Training

Manual

MODULE - 3

IMS WEST
Derivatives - Meaning

 Is an Instrument whose value depends upon the value of

underlying asset.

 Are primarily used for hedging Risks.

 In Derivatives two types of positions can be taken i.e.

Short and Long.

 Short Position means when one has agreed to sell the

underlying.

 Long Position means when one has agreed to buy the

underlying.
Types of Derivatives

 Futures

 Forward Contracts

 Options

 Swaps
Types of Derivatives

Futures

Forward Contracts
Are Contracts to buy or sell the underlying
in future at pre agreed price.
Options
 Are Traded On Stock Exchange.

Swaps
Types of Derivatives

Futures

Forward Contracts Are Contracts to buy or sell the underlying in

future at pre agreed price.

Options
Are Traded Over the Counter

Swaps
Types of Derivatives

Futures
 Option gives the holder (buyer of Option),
a right and not obligation, to buy or sell the
Forward Contracts underlying in future at pre agreed price from
the writer (seller of Option).

Options
 For this, the Option Holder pays the writer,
a nominal amount, upfront, known as
Swaps Option Premium.
Types of Derivatives

Futures

 A standard swap is an agreement between

Forward Contracts two counter parties in which the cash flows
from two assets are exchanged as they are
received for a fixed time period, with the
Options terms initially set so that its present
value is zero.

Swaps
Futures : Explained

 Are contacts to buy or sell underlying in future at pre agreed

price.

 When Long Position is taken, it is known as Buy To Open

(B2O).

 When Short Position is taken, it is known as Sell To Open

(S2O).
Forwards : Explained

 Are Contracts to buy or sell the underlying in future at

pre agreed price.

 Are Traded Over the Counter.

Futures Vs. Forwards

 Futures are standardize contracts whereas Forwards

are custom made contracts.

 Futures are stock exchange traded whereas

Forwards are Over the Counter (OTC).

 In Forwards Default Risk is very high whereas in

Futures risk is minimum.

 Futures requires margin payments whereas forwards

do not require so.`
Futures – Trading Mechanism

Three Stages are involved in Trading of Futures :

A. Initialization.

B. Mark To Market.

C. Settlement.
Futures – Trading Mechanism

Initialization

 When a Futures contract is bought or sold, some deposit has

to be kept with the broker, to ensure that there would be no
default of payment in future.

 Deposit can be either in cash or in the form of Securities. If

in the form of cash, it is known as “Initial Margin Deposit”, if
in the form of securities it is known as “Broker Collateral
In/Out”.
Futures – Trading Mechanism

Mark to Market
 Mark to Market means linking the portfolio with dailies
prices and the difference between the prior day’s value
and current day’s value has to be actually paid or
received.

For example:
Today (i.e. T0) 100 futures are bought and today’s price
is 1000/-so my portfolio today is worth
100,000(100*1000) Now if the next day i.e. T1 price is
1100/- then my portfolio would be of 110,000
(100*1100) that means a gain or loss of 10,000 and this
10,000 has to be cash settled. Similarly if price at T2 is
950/- then my portfolio value would be 95,000
(100*950) i.e. a gain or loss of 15,000 (which again has
to be cash settled) and so on.
Futures – Trading Mechanism

Mark to Market

 This mark to market concept will continue till the futures

get expired or settled.

 Since it is not practical to make cash adjustments on daily

basis, a Deposit is kept with the Broker to be used for Mark
to market and all gains & losses are adjusted against this
Deposit.

 This Deposit is known as “Financial Futures

Maintenance” or “Variation Margin”.
Futures – Trading Mechanism
Settlement
Futures are always Cash Settled, meaning thereby, the difference
between the agreed price and the prevailing market price has to be
either paid or received.

When Futures are settled one has to take reverse position to square
off it’s original position i.e. when at the initialization stage Long position
is taken then, for squaring it off, one has to take Short position.

This implies :

Original Position Reverse Position

Buy To Open (B2O) Sell To Close (S2C)
Sell To Open (S2O) Buy To Close (B2C)
Futures – Trading Mechanism
Settlement

Settlement has two parts :

Futures Gain/Loss : Difference between the prior day’s price and

current day’s price.

B2C/S2C : It is the difference between the original

agreed price and the market price prevailing
in the cash market.
Options : Explained

Terminologies:

 Option Holder : buyer of the option.

 Option Writer : seller of the option.

 Option Premium : nominal amount paid by the option holder

to the option writer upfront.

 Strike Price : is the pre-agreed price.

Options : Explained

Terminologies:

 In The money : An option is said to be in the money, if it

results to positive inflow, had it been
exercised immediately.

 Out of Money : An Option is said to be out of money, if it

results to outflow , had it been exercised

immediately.

 At the Money : An Option is said to be at the money, if

there has been no inflows or outflows , had
it been exercised immediately.
Options : Explained

Styles:

 American Options:

These can be exercised at any time between the date of

purchase and the expiration date.

 European Options:

These can be exercised only at the expiration date.

Future & Options : Difference

 Futures are obligations for both the parties whereas Options

are right for buyer and obligation for seller.

 In Futures, Initial outflow is more than Option.

 In futures, both the parties are exposed to potential huge

losses, whereas in Options, potential loss of buyer is limited.
Options : Types

 Call Options : gives a right to the holder to buy the

underlying.
For Example: Mr. A entered into an contract with Mr. B
to buy 100 Satyam Shares at Rs.110/- each two months
after the date.

 Put Options : gives a right to the holder to sell the

underlying.
For Example: Mr. A entered into an contract with
Mr. B to sell 100 Satyam Shares at Rs.110/- each two
months after the date.
Call & Put Option : Difference

 Call Options gives the holder a right to buy the underlying

whereas Put Option gives the holder a right to sell the
underlying.

 For better understanding, it has to be seen from the viewpoint

of the person who has taken initiative. If that person is buying
the underlying then it would be call option but if that person is
selling the underlying then it would be Put Option.
Call & Put Option : Difference

 Call Options : gives a right to the holder to buy the underlying.

For Example: Mr. A entered into an contract with

Mr. B to buy 100 Satyam Shares at Rs.110/- each two
months after the date.

 Put Options : gives a right to the holder to sell the underlying.

For Example: Mr. A entered into an contract with

Mr. B to sell 100 Satyam Shares at Rs.110/- each two
months after the date.
Call & Put Option : Difference Explained

Lets see another example :

Mr. A entered into an contract with Mr. B to sell 100 Satyam shares at Rs.110/-
each two months after the date.

Option holder : Since Mr. A has taken initiative, he is Option Holder i.e.
Option Buyer. So it is his right whether to exercise it or not.

Option Writer : Mr. B will be Option Writer or Option Seller and it is his
obligation.

Type of Option : Since Mr. A is selling the underlying, it is said to be Put

Option.

Strike Price : is the pre agreed price i.e. Rs.110/-.

Options – When are they exercised
In the money or At the money

Call Option :
Mr. A entered into an contract with Mr. B to buy 100 Satyam
Shares at Rs.110/- each two months after the date for which he paid
Rs.2/- as Option premium to Mr. B.

Case 1 :
Now Suppose at T2 price is 90/- in the market. Should Mr. A exercise
his right?

If Mr. A exercise his right, then he has to pay 110/- to Mr. B, but if he does
not exercise his right and instead buy if from from the market then he has to
pay only 90/- thereby a saving of Rs.20/- on each share. The maximum loss
which he has to bear is Rs.2/- which he has paid as premium, but still he has
a gain of Rs.18/- (20-2)
Options – When are they exercised

Case 2 :

Now Suppose at T2 price is 120/- in the market. Should Mr. A exercise

his right?

If Mr. A exercise lapse his right, then he has to pay 120/- to buy the
share, but if he exercise his right then he has to pay only 110/- thereby
a saving of Rs.10/- on each share. Since he has paid Rs.2/- as
premium, his net gain 8/- ( 10-2 ).
Options – When are they exercised

In the money or At the money

Put Option :

Mr. A entered into an contract with Mr. B to sell 100 Satyam Shares at Rs.110/-
each two months after the date for which he paid Rs.2/- as Option premium to
Mr. B.

Case 1 :

Now Suppose at T2 price is 90/- in the market. Should Mr. A exercise his right?

If Mr. A exercise lapse his right, then he will get only 90/- whereas if he exercise
his right then he will get 110/- thereby a gain of Rs.20/- on each share. Since
he has paid Rs.2/- as premium, his net gain 18/- ( 20-2 ).
Options – When are they exercised

Case 2 :

Now Suppose at T2 price is 120/- in the market. Should Mr. A exercise

his right?

If Mr. A exercise his right, then he will get 110/- from Mr. B, but if he
does not exercise his right and instead sell it in the market then he
will get 120/- thereby a gain of Rs.20/- on each share. The maximum
loss which he has to bear is Rs.2/- which he has paid as premium, but
still he has a gain of Rs.18/- (20-2)
Options : Conclusion

 Are always right for Option Holder whereas Obligations for Option
Writer.

 Loss for Option Holder is limited whereas for Option Writer is unlimited.

 Gains for Options Holder is unlimited whereas limited gains for Option
Writer.
Swaps

 A standard swap is an agreement between two counter parties in which the

cash flows from two assets are exchanged as they are received for a fixed
time period, with the terms initially set so that its present value is zero.

 The swap market developed because two different investors would find that
while one of them had a comparative advantage in borrowing in one market,
he was at a disadvantage in the particular market in which he wanted to
borrow. If these markets were counter-matched by the two parties with their
relative advantages, the two could get the best of both worlds through a
swap.
Types of Swaps

 Interest Rate Swaps (IRS)

 Credit Default Swaps (CD-SWAPS)

 Currency Swaps

 Bond Swaps
Interest Rate Swaps

 It is an agreement between two parties (known as counter parties)

where one stream of future interest payment is exchanged for
another on a notional principal.

 As they are traded Over the Counter (OTC), they can be customised
in number of ways.
Currency Swaps

 It involves the exchange of Principal and Interest in one currency with

the other currency.

 It is done to get around the problems of Exchange controls and also

to take advantage of interest rates in two different countries.
Credit Default Swaps

 It is designed to transfer the credit exposure of fixed income

products between parties.

 Buyer of Credit Swaps receives credit protection whereas seller

guarantees the credit worthiness of the product. By doing this
risk of default is transferred from the holder of the security to the
seller of the swap.

 For e.g. buyer should be entitled to the par value of the bond by
the seller of the swap, should the bond default in it’s coupon
payments.