 Participants: MNCs, Banks, Sovereign and
Public Sector Institutions, etc.
 Facilitators: Dealers and Brokers
 Swaps can be used to lower borrowing costs and
generate higher investment returns.
 Swaps can be used to transform floating rate
assets into fixed rate assets, and vice versa.
 Swaps can transform floating rate liabilities into
fixed rate liabilities, and vice versa.
 Swaps can transform the currency behind any asset
or liability into a different currency.
 Credit default swaps allow one party to "buy"
protection from another party for losses that
might be incurred as a result of default by a
specified reference credit (or credits).

The "buyer" of protection pays a premium for

the protection, and the "seller" of protection
agrees to make a payment to compensate the
buyer for losses incurred upon the occurrence
of any one of several specified "credit events."
Suppose Bank A buys a bond which issued by a Steel
Company.

To hedge the default of Steel Company:

Bank A buys a credit default swap from Insurance

Company C.

Bank A pays a fixed periodic payments to C, in

exchange for default protection.
 Credit Default Swap

Credit Risk

Premium Fee Insurance Company C

Bank A Buyer Contingent Payment On Seller
Credit Event

Steel company
Reference Asset
 A forward contract is the simplest
mode of a derivative transaction.
 It is an agreement to buy or sell an
asset (of a specified quantity) at a
certain future time for a certain
price.
 No cash is exchanged when the
contract is entered into.
 Shyam wants to buy a TV, which costs
Rs 10,000 but he has no cash to buy it
outright.
 He can only buy it 3 months hence.
He, however, fears that prices of
televisions will rise 3 months from
now.
 So in order to protect himself from
the rise in prices Shyam enters into a
contract with the TV dealer that 3
months from now he will buy the TV
for Rs 10,000.
 What Shyam is doing is that he is
locking the current price of a TV for a
forward contract. The forward
contract is settled at maturity.

 The dealer will deliver the asset to

Shyam at the end of three months
and Shyam in turn will pay cash
equivalent to the TV price on
delivery.
 Ram is an importer who has to make a
payment for his consignment in six
months time.
 In order to meet his payment obligation
he has to buy dollars six months from
today.
 However, he is not sure what the Re/$
rate will be then.
 In order to be sure of his
expenditure he will enter into a
contract with a bank to buy dollars
six months from now at a decided
rate.
 As he is entering into a contract
on a future date it is a forward
contract and the underlying
security is the foreign currency.
 If you agree in April with your Aunt that you will buy
five kgs of tomatoes from her garden for Rs 75, to be
delivered to you in July, you just entered into a
futures contract!
 A future contract is a standardised forward
contact between two parties where one of the
parties commits to sell and other to buy a
stipulated quantity of a security or an index at
an agreed price on or before a given date in
the future
Seller Buyer
A B
CLEARING
HOUSE
 Future price = spot price +carry cost
 Futures

Individual stock future Index futures

Underlying asset is the Underlying asset is the stock

individual stock Index

Bombay Sensex future Nifty Future

 Let us take an example of a simple
derivative contract:
 Ram buys a futures contract.
 He will make a profit of Rs 1000 if the
price of Infosys rises by Rs 1000.
 If the price is unchanged Ram will receive
nothing.
 If the stock price of Infosys falls by Rs 800
he will lose Rs 800.
 Exchange traded & transparent v/s
Private contract.
 futures contracts are traded on an
exchange whereas forward
contracts are generally traded off
an exchange
 Standardised v/s customised.
 Settlement through Clearing House
v/s settlement between buyers
and sellers
 Require margin payment v/s no
margins
 Mark to market margins v/s no
margins
 Counter party risk is absent in
futures ( settlement of trade is
guaranteed )
 Options are special contractual
arrangements giving the owner the
right to buy or sell an asset at a
fixed price anytime on or before a
given date.

 They give the buyer the right, but

not the obligation to exercise the
contract.
 Call option
 Put option
 A call is the right but not an obligation to
buy an underlying assest for a specified price
by a specified date

 When you buy a Call option, the price you

pay for it, called the option premium,
secures your right to buy that certain stock
at a specified price called the strike price. If
you decide not to use the option to buy the
stock, and you are not obligated to, your
only cost is the option premium.
 A call option allows you to guarantee a
maximum price you will have to pay.
 For example: suppose that the stock is
currently at Rs 1000 and you protect yourself
by purchasing a call option with strike price
Rs 1000. When the contract expires, if the
stock has risen to Rs 1200, you have the right
to buy it for Rs 1000
 Ram purchases a March call option at Rs 40
for a premium of Rs 15.
 That is he has purchased the right to buy
that share for Rs 40 in March.
 If the stock rises above Rs 55 (40+15) he will
break even 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 and
thus limiting his loss to Rs 15.
 A put is the right but not obligation to sell an
underlying asset for a specified price by a
specified date .

 Put Options are options to sell a stock at a

specific price on or before a certain date.
 In this way, Put options are like insurance
policies
 Suppose you hold a stock and want to sell it in a
year’s time. . .
 A put option allows you to ‘lock-in’ a minimum
price for your stock, but to keep the unlimited
upside.
 For example: suppose that the stock is currently
at Rs 1000 and
 you protect yourself by purchasing a put option
with strike price Rs1000. When the contract
expires, if the stock has risen to Rs1200, you can
sell it for Rs 1200. But if it has fallen to Rs800,
you have the right to sell it for Rs 1000.
 Raj 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 rising so purchases a put option at
Rs 70 . By purchasing the put option Raj
has the right to sell the stock at Rs 70 but
he has to pay a fee of Rs 15 (premium

 So he will breakeven only after the stock

falls below Rs 55 (70-15) and will start
making profit if the stock falls below Rs 55.
 In-the-Money: The option has an exercisable
value, i.e. in the case of a Call Option the
exercise price is below the spot price; and in
the case of a Put Option, the exercise price is
above the prevailing spot price.
 At-the-Money: The Option exercise price equals
the prevailing price of the underlying asset
 Out-of-the-Money: The Option price lies above
the prevailing price of the underlying asset in the
case of a Call or below in the case of a Put