Derivatives Group 1 Group 1 NameRoll No Jatin Gala 18 Rajesh Jain 27 Komal Parikh 40 Meghana Patil 42 Rohit Rajas 47 Sangeeta Ramdas 48 Nishit Shah 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 HedgerSpeculator 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,  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.UnderlyingSymbolMarket Lot 1S&P CNX NiftyNIFTY200 Derivatives on Individual Securities 1 Associated Cement Co. Ltd. ACC1500 2Bajaj Auto Ltd.BAJAJAUTO800 3Bharat Electronics Ltd.BEL Bharat Heavy Electricals Ltd. BHEL Bharat Petroleum Corporation Ltd. BPCL1100 6BSES Ltd.BSES1100 7Cipla Ltd.CIPLA200 8Digital Globalsoft Ltd.DIGITALEQP400 9 Dr. Reddy's Laboratories Ltd. DRREDDY400 10Grasim Industries Ltd.GRASIM Gujarat Ambuja Cement Ltd. GUJAMBCEM HCL Technologies Ltd.HCLTECH Housing Development Finance Corporation Ltd. HDFC600 14Hero Honda Motors Ltd.HEROHONDA800 15Hindalco Industries Ltd.HINDALC Hindustan Lever Ltd.HINDLEVER Hindustan Petroleum Corporation Ltd. HINDPETRO ICICI Bank Ltd.ICICIBANK Infosys Technologies Ltd.INFOSYSTCH Indian Petrochemicals Corpn. Ltd. IPCL ITC Ltd.ITC300 22Larsen & Toubro Ltd.L&T Mahindra & Mahindra Ltd. M&M Mastek Ltd.MASTEK Mahanagar Telephone Nigam Ltd. MTNL National Aluminium Co. Ltd. NATIONALUM NIIT Ltd.NIIT Oil & Natural Gas Corp. Ltd. ONGC600 29Polaris Software Lab Ltd.POLARIS Ranbaxy Laboratories Ltd.RANBAXY800 31Reliance Industries Ltd.RELIANCE Satyam Computer Services Ltd. SATYAMCOMP State Bank of IndiaSBIN Shipping Corporation of India Ltd. SCI Sterlite Optical Technologies Ltd. STROPTICAL600 36Tata Power Co. Ltd.TATAPOWER Tata Tea Ltd.TATATEA Tata Engineering and Locomotive Co. Ltd. TELCO Tata Iron and Steel Co. Ltd. TISCO Videsh Sanchar Nigam Ltd.VSNL700 41Wipro Ltd.WIPRO200

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 Option View : Bullish  Buy a one month Nifty Call  With the Strike of 1250  Premium of Rs. 100 NIFTY SPOT Below Strike At StrikeBreak even Above Strike Value of 1250 Call Premium Paid -100 Net Profit / (loss) (100)

Pay Off Matrix

Writing a CALL Option View : Bearish  Sell/Write a one month Nifty Call  With the Strike of 1250  Premium of Rs. 100 NIFTY SPOT Below Strike At StrikeBreak even Above Strike Value of 1250 Call Premium Recd 100 Net Profit / (loss) 100 0(100)(200)

Pay Off Matrix

Buying a PUT Option View : Bearish  Buy a one month Nifty Call  With the Strike of 1250  Premium of Rs. 100 NIFTY SPOT Below Strike At StrikeBreak even Above Strike Value of 1250 Call Premium Paid -100 Net Profit / (loss)

Pay Off Matrix

Selling a PUT Option View : Bullish  Sell/Write a one month Nifty Call  With the Strike of 1250  Premium of Rs. 100 NIFTY SPOT Below Strike At StrikeBreak even Above Strike Value of 1250 Call Premium Paid 100 Net Profit / (loss) (150)(50)0100

Pay Off Matrix

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 PRICERs.240/- CALL March24012 March2606 PUT March2409 March2205 Trading Strategy What it isImpactIllustration / Initial Investment (Rs.) STRADDLEBUY / 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 STRANGLECombination 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 Straddle & Strangle Illustration

22 Straddle BUY a March 240 CALL -12 BUY 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 -6 BUY 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

26 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 13 SELL a March 240 PUT 11 Initial Income 24 Buy a March 260 CALL -5 Buy 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 Straps CASH PRICERs.310/- CALL March31021 PUT March2702 March31042 Trading Strategy What it isImpactIllustration / Initial Cash Flow (Rs.) STRIPSLong 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 STRAPSLong 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

Strips BUY a March 310 CALL - 21 BUY TWO March 310 PUT- 84 Initial Cost -105 Market Price 1 Profit on CALL 2 Profit on PUT 3 Initial Cost 4 Net Profit 5 =

Straps BUY 2 March 310 CALL -42 BUY 1 March 310 PUT-42 Initial Cost -84 Market Price 1 Profit on CALL 2 Profit on PUT 3 Initial Cost 4 Net Profit 5 =

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.” Types Fixed to FloatingFloating to Fixed

Fixed to Floating Swap In 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 Swap In 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 of Bank 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, Rs. 10,000 lacs, trade date Dec 24, Notional Principal: lacs Value date: Dec 24, 2002 Duration of swap: 7 days (Fig in Rs. Lacs) Start date: Dec 26, 2002 Fixed Rate: 5.60% (Call rate in %) Settlement date: Jan 2, 2003 Normal Rate Rate cut Rate Hike DateCallInt. Cl. Pr. CallInt.Cl.Pr.CallInt. 26 – Dec Dec Dec Dec Dec Jan Floating Int: Pays fixed interest: Net Interest Received: 0.08 Paid: 0.59 Received: 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 Bonds Issues Bonds Buys Bonds Lends a Loan Pays AmountPays 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 BuyerOption Seller USD 1.3 MMEUR 1 MM Strike Rate 0.3 MM - USD 0.1 MM+ USD 0.3 MM Currency Swap

Settlement Schedule Product SettlementSchedule Futures Contracts on Index & Individual SecuritiesDaily Mark-to-Market Settlement Pay-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 IndexExercise & Final Settlement Pay-in : T+1 working day Payout : T+1 working day. (T is expiration day of contract) Options Contract on Individual Securities Interim Exercise Settlement Pay-in : T+2 working day Payout : T+2 working day (T is exercise day) Options Contract on Individual Securities Exercise & Final Settlement Pay-in : T+2 working day Payout : T+2 working day (T is expiration day)