W E L C O M E

FINANCIAL DERIVATIVES
BY

Dr.P.Viswanadham,
Professor
Dept. of Commerce & Mgt. Studies
ANDHRA UNIVERSITY
Visakhapatnam
FINANCIAL SYSTEM

INTERMEDIARIES

SERVICES

INSTRUMENTS MARKETS
 FINANCIAL PRODUCTS
 TRADITIONAL PRODUCTS
1. GOLD
2.CHIT FUNDS
3. REAL ESTATE
 SAFETY PRODUCTS
1. SMALL SAVINGS
2. BANK DEPOSITS
3. BONDS
4. COMPANY DEPOSITS
 FINANCE PRODUCTS
1. HOME LOANS
2. INSURANCE

 CONVENIENCE PRODUCTS MUTUAL FUNDS

 RISK PRODUCTS STOCKS

 HEDGE PRODUCTS FINANCIAL DERIVATIVES

 FINANCIAL RISKS IN FINANCIAL
PRODUCTS
1. MARKET RISK/PRICE RISK
2. INTEREST RATE RISK
3. FOREIGN EXCHANGE RISK
4. INFLATION RISK

 HOW TO MANAGE FINANCIAL RISK?

a. HEDGING THROUGH PRODUCTS
b. HEDGING THROUGH PROCESSES
c. HEDGING THROUGH STRATEGIES
FINANCIAL DERIVATIVES

 CONCEPT

 REGULATION

 TRADING

 SETTLEMENT

 PRICING

 APPLICATION/ STRATEGIES
WHAT IS FINANCIAL DERIVATIVE?

“ FINANCIAL DERIVATIVE IS A FINANCIAL

CONTRACT AND WHOSE VALUE IS
DERIVED FROM THE VALUE OF
UNDERLYING WIDELY HELD AND EASILY
MARKETABLE ASSET - COMMODITIES OR
SHORT TERM OR LONG TERM FINANCIAL
INSTRUMENTS OR INDEXES”
FEATURES OF FINANCIAL DERIVATIVES
 it is a product of financial engineering/ financial innovation

 it is a derived product

 It has no independent value

 it is a financial contract/ product

 It is a hedging tool/ technique

 it is a future/ forward contract

 It is a OTC/ NON-OTC product

 It is a financial security as defined by SCRA 56

 It requires no initial investment

 The size of the derivative contract depends upon its notional amount

 Margins are fixed according to notional amount

 It is off- the balance sheet instrument

 It has no primary market

 in derivatives trading, settlement is different from equity trading

 Derivatives trading in the world started in the International Money Market as a

division of Chicago Mercantile Exchange in 1972 for futures trading in foreign currency
 in 1982 Stock Index futures were introduced by Chicago Mercantile Exchange

 the Philadelphia stock exchange offered option market

 DERIVATIVES IN INDIA
 Promulgation of securities laws (amendment ) ordinance in 1995
 L.C.Gupta Committee developed the regulatory frame work in 1996

 J. R. Varma Committee recommended operational details in 1998

 Amendment of SCRA to Include Derivatives as securities in 1999

 Forward trading allowed in India in 2000

 SEBI Granted final approval in trading in BSE and NSE in 2001

 Index futures at NSE on 12th June 2000

 Index Options at NSE on 4th June 2001

 individual options at NSE on 2nd July 2001
 individual stock futures at NSE on 9 th November 2001
 Sensex options at BSE on 4th June 2001
 individual Stock options at BSE on July 2001
 Futures trading at BSE on November 2001
 TYPES OF DERIVATIVES

FORWARDS FUTURES OPTIONS OTHERS

SWAPS

COMMODITY FINANCIAL CALL PUT

COLLARS

CAPS, FLOORS
EQUITY INT. RATE CURRENCY RATE AMERICAN EUROPEAN

WARRANTS
COMMODITY FINANCIAL
STOCK INDEX
LEAPS

EQUITY INT. RATE CURRENCY RATE EXOTIC OPTIONS

CREDIT
DERIVATIVES
STOCK INDEX
SYNTHETIC
PARTICIPANTS IN DERIVATIVE
MARKETS

HEDGERS SPECULATORS

DERIVATIVE
MARKET

ARBITRAGEURS
 NEED FOR / FUNCTIONS OF DERIVATIVE
MARKETS

RISK TRANSFER
LOW INVESTMENT
 MARKET COMPLETION
PRICE DISCOVERY
LOW TRANSACTION COST
What is a forward contract ?
A forward contract is a simple customized
contract between two parties to buy or sell an
asset at a certain time in the future for a certain
price.
What is a futures contract ?
A futures contract is a standardized and
exchange- traded agreement between two parties
to buy or sell a specified quantity of an asset at a
specified price and at a specified time and place.
 DIFFERENCES BETWEEN FORWARDS / FUTURES

STANDARDIZATION
LIQUIDITY
CONCLUSION OF CONTRACT
 MARGINS
 CLEARING HOUSE
 SETTLEMENT – MARKED TO MARKET
 PRICE LIMITS- TICK SIZE
THE ROLE OF CLEARING HOUSE IN FUTURES MARKET

GOODS (ASSETS)

BUYER FUNDS SELLER

(a) OBLIGATIONS WITH OUT A CLEARING HOUSE

GOODS GOODS
BUYER (ASSETS) (ASSETS)
SELLER
CLEARING
HOUSE
(MEMBER) FUNDS FUNDS MEMBER
(b) OBLIGATIONS WITH A CLEARING HOUSE
FUTURES MARKET : TRADING MECHANISM

 EXCHANGE

 TYPE OF ORDER

MARKET ORDER
LIMIT ORDER
STOP ORDER
MARKET- IF- TOUCHED
CONTINGENT ORDER
 STANDARDIZATION
ASSETS

CONTRACT SIZE

CONTRACT PERIOD

 CLEARING HOUSE

 MAINTENANCE OF MARGINS

 MARKING TO MARKET
FUTURES MARKET SETTLEMENT

 PHYSICAL DELIVERY

CASH SETTLEMENT

 OFFSETTING
 PRICING FUTURES

1) Carry pricing model :- Using this concept

the fair value of a futures contract is
computed as follows
Price = Spot Price + Carry Costs – Carry Returns
Carry Cost= holding costs +borrowing cost
Carry return= dividends or income received on shares
 Valuation Concepts
Continuous Compounding: The Calculation of forward prices and option prices is based
on the concept of continuous compounding.

Compounding Value: A = P (1 + r/m) mn

Where r = rate of interest, m= number of compoundings per annum, n= number of
years, P = spot price , A = compound amount.
Continuous compounding
A = P e nr

Where e = 2.7183
nr = number of years x rate of return
 Pricing of Forward/ Futures
Contracts

Case:1 Securities Providing No income:

F = So e rt

When Market Price is more than F, the arbitrageur

should short a contract

When Market Price is less than F, the arbitrageur

should long a contract.
 Example:
 Consider a futures contract, on a non-
dividend paying share which is available at
Rs.70, to mature in 3-months’s time. If the
riskfree rate of interest be 8% per annum
compounding continuously, the contract
should be Priced (fair price) at:
 F = So ert
70 e (0.25)(0.08)
Or 70 x 1.0202 = Rs.71.41.
 ii. Securities with known cash income:

 Value of Futures contract

. F = (So – I) e rt. , where So =spot price, I = pv of
income received, r= rate of return and t = time
Example: A 6-month futures contract on 100 shares
with a price of Rs.38 each. The riskfree rate of
interest (continuously compounding) is 10% per
annum. The share is expected to yield a dividend
of Rs.1.50 in 4 months from now. Determine the
intrnsic value of futures
Solution:
 Dividend receivable after 4 months: 150

 PV of Dividend (I) = 150 e –(4/12)(0.10)

= 150 x .9672 = Rs.145.08
F ( intrinsic value): (3800-145.08)e (0.5)(0.10)
= 3654.92 x 1.05127
= Rs.3842.31
 The Basis:
 The difference between the futures price and the
current spot price is known as the basis.
 Basis is positive when F > So
 Basis is negative when So > F
 Convergence: As the delivery month
approaches, the basis declines until the spot and
futures prices are approximately the same. This
phenomenon is known as Convergence:
 APPLICATION OF FUTURES

Hedging:
i) Long Hedge ii) Short Edge iii) Cross

Hedge ratio: It is the ratio of the position

taken in futures contracts to the size of
the exposure:
Hr = Futures Position/ Cash market position
ii. SPECULATION
 i. Bullish Security, Buy Futures
 ii. Bearish Security, Sell futures

iii. ARBITRAGE:
i. Overpriced futures: Buy Spot, sell
futures
ii. Underpriced futures: Buy futures, sell
spot.
 OPTIONS
 BASICS

 PRODUCT CLASSIFICATION

 HOW OPTIONS WORK?

 REGULATION

 OPTION PRICING
 EXERCISING THE OPTION
 TRADING STRATEGIES

 CLEARING AND SETTLEMENT

WHAT IS AN OPTION?
OPTION

HOLDER CONTRACT WRITER

SHARE/ STOCK INDEX/ COMMODITY/

INT. RARE/EXCHANGE, RATE.
OPTION TERMINOLOGY

EXERCISE PRICE OR STRIKE

PRICE
EXPIRATION DATE
SPOT PRICE/ MARKET PRICE
OPTION PREMIUM
OPTION POSITIONS
 Call option at expiration (Long Position)
i) If S1 < E Out of the money Un exercised
Loss = Call Premium
ii) If S1 = E at-the- money Un exercised
Loss = Call Premium
iii) If S1 > E in the money Exercised
If C <(S1 > E) Profitable

If C >(S1 > E) Loss Not Exercised

If C = (S1 > E) Break even

 TYPES OF OPTIONS
Call / Put Option
American/European option
Exchange traded /OTC
Stock/ Index Option
Cash/ interest rate Options
Covered/ Naked Options
Synthetic/ Exotic Options
LEAPS/ FLEX OPTIONS
 HOW OPTIONS WORK ?
Pay off profile of Call option
in – The – Money S1 > E
At- The- Money S1 = E
Out- Of – The - Money S1 < E

Out of the
Money

In- the
Money

E S
At the Money
Break Even Price: it is that price of the stock where the gain on the option is just
equal to option premium break even price = gain – option premium = -0
 HOW OPTIONS WORK ?
Pay off profile of Put option
in – The – Money S1 < E
At- The- Money S1 = E
Out- Of – The - Money S1 > E

Out of the
Money

In- The
Money

E S
At the Money

Break Even Price: it is that price of the stock where the gain on the option is
just equal to option premium break even price = gain – option premium = -0
 Option Valuation

Intrinsic Value Time Value

Premium – Intrinsic Value

Call Option = S1 > E
Put Option = S1 < E

There fore premium = Time Value + Intrinsic Value

Premium Time value

Intrinsic value

L In the money S
 Exercising the Option

The Holder Has 3 Alternatives

 Do nothing
 Clouse out the position,
by reversing the transaction
 Exercise option
 Put option at expiration
(Short Position)
i) If E < S1 Out of the money Un exercised
Loss = Put Premium
ii) If E = S1 at-the- money Un exercised

Loss = Put Premium

iii) If E > S1 in the money Exercised
i) If (E > S1 ) > Premium profitable
exercise

ii) If (E = S1 ) = Premium BEP NIL

iii) If( E > S1 ) < Premium Loss Not

Exercised
Options Trading Strategies
Hedging
Have portfolio , buy put option

Speculation

Bullish index, buy calls or sell puts

 Bearish index, Sell calls or buy puts

 Anticipate volatility , buy a call and put at same strike price

 Bull spreads, buy a call and sell another

Bears spreads, sell a call and buy another

Butterfly spreads , buy two calls at the different

Prices and selling two calls with same strike price

Combinations, straddle buy a call and put with

same exercise price and ate of expiration

Strangle buy a put and a call with same expiration

date but with different exercise prices

Arbitration
Put - call parity with spot options arbitrage
 Trading clearing and settlement

Trading :
 NEAT : F & O trading system – screen based trading,
supports order driven markets
 Entities in trading system; Trading members,
Clearing members professional clearing members and
participants
 Bases for trading
 Order types and conditions
 Contract cycle
 Contract size
 Clearing

 Clearing Member
 Clearing Banks
 Clearing Mechanism
– Working out open positions and
obligations
Settlement Mechanism
 Cash settlement
 MTM (Market to Market
Settlement )
 T+1 Settlement Daily Premium
Settlement
 Exercise Settlement
 Interim Exercise Settlement
 Final Exercise Settlement