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Team Members
Snehal Bhatkar M4207
Shweta Gurram M4218
Aditi Hilage M4220
Sonal Parab M4239
Monisha Parekh M4240
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Contents
SR.NO. Particulars Slide. No
1 Introduction to derivatives

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2 Types of Derivatives 8
3 Terminologies in Derivatives 10
4 Participants in Derivatives Market 32
5 Uses of Derivatives 40
6 Derivatives Traded on NSE 42
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Introduction
What are Derivatives?
Derivatives are nothing but a kind of security whose price or value is determined
by the value of the underlying variables. It is more like a contract of future date in
which two or more parties are involved to alleviate future risk. Some of the widely
known underlying assets are:
Indexes (consumer price index (CPI), stock market index, weather conditions
or inflation)
Bonds
Currencies
Interest rates
Exchange rates
Commodities
Stocks (equities
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Origin of Derivatives

Products have grown tremendously in recent times, the earliest evidence
of this types of instruments can traced back ancient Greece. The
derivatives have been in existence in some form or the other since ancient
times, the advent of modern days derivatives contracts is attributed to
farmers need to protect themselves against a contract developed in
commodities. The first futures contracts can be traced to the yodoya rice
market in Osaka, Japan around 1650. Farmers were afraid of rice prices
falling in the future at the time of harvesting. To lock the price (i.e. to sale
the rice at the predetermined price in future), this the reason farmers
entered into contract with the buyers.
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Derivatives in India
In India, derivatives markets have been functioning since 19
th
century, with
organized trading in cotton through the establishment of the cotton trade
association in 1875. The National Stock Exchange (NSE) is the largest
exchange in India in derivatives. The first contract to be launched on NSE
was the NIFTY FIFTY index futures contract. NSEs equity derivatives segment
is called the futures and options segment. In 1993, the NSE was established
as an electronic, national exchange and its started operations in 1994.
The security contracts act, 1956 defines
A security derives from a debit instrument, share, loan whether secured or
unsecured, risk instruments.
A contract which derived its value from the price, or index of prices, of
underlying securities.
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Types of Derivatives
Forwards
Futures
Options
Swaps
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Types of Derivatives
Exchange Traded
Over The Counter
Futures Options
Forwards Swaps
Call Put
Currency Interest
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Terminologies in Derivatives
Spot Price (ST): Spot price of an underlying asset is the price that is quoted
for immediate delivery of the asset.
E.g. : NSE, the spot price of Reliance Ltd. At any given time is the price
at which Reliance Ltd. Shares are being traded at the time in the cash
market segment of NSE.
Forward price or Future price(F): Forward price or Future price is the price
that is agreed upon at the date of the contract for the delivery of an
asset at a specific future date. The price depend on the spot price, the
prevailing interest rate and the expiry date of the contract.
Strike Price(K): The price at which the buyer of an option can buy the
stock or sell the stock on or before the expiry date of option contracts is
called strike price.
Expiration date(T): In the case of Futures, Forwards, Index and Stock
Options, Expiration Date is the date on which settlement takes places. It is
also called the final settlement date.

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Types of options- Options can be divided into two different categories
depending upon the primary exercise styles associated with options.
These are-
European Options- European options are options that can be
exercised only on the expiration date.
American options American are options that can be exercised on
any day on or before the expiry date. They can be exercised by the
buyer on any day on the day or before the final settlement date or
the expiry date.
Contract Value Contract value is the notional value of the
transaction in case one contract is bought or sold. Its is the contract
size multiplied by the price of the futures. Contract value is used to
calculate margins for contracts.

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Contract Size As futures and options are
standardized contracts traded on an exchange ,
they have a fixed contract size. One contract of a
derivatives instrument represents a certain number
of shares of the underlying asset.
Example If one contract of BHEL consists of 300
shares of BHEL, then if one buys one futures contract
of BHEL, then for every Re.1 increase in BHELs futures
price, the buyer will make a profit of Rs. 30*1 = Rs.300
and for every fall in the BHELs futures price, he will
lose Rs.300

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Futures

Futures contract is an agreement between two parties in which the buyer agrees
to buy an underlying asset from seller, at a future date at the price that is agreed
upon today. Futures contract is standardized by the exchange all the terms other
than the price, are set by the stock exchange. Both buyer and seller of the
futures contract are protected against the counter party risk by the entity called
the clearing corporations. It provides guarantee to ensure that the buyer or the
seller of futures contract does not suffer. The clearing corporations steps in to
fulfill the obligation of this party, so the other party does not suffer due to non
fulfillment of the contract. This amount is called the margin money and can be in
the form of cash of other financial assets.
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Futures Example
On Monday we enter into a futures contract to buy
our book on Friday. We are required to place a
deposit for the book of 50% 500 Rs. We are told
that if the book appreciates in value we may be
required to increase the deposit. If the book
depreciates in value, we may take back some of the
money. Wednesday the book goes to 1500.
We must deposit another 250 Rs. On Thursday the book
drops to 750 Rs. We can collect 375 Rs. On Friday
the book value is 800 Rs therefore we owe 425 Rs
on the remaining balance.

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Options


An Options is a derivative contract between buyer and a seller, where one party
gives to the other the right, but not the obligation to buy from the first party the
underlying assets on or before the specific day at an agreed upon price. In
return for granting the options, the party granting option collects a payment from
the other party. The payment collected is called the premium or price of the
options. Options can be traded either on the stock exchange or in over the
counter (OTC) markets.
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TYPES OF OPTIONS
Call options
Put options

1) Call options : A call option granting the right to the buyer of the option to
buy the underlying assets on a specific day at an agreed upon price, but not
the obligation to do so. It is the seller who grants this right to the buyer of the
option. It may be noted that the person who has the right to buy the
underlying as the buyer of the call option. The price at which the buyer has
the right to buy the assets is agreed upon at the time of entering the
contract. The price is known as the strike price of the contract. The
buyer of the call option has the right to buy the underlying assets, he
will exercise his right to buy the underlying asset if & only if the price of
the underlying asset is more than the strike price on or before expiry
date.

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Contd
2) Put Option: Put option is contract granting the right to the buyer of the
option to sell the underlying asset on or before a specify day at an agreed
price. It is the seller who grants this right to the buyer of the option. The
person who has right to sell the underlying assets is known as the buyer of
the put option. Price at which the buyer has the right to sell the assets is
agreed upon at the time of entering the contract. Buyer of the put option
has right to sell the underlying asset, he will exercise his right to sell the
underlying asset if & only if the price of the underlying asset in the market is
less than the strike price on or before the expiry date.
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Options
Buying the Option
Selling the Option
Call Option RIGHT
to buy the asset
Put Option RIGHT
to sell the asset
Call Option OBLIGATION
to buy the asset
Put Option OBLIGATION
to sell the asset
ST>K
K>ST
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Forwards
A forward contract is a contract between two parties to buy of sell an
asset at a certain future date for a certain price which is pre decided on
the date of the contract. A forward contract is an agreement between
two parties in which one party, the buyer, enters into an agreement with
the other party, the seller that he would buy from the seller an underlying
assets on the expiry date at the forward price. Therefore both parties
engaged in the transaction at the later date with price set in advance. It
is different from spot market contract, which involves immediate payment
and immediate transfer of the asset. Forward contract are traded only in
over the counter (OTC) market and not in stock exchange
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Swaps
Swap is another trading instrument. In fact, it is a combination of forwards
by two counterparties. It is arranged to reap the benefits arising from the
fluctuations in the market- either currency market or interest rate market or
any other market for that matter.
Unlike most standardized options and futures contracts, swaps are not
exchange-traded instruments. Instead, swaps are customized contracts that
are traded in the over-the-counter (OTC) market between private parties.
Firms and financial institutions dominate the swaps market, with few (if any)
individuals ever participating. Because swaps occur on the OTC market,
there is always the risk of a counterparty defaulting on the swap.
The first interest rate swap occurred between IBM and the World Bank in
1981. However, despite their relative youth, swaps have exploded in
popularity. In 1987, the International Swaps and Derivatives
Association reported that the swaps market had a total notional value of
$865.6 billion. By mid-2006, this figure exceeded $250 trillion, according to
the Bank for International Settlements. That's more than 15 times the size of
the U.S. public equities market.
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Plain Vanilla Interest Rate Swap
The most common and simplest swap is a "plain vanilla"
interest rate swap. In this swap, Party A agrees to pay
Party B a predetermined, Fixed rate of Interest on
a Notional Principal on specific dates for a specified
period of time. Concurrently, Party B agrees to make
payments based on a floating Interest Rate to Party A on
that same notional principal on the same specified dates
for the same specified time period. In a plain vanilla
swap, the two cash flows are paid in the same currency.
The specified payment dates are called Settlement dates
and the time between are called settlement periods.
Because swaps are customized contracts, interest
payments may be made annually, quarterly, monthly, or
at any other interval determined by the parties.
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For example, on Dec. 31, 2006, Company A and Company B enter into a five-
year swap with the following terms:
Company A pays Company B an amount equal to 6% per annum on a
notional principal of $20 million.
Company A pays Company B an amount equal to 6% per annum on a
notional principal of $20 million.
Company B pays Company A an amount equal to one-year LIBOR + 1% per
annum on a notional principal of $20 million.
LIBOR, or London Inter Bank Offer Rate, is the interest rate offered by London
banks on deposits made by other banks in the Euro Dollar markets. The
market for interest rate swaps frequently (but not always) uses LIBOR as the
base for the floating rate. For simplicity, let's assume the two parties exchange
payments annually on December 31, beginning in 2007 and concluding in
2011.


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Figure 1: Cash flows for a plain vanilla
interest rate swap
At the end of 2007, Company A will pay Company B $20,000,000 * 6% = $1,200,000.
On Dec. 31, 2006, one-year LIBOR was 5.33%; therefore, Company B will pay
Company A $20,000,000 * (5.33% + 1%) = $1,266,000. In a plain vanilla interest rate
swap, the floating rate is usually determined at the beginning of the settlement
period. Normally, swap contracts allow for payments to be netted against each
other to avoid unnecessary payments. Here, Company B pays $66,000, and
Company A pays nothing. At no point does the principal change hands, which is
why it is referred to as a "notional" amount. Figure 1 shows the cash flows between
the parties, which occur annually (in this example)
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Plain Vanilla Foreign Currency
Swap
The plain vanilla currency swap involves exchanging principal and
fixed interest payments on a loan in one currency for principal and
fixed interest payments on a similar loan in another currency. Unlike
an interest rate swap, the parties to a currency swap will exchange
principal amounts at the beginning and end of the swap. The two
specified principal amounts are set so as to be approximately equal
to one another, given the exchange rate at the time the swap is
initiated.

For example, Company C, a U.S. firm, and Company D, a European
firm, enter into a five-year currency swap for $50 million. Let's assume
the exchange rate at the time is $1.25 per euro (e.g. the dollar is
worth 0.80 euro). First, the firms will exchange principals. So,
Company C pays $50 million, and Company D pays 40 million Euros.
This satisfies each company's need for funds denominated in another
currency (which is the reason for the swap).
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Figure 2: Cash flows for a plain vanilla currency
swap
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Step 1.Then, at intervals specified in the swap agreement, the parties will
exchange interest payments on their respective principal amounts. To
keep things simple, let's say they make these payments annually,
beginning one year from the exchange of principal. Because Company C
has borrowed euros, it must pay interest in euros based on a euro interest
rate. Likewise, Company D, which borrowed dollars, will pay interest in
dollars, based on a dollar interest rate. For this example, let's say the
agreed-upon dollar-denominated interest rate is 8.25%, and the euro-
denominated interest rate is 3.5%. Thus, each year, Company C pays
40,000,000 euros * 3.50% = 1,400,000 euros to Company D. Company D will
pay Company C $50,000,000 * 8.25% = $4,125,000.

As with interest rate swaps, the parties will actually net the payments
against each other at the then-prevailing exchange rate. If, at the one-
year mark, the exchange rate is $1.40 per euro, then Company C's
payment equals $1,960,000, and Company D's payment would be
$4,125,000. In practice, Company D would pay the net difference of
$2,165,000 ($4,125,000 - $1,960,000) to Company C.
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Figure 3: Cash flows for a plain vanilla currency swap Step 2Finally, at
the end of the swap (usually also the date of the final interest
payment), the parties re-exchange the original principal amounts.
These principal payments are unaffected by exchange rates at the
time.
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Figure 4: Cash flows for a plain vanilla currency swap,
Step 3


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Who Would Use a Swap?
The motivations for using swap contracts fall into two basic
categories: commercial needs and comparative advantage. The
normal business operations of some firms lead to certain types of
interest rate or currency exposures that swaps can alleviate. For
example, consider a bank, which pays a floating rate of interest on
deposits (e.g. liabilities) and earns a fixed rate of interest on loans
(e.g. assets). This mismatch between assets and liabilities can cause
tremendous difficulties. The bank could use a fixed-pay swap (pay a
fixed rate and receive a floating rate) to convert its fixed-rate assets
into floating-rate assets, which would match up well with its floating-
rate liabilities.

Some companies have a comparative advantage in acquiring
certain types of financing. However, this comparative advantage
may not be for the type of financing desired. In this case, the
company may acquire the financing for which it has a comparative
advantage, then use a swap to convert it to the desired type of
financing.
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Participants in Derivatives Market
As equity markets developed, different categories of investors started
participating in the market. In India, equity market participants currently
include retail investors, corporate investors, mutual funds, banks foreign
institutional investors etc. Each of these investor categories uses the
derivatives market to as a part of risk management, investment strategy or
speculation. Based on the applications that derivatives are put to, these
investors can be broadly classified into three groups:
Hedgers
Speculators, and
Arbitrageurs
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Hedgers
These investors have a position (i.e. have bought the
assets in the underlying market but are worried about
potential loss arising out of change in asset price in the
future.
Hedgers participate in the derivatives market to lock
the prices at which they will be able to transact in the
future.
Different hedgers take different positions in the
derivatives market based on their exposure in the
underlying market. A hedger normally an opposite
position in the derivatives market to what he has in the
underlying market.
Hedging in the futures market can be done through
two positions, viz. Short hedge and Long hedge.
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Short Hedge ( Short position sell)
Short hedge position is taken by someone who already
owns the underlying asset or is expecting a future
receipt of the underlying asset.
Example- An investor holding Reliance shares may be
worried about adverse future price movements and
may want to hedge the price risk. He can do so by
holding a short position in the derivatives market. The
investor can go short in Reliance Futures at NSE .This
protects him from price movements in Reliance stock.
In case the price of reliance share falls, the investor will
lose money in the shares but will make up for this loss by
gain made in the price of underlying asset falls in the
future. In this way, futures contract allows an investor to
manage his price risk.
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Long Hedge ( Long Position Buy )
A long hedge involves holding a long position in the
futures market. A Long position holder agrees to buy
the underlying asset at the expiry date by paying the
agreed futures price. This is used by those who will need
to acquire the underlying asset in the future.
Example A chocolate manufacturer who needs to
acquire sugar in the future will be worried about any
loss that may arise if the price of sugar increases in
future. To hedge against this risk , the chocolate
manufacturer can hold a long position in the sugar
futures. If the price of the sugar rises , the chocolate
manufacturer may have to pay more to acquire sugar
in normal market, but he will be compensated against
this loss through that a profit that will arise in the futures
market. A long position holder in a futures contract
makes a profit if the price of the underlying asset
increases in the future.
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Speculators
A speculator is the one who bets on the derivatives market
based on his views on the potential movement of the
underlying stock price.
Speculators take large, calculated risks as they trade based on
anticipated future price movements. They hope to make quick,
large gains; but may not be always be successful.
They normally have shorter holding time for their positions as
compared to hedgers.
If the price of the underlying moves as per their expectation
they can make large profits. However, if the price moves in the
opposite direction of their assessment , the losses can also be
enormous.

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Illustration
Currently ICICI Bank is trading at say, Rs.500 in the cash
market and also at Rs.500 in the futures market. A
speculator feels that post the RBIs policy announcement ,
the share price of the ICICI will go up. The speculator can
buy the stock in the spot market or the derivatives market.
If the derivatives contract size of ICICI is 1000 and if the
speculator buys one futures contract of ICICI, he is buying
ICICI futures worth Rs.500*1000 = Rs. 5,00,00.for this he will
have to pay to a margin of say 20% of the contract value
to the exchange. The margin that the speculator needs to
pay to the exchange is 20 % of the Rs.5,00,000 = Rs.
1,00,000. This is Rs.1,00,000 is his total investment for the
futures contract.
On the other hand, if the speculator would have invested
Rs. 1,00,000 in the spot market, he could purchase only
100000/500 = 200 shares of ICICI

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Let us assume that post RBI announcement price of
ICICI share moves to Rs.520.With 1,00,000 investment
each in the futures and the cash market, the profit
would :
(520-500)*1000 = Rs. 20,000 in case of futures market
and
(520-500)*200 = Rs.4000 in case of cash market.
It should be noted that the opposite will result in
case of adverse movement in stock prices, wherein
the speculator will be losing more in the futures
market than in the spot market. This is because the
speculator can hold a larger position in the futures
where he has to pay only the margin money.

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Arbitrageurs
Arbitrageurs attempt to profit from pricing inefficiencies in the market by making
simultaneous trades that offset each other and capture a risk-free profit. An
arbitrageur may also seek to make profit incase there is price discrepancy
between the stock price in the cash and derivatives markets.
Example- If on 1
st
August,2009 the SBI shares is trading at Rs. 1780 in the cash
market and the futures contract of SBI is trading at Rs. 1790, the arbitrageur would
buy the SBI shares (i.e. make an Investment of Rs. 1780) in the spot market and sell
the same number of SBI futures contracts. On expiry day ( say 24
th
Aug 2009),the
price of SBI futures contracts will close at the price at which SBI closes in the spot
market. In the other words, the settlement of the futures contract will happen at
the closing price of the SBI shares and that is why the Futures and spot prices are
said to converge on the expiry day. On expiry day, the arbitrageur will sell the SBI
stock in the spot market and buy the futures contract, both of which will happen
at the closing price of SBI in the spot market. Since the arbitrageur has entered
into off-setting positions, he will be able to earn at RS. 10 irrespective of the
prevailing market price on the expiry date.
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Uses of Derivatives
Risk Management: The most important purpose of the derivatives market
is risk management. Risk management for an investor comprises of the
following three processes:
Identifying the desired level of risk that the investor is willing to take on his
investments.
Identifying and measuring the actual level of risk that the investor is
carrying.
Making arrangements which may include trading (buying/selling) of
derivatives contract that allow him to match the actual and desired
levels of risk.
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Contd.
Market efficiency: Efficient markets are fair and competitive and do not
allow an investor to make risk free profits. Derivatives assist in improving the
efficiency of the markets, by providing a self correcting mechanism.
Arbitrageurs are one section of the market participants who trade
whenever there is an opportunity to make risk free profits till the
opportunity ceases exist. When trading occurs, there is a possibility that
some amount of mispricing might occur in the markets.
Price discovery: One of the primary functions of derivatives is price
discovery. They provide valuable information about the prices and
expected price fluctuations of the underlying assets in 2 ways:
1) Many of these assets are traded in market in different geographical
locations. Assets may be traded at different price in different markets.
2) Prices of the futures contracts serve as price that can be used to get a
sense of the market expectation of the future prices.
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Derivatives Traded on NSE
The F & O segment on NSE provides trading facilities
for the following derivative instruments
Index Futures
Index Options
Individual stock Futures and
Individual stock Options


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bibliography


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info
Scanned images
Video
Derivatives in world market- American & European
More terms
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