BASICS OF DERIVATIVES BY- Masoodkhanrabbani Dated-july 28 th 2009

Derivatives  A financial contract of pre-determined duration, whose value is derived from the value of an underlying asset  Securities  commodities  bullion  precious metals  currency  livestock  index such as interest rates, exchange rates

What do DERIVATIVES do?  Derivatives attempt either to minimize the loss arising from adverse price movements of the underlying asset  Or maximize the profits arising out of favorable price fluctuation. Since derivatives derive their value from the underlying asset they are called as derivatives.

Types of Derivatives ( UA: Underlying Asset)  Based on the underlying assets derivatives are classified into.  Financial Derivatives (UA: Fin asset)  Commodity Derivatives (UA: gold etc)  Index Derivative (BSE sensex)

How are derivatives used?  Derivatives are basically risk shifting instruments. Hedging is the most important aspect of derivatives and also their basic economic purpose  Derivatives can be compared to an insurance policy. As one pays premium in advance to an insurance company in protection against a specific event, the derivative products have a payoff contingent upon the occurrence of some event for which he pays premium in advance.

What is Risk?  The concept of risk is simple. It is the potential for change in the price or value of some asset or commodity. The meaning of risk is not restricted just to the potential for loss. There is upside risk and there is downside risk as well.

What is a Hedge  To Be cautious or to protect against loss.  In financial parlance, hedging is the act of reducing uncertainty about future price movements in a commodity, financial security or foreign currency.  Thus a hedge is a way of insuring an investment against risk.

Derivative Instruments.  Forward contracts  Futures Commodity Commodity Financial (Stock index, interest rate & currency ) Financial (Stock index, interest rate & currency )  Options Put Put Call Call  Swaps. Interest Rate Interest Rate Currency Currency

Forward Contracts.  A one to one bipartite contract, which is to be performed in future at the terms decided today.  Eg: Jay and Viru enter into a contract to trade in one stock on Infosys 3 months from today the date of the a price of Rs4675/-  Note: Product,Price,Quantity & Time have been determined in advance by both the parties.  Delivery and payments will take place as per the terms of this contract on the designated date and place. This is a simple example of forward contract.

Risks in a forward contract  Liquidity risk: these contracts a biparty and not traded on the exchange.  Default risk/credit risk/counter party risk.  Say Jay owned one share of Infosys and the price went up to 4750/- three months hence, he profits by defaulting the contract and selling the stock at the market.

Futures.  Future contracts are organized/standardized contracts in terms of quantity, quality, delivery time and place for settlement on any date in future. These contracts are traded on exchanges.  These markets are very liquid  In these markets, clearing corporation/house becomes the counter-party to all the trades or provides the unconditional guarantee for the settlement of trades i.e. assumes the financial integrity of the whole system. In other words, we may say that the credit risk of the transactions is eliminated by the exchange through the clearing corporation/house.

 The key elements of a futures contract are: Futures price Futures price Settlement or Delivery Date Settlement or Delivery Date Underlying (infosys stock) Underlying (infosys stock)

Illustration.  Let us once again take the earlier example where Jay and Viru entered into a contract to buy and sell Infosys shares. Now, assume that this contract is taking place through the exchange, traded on the exchange and clearing corporation/house is the counter-party to this, it would be called a futures contract.

Positions in a futures contract  Long - this is when a person buys a futures contract, and agrees to receive delivery at a future date. Eg: Viru’s position  Short - this is when a person sells a futures contract, and agrees to make delivery. Eg: Jay’s Position

How does one make money in a futures contract?  The long makes money when the underlying assets price rises above the futures price.  The short makes money when the underlying asset’s price falls below the futures price.  Concept of initial margin  Degree of Leverage = 1/margin rate.

Options  An option is a contract giving the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An option is a security, just like a stock or bond, and is a binding contract with strictly defined terms and properties.

Options Lingo  Underlying: This is the specific security / asset on which an options contract is based.  Option Premium: Premium is the price paid by the buyer to the seller to acquire the right to buy or sell. It is the total cost of an option. It is the difference between the higher price paid for a security and the security's face amount at issue. The premium of an option is basically the sum of the option's intrinsic and time value.

 Strike Price or Exercise Price :price of an option is the specified/ pre-determined price of the underlying asset at which the same can be bought or sold if the option buyer exercises his right to buy/ sell on or before the expiration day.  Expiration date: The date on which the option expires is known as Expiration Date  Exercise: An action by an option holder taking advantage of a favourable market situation.’Trade in’ the option for stock.

 Exercise Date: is the date on which the option is actually exercised.  European style of options: The European kind of option is the one which can be exercised by the buyer on the expiration day only & not anytime before that.  American style of options: An American style option is the one which can be exercised by the buyer on or before the expiration date, i.e. anytime between the day of purchase of the option and the day of its expiry.

 Asian style of options: these are in-between European and American. An Asian option's payoff depends on the average price of the underlying asset over a certain period of time.  Option Holder  Option seller/ writer  Call option: An option contract giving the owner the right to buy a specified amount of an underlying security at a specified price within a specified time.  Put Option: An option contract giving the owner the right to sell a specified amount of an underlying security at a specified price within a specified time

 In-the-money: For a call option, in-the-money is when the option's strike price is below the market price of the underlying stock. For a put option, in the money is when the strike price is above the market price of the underlying stock. In other words, this is when the stock option is worth money and can be turned around and exercised for a profit.

Intrinsic Value: The intrinsic value of an option is defined as the amount by which an option is in-the- money, or the immediate exercise value of the option when the underlying position is marked-to- market. Intrinsic Value: The intrinsic value of an option is defined as the amount by which an option is in-the- money, or the immediate exercise value of the option when the underlying position is marked-to- market.  For a call option: Intrinsic Value = Spot Price - Strike Price  For a put option: Intrinsic Value = Strike Price - Spot Price

Example of an Option  Elvis and crocodiles.

Positions  Long Position: The term used when a person owns a security or commodity and wants to sell. If a person is long in a security then he wants it to go up in price.  Short position: The term used to describe the selling of a security, commodity, or currency. The investor's sales exceed holdings because they believe the price will fall.

Profit/Loss Profile of a Long call Position Profit Loss Price of Asset XYZ at expira tion Option Price = Rs3 Strike Price = Rs100 Time to expiration = 1month

Profit /Loss Profile for a Short Call Position Profit Loss Price of the Asset XYZ at expiration +3 Initial price of the asset = Rs100 Option price= Rs3 Strike price = Rs100 Time to expiration = 1 month

Profit/Loss Profile for a Long Put Position Price of the Asset XYZ at expiration Profit Loss Initial price of the asset XYZ = Rs100 Option Price = Rs2 Strike price = Rs100 Time to expiration = 1 month

Profit/Loss Profile for a Short Put Position Price of the Asset XYZ at expiration Profit Loss Initial price of the asset XYZ = Rs100 Option Price = Rs2 Strike price = Rs100 Time to expiration = 1 month

Summary  The profit and loss profile for a short put option is the mirror image of the long put option. The maximum profit from this position is the option price. The theoritical maximum loss can be substantial should the price of the underlying asset fall.  Buying calls or selling puts allows investor to gain if the price of the underlying asset rises; and selling calls and buying puts allows the investors to gain if the price of the underlying asset falls.

Long Call Short Put Long Put Short Call Price rises Price Falls

Stock Index Option  Trading in options whose underlying instrument is the stock index.  Here if the option is exercised, the exchange assigned option writer pays cash to the options buyer. There is no delivery of any stock.  Dollar Value of the underlying index = Cash index value * Contract multiple.  The contract multiple for the S&P100 is $100. So, for eg, if the cash index value for the S&P is 720,then dollar value will be $72,000

 For a stock option, the price at which the buyer of the option can buy or sell the stock is the strike price. For an index option, the strike index is the index value at which the buyer of the option can buy or sell the underlying stock index. For Eg: If the strike index is 700 for an S&P index option, the USD value is $70,000. If an investor purchases a call option on the S&P100 with a strike of 700, and exercises the option when the index is 720, then the investor has the right to purchase the index for $70,000 when the USD value of the index is $ The buyer of the call option then receive$2000 from the option writer.

Swaps  An agreement between two parties to exchange one set of cash flows for another. In essence it is a portfolio of forward contracts. While a forward contract involves one exchange at a specific future date, a swap contract entitles multiple exchanges over a period of time. The most popular are interest rate swaps and currency swaps.

Interest Rate Swap A B Fixed Rate of 12% LIBOR ‘A’ is the fixed rate receiver and variable rate payer. ‘B’ is the variable rate receiver and fixed rate payer. Rs50,00,00, – Notional Principle Counter Party

 The only Rupee exchanged between the parties are the net interest payment, not the notional principle amount.  In the given eg A pays LIBOR/2*50crs to B once every six months. Say LIBOR=5% then A pays be 5%/2*50crs= 1.25crs  B pays A 12%/2*50crs=3crs  The value of the swap will fluctuate with market interest rates.  If interest rates decline fixed rate payer is at a loss, If interest rates rise variable rate payer is at a loss. Conversely if rates rise fixed rate payer profits and floating rate payer looses.

How Swaps work in real life Maruti BOA BOT LIBOR +3/8% 10.5% Fixed LIBOR +3/8%