2. WHAT ARE DERIVATIVES
Derivative is a financial instrument whose price is dependent upon or
derived from one or more underlying is called derivatives.
When price of underlying changes value of derivative also changes.
Derivative is not a product . It is a contract which derives value from
underlying.
Example
Value of sbin future contract derive the value of underlying
assets i.e. sbin equity.
5. Forward
Forward is a contract between two parties to buy or sell an assets on a pre-specified future date at a pre
specified price.
Forward contract settlement comes on a pre-specified future date.
This is traded only in over the counter market.
This is customized contract.
Counterparty risk
No money involve at imitation of contract.
Liquidity risk
7. Future contract is an agreement between two parties to buy or sell an assets at a certain time in the future
at a certain price .
This is standardized exchange traded contract.
Standardisations-
-Quantity of underlying
-Central clearing facility
-Delivery Dates
-Price quotes
It is traded on an organised exchange.
Indian equity market concern , NSE is having the most developed equity derivatives market . They have
launched 3 month series for future contract cycle i.e. Current month, next month and far month.
Expiry date – usually last Thursday of every month or previous day if Thursday is
public holiday.
8. comparison Forward Future
Traded on organized
exchange
No Yes
Standardized contract No Yes
Involve clearing house No Yes
Required margin payment
and daily settlements
No Yes
Market are transparent No Yes
Marked to market daily No Yes
Closed prior to delivery No Yes
Profit and losses realized
daily
No yes
9. Options
An option is contract between two party , where one party gives to other
the right , but not obligations, to buy from (or sell to) the first party the
underlying assets on or before specific day at an agreed price.
In return for giving the right , the party collect the payment from the other
party the payment collected is called premium or price of option.
10. Swaps
Swaps are private agreements between two parties to exchange cash flow
in the future according to a pre-agreed price.
Interest rate swap- interest related cash flow between the parties in the
same currency.
Currency swaps- Under this consider different currency.
12. Arbitrageur
A person who enter into transactions in two or more market to take an
advantage of the discrepancies between prices in these markets.
Arbitrage involve making profit from relative mispricing.
Arbitrageurs also help to make market liquid , ensure accurate and uniform
pricing, and enhance price stability.
They help in bringing about price uniformity and discovery.
13. Some basic Terminology
Long position – Buyer (+)
Short position – Seller (-)
Spot Price - price of the asset in the spot market (market price)
Forward price – price of the asset at the delivery date.
Contract size - The amount of the asset that has to be delivered under one
contract. All future are sold in multiples of lots which is decided by the
exchange board. Contd….
14. Contract Cycle – period for which contract trades.
Strike price – The agreed price of the deal is called the strike price.
Daily price range(DPR)-we can trade with in this limit. Beyond this limit if
we initiate order than trade will not go in to the market.
Open Interest(OI)- The number of outstanding contract.
Strike Price (Exercise price) (X)– The fixed price at which the underlying
assets can be purchased.
Only short can default in option.
Option price – The amount per share that an option buyer pay to seller.
15. OPTION
An option is an derivative financial instrument that specifies a contract
between two parties for future transaction on an assets at a reference
price.
The buyer of an option gain the right but not to obligation, to engage in
that transaction, while the seller incurs the corresponding obligation to full
fill the transaction
16. Summary of option
Option give the right not the obligation.
Right for specified time period.
Option con be exchange traded derivatives or even over the counter
derivatives.
Option can be cash settled or settled by physical delivery.
Option in India are cash settled
18. Type of option
Call option- An option Which gives a right to buy the underlying assets at
a strike price.
Put option –An option which gives a right to sell the underlying assets at a
strike price.
Style of option -
American option – An option can expire on or before the expiry
date.
European option – An option can expire only on expiry date.
Bermuda option – An option can exercise at the date and
certain specified dates that occur between the purchase date and
date of expiration.
19. Type of option
In the money
(ITM)
At the money
(ATM)
Out of the
money (OTM)
20. Call option buying (bullish about
underlying )
Expect stock price to
go up hence he buy
Stock
Call option on stock
21. Call option selling (Bearish about the
underlying)
Expect stock price to
go down hence he buy
Sell Stock
Sell Call option on
stock
22. Put option buying (Bearish about
underlying stock)
Expect stock price to
go down hence he buy
Sell Stock
buy put option on
stock
23. Put option selling(bullish about
underlying stock)
Expect stock price to
go up hence he sell
Buy Stock
Sell put option on
stock
24. Important notes
Both call and put option buyers are buying the right i.e. they are
transferring their risk to seller of the option.
For this transfer of risk to the sellers, buyer have to compensate by paying
option premium.
Option premium is also known as price of option, cost or value of the
option.
25. Option pricing
Component of option
pricing
Intrinsic value
Time value (volatility,
time to expiry and rate
of interest)
26. Pricing and valuation of the contact
CE PE
SPOT Positive Negative
STRIKE Negative Positive
VOLITALITY Positive Positive
TIME TO EXPIRATION Negative Negative
RATE OF INTEREST Positive Negative
