DERIVATIVES:

FORWARDS,
FUTURES &
OPTIONS
 DERIVATIVES
The term “derivatives” is used to refer to financial instruments which
derive their value from some underlying assets. The underlying assets
could be equities (shares), debt (bonds, T-bills, and notes), currencies, and
even indices of these various assets, such as the Nifty 50 Index.

In the Indian context the securities contracts (Regulation)Act,

1956(SC(R)A) defines “Derivative” to include :

A security derived from a debt instrument ,share, loan whether secured or

unsecured, risk instrument or contract for differences or any other form of
security.
A contract which derives its value from the prices, or index of prices, of
underlying securities.
There are various types of derivatives traded on exchanges across the world.
They range from the very simple to the most complex products. The
following are the three basic forms of derivatives, which are the building
blocks for many complex derivatives instruments.

Forwards

Futures

Options
Forward
It is an agreement to buy or sell an asset at a certain price. It can be
contrasted with a spot contract , which is an agreement to buy or sell an
asset today. A forward contract is traded in the over –the- counter market
– usually between two financial institutions or between a financial
institution & one of its clients.

One of the parties to a forward contract assumes a long position & agree to
buy the underlying asset on a certain specified price. The other party
assumes a shot position & agrees to sell on the same date
The buyer and the seller know each other.
The negotiation process leads to customized agreements.
What to trade; Where to trade; When to trade; How much to trade—
all can be customized.
Important: The price at which the trade will occur is also determined
when the agreement is made.
This price is known as the forward price.

One party faces default risk, because the other party might have an
incentive to default on the contract.

To cancel the contract, both parties must agree.

One side might have to make a dollar payment to the other to get the
other side to agree to cancel the contract.

Limitations
Difficult to find a counterparty (no liquidity)

Subject to default risk

Lack of centralization of trading

 Futures
An agreement between two parties to buy or sell an asset at a certain time
in the future at a certain price . Futures contacts are special types of
forward contracts in the contracts in the sense that the former are
standardized exchange-traded contracts.

Difference between forwards and futures

Basis Forward Contract Futures Contract

Standardized. Initial
Customized to customers
Structure margin
: need.
payment required.
 Opposite contract with
same or

Method of different counterparty. Opposite contract on

pre- Counterparty risk remains the
termination: while exchange.
terminating with different
Low counterparty
Risk: High counterparty risk
counterparty.
risk
Government
Market regulated
Not regulated
regulation:
market
Institutional
The contracting parties Clearing House
guarantee:

Contract
Customized Standardized
size:
 Depending on the
Expiry date: Standardized
transaction
Negotiated directly by the
Transaction Quoted and traded on
buyer
method: the Exchange
and seller
Both parties must
No guaranteed of deposit
settlement
an initial guarantee
until the date of maturity
(margin). The value of
only
the
the forward price, based on
Guarantees: operation is marked to
the
market rates with daily
spot price of the
underlying settlement of profits
and
asset is paid
losses.
Futures Terminology
•Spot price: The price at which an underlying asset trades in the spot
market.

•Futures price: The price that is agreed upon at the time of the contract for
the delivery of an asset at a specific future date.

•Contract cycle: It is the period over which a contract trades.

•Expiry date: is the date on which the final settlement of the contract takes
place.

•Contract size: The amount of asset that has to be delivered under one
contract.

•Basis: Basis is defined as the futures price minus the spot price.

•Cost of carry: Measures the storage cost plus the interest that is paid to
finance the asset less the income earned on the asset.
•Initial margin: The amount that must be deposited in the margin account
at the time a futures contract is first entered into is known as initial margin.

•Marking-to-market: In the futures market, at the end of each trading day,

the margin account is adjusted to reflect the investor’s gain or loss
depending upon the futures closing price. This is called marking-to-market.

•Maintenance margin: Investors are required to place margins with their

trading members before they are allowed to trade. If the balance in the
margin account falls below the maintenance margin, the investor receives a
margin call and is expected to top up the margin account to the initial
margin level before trading commences on the next day.
The Derivatives Markets perform a number of economic functions

Price Discovery:
Prices in organized derivatives markets reflects the perception of market
participants about the future and lead the prices of underlying to perceived
future level. The prices of derivatives converge with the prices of the
underlying at the expiration of the derivative contract. Thus derivatives help
in discovery of future as well current price.
Transfer of risk:
The derivative market helps to transfer to the risks from those who have
them but may like them those who have an appetite for them. We can also
term the derivative market as the insurance company, whereby certain
players assumes the risk by receiving premium amount.
Increased volume in the cash market:
Derivatives due to their inherent nature are linked to the underlying cash
markets. With the introduction of derivative, the underlying market, witness
higher trading volumes because of participation by more players who would
not otherwise participate for lack of an arrangement to transfer risk.
New Entrepreneurial activities:

Derivatives have a history of attracting many bright, creative, well-

educated people with an entrepreneurial, new products and new
employment opportunities, the benefits of which a reimmense.
Increase in saving:

Derivatives market helps increase savings and investments in the long run
Transfer of risk enables market participants to expand their volume of
activities.
Participants in the Derivatives Market
•Hedgers - Operators, who want to transfer a risk component of their
portfolio.

•Speculators - Operators, who intentionally take the risk from hedgers

in pursuit of profit.

•Arbitrageurs - Operators who operate in the different markets

simultaneously, in pursuit of profit and eliminate mis-pricing.
 Future & Option Market
Instruments
The F&O segment of NSE provides trading
facilities for the following derivative
instruments:
 Index based futures

 Index based options

 Individual stock options

 Individual stock futures

Pay-off Matrix of Futures
Pay-off diagram for a long futures position
Pay-off diagram for a Short futures position
A theoretical model for Future pricing
While futures prices in reality are determined by demand and supply, one
can obtain a theoretical

Futures price, using the following model:

Where:
F = Futures price
S = Spot price of the underlying asset
r = Cost of financing (using continuously compounded interest rate)
T = Time till expiration in years
e = 2.71828
Example: Security XYZ Ltd trades in the spot market at Rs. 1150.
Money can be invested at 11% per
 USING STOCK FUTURES
 Hedging: long security, sell future

 Speculation: bullish security, buy Futures

 Speculation : bearish Security, Sell Futures

 Arbitrage: overpriced Futures: buy spot, sell futures

 Arbitrage: underpriced Futures: buy spot, sell futures

OPTIONS
An option is a claim without any liability. An option is a contract that gives
the holder a right, without any obligation, to buy or sell an asset at an
agreed price on or before a specified period of time .
There are two type of option.
Call Option
A call option gives holder the right to buy the underlying asset by a
certain date for a certain price.
Put Option

A put option gives the holder the right to sell the underlying asset by a
certain date for a certain price.
 Option Terminology
Index options: These options have the index as the underlying. In India,
they have a European style settlement.

Stock options: They are options on individual stocks and give the
holder the right to buy or sell shares at the specified price. They can
be European or American.
Buyer of an option: The buyer of an option is the one who by paying
the option premium buys the right but not the obligation to exercise his
option on the seller/writer.
Writer of an option: The writer of a call/put option is the one who
receives the option premium and is thereby obliged to sell/buy the asset
if the buyer exercises on him.

Option price/premium: It is the price which the option buyer pays

to the option seller. It is also referred to as the option premium.
Expiration date: The date specified in the options contract is known as the
expiration date, the exercise date, the strike date or the maturity.

Strike price: The price specified in the options contract is known as the
strike price or the exercise price.

American options: American options are options that can be exercised at

any time up to the expiration date.

European options: European options are options that can be exercised only
on the expiration date itself.

In-the-money option: An in-the-money (ITM) option would lead to a

positive cash flow to the holder if it were exercised immediately. A call
option on the index is said to be in-the-money when the current index
stands at a level higher than the strike price(i.e. spot price > strike price).
Out-of-the-money option: An out-of-the-money (OTM) option is an
option that would lead to a negative cash flow if it were exercised
immediately. A call option on the index is out-of-the-money when the
current index stands at a level which is less than the strike price (i.e. spot
price < strike price). If the index is much lower than the strike price, the
call is said to be deep OTM.
At-the-money option: An at-the-money (ATM) option would lead to zero
cash flow if it were exercised immediately. An option on the index is at-
the-money when the current index equals the strike price (i.e. spot price =
strike price).

Time value of an option: The time value of an option is the difference

between its premium and its intrinsic value. Both calls and puts have
time value. An option that is OTM or ATM has only time value. Usually,
the maximum time value exists when the option is ATM. The longer the
time to expiration, the greater is an option's time value, all else equal.
At expiration, an option should have no time value.
 Options Payoffs Matrix
Payoff profile for buyer of call options: Long call
A call option gives the buyer the right to buy the underlying asset at the
strike price specified in the option. The profit/loss that the buyer makes
on the option depends on the spot price of the underlying. If upon
expiration, the spot price exceeds the strike price, he makes a profit.
Higher the spot price, more is the profit he makes. If the spot price of the
underlying is less than the strike price, he lets his option expire un-
exercised. His loss in this case is the premium he paid for buying the
option.
Risk Reward Scenario
Maximum Loss = Limited(Premium Paid) (Rs. 86.60)

Maximum Profit = Unlimited

Profit At Expiration = Stock Price At Expiration – Strike

Price – Premium Paid

Break Even Point At Expiration = Strike Price + Premium Paid

BEP = 2250+86.60 = 2336.60

Stock price at expiration > Strike price

Payoff profile for writer (seller) of call options: Short call

For selling the option, the writer of the option charges a premium. The
profit/loss that the buyer makes on the option depends on the spot price of
the underlying. Whatever is the buyer's profit is the seller's loss. If upon
expiration, the spot price exceeds the strike price, the buyer will exercise
the option on the writer. Hence as the spot price increases the writer of the
option starts making losses. Higher the spot price, more is the loss he
makes.
Risk Reward Scenario
Maximum Loss – Unlimited (Higher the spot price losses will be
very high)
Maximum Profit – Limited (to the extent of option premium)
( Rs. 86.60)

Makes profit if the Stock price at expiration < Strike price +

premium
 Payoff profile for buyer of put options: Long put
A put option gives the buyer the right to sell the underlying asset at the
strike price specified in the option. The profit/loss that the buyer makes on
the option depends on the spot price of the underlying. If upon expiration,
the spot price is below the strike price, he makes a profit. Lower the spot
price, more is the profit he makes. If the spot price of the underlying is
higher than the strike price, he lets his option expire un-exercised.
Risk Reward Scenario
Maximum Loss – Limited (Premium Paid) ( Rs. 61.60)

Maximum Profit - Unlimited to the extent of price of Stock

Profit at expiration - Strike Price – Stock Price at expiration -

Premium paid

Break even point at Expiration = Strike Price - Premium paid

BEP = 2250 – 61.70 = 2188.30

Strike price > Stock price at expiration

 Payoff profile for writer (seller) of put options: Short put

the writer of the option charges a premium. The profit/loss that the buyer
makes on the option depends on the spot price of the underlying.
Whatever is the buyer's profit is the seller's loss. If upon expiration, the
spot price happens to be below the strike price, the buyer will exercise the
option on the writer. If upon expiration the spot price of the underlying is
more than the strike price, the buyer lets his option un-exercised and the
writer gets to keep the premium.
Risk Reward Scenario
Maximum Loss – Unlimited

Maximum Profit – Limited (to the extent of option premium)

(Rs. 61.70)

Makes profit if the Stock price at expiration > Strike price – premium
 Some More Options Strategies
 Synthetic Long Call: Buy Stock, Buy Put

 Covered Call :Buy The Stock & Write a Call

 Long Combo : Sell A Put, Buy a Call

 Protective Call /Synthetic Long Put : Sell Stock +

Buy Call

 Covered Put : Buy the Stock & Write A Call

 Long Straddle : Buying a Call & put on

the same Stock for the
same maturity and
 Short Straddle: sells a Call and a Put on the same
stock for the same maturity and
strike price.

 Long Strangle : Buy OTM Put & buy OTM Call

 Short Strangle: Sell OTM Put & Sell OTM Call

 Collar : Buy Stock , Buy Put & Sell Call

 Bull Call Spread : Buy a Call with a lower strike

Strategy (ITM) & Sell a Call
with a higher
strike (OTM)
 Bull Put Spread Strategy : Sell a Put & Buy a Put
Bear Call Spread Strategy : Sell a Call with a lower
strike (ITM)& Buy a Call
with a higher strike(OTM)

Bear Put Spread Strategy : Sell lower strike Put &

Buy Put
Long Call Butterfly : Sell 2 ATM Call, Buy 1 ITM Call
Option & Buy 1 OTM Call Option

Short Call Butterfly : Buy 2 ATM Call Options, Sell

1 ITM Call Option & Sell 1
OTM Call Option
Long Call Condor : Buy 1 ITM Call Option (Lower
strike), Sell 1 ITM Call Option
(Lower Middle),sell 1 OTM Call
Option (Higher Middle), Buy
1OTM Call Option (Higher
Strike)
Short Call Condor : Short 1 ITM Call Option (Lower
Strike), Long 1 ITM Call Option
(Lower Middle),Long 1 OTM
Call Option (Higher Middle),
Short1 OTM Call Option
(Higher Strike)
Thank you

M. L.
Patidar