Dhaval Sanghavi (MMS) Pratik Mistry (PG FS) Forwards Futures Options Swaps Forwards Futures Options Swaps

What are Derivatives ?

Equities (most common in Indian markets) Commodities (the oldest form of derivatives) Currencies (forex rates) Interest rates Debt instruments (bonds, T – Bills)

Traded on stock/derivative exchange Derivative Exchange/Segment - Self- Regulatory Organization (SRO) SEBI - oversight regulator. Clearing & settlement is done through a Clearing House Entities to trading system  Trading member  Clearing member  Trading member – Clearing member  Self clearing member

Participants Hedgers Speculators Speculators Arbitrageurs

TYPES FORWARD S FUTURES OPTION S SWAPS

A Forward contract is an agreement to buy or sell an asset on a specified date for a specific price. Forwards At start Rs 10,40,000Omkar Buy Ashika (Initial price- 10,00,000) Sell Buy Sell OmkarAshika (Market valuation- 11,00,000) Rs 10,40,000 At end of 1 year

Bank 4% How prices are agreed upon Omkar Buy Rs 10,40,000 Sell Ashika Rs.10,00,000

A future contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. They are standard and highly liquid. Futures Example Rahul purchases following two lots of Nifty Futures Contracts on 4th Sept. 2000: Initial Margin is 6%, Amount of Margin -Rs 16,050 (50 Units per Contract on the NSE). October 2000 Series 1 2,500 November 2000 Series 1 2,850

Futures payoff

Futures Terminology Spot Price (S) Futures price (F) Contract cycle Basis Futures Payoff Cost of carry Contract Size Open Interest Normal Backwardation Contango

Initial margin Mark to Market (MTM) margin Example Romit buys Nifty futures at 1300 Day Closing MTM a/c One Two Three Total +15 Maintenance Margin

i. Futures price spot price during the delivery Period: Sell a futures contract Buy the asset Make delivery ii. Futures price spot price during the delivery period : Companies will acquire the asset. Convergence of Future price to spot price Delivery period – Future price = Spot price

June 300 (spot price) September 350 (future price) September Spot price < 350 Later September Future price Now Future price and Expected Future spot Price September Spot price > 350 September Future price OR Commodity-Corn

An option is a contract giving the buyer the right, but not the obligation, to buy or sell an underlying (a stock or index) at a specific price on or before certain date. American option Exercise before maturity European option Exercise only on maturity Options

Options Terminology Index options Stock Options Option buyer Option seller Option premium Strike Price Expiration Date Open Interest

A call option is a contract giving the buyer the right, but not the obligation, to buy an underlying (a stock or index) at a specific price on or before a certain date. Call Options

Eg: Spot price: Rs 1000 Strike price = Rs 975 Option premium= Rs 50 Maturity: 3 months Case I : Spot price < Strike price (Rs 950) (Rs 975) Case II : Spot price > Strike price (Rs 1025) (Rs 975) CALL OPTION

Spot price ExercisedNo Yes Buyer Writer

Call option pay-off BEP BEP= Strike price + Premium

A put option is a contract giving the buyer the right, but not the obligation, to sell an underlying (a stock or index) at a specific price on or before a certain date. Put Options

Eg: Spot price: Rs 1000 Strike price = Rs 975 Option premium= Rs 50 Maturity: 3 months Case I : Spot price < Strike price (Rs 950) (Rs 975) Case II : Spot price > Strike price (Rs 1025) (Rs 975) PUT OPTION

Spot price ExercisedYes No Buyer Writer

Put option pay-off BEP BEP= Strike price - Premium

Moneyness of an option Call Option S>X In the Money S=X At the money S<X Out of the Money Put Option S>X Out of the money S=X At the money S<X In the money

Pricing of options Call option Put option INTRINSIC VALUE TIME VALUE = = Rs.50 = 950 – 1000 = Rs.0 Case I - current stock price = Rs 1000 Strike price = Rs 950 option premium = Rs 110 Call option : 110 – 50 = Rs 60 Put option : 110 – 0 = Rs 110

Swaps are agreements between two parties to exchange assets or sets of financial obligations or a series of cash flows for a specified period of time at predetermined intervals. They are customized transactions They are not traded on organized secondary market Swaps are largely unregulated Swaps

Types of Swap Fixed for Fixed currency Swap Interest rate Swap Equity Swap

Fixed for Fixed Currency Swap BB can borrow in 9% and in 8% AA can borrow in 7% and in 10% BB & AA wants to do business in each others country AA needs USD 1 million & BB needs AUD 2 million Both parties will buy fund in local currency. USA rate : 9% Australia rate: 7% Swap period: 5 yrs

Fixed for Fixed Currency Swap AA borrows AUD 2 million from Australian 7% (AUD 1,40,000) BB borrows USD 1 million from USA 9% (USD 90,000) AA & BB Swap their currency AA gets USD 1 million, agreeing to pay 10% BB gets AUD 2 million, agreeing to pay 8% Now AA owes BB 1,00,000 & BB owes AA 1,60,000 USA rate : 9% Australia rate: 7% Swap period: 5 yrs

Fixed for Fixed Currency Swap AA pays Australian bank 7% and gets 1,60,000 from BB to whom he lend 8% (Gain of 20,000) BB pays USA bank 9% and gets 1,00,000 from AA to whom he lend 10% (Gain of 10,000) After 5 yrs they will reverse the Swap USA rate : 9% Australia rate: 7% Swap period: 5 yrs