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A presentation by Vishal Trehan Roll No. 880506 CBM Department Guru Nanak Dev University
Derivatives
D e ri ti va ve i s a p ro d u ct w h o se va l e i d e ri d fro m th e va l e u s ve u o f o n e o r m o re b a si va ri b l s, ca l e d c a e l u n d e rl n g a sse ts. T h o se a sse ts ca n yi 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
E xch a n g e Tra d e d vs O TC D e ri ti s M a rke t va ve As the word suggests, derivatives that trade on an exchange are called exchange traded derivatives, where as privately negotiated derivative contracts are called OTC contracts. The former have rigid structures compared to the latter.
OTC derivatives markets have the following features compared to exchange traded derivatives : 1.The management of counter-party risk is decentralized and located within individual institutions. 2.There are no formal centralized limits on individual positions, leverage, or margining 3.There are no formal rules for risk and burden sharing, 4. There are no formal rules or mechanisms for ensuring market stability and integrity, and for safeguarding the collective interests of market participants, and The OTC contracts are generally not regulated by a regulatory authority and the exchanges self regulatory organisation, although they are affected indirectly by national legal systems, banking supervision and market surveillance.
5.
The National Stock Exchange of India Limited (NSE) commenced trading in derivatives with the launch of index futures on June 12, 2000. The futures contracts are based on the popular benchmark S&P CNX Nifty Index. The Exchange introduced trading in Index Options (also based on Nifty) on June 4, 2001. NSE also became the first exchange to launch trading in options on individual securities from July 2, 2001. Futures on individual securities were introduced on November 9, 2001. Futures and Options on individual securities are available on 224 securities stipulated by SEBI. The Exchange provides trading in other indices i.e. CNX-IT, BANK NIFTY, CNX NIFTY JUNIOR, CNX 100 and NIFTY MIDCAP 50 indices. The Exchange is now introducing mini derivative (futures and
PARTICIPANTS
Speculators - willing to take on risk in pursuit of profit. Hedgers - transfer risk by taking a position in the Derivatives Market.
Arbitrageurs - aim to make a risk less profit by taking advantage of price differentials and thus bring about an alignment in prices by participating in two markets simultaneously
Types of derivatives
Forward Contract
A Forward Contract is an agreement to buy or sell an asset on a specified date for a specified price.
Salient Features :
1.They are bilateral Contracts and hence exposed to counter party risk. 2.Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality. 3. 3. The contract price is generally not available in public domain 4. On the expiration date, the contract has to be settled by delivery of the asset. 5. 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.
Futures Contract
Futures markets were designed to solve the problems that exist in forward markets. 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.
Salient Features Obligation to buy or sell Stated quantity At a specific price Stated date (Expiration Date) Marked to Market on a daily basis
OPTIONS
An Options contract confers the right but not the obligation to buy (call option) or sell (put option) a specified underlying instrument or asset at a specified price the Strike or Exercised price up until or an specified future date the Expiry date.
The Price is called Premium and is paid by buyer of the option to the seller or writer of the option.
Call Option
In-the-Money (ITM) Strike price < Spot price(current price) At-the-Money (ATM) Strike price = Spot price Out-of-the-Money (OTM) Strike price >Spot price
Put Option
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. This is generally depicted in the form of payoff diagrams which show the price of the underlying asset on theX-axis and the profits/losses on the Yaxis.
FUTURES PAYOFFS
PRICING FUTURES
Without dividend With expected dividend
where: F S r q T
futures price spot index value cost of financing expected dividend yield holding period
Example: Security XYZ Ltd trades in the spot market at Rs. 1150. Money can be invested at 11% p.a. The fair value of a one-month futures contract on XYZ is calculated as follows
OPTIONS PAYOFFS
Long call
The figure shows the profits/losses for the buyer of a threemonth Nifty 2250 call option. As can be seen, as the spot Nifty rises, the call option is in-the-money. If upon expiration, Nifty closes above the strike of 2250, the buyer would exercise his option and profit to the extent of the difference between the Nifty-close and the strike price. The profits possible on this option are potentially unlimited. However if Nifty falls below the strike of 2250, he lets the option expire. His losses are limited to the extent of the premium he paid for buying the option.
PRICING OPTIONS
The buyer of a bull spread buys a call with an exercise price below the current index level and sells a call option with an exercise price above the current index level.
Straddles
Particulars
4500
Payoff of Nifty Call/Put 200 Total Premium Net Payoff Lot Size (120) 80 50
Stranglers
Nifty Lot Size = 50 Shares On settlement if Nifty touches 4600 4000 4300
Particulars Payoff Nifty Call/Put Total Premium Net Payoff Lot Size Profit/Loss (Net Payoff*Lot Size)