Derivatives

Group 1Group 1

NameName Roll NoRoll No

Jatin GalaJatin Gala 18 18Rajesh JainRajesh Jain 27 27Komal ParikhKomal Parikh 40 40Meghana PatilMeghana Patil 42 42Rohit RajasRohit Rajas 47 47Sangeeta RamdasSangeeta Ramdas 48 48Nishit ShahNishit Shah 52 52

Derivatives “Derivatives are financial instruments whose values are derived from values of some

underlying assets like interest rates, commodities, stocks, index or currencies”

“Derivative instruments have a pre-determined finite life at the end of which they expire, and usually involve an exchange of payments, which is small in comparison with the notional underlying value of transactions.”

Large multinationals, banks and corporations wanted to hedge themselves against volatile interest and currency rate movements.

Dealing in derivatives exceeds and amount of USD 1 trillion per day.

Several factors which contributed to the explosive growth of derivatives like world wide interlinking of trade and capital flows, progress in communication and technology, advancement in computer technology, professionalism amongst market makers.

Hedging & Speculation

What if Prices of crops fall

down ?

The price will definitely rise

Hedger Speculator

Reasons:

Low / Excess Rainfall

Inflation

Low Demand

Types of Derivatives

Two types - 1)Exchange traded products 2)Over the counter products Exchange traded products- Traded under rules and

regulations of a centralized market place. Highly standardized in terms of various characteristics like amount, maturity etc.

OTC are those which are traded over the counter and normally settled by agreements.

Swap is a contractual agreement in which 2 parties agree to exchange periodic payments to each other.

Futures contract is an agreement to buy or sell on an exchange, a standard quantity of an underlying asset at a future date at a price agreed to between the parties to the contract.

An Option is the right, not the obligation to buy or sell an underlying instrument.

Features of Futures They are the most common form of derivatives, introduced In Indian stock exchanges on 9 th June,

2000.

Futures contract is an agreement between 2 parties to buy or sell in future, on a designated exchange, a specific quantity of asset at a specific price. The specified asset may be commodity, currency, Index etc.

Price of an asset, to be exchanged at a future date, agreed upon today.

Though the contract matures on a fixed future date, it is not mandatory to carry the contract till maturity.

In fact most futures contracts are closed out prior to maturity.

Improvement over Forwards in terms of standardization, guaranteed performance etc.

They can be bought or sold like commodities in a future exchange.

Long position: Investor buying a futures

Short position: Investor selling a futures

No. Underlying Symbol Market Lot

1 S&P CNX Nifty NIFTY 200

Derivatives on Individual Securities

1 Associated Cement Co. Ltd.

ACC 1500

2 Bajaj Auto Ltd. BAJAJAUTO 800

3 Bharat Electronics Ltd. BEL 1100

4 Bharat Heavy Electricals Ltd.

BHEL 1200

5 Bharat Petroleum Corporation Ltd.

BPCL 1100

6 BSES Ltd. BSES 1100

7 Cipla Ltd. CIPLA 200

8 Digital Globalsoft Ltd. DIGITALEQP 400

9 Dr. Reddy's Laboratories Ltd.

DRREDDY 400

10 Grasim Industries Ltd. GRASIM 700

11 Gujarat Ambuja Cement Ltd.

GUJAMBCEM 1100

12 HCL Technologies Ltd. HCLTECH 1300

13 Housing Development Finance Corporation Ltd.

HDFC 600

14 Hero Honda Motors Ltd. HEROHONDA 800

15 Hindalco Industries Ltd. HINDALC0 300

16 Hindustan Lever Ltd. HINDLEVER 1000

17 Hindustan Petroleum Corporation Ltd.

HINDPETRO 1300

18 ICICI Bank Ltd. ICICIBANK 1400

19 Infosys Technologies Ltd. INFOSYSTCH 100

20 Indian Petrochemicals Corpn. Ltd.

IPCL 2200

21 ITC Ltd. ITC 300

22 Larsen & Toubro Ltd. L&T 1000

23 Mahindra & Mahindra Ltd.

M&M 2500

24 Mastek Ltd. MASTEK 400

25 Mahanagar Telephone Nigam Ltd.

MTNL 1600

26 National Aluminium Co. Ltd.

NATIONALUM 2300

27 NIIT Ltd. NIIT 1500

28 Oil & Natural Gas Corp. Ltd. ONGC 600

29 Polaris Software Lab Ltd. POLARIS 1400

30 Ranbaxy Laboratories Ltd. RANBAXY 800

31 Reliance Industries Ltd. RELIANCE 600

32Satyam Computer Services Ltd.

SATYAMCOMP 1200

33 State Bank of India SBIN 1000

34Shipping Corporation of India Ltd.

SCI 3200

35Sterlite Optical Technologies Ltd.

STROPTICAL 600

36 Tata Power Co. Ltd. TATAPOWER 1600

37 Tata Tea Ltd. TATATEA 1100

38Tata Engineering and Locomotive Co. Ltd.

TELCO 3300

39 Tata Iron and Steel Co. Ltd. TISCO 1800

40 Videsh Sanchar Nigam Ltd. VSNL 700

41 Wipro Ltd. WIPRO 200

Options- Various Terminologies Call Option: The buyer of the option gets a right but not an obligation to buy the

underlying asset

Put Option : This option gives the buyer the right but not the obligation to sell the underlying asset

Intrinsic Value: When the strike price is better than the current market price, the intrinsic value is the difference between the two

At the money option: The option in which the strike rate is the same as the current market rate

In the money option: An option whose strike rate is better than current market rate

Out of money option: This is the option whose strike rate is worse than the current market rate.

American Option: An option that can be exercised on any date up to expiry

European Option: An Option that can be exercised only on its expiry date

Buying a CALL OptionView : Bullish Buy a one month Nifty Call With the Strike of 1250 Premium of Rs. 100

NIFTY SPOT

1000 1100 1200 1250 1350 1400 1500

Below Strike

Below Strike

Below Strike

At Strike Break even

Above Strike

Above Strike

Value of 1250 Call

0 0 0 0 100 150 250

Premium Paid

-100 -100 -100 -100 -100 -100 -100

Net Profit / (loss)

(100) (100) (100) (100) 0 50 150

Pay Off Matrix200

150

100

50

0

-50

-100

-150

10001100 1200 1250 1350 1400 1500

Writing a CALL OptionView : Bearish Sell/Write a one month Nifty Call With the Strike of 1250 Premium of Rs. 100

NIFTY SPOT

1000 1100 1200 1250 1350 1450 1550

Below Strike

Below Strike

Below Strike

At Strike Break even

Above Strike

Above Strike

Value of 1250 Call

0 0 0 0 -100 -200 -300

Premium Recd

100 100 100 100 100 100 100

Net Profit / (loss)

100 100 100 100 0 (100) (200)

Pay Off Matrix

10001100 1200 1250 1350 1450 1550

0

200

150

100

50

-50

-100

-150

-200

Buying a PUT OptionView : Bearish Buy a one month Nifty Call With the Strike of 1250 Premium of Rs. 100

NIFTY SPOT

1000 1100 1150 1250 1350 1450 1550

Below Strike Below Strike

Below Strike

At Strike Break even

Above Strike

Above Strike

Value of 1250 Call

250 150 100 0 0 0 0

Premium Paid

-100 -100 -100 -100 -100 -100 -100

Net Profit / (loss)

150 50 0 -100 -100 -100 -100

Pay Off Matrix200

150

100

50

0

-50

-100

-150

950 1050 1150 1250 1350 1400 1500

Selling a PUT OptionView : Bullish Sell/Write a one month Nifty Call With the Strike of 1250 Premium of Rs. 100

NIFTY SPOT

1000 1100 1150 1250 1350 1450 1550

Below Strike Below Strike

Below Strike

At Strike Break even

Above Strike

Above Strike

Value of 1250 Call

-250 -150 -100 0 0 0 0

Premium Paid

100 100 100 100 100 100 100

Net Profit / (loss)

(150) (50) 0 100 100 100 100

Pay Off Matrix

950 1050 1150 1250 1350 1450 1550

0

200

150

100

50

-50

-100

-150

-200

Derivative Strategies Bullish View

Buy a Future Script or Index Buy a Call Option Sell a Put Option Create a Bull Spread using Calls or Puts

Bearish View Sell a Future Script or Index Buy Put Option Sell Call Option Bear Spreads using Calls or Puts Combinations of Options and Futures

Volatile or Neutral View Straddle, Strangle, Butterfly, Strips, Straps

Bull and Bear Spread Simple option positions carry unlimited profits,

limited losses for buyers and limited profits, unlimited losses for sellers (writers).

Spreads create a limited profit, limited loss profile for users.

Those spreads which will generate gains in a bullish market are bull spreads.

Those spreads which will generate gains in a bearish market are bear spreads.

Spreads can be created either using Calls or Puts.

Bull Spread Illustration

Maximum loss of Rs 19 will arise if Stock closes at Rs 260 or below (i.e. the lower strike price) and the maximum profit of Rs 21 will arise if Stock closes at Rs 300 or above (i.e. the higher strike price)

ABC stock currently quoting at Rs. 260

Straddle and Strangle

These strategies are used by the investors when they believe that the market will remain neutral or volatile (but not sure whether it will go up or down).

Buy Straddle or Strangle when the market is believed to remain volatile.

Sell Straddle or Strangle when the market is believed to remain neutral.

21

CASH PRICE Rs.240/-CALL

March 240 12March 260 6

PUT March 240 9March 220 5

Trading Strategy

What it is Impact Illustration / Initial Investment (Rs.)

STRADDLE BUY / SELL

CALL & PUT at same Exercise Price & same Expiration Date

Right to Buy

Right to Sell

OR

Obligation to Buy

Obligation to Sell

BUY a March 240 CALL -12

BUY a March 240 PUT -9

-21

STRANGLE Combination of a CALL & PUT with same expiration date and different Exercise Price chosen in such a way that CALL Exercise Price > Put Exercise Price

Right to Buy

Right to Sell

BUY a March 260 CALL -6

BUY a March 220 PUT -5

-11

Straddle & Strangle Illustration

22

Straddle

BUY a March 240 CALL -12BUY a March 240 PUT -9 Initial Cost -21

Breakeven points = 219 & 261

Maximum profit is made if the price falls significantly to Rs 200 or rises significantly to Rs 280. Maximum loss can be Rs 21 (initial cost) if the price remains wherever it currently is.

23

Strangle

BUY a March 260 CALL -6BUY a March 220 PUT - 5 Initial Cost -11

Breakeven points = 209 & 271

Maximum profit is made if the price falls significantly to Rs 200 or rises significantly to Rs 280. Maximum loss can be Rs 11 (initial cost) if the price remains wherever it currently is.

Straddle Pay Off Matrix

25

• Straddle and strangle seller is exposed to unlimited losses.

• The butterfly strategy helps you to reduce unlimited losses.

• To cut the wings on straddle, one can buy a Call with a higher strike price and buy another put with a lower strike price than that of the Straddle.

Butterfly Spread

2626

Maximum profit of Rs 13 is generated if Stock remains at Straddle Strike price of Rs 240. Maximum loss is restricted to Rs 7 which happens when Satyam moves either below Rs 220 or above Rs 260. This loss is capped on both sides.

Butterfly Illustration

SELL a March 240 CALL 13SELL a March 240 PUT 11 Initial Income 24

Buy a March 260 CALL -5Buy a March 220 PUT -6 Initial Cost -11

Strips and Straps

• Strip strategy appeals investors who want to take position in asset which is volatile but likely to decline sharply.

• Strap strategy appeals investors who want to take position in asset which is volatile but likely to rise sharply.

Strips and StrapsCASH PRICE Rs.310/-CALLMarch 310 21PUT March 270 2March 310 42

Trading Strategy

What it is Impact Illustration / Initial Cash Flow (Rs.)

STRIPS Long Position in ONE CALL and TWO PUTS with same Exercise Price & same Expiration Period

Right to Buy

Right to Sell

BUY ONE March 310 CALL - 21

BUY TWO March 310 PUT - 84

-105

STRAPS Long Position in TWO CALLS and ONE PUT with same Exercise Price & same Expiration Date

Right to Buy

Right to Sell

BUY TWO March 310 CALL -42

BUY ONE March 310 PUT -42

-84

StripsBUY a March 310 CALL - 21BUY TWO March 310 PUT - 84Initial Cost -105

Market Price

1

Profit on CALL

2

Profit on PUT

3

Initial Cost

4

Net Profit

5 = 2 + 3 -4

220 0 180 105 75

240 0 140 105 35

260 0 100 105 -5

270 0 80 105 -25

300 0 20 105 -85

310 0 0 105 -105

320 10 0 105 -95

340 30 0 105 -75

360 50 0 105 -55

400 90 0 105 -15

StrapsBUY 2 March 310 CALL -42BUY 1 March 310 PUT -42Initial Cost -84

Market Price

1

Profit on CALL

2

Profit on PUT

3

Initial Cost

4

Net Profit

5 = 2 + 3 - 5

220 0 90 84 6

240 0 70 84 -14

260 0 50 84 -34

270 0 40 84 -44

300 0 10 84 -74

310 0 0 84 -84

320 20 0 84 -64

340 60 0 84 -24

360 100 0 84 16

400 180 0 84 96

Interest Rate Swaps“A Single Currency Interest Rate Swap (IRS) is an exchange of cash flows between two counter parties at predetermined specifications. It is an obligation between them for exchange of interest payments or receipts on investments, in the same currency on an agreed amount of notional principal at regular intervals, over an agreed period of time.”

Fixed to Floating SwapIn this type of a swap the customer receives cash flows at a fixed rate of interest and simultaneously pays cash flows at a floating rate of interest or vice versa. The cash flows are calculated on a Notional Principal amount. The floating rate of interest is usually determined by reference to a transparent benchmark

Floating to Fixed SwapIn this kind of a swap, both the counter-parties exchange interest amounts based on two different floating reference rates, through the life of the swap.

IRS: Cash Flows Using Overnight Index (NSE MIBOR)

Bank A pays 7 day fixed rate of 5.60%, receives floating overnight rate for a notional ofBank A pays 7 day fixed rate of 5.60%, receives floating overnight rate for a notional of

Rs. 10,000 lacs, trade date Dec 24, 2002.Rs. 10,000 lacs, trade date Dec 24, 2002.

Notional Principal: 10000 lacsNotional Principal: 10000 lacs Value date: Dec 24, 2002Value date: Dec 24, 2002

Duration of swap: 7 daysDuration of swap: 7 days (Fig in Rs. Lacs)(Fig in Rs. Lacs) Start date: Dec 26, 2002Start date: Dec 26, 2002

Fixed Rate: 5.60%Fixed Rate: 5.60% (Call rate in %)(Call rate in %) Settlement date: Jan 2, 2003Settlement date: Jan 2, 2003

Normal RateNormal Rate Rate cutRate cut Rate HikeRate Hike

DateDate Call Call Int.Int. Cl. Pr.Cl. Pr. CallCall Int.Int. Cl.Pr.Cl.Pr. CallCall Int.Int. Cl. Pr.Cl. Pr.

26 – Dec26 – Dec 5.755.75 1.581.58 10001.5810001.58 5.255.25 1.441.44 10001.4410001.44 6.006.00 1.641.64 10001.6410001.64

27 - Dec27 - Dec 5.705.70 1.561.56 10003.1410003.14 5.205.20 1.421.42 10002.8610002.86 5.805.80 1.591.59 10003.2310003.23

28 - Dec28 - Dec 5.625.62 3.083.08 10006.2210006.22 5.355.35 2.932.93 10005.7910005.79 5.855.85 3.213.21 10006.4410006.44

30 - Dec30 - Dec 5.655.65 1.551.55 10007.7710007.77 5.255.25 1.441.44 10007.2310007.23 5.755.75 1.581.58 10008.0210008.02

31 - Dec31 - Dec 5.555.55 1.521.52 10009.2910009.29 5.305.30 1.451.45 10008.6810008.68 5.835.83 1.601.60 10009.6210009.62

1 - Jan1 - Jan 5.585.58 1.531.53 10010.8210010.82 5.355.35 1.471.47 10010.1510010.15 5.775.77 1.581.58 10011.2010011.20

Floating Int:Floating Int: 10.8210.82 10.1510.15 11.2011.20

Pays fixed interest: 10.74 Pays fixed interest: 10.74

Net Net InterestInterest

Received: 0.08Received: 0.08 Paid: 0.59Paid: 0.59 Received: 0.46Received: 0.46

Credit Default Swaps Credit default swaps allow one party to "buy" protection from another party for losses that might be incurred as a result of default by a specified reference credit (or credits).

The "buyer" of protection pays a premium for the protection, and the "seller" of protection agrees to make a payment to compensate the buyer for losses incurred upon the occurrence of any one of several specified "credit events."

CDS is the most widely traded credit derivative product. Typical term of CDS contract is 5 years (up to 10-year CDS).

CDS documentation is governed by the International Swaps and Derivatives Association (ISDA), which provides standardized definitions of credit default swap terms, including definitions of what constitutes a credit event.

Default

Protection

Seller (Y)

Default

Protection

Buyer (X)

Microsoft

Reference Entity

BondsIssues Bonds

Buys Bonds

Lends a Loan

Pays Amount

Pays Premium

Credit Event

CDS Contract

Potential Benefits

In addition, to hedging event risk, the CDS provides the following benefits:

A short positioning vehicle that does not require an initial cash outlay.

Access to maturity exposures not available in the cash market.

Access to credit risk not available in the cash market due to a limited supply of the underlying bonds.

Investments in foreign credits without currency risk.

Ability to effectively ‘exit’ credit positions in periods of low liquidity.

Currency Swaps“A currency swap is a foreign-exchange agreement between two parties to exchange aspects (namely the principal and/or interest payments) of a loan in one currency for equivalent aspects of an equal in net present value loan in another currency.”

A combination of a spot foreign exchange transaction and an offsetting forward foreign transaction undertaken with the same counterparty

An exchange of debt or assets denominated in one currency for debt or assets denominated in another currency

They are OTC instruments

Involves exchange of principal and interest payments for an agreed period of time and to exchange rate of maturity

A currency swap between the World Bank and IBM in August 1981 was the first of its kind with Salomon Brothers actins as intermediary between the two.

Option Buyer Option SellerUSD 1.3 MM

EUR 1 MM

Strike Rate0.3 MM

- USD 0.1 MM + USD 0.3 MM

Currency Swap

Settlement Schedule

ProductSettlement Schedule

Futures Contracts on Index & Individual Securities Daily Mark-to-Market SettlementPay-in : T+1 working day Payout : T+1 working day

Futures Contracts on Index &Individual Securities

Final Settlement

Pay-in : T+1 working Payout : T+1 working day .

(T is expiration day of contract)

Options Contracts on Index &Individual Securities

Premium Settlement

Pay-in : T+1 working day.

Payout : T+1 working day.

(T is trade day)

Options Contracts on Index Exercise & Final Settlement

Pay-in : T+1 working day

Payout : T+1 working day.

(T is expiration day of contract)

Options Contract on IndividualSecurities

Interim Exercise Settlement

Pay-in : T+2 working day

Payout : T+2 working day

(T is exercise day)

Options Contract on IndividualSecurities

Exercise & Final Settlement

Pay-in : T+2 working day

Payout : T+2 working day

(T is expiration day)