DERIVATIVES
Presented By:
Errol Crasto
DERIVATIVE ?
• The term “derivatives” is used to refer to
financial instruments which derive their
value from some underlying assets.
Or
• Derivative is a product whose value is
derived from the value of one or more
underlying variable (underlying asset,
index, or reference rate)
Characteristics
• A contract entered between a buyer and
seller to undertake their obligations.
• Exchange traded .
• Helps mitigate the risk arising from the
future uncertainty of prices
Underlying Assets
Stocks
Bonds
Commodities
Currencies
Interest rates
Market indexes
Need / Participants
Hedge ( manage risk )
Speculate ( undertake risk )
Arbitrage ( exploit unfair prices )
Types of Derivatives
Futures
Forwards
Options
Swaps
Warrants / LEAPS
Forwards
• A forward contract is a customized
contract between two parties where
settlement takes place on a specific date
in the future at today's agreed price.
Futures
• A futures contract is an agreement
between two parties to buy or sell an asset
at a certain time in the future at a certain
price. Futures contracts are different from
forward contracts in the sense that the
former are standardized exchange traded
contracts which guarantee settlement.
Options
• Options are of two types - calls and puts.
Calls give the buyer the right but not the
obligation to buy a given quantity of the
underlying asset, at a given price on or
before a given future date. Puts give the
buyer the right, but not the obligation to
sell a given quantity of the underlying
asset at a given price on or before a given
date.
Warrants/LEAPS
• Options generally have lives of upto one year,
the majority of options traded on options
exchanges having a maximum maturity of nine
months. Longer-dated options are called
warrants and are generally traded over-the-
counter.
• The full form of LEAPS means Long-Term
Equity Anticipation Securities. These are options
having a maturity of upto three years.
Swaps
• Swaps are private agreements between two parties to
exchange cash flows in the future according to a
prearranged formula. They can be regarded asportfolios
of forward contracts.
The two commonly used swaps are:
• Interest rate swaps: These entail swapping only the
interest related cash flows between the parties in the
same currency.
• Currency swaps: These entail swapping both principal
and interest between the parties, with the cash flows in
one direction being in a different currency than those in
the opposite direction.
Terminology
• Spot Market :
The spot market or cash market is a securities
market in which securities are sold for cash and
delivered immediately. The delivery happens
after the settlement period The settlement period
in this market is on a T+2 basis i.e., the buyer of
the shares receives the shares two working days
after trade date and the seller of the shares
receives the money two working days after the
trade date.
Futures Price
• The price at which the futures contract
trades in the futures market.
Futures 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. These prices are dependent on the
spot price, the prevailing interest rate and
the expiry date of the contract.
Contract cycle
• Period over which a contract trades
usually 1, 2 & 3 months .
Strike Price
• The price at which the buyer of an option
can buy the stock (in the case of a call
option) or sell the stock (in the case of a
put option) on or before the expiry date of
option contracts is called strike price. It is
the price at which the stock will be bought
or sold when the option is exercised.
Strike price is used in the case of options
only; it is not used for futures or forwards.
Types of Options
• European Options : European options
are options that can be exercised only on
the expiration date. Eg Index Options
• American options: American options are
options that can be exercised on any day
on or before the expiry date. Eg Stock
Options
Contract Size
• One contract of a derivatives instrument
represents a certain number of shares of
the underlying asset. (Lot Size)
• Eg: Nifty Futures
Lot Size =50
50 * 5000 = Rs 2,50,000 (Contract Value)
Moneyness of Options
• “Moneyness” of an option indicates whether an option
is worth exercising or not i.e. if the option is exercised
by the buyer of the option whether he will receive
money or not.
3 Kinds
In-the-Money
At-the-Money
Out-of–the Money
Cost of Carry
• The relationship between futures prices
and spot prices is known as the cost of
carry. It measures Cost of Finance &
Storage cost of the asset less the income
earned on the asset.
Initial margin
• The amount that must be deposited in the
margin account at the time a futures
contract is first entered into is known as
initial margin. It is usually a certain
percentage of the contract value.
Maintenance margin
• This is somewhat lower than the initial
margin money. It is done to ensure that
the balance in the margin account never
becomes negative. If the balance in the
margin account falls below the
maintenance margin, the investor receives
a margin call from his broker and is
expected to add further margin to the
account to the initial margin level.
Marking-to-market
• In the futures market, at the end of each
trading day, the margin account is
adjusted to the investor's gain or loss
depending upon the futures closing price.
This is called marking-to-market and is
based on the concept one parties gain is
the other parties loss.
Trading on Exchanges
• Index futures,
• Index options,
• Individual stock futures, and
• Individual stock options.
Contract Specifications
• Underlying Index
• Trading Exchange
• Security Descriptor
• Contract Size
• Trading Cycle
• Expiry Date
• Settlement Basis
• Settlement Price
Flow Chart
Futures Settlement
• National Securities Clearing Corporation Limited
(NSCCL) undertakes the clearing and settlement of all
trades executed on the F&O segment of NSE.
• When two parties trade a futures contract, both have to
deposit margin money which is called the initial margin.
• Futures contracts have two types of settlement:
(i) the mark-to-market (MTM) settlement which happens
on a continuous basis at the end of each day, and
(ii) the final settlement which happens on the last trading
day of the futures contract i.e., the last Thursday of the
expiry month.
Options Settlement
• Three types of settlement in stock option
contracts:
(1) daily premium settlement,
(2) exercise settlement and
(3) interim exercise settlement.
In index options, there is no interim exercise
settlement as index options cannot be
exercised before expiry.
THANK YOU
Questions ????
