DERIVATIVEDerivative is an instrument whose value is derived from another security or economic variable called underlying assets. The underlying assets could be a stock ( for example futures on Infosys), currencies( Dollar Futures),stock index, Futures on BSE Sensex , physical commodity ( oil Futures), interest banking instruments ( T- bill futures).They can be either exchange traded or traded over the counter. OVER THE COUNTER EXCHANGE TRADED

Forward Contract Futures

Financial Swaps Options

Forward Rate Agreement (FRA)

Forward Rate Agreement (FRA)FRA is a forward contract on Interest Price.

Settlement of FRA Actual Borrowing/Investment does not take place in FRA. Instead FRA is considered to be a bet on some reference rate usually LIBOR or MIBOR. The one who wins the bets gets an amount equal to present value of the Rupee difference between Actual LIBOR and FRA rate. These are used by borrowers or lenders to protect themselves from unfavorable changes in interest rates. The Buyer of FRA is safeguarded against rise in interest rates but suffers a loss if interest rates fall The seller of FRA is safeguarded against fall in interest rates but suffers when interest rates rise. If LIBOR > FR the seller owes the payment to the buyer, and if LIBOR < FR the buyer owes the seller the absolute value of the payment amount determined by the formula below.

Payment=Notional Amount*(Reference Rate-Forward Rate)(FRA Days/360 or 365)[1+Reference Rate* FRA Days/360 or 365]Pricing and ArbitrageThe pricing of FRA is set in such a way that there is no scope for arbitrage.

FINANCIAL SWAPSA Financial swap is a Bunch of forward contract. Here cash flows are exchanged periodically according to a pre-defined formula. In an interest rate swap one party agrees to pay fixed interest and other party pays floating interest on notional principal.Financial Swaps comes in various flavors

Motives of Financial Swapa) Swaps are designed to reduce the effective cost of preferred fundingb) Swaps are also used to convert the nature of fundingc) Swap based on comparative advantage theory

Pricing and valuation of swapSwap price refers to the rate applicable for the fixed legs of the swap.

The price of the swap is set in such manner that Value of Swap is NIL to begin with.V fixed=V floatingV swap= V floating - V fixedV fixed= PV of the coupon and redemption discounted at market rateV floating= on[RESET DATE]=Par ValuePeriodic swap price =Where d=R= Periodic LIBORValuation of Currency Swap takes is similar like valuing a normal swap. We just have to convert one leg into another using exchange rate on the date of valuation.Overnight Index Swap is a fixed floating swap where the floating leg is based on MIBOR compounded daily.FUTURESFuture are derivative instruments which involve a Standardized Contract to Buy/Sell a certain amount of the underlying asset at an agreed upon price called future price.Long Position : If a person buys or holds an asset , he is said to be in a Long Position . When trading in long position contract should be bought , upside betting Short Position : If a person sells an asset , he is said to be in a Short Position. When trading in short position contract should be sold , downside betting.Margin MaintenanceIf there is an adverse price movement there is a possibility of default on the part of the trader. To mitigate the same, the clearing house requires every futures trader to make a security deposit called Initial margin.This margin balance may fluctuate due to the marking to market feature. There is a minimum margin requirement called maintenance margin. If the margin balance on a particular day goes below the maintenance margin , the customer has to bring in an amount called variation margin to achieve theinitial margin , also any amount over and above the initial margin is allowed to be withdrawn.Calculation of Future Value under various situationsi)When interest is Compounded continuously Future Value=Present Value*erisk free rate x time to maturity expressed In years

Present Value= Future Value/ ert= Future Value*e-rtNote :Value of e = 2.71828 ;Note :Value of Log e = .4343 ii) Securities providing With No IncomeFair Future Value =Spot Price* ertiii) Securities Providing Known Cash Income(Dividend) expressed in Amount(Rs)Fair Future Value =(Spot Price-Present Value of Expected Dividend)* ertPV of Expected Dividend=Dividend* e-rtiv) Securities Providing Known Cash Income(Dividend) expressed in Percentage or Known YieldFair Future Value =(Spot Price* e(r-y)tWhere,Y=dividend yield p.a. expressed as %Relation between spot price and futures priceFuture price are priced as per the Cost of carry model which is based on the prevention of arbitrage principal.As per the modelTheoretical Future Price=Spot Price+Cost of CarryCost of carry= Interest saved + storage cost saved-convenience yield foregoneWhen the cost of carry model is applied in a continuous framework i.e. , when interest rates and dividend yield are continuously compounded , we haveF=S x e(r-d)tv)Securities with Storage cost expressed in AmountFair Future Value =(Spot Price+Present Value of Storage Cost)* ertPV of storage cost=Storage cost* e-rtvi) Securities with Storage cost expressed in PercentageFair Future Value =(Spot Price* e(r+s)t)Where s= storage cost p.a. expressed in%vii)Securities with Convinience Yield expressed in amountFair Fair Future Value =(Spot Price-Present Value of Convinience Yield)* ertPV of Convinience Yield = Convinience Yield * e-rt

viii) Securities with Convinience Yield expressed in%

Fair Future Value =(Spot Price* e(r-c)t)Where c = convenience yield p.a expressed in percentageNote: The above valuations could have also be done by using Normal Compounding.

OPEN INTERESTOpen interest denotes number of contracts still outstanding. It is the sum total of all the long positions or equivalently it is the sum of all short positions that has not been squared off, closed or expired. When a new series is opened, fresh positions are entered and open interest rises.ExIf A buys 2 Futures& B Sells 2 futures on 1st FebOpen Interest is 2If D buys 5 Futures & C sells 5 futures on 2nd Feb Open Interest is 2+5=7Now on 3rd Feb A sells 1 Futures & C buys 1 futuresOpen Interest is 7-1=6

Buy Signal- Rise in future priceSell Signal- Fall in future priceTake a lot size to be 100 if not given, however for nifty futures, lot size would be 50Stock future ArbitrageIf the cost of carry model does not holds good (actual F not = theoretical F ), there is a clear cut arbitrage opportunity .Whatever be the type of arbitrage, profit will be equal to the amount of mispricing.CONCEPT OF ARBITRAGE UNDER FUTURE MARKET:

Case Valuation Borrow/Invest Cash Future Arbitrage Market MarketActual FV > Fair FV Overvalued Borrow Buy Sell Cash & CarryActual FV < Fair FV Undervalued Invest Sell Buy Reverse Cash & Carry* here we are assuming that arbitrageur holds one share .

Stock index futuresThese are futures on well publish index like NIFTY futures, IT index futures , Bank Nifty futures.

Beta management using stock index futuresNo. of NIFTY FUTURES Contracts (N) ==Value of Portfolio (Target Beta-Beta of Portfolio) Future Price x Lot Size x Beta of Hedging toolHedging refers to taking offsetting position in Index futuresi.e If you are long on a securityTo Hedge you should go short in Index FuturesIf you are short on a securityTo Hedge you should go long in Index FuturesHedging through currency futureIn order to hedge a transaction exposure i.e. a known foreign currency payable/receivable , we can use futures cover..Foreign currency receivableBuy Home Currency (Rupees) FutureNo. of Contracts = On the day of lifting the hedge rupee futures are squared off resulting in profit or loss in FCForeign Currency PayableSell Home Currency FuturesNo. of Contracts = Speculation through futuresOUTRIGHT Trading 1) Buy futures on a currency you feel will appreciate. 2) Sell futures on the currency you feel will depreciateSPREAD TradingIt involves simultaneously selling and buying futures. It is non directional and less risky. It is a bet on the spread i.e. the gap between the futures bought and futures sold.Inter commodity spread involves buying and selling futures on the same commodity for different maturities

Intra commodity spread involves buying and selling futures on different commodities for the same maturityGain or Loss Under Futures ContractPositon in FuturesSpot Price on ExpirationProfit/LossLong Increase ProfitLong Decrease LossShort Increase LossShort Decrease ProfitUsing Futures to change the beta of the portfolioi) Sale Future if Desired or Target Beta is less than the Existing Betaii) Buy Future if Desired or Target Beta is more than the Existing BetaThe number of futures contract to be taken for increasing and reducing beta to a desired level is given by the following formulaCurrent PortfolioValue[ExistingBetaofthePortfolio-DesiredBetaofthePortfolio]Value of one Contract Futures

BASISBasis = Future Price ( the actual price that is quoted in the future market ) - Spot Price ( the price that is quoted in the cash market )F>SMarket is said to be in Contango Basis is negative

F Strike PriceIn the MoneyOut of the Money

Market PriceSellingPrice Yes Profit=MP-SP-Premium

Market PriceSellingPrice No Loss=Amount of Premium Paid

Market Price