Introduction

What is a Derivative?
A derivative is an instrument whose value
depends on, or is derived from, the value of
another asset.
Examples: futures, forwards, swaps, options,
exotics…
Why do we need derivative
products?
Hedging
Market efficiency
Risk management- Transfer of risk
Why Derivatives Are Important
Derivatives play a key role in transferring risks in the
economy
The underlying assets include stocks, currencies,
interest rates, commodities, debt instruments,
electricity prices, the weather, etc
Many financial transactions have embedded
derivatives
The real options approach to assessing capital
investment decisions has become widely accepted
Business Growth in CM and FNO Segment

Business Growth in CM and FNO Segment

Derivative Turnover( Derivative/CM
Year CM_VALUE(₹ Trillion) Derivative/CM
Trillions)
8,000.00
2000-01 0.84 0.24 0.28
2001-02 1.34 10.19 7.61
7,000.00
2002-03 0.51 43.99 85.72
2003-04 0.62 213.06 344.77
6,000.00
2004-05 1.10 254.70 231.64
2005-06 1.14 482.42 423.15
5,000.00
2006-07 0.84 735.62 871.09
2007-08 1.95 1,309.05 672.93
4,000.00
2008-09 3.55 1,101.05 310.06
2009-10 2.75 1,766.37 641.84
3,000.00
2010-11 4.14 2,924.82 706.82
2011-12 3.58 3,134.97 876.32
2,000.00
2012-13 2.81 3,153.30 1,121.81
2013-14 2.71 3,821.14 1,410.91
1,000.00
2014-15 2.81 5,560.65 1,979.94
2015-16 4.33 6,482.58 1,497.25
0.00
2016-17 4.24 9,437.03 2,227.30
2018-19 7.23 23,759.10 3,283.99
2019-20 7.95 34,539.14 4,345.09
2020-21 9.00 64,361.81 7,152.26 Derivative/CM
2021-22 15.40 1,05,623.03 6,859.57
List down some innovative
derivative products?
How Derivatives Are Traded
On exchanges such as the Chicago Board
Options Exchange (CBOE), NSE, BSE
In the over-the-counter (OTC) market where
traders working for banks, fund managers
and corporate treasurers contact each other
directly
 Greed Fear Ego

The Lehman Bankruptcy (Business

Snapshot 1.1)

Lehman’s filed for bankruptcy on September 15, 2008.

This was the biggest bankruptcy in US history
Lehman was an active participant in the OTC derivatives
markets and got into financial difficulties because it took
high risks and found it was unable to roll over its short
term funding
It had hundreds of thousands of transactions
outstanding with about 8,000 counterparties
Unwinding these transactions has been challenging for
both the Lehman liquidators and their counterparties
 Greed Fear Ego

Largest bankruptcies in the US

Size of OTC and Exchange-Traded Markets
(Figure 1.1, Page 5)

Source: Bank for International Settlements. Chart shows total principal amounts for
OTC market and value of underlying assets for exchange market
How Derivatives are Used
To hedge risks
To speculate (take a view on the
future direction of the market)
To lock in an arbitrage profit
To change the nature of a liability
Forward Price
The forward price for a contract is the
delivery price that would be applicable to
the contract if were negotiated today
(i.e., it is the delivery price that would
make the contract worth exactly zero)
The forward price may be different for
contracts of different maturities (as
shown by the table)
Foreign Exchange Quotes for GBP,
May 3, 2016 (See page 6)
Bid Offer
Spot 1.4542 1.4546

1-month forward 1.4544 1.4548

3-month forward 1.4547 1.4551

6-month forward 1.4556 1.4561

Terminology
The party that has agreed to buy
has what is termed a long position
The party that has agreed to sell
has what is termed a short position
Futures Contracts (page 8)
Agreement to buy or sell an asset for a
certain price at a certain time
Similar to forward contract
Whereas a forward contract is traded OTC,
a futures contract is traded on an exchange
Options
A call option is an option to buy a certain
asset by a certain date for a certain price (the
strike price)
A put option is an option to sell a certain
asset by a certain date for a certain price (the
strike price)
American vs European Options
An American option can be exercised at any
time during its life
A European option can be exercised only at
maturity
Google Call Option Prices from CBOE (May 3, 2016; Stock
Price is bid 695.86, offer 696.25); See Table 1.2 page 9

Strike Jun 2016 Jun 2016 Sep 2016 Sep 2016 Dec 2016 Dec 2016
Price Bid Offer Bid Offer Bid Offer
660 43.40 45.10 60.80 62.70 72.70 76.70

680 29.20 30.60 47.70 50.70 60.90 64.70

700 18.30 18.90 37.00 39.20 49.70 52.50

720 9.90 10.50 27.50 29.50 40.10 42.80

740 4.70 5.20 19.80 21.60 31.40 34.40

Google Put Option Prices from CBOE (May 3, 2016; Stock
Price is bid 695.86, offer 696.25); See Table 1.3 page 9

Strike Jun 2016 Jun 2016 Sep 2016 Sep 2016 Dec 2016 Dec 2016
Price Bid Offer Bid Offer Bid Offer
660 7.50 8.20 24.20 26.20 35.60 38.10

680 13.30 14.00 31.90 33.80 43.40 46.00

700 21.70 23.00 40.80 42.70 52.40 55.20

720 33.10 34.80 51.10 53.20 62.60 65.20

740 47.70 49.60 63.10 65.20 74.10 76.70

Options vs Futures/Forwards
A futures/forward contract gives the holder
the obligation to buy or sell at a certain price
An option gives the holder the right to buy or
sell at a certain price
Types of Traders
Hedgers
Speculators
Arbitrageurs
Hedging Examples (pages 11-13)
A US company will pay £10 million for
imports from Britain in 3 months and
decides to hedge using a long position in a
forward contract
An investor owns 1,000 Microsoft shares
currently worth $28 per share. A two-month
put with a strike price of $27.50 costs $1.
The investor decides to hedge by buying 10
contracts
Value of Microsoft Shares with and
without Hedging (Fig 1.4, page 13)
40,000 Value of Holding
($)

35,000

No Hedging
30,000 Hedging

25,000

Stock Price ($)

20,000
20 25 30 35 40
Speculation Example
An investor with $2,000 to invest feels that
a stock price will increase over the next 2
months. The current stock price is $20 and
the price of a 2-month call option with a
strike of 22.50 is $1
What are the alternative strategies?
Arbitrage Example
A stock price is quoted as £100 in London
and $150 in New York
The current exchange rate is 1.5300
What is the arbitrage opportunity?
Dangers
Traders can switch from being hedgers to
speculators or from being arbitrageurs to
speculators
It is important to set up controls to ensure that
trades are using derivatives in for their
intended purpose
Hedge Funds (see Business Snapshot 1.3, page 12)
Hedge funds are not subject to the same rules as
mutual funds and cannot offer their securities
publicly.
Mutual funds must
disclose investment policies,
make shares redeemable at any time,
limit use of leverage
Hedge funds are not subject to these constraints.
Hedge funds use complex trading strategies are big
users of derivatives for hedging, speculation and
arbitrage