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Derivatives Derivative is a product whose value is derived from the value of one or more basic variables, called underlying

assets. Those assets can be These underlying assets are of various categories like Stocks(Equity) Agri Commodities including grains, coffee beans, etc. Precious metals like gold and silver. Foreign exchange rate Bonds Short-term debt securities such as T-bills

Basic Derivatives are Futures Index Futures Stock Futures Options Call Put Forwards Swaps

Derivatives Markets Exchange Traded Contracts standardized products trading floor or computerized trading virtually no credit risk

Over The Counter Market often non-standard (customized) products telephone (dealer) market some credit risk

The Role of Derivative Markets

Risk Management a) Hedging vs. speculation b) Setting risk to an acceptable level Price Discovery

Operational Advantages a) Transaction costs b) Liquidity c) Ease of short selling

Market efficiency Market Participants Hedger Hedgers face risk associated with the price of an asset. They use futures or options markets to reduce or eliminate this risk Speculators Speculators wish to bet on future movements in the price of an asset. Derivatives can give them an extra leverage to enhance their returns Arbitrageurs Arbitragers work at making profits by taking advantage of discrepancy between prices of the same product across different markets Types of Financial Derivative Can be plain vanilla or exotic Forward Futures Options Swaps

Forwards Forward contract is a binding contract which fixes now the buying/selling rate of the underlying asset to be bought/sold at some time in future. Long Forward Binding to buy the asset in future at the predetermined rate. Short Forward Binding to sell the asset in future at the predetermined rate.

Basic Features Pay Off Pay Off = ST K (for the long forward) Pay Off = K ST (for the short forward) T = Time to expiry of the contract ST = Spot Price of the underlying asset at time T K = Strike Price or the price at which the asset will be Bought/sold Forward Contract Payoff Long/Short Pay Off Binding Contract OTC Transaction/Contract Risk/Uncertainty Elimination Zero Cost Product Credit Risk

Futures A futures contract is a standardized contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a specified price Advantages

Easy to own underlying commodity or stock. No need for holding/storing the underlying commodity or equity. Standardized contracts guarantee the quality and quantity of underlying product. Reasonable market liquidity available for all major futures types. Instant execution of market orders. Availability of both standard and mini contracts helps traders to choose; especially with modest accounts. Futures trading usually include simple and reasonably low commission fees and plans. By using futures contracts, traders can maximize profit or limit risk on trading other funds, equities or commodities

Disadvantages of Future Contracts

Subject to margin calls Unable to take advantage of favorable price moves Net price is subject to Basis change

Futures Terminology

Spot price Futures price Contract cycle Expiry date Contract size Initial margin Marking-to-market Maintenance margin

No 1 2 3 4 5 6

Forward Exchange traded & Transparent standardized Settlement through clearing house Require margin payment Mark-to-market margins Most settled by offset and very few by delivery. customized

Future Private contracts Settlement b/w buyers and sellers No margins No margins Most settled by actual delivery.

Swaps A swap is a derivative in which two counterparties agree to exchange one Stream of cash flows against another stream. These streams are called the legs of the swap. There are two basic types of swaps: 1. Interest Rate Swap An agreement between two parties where one stream of future interest payments is exchanged for another based on a specified principal amount. Interest rate swaps often exchange a fixed payment for a floating payment that is linked to an interest rate. Characteristics of the Interest Rate Swaps: The principal amount is only notional. Opposing payments through the swap are normally netted. The frequency of payment reflects the tenor of the floating rate index.

2. Currency Swaps A swap that involves the exchange of principal and interest in one currency for the same in another currency. It is considered to be a foreign exchange transaction and is required by law to be shown on the balance sheet. Options

An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date.

Types of Options

a) On the basis of payoff structures Call option A call gives the holder the right to buy an asset at a certain price within a specific period of time. Put option A put gives the holder the right to sell an asset at a certain price within a specific period of time. b) On the basis of exercise options American options Can be exercised at any time between the date of purchase and the expiration date. Mostly American options are exercised at the time of maturity. But when the underlying makes cash payments during the life of option, early exercise can be worthwhile. European options Can only be exercised at the end of their lives c) On the basis of versatility Vanilla Option A normal option with no special or unusual features Exotic Option A type of option that differs from common American or European options in terms of the underlying asset or the calculation of how or when the investor receives a certain payoff. Option Terminology Index options Stock options Buyer of an option Writer of an option Option price/premium

Expiration date Strike price American options European options Strike Price Terminology Call Option In-the-Money At-the-Money Out-of-the-Money Spot > Strike Spot = Strike Spot < Strike Put Option Spot < Strike Spot = Strike Spot > Strike

Pay offs What is payoff? A payoff is the likely profit/loss that would accrue to a market participant with Change in the price of the underlying asset. Payoff for buyer of futures: Long futures The figure shows the profits/losses for a long futures position. The investor bought futures when the index was at 2220. If the index goes up, his futures position starts making profit. If the index falls, his futures position starts showing losses.

Payoff for seller of futures: Short futures The figure shows the profits/losses for a short futures position. The investor sold futures when the index was at 2220. If the index goes down, his futures position starts making profit. If the index rises, his futures position starts showing losses

Options Payoffs

Derivative Pricing Pricing Objectives: Market price, i.e. the price at which traders are willing to buy or sell the contract. Arbitrage-free price, meaning that no risk-free profits can be made by trading in these contracts

Option Pricing Theory: The value, or premium, of an option is determined by the future price of its underlying asset To help estimate this price, techniques have been developed using probabilities and statistics.

Determinants of Option Prices: Current Price of Asset Strike Price Time to Expiration Volatility Risk-Free rate

Option Pricing Models: Black-Scholes model: The Black-Scholes Model was first discovered in 1973 by Fischer Black and Myron Scholes, Best ways of determining fair prices of options, The model assumes that the price of heavily traded assets follow with constant drift and volatility,

The Black and Scholes Call Models

Assumptions of the Black Scholes Model: 1) The stock pays no dividends during the option's life 2) European exercise terms are used 3) Markets are efficient 4) No commissions are charged 5) Interest rates remain constant and known 6) Returns are log normally distributed Advantages: Speed- It lets you calculate a very large number of option prices in a very short time. Limitations: It cannot be used to accurately price options. Binomial model: It involves the construction of a binomial tree, This tree is used to represent all of the possible paths that the price of an underlying asset may take during the life of the option.

Advantages: Accurate price compare to Black-Scholes model

Limitations: The binomial model is its relatively slow speed.

What Is Volatility? Volatility is a measure of the rate and magnitude of the change of prices (up or down) of the underlying If volatility is high, the premium on the option will be relatively high, and vice versa Implied Volatility: The estimated volatility of a security's price. Volatility Measures Standard Deviation Beta R-Squared Alpha Hedge Ratio: The number of shares needed to replicate one call is called hedge ratio or option delta which is = spread of possible option prices/ spread of possible share prices