2. Definition of Derivative
• The derivatives are the Contracts which derives its value from the
underlying securities ( it may be debt, bullion, livestock, Currency, shares
etc). The price is decided by the fluctuation of price in the Asset.
• Basic example of Derivatives : Curd is a derivative of Milk, Juices are
derivative of Fruits, Ornaments are derivative of Gold etc.
• Financial Example of Derivatives : Forwards, Futures, Options, Swap etc.
3. Why Derivatives are required ?????
• Derivatives are important because, They reduce financial risk
involved in a transaction by making people commit to prices in the
present for future dates. They also allow a person to transfer the risk
to another person who is willing to take it.
4. Users of Derivatives:
• There are four kinds of participants in a derivatives market: hedgers,
speculators, arbitrageurs, and margin traders.
• Hedger: The contracts undertaken to safeguard the genuine Financial
Transactions to save from the risk of fluctuation in prices.
• Speculator: Purely Gambling purpose.
• Arbitrageurs : Most active traders who earns from the differential of
prices of same contract at two exchanges.
• Margin Traders : Daily speculative traders.
5. Types of Derivatives
• Financial Derivatives :
a) Forex Derivatives : Currency Futures, Currency Swaps etc.
b) Interest Derivatives : Interest rate Forward/Future, Interest Rate
Swaps, etc.
c) Stock Derivatives.: Stock Options, Stock Futures, Warrants etc.
• Non Financial Derivatives:
a) Commodity Derivatives
7. Brief description of Derivatives:
• Forward Contracts: Usually for short tenor, Big ticket transaction
involved, Higher margin requirement, obligation to purchase. For true
businesses.one settlement date, no trading allowed, Privately
negotiated agreement, more flexible,.
• Future Contracts: Available in small ticket of transactions in the
business, low margin requirement, exchange traded, for true
businesses and speculation, no obligation to purchase at the end of the
period.
• Options Contracts: mainly for speculation purposes. Very low
margin involved.
Option contracts are of 2 type a) Call option b) Put option.
8. Forward/Future Contracts: Key Variables.
• Forward price = Spot Price* (1+ Home interest rate)/(1+foreign
interest rate).
• Forward Interest Rate Calculation : R2T2-R1T1
T2-T1
• How many contracts to be bought for Hedging Strategy:
= Portfolio value*( Desired Beta- present Beta)/contract value
9. Forward/Future: Key aspects
• Hedge Ratio :: We can define hedge ratio “as the number of futures
contracts to hold for a given position in the underlying asset
• For a perfect Hedge, the Hedge ration is its Beta.
10. Options Contracts : Brief introduction
• mainly for speculation purposes. Very low margin involved.
• Option contracts are of 2 type a) Call option b) Put option.
• Every option has Strike/Excersice price and expiry date and
accordingly priced on the Exchanges.
• The options are always at one of the following stages
• in the money, : for call , CMP> SP for Put just Opposite
• at the money or : for Call , CMP=SP for Put just Opposite
• out of the money : for Call CMP<SP for Put just Opposite
11. Option Contracts : …. Contd.
• Buying an Option is called Long the Option and selling the Option is
called Writing the Option
• Benefits of Option over Future contract or other investment:
• EYE OPNER : Suppose you have invested 100/- in any Share or
Future contract and the share rose to 105 after a month so your gain
would be you earned 5% but for option business you only need to
invest 10 Rupees and if the share rose to 105 then the profit is 5 rupees
then your profit would be ( 5/10)*100 = 50% .
12. Option Contracts : Pricing and valuation
• The price of the Option is decided by Put Call Parity :
• S+P= C+X/(1+r)^t
• S : Spot Price, P: Put Price, C: Call Price, X : Strike Price, T: time
• The value of the Option is decided by a) Black Scholes Model b)
Binominal Tree Method c) Risk Neutral Method.
• We will discuss Black and Schole Model here.
• The value of the option is the difference between expected benefit of
from the stock acquired and present excersice price of the option.
N(D1)x SP- N(D2)xEP*e^-rt
13. Option Contracts: Valuation Model
• The value of the option is the difference between expected benefit of
from the stock acquired and present excersice price of the option.
N(D1)x SP- N(D2)xEP*e^-rt
• D1
• D2
15. The Greeks :
• Delta : change of option price /change in stock price
• Gama : Curvature of change
• Vega/Lambda : Option price relation with Volatality in stock price.
• Theeta : Change of option price wrt time
• Rho: Change of option price wrt change in risk free interest rate
16. SWAPS: Introduction
• A swap is an agreement between two parties to exchange sequences of
cash flows for a set period of time.
• Usually, at the time the contract is initiated, at least one of these series
of cash flows is determined by a random or uncertain variable, such as
an interest rate, foreign exchange rate, equity price or commodity
price.
• Types of Swaps.
a) Interest Swaps b) Commodity Swaps
C) Credit Swaps d) Currency Swaps e) Equity Swaps.
17. Swaps Contracts: Benefits
• Low cost borrowing
• Accessing the new Financial Markets,
• Hedging of Risk,
• Tool to correct Asset-Liability Mismatch
• Additional Income flow
18. Swap Contracts : Valuation
• Value of Swap: From the point of view of the floating-rate payer, a
swap can be regarded asa long position (Buy Bond) in a fixed rate
bond and a short position (Sell Bond) in a floating-ratebond.
VSWAP = BFIX — Bfl
Where, VSWAP = Value of Swap BFIX = Value of Fixed Rate Bond
(corresponding to payments that are made) B FL = Value of Floating
Rate bond (corresponding to payments that are received)
19. SWAPTATION : Hybrid Derivatives
• A swaption is an option on a forward start swap which provides the
purchaser the right to either pay or receive a fixed rate. A buyer of a
swaption who has the right to pay fixed and receive floating is said to
have purchased a ‘payers swaption’. Alternatively, the right to exercise
into a swap whereby the buyer receives fixed and pays floating is
known as a ‘receivers swaption’.
20. SWAPTION : Benefits
• A Swaption is designed to give the holder the benefit of the agreed upon
strike rate if the market rates are higher, with flexibility to enter into the
current market swap rate if they are lower
• If strike rate of the swap is more favorable than prevailing market swap rate,
then the swaption will be exercised and counterparties enter into an interest
rate swap as per the swaption agreement.
• A Swaption not only hedges the buyer against downside risk, it also enables
the buyer to reap the upside benefits. If the swaption is not exercised by
maturity, it lapses on that date.
• It is therefore a valuable tool when a borrower has decided to do a swap but
is not sure of the timing.
21. Interest Rate Derivatives
• A Financial Instrument (with the underlying financial security) whose value is
affected by change in interest rates.
• Usually used by Institutions i.e Banks, NBFC etc.
• 3 types
a) Interest rate Cap- : An Interest Rate Cap is a contract that guarantees a maximum
level of Libor
b) Interest rate Collars: The investor purchases an interest rate ceiling for a
premium, which is offset by selling an interest rate floor. This strategy protects the
investor by capping the maximum interest rate paid at the collar’s ceiling, but
sacrifices the profitability of interest rate drops.
c) Interest rate floors : Borrowers with variable-rate loans buy collars to limit
effective borrowing rates to a range of interest rates between maximum determined
by the cap rate and a minimum fixed by the floor strike price
