UNIT-1 INTRODUCTION

History of derivatives
Derivatives are financial tools that get their value from another asset, like
stocks, commodities, or currencies. They have been used in various
forms throughout history to manage risks and stabilize prices.
• Ancient Beginnings: Traders in ancient Mesopotamia and
Greece used early contracts to agree on future prices of goods,
helping reduce uncertainty. In Japan, during the 1600s, merchants
used rice futures to protect themselves from price changes. This
was one of the first organized ways of trading derivatives.
• 19th Century Developments: By the 1800s, farmers and traders
in the U.S. began using futures contracts for crops like wheat and
corn to secure prices in advance. This was formalized through the
creation of exchanges like the Chicago Board of Trade (CBOT),
making these contracts more reliable.
• 20th Century Expansion: As economies became more complex,
derivatives expanded beyond commodities. After the collapse of
the Bretton Woods system in the 1970s, new financial products
like currency and interest rate futures emerged to help companies
manage risks in a world with fluctuating exchange rates and
interest rates.
• Challenges and Risks: While derivatives can help businesses
manage risk, they can also lead to problems. For example,
complex instruments like credit default swaps (CDS)
contributed to the 2008 financial crisis by hiding risky loans. After
the crisis, new rules and regulations were introduced to make
these markets more transparent and safer.
• Present and Future: Today, derivatives are used in new ways,
such as with cryptocurrencies (like Bitcoin futures) and ESG-
linked products that help companies meet sustainability goals.
While they are still crucial for managing risks, modern derivatives
also require careful regulation to avoid financial instability.
Origin of Derivatives in India
The history of derivatives in India dates back centuries, but their formal
development evolved gradually.
1. Ancient Roots (Pre-Colonial Era):
In India, early forms of forward contracts were used by traders in
agricultural markets. Merchants and farmers entered informal
agreements to fix the price of crops in advance, helping them
manage price risks associated with monsoon-dependent farming.
2. Bombay Cotton Trade Association (1875):
The first organized attempt at setting up a derivatives market came
with the establishment of the Bombay Cotton Trade Association.
This marked the start of trading cotton futures to help manage
price fluctuations, particularly because cotton was a key export
commodity.
3. Expansion and Ban (1900s):
As commodity derivatives became popular, forward trading
extended to other agricultural products. However, speculation led
to concerns about market stability, and the government imposed
bans on many forward and futures markets during the 1960s,
believing they contributed to inflation and volatility.
4. Liberalization and Revival (1990s-2000s):
Following India’s economic liberalization in 1991, the need for
more sophisticated financial markets grew.
o In 2000, the National Stock Exchange (NSE) introduced
futures trading in equity indices, followed by individual stock
futures and options.
o Simultaneously, commodity derivatives markets were
revived, and exchanges like the Multi Commodity
Exchange (MCX) and National Commodity and
Derivatives Exchange (NCDEX) were established to
facilitate trading in metals, agricultural products, and other
commodities.
 5. Growth and Regulation:
The Securities and Exchange Board of India (SEBI) began
overseeing derivatives markets to ensure fair practices and
transparency. In recent years, interest rate futures, currency
futures, and more complex instruments have been introduced,
expanding the market further.
6. Current Landscape:
Today, India has a robust derivatives market, with instruments
available across asset classes like equities, commodities,
currencies, and interest rates. NSE and BSE (Bombay Stock
Exchange) are major hubs for financial derivatives, while MCX and
NCDEX lead in commodities.

Classification of Derivatives
Derivatives can be broadly categorized into Commodity Derivatives
and Financial Derivatives, based on the type of underlying asset they
represent.
1. Commodity Derivatives
Commodity derivatives are based on physical goods or raw materials,
allowing buyers and sellers to hedge against price fluctuations in those
commodities. These instruments are widely used by producers, traders,
and industries reliant on commodities.
Types of Commodity Derivatives:
• Agricultural Commodities:Used by farmers and manufacturers to
protect against uncertain crop prices due to weather or market
conditions.
Examples: Wheat, rice, cotton, coffee, sugar
• Energy Commodities:Energy companies use these derivatives to
manage the risk of fluctuating fuel prices.
Examples: Crude oil, natural gas, coal
• Metal Commodities:Commonly used in the jewelry industry and
by investors for speculation and hedging.
Examples: Gold, silver, copper, aluminum
Purpose of Commodity Derivatives:
• Hedging:Producers and consumers protect themselves against
unfavorable price movements.
• Speculation:Traders take positions hoping to profit from changes
in commodity prices.
• Arbitrage:Traders exploit price differences between different
markets for the same commodity.
2. Financial Derivatives
Financial derivatives derive their value from financial assets, such as
stocks, bonds, interest rates, or currencies. These instruments help
manage financial risks, like market volatility, interest rate changes, or
currency fluctuations.
Types of Financial Derivatives:
• Equity Derivatives:Investors use these to hedge their stock
positions or speculate on price movements.
Examples: Stock futures, stock options
• Interest Rate Derivatives:Used by banks and businesses to
manage the risk of fluctuating interest rates.
Examples: Interest rate swaps, futures on government bonds
• Currency (Forex) Derivatives:Used to hedge risks associated
with foreign exchange rate fluctuations, especially in global trade.
Examples: Currency futures, currency options
• Credit Derivatives:Used by lenders to transfer the risk of default
on loans or bonds to other parties.
Examples: Credit default swaps (CDS)
Purpose of Financial Derivatives:
• Hedging:
Investors and companies reduce exposure to financial risks, such
as currency or interest rate volatility.
• Speculation:
Traders profit from anticipated movements in financial markets
without holding the underlying asset.
• Arbitrage:
Traders exploit differences in prices across markets to make risk-
free profits.

Role of the Derivatives Market

1. Risk Management (Hedging):
o Derivatives allow businesses and investors to protect
themselves from adverse price movements in assets like
commodities, stocks, interest rates, or currencies.
o Example: A farmer can lock in a price for their crop using
futures, ensuring they aren’t hurt by a drop in market prices
at harvest.
2. Price Discovery:
o Derivative markets provide insight into future expectations
about prices, helping businesses and investors plan better.
o Example: Oil futures reflect market expectations about future
energy prices, influencing production and supply chain
decisions.
3. Market Liquidity:
o Derivatives add liquidity to financial markets by attracting
speculators, ensuring that buyers and sellers can trade
easily without affecting prices.
 o Example: Stock options on popular exchanges increase the
number of trades, making it easier for investors to enter or
exit positions.
4. Efficient Capital Allocation:
o Derivatives help investors allocate capital more efficiently by
focusing on key market trends without holding physical
assets.
o Example: An investor might use stock index futures to gain
exposure to the broader market instead of buying individual
stocks.
5. Arbitrage Opportunities:
o Traders use derivatives to exploit price differences between
related markets, helping align prices and create market
efficiency.
o Example: Arbitrageurs buy gold in one market while selling it
in another via futures, ensuring price parity.

Investment Objectives in the Derivatives Market

1. Hedging:
o Objective: Reduce or eliminate exposure to risks, such as
changes in interest rates, currency exchange rates, or
commodity prices.
o Example: A company with foreign currency exposure uses
currency futures to lock in exchange rates, minimizing loss
from fluctuations.
2. Speculation:
o Objective: Profit from anticipated movements in the price of
an underlying asset without holding the asset itself.
o Example: A trader buys call options on a stock expecting its
price to rise. If it does, they profit by selling the option at a
higher price.
 3. Arbitrage:
o Objective: Earn risk-free profits by exploiting price
differences between two or more related markets.
o Example: A trader buys a commodity in one market and
simultaneously sells its futures in another market to
capitalize on price discrepancies.
4. Portfolio Diversification:
o Objective: Enhance the performance of a portfolio by
including derivatives that may behave differently than
traditional assets during market shifts.
o Example: Investors use derivatives like options or futures to
balance exposure across different asset classes, reducing
overall portfolio risk.
5. Leverage:
o Objective: Gain larger exposure to an asset with a relatively
small capital outlay, amplifying potential returns (but also
risks).
o Example: A trader buys futures on an index, gaining control
over a larger value of the index with only a small margin
deposit.
Basic Functions of the Derivatives Market
The derivatives market plays an essential role in the financial ecosystem
by providing various tools and functions that benefit businesses,
investors, and the economy at large. Here are the key functions:
1. Risk Management (Hedging)
• Derivatives allow participants to protect themselves against
unfavorable price movements by locking in future prices. This
helps businesses, investors, and producers reduce uncertainty.
• Example: A wheat farmer uses futures to fix the selling price
before harvest, reducing the risk of a price drop.
2. Price Discovery
• Derivative markets help in determining the future prices of assets
based on current market conditions and participants' expectations.
• Example: The prices of oil futures give an indication of how the
market expects oil prices to move in the future.
3. Market Efficiency
• Derivatives markets help ensure that prices remain aligned across
different markets through arbitrage. Arbitrageurs exploit price
differences, which brings consistency to markets.
• Example: If the spot price of gold differs from the futures price,
arbitrage activity corrects this discrepancy, making both markets
efficient.
4. Liquidity Enhancement
• Derivatives attract a large number of traders and investors,
including speculators, which increases market liquidity. Higher
liquidity makes it easier for participants to enter or exit trades
without impacting prices.
• Example: Stock options attract traders, making it easier to buy or
sell stocks with minimal price fluctuations.
5. Speculation Opportunities
• Derivative markets offer avenues for speculators to take positions
on the future movement of asset prices, which adds to market
activity and liquidity.
• Example: A trader buys a call option on a stock, hoping to profit if
the stock price rises.
6. Leveraging Capital
• Derivatives allow participants to gain larger market exposure with
relatively small initial investments (margins). This increases the
potential for higher returns but also amplifies risks.
• Example: A trader controls a large value of shares using stock
futures by only paying a small margin upfront.
7. Arbitrage Opportunities
• Arbitrageurs benefit from discrepancies in prices between related
markets, which helps align prices across markets and maintain
consistency.
• Example: A trader buys a stock in one market while selling its
future in another, profiting from the price difference.
8. Reduction of Transaction Costs
• Compared to spot markets, trading derivatives can be more cost-
effective due to lower transaction fees and the ability to trade on
margins.
• Example: A business hedges currency risk using forex futures,
avoiding the need for multiple currency exchanges and reducing
transaction costs.
 UNIT-2 FORWARD CONTRACTS
Basic Features of Forward Contracts
A forward contract is a simple type of derivative where two parties
agree to buy or sell an asset at a predetermined price on a specific
future date. These contracts are often used for hedging purposes or to
lock in prices, especially in markets for commodities and currencies.
Below are the key features of forward contracts:
1. Customized Agreement (Over-the-Counter, OTC)
• Forward contracts are not traded on an exchange but are
privately negotiated between two parties.
• The terms (price, quantity, delivery date) are tailored to meet the
needs of both parties.
2. Binding Contract
• A forward contract is a legal obligation, meaning both parties
must fulfill the agreement at the predetermined price, regardless of
future market conditions.
3. No Initial Payment (Zero Premium)
• Typically, no upfront payment is required to enter into a forward
contract, unlike options which require a premium.
4. Settlement on a Future Date
• Forward contracts are settled on a specific future date agreed
upon by both parties. Settlement can be in the form of:
o Physical Delivery: The actual asset is delivered.
o Cash Settlement: The difference between the contract price
and the market price at settlement is paid.
5. No Standardization
• Unlike futures contracts, forwards are not standardized. Each
contract is customized in terms of quantity, quality, and delivery
terms.
6. Counterparty Risk
• Since forwards are over-the-counter (OTC) contracts, there is a
risk that one party may default on the agreement, leading to credit
risk or counterparty risk.
7. Illiquidity
• Forward contracts are generally illiquid because they are
customized and cannot be easily transferred or sold to another
party before the settlement date.
8. Used for Hedging and Speculation
• Hedging: Forward contracts are commonly used by businesses to
protect against price fluctuations. For example, an importer can
lock in a currency exchange rate to avoid future forex volatility.
• Speculation: Traders can use forward contracts to bet on the
future direction of asset prices to make a profit.
Example of a Forward Contract
A wheat farmer and a bread manufacturer enter into a forward contract
where the farmer agrees to sell 1,000 bushels of wheat at $5 per bushel
in six months. Regardless of the market price at that time, the sale will
happen at the agreed price, helping both parties manage their risks.

Summary
Forward contracts are customizable, private agreements used to lock in
future prices. While they offer flexibility, they also carry counterparty risks
and are generally less liquid compared to standardized derivatives like
futures. These contracts are widely used by businesses for hedging
purposes and by traders for speculation.
Concept of Long and Short Positions in Forward Contracts
and Their Payoffs
In a forward contract, two parties agree to exchange an asset at a
predetermined price on a future date. The two key positions involved are
long and short positions. The payoff for each position depends on how
the market price of the underlying asset changes relative to the agreed
price (called the forward price).
1. Long Position in a Forward Contract
• Concept:
The buyer of the forward contract takes a long position. This
means the buyer agrees to purchase the underlying asset at the
specified price on the agreed future date.
• Payoff for the Long Position:
The long position benefits if the market price at maturity is
higher than the forward price, as they can buy the asset at the
lower forward price. If the market price is lower, the long position
incurs a loss.
Payoff Formula for the Long Position:
Payoff (Long)=ST−F0\text{Payoff (Long)} = S_T - F_0Payoff (Long)=ST
−F0
Where:
• STS_TST = Spot price of the asset at maturity
• F0F_0F0 = Forward price agreed upon
• Example:
Suppose a trader enters into a forward contract to buy 100 barrels
of oil at $50 per barrel after 3 months.
o If the market price of oil after 3 months is $60 per barrel, the
trader gains: 60−50=1060 - 50 = 1060−50=10 per barrel.
o If the market price is $45 per barrel, the trader loses:
45−50=−545 - 50 = -545−50=−5 per barrel.
2. Short Position in a Forward Contract
• Concept:
The seller of the forward contract takes a short position. This
means the seller agrees to sell the underlying asset at the
specified forward price on the future date.
• Payoff for the Short Position:
The short position benefits if the market price at maturity is
lower than the forward price, as they can sell the asset at the
higher forward price. If the market price is higher, the short position
incurs a loss.
Payoff Formula for the Short Position:
Payoff (Short)=F0−ST\text{Payoff (Short)} = F_0 - S_TPayoff (Short)=F0
−ST
Where:
• STS_TST = Spot price of the asset at maturity
• F0F_0F0 = Forward price agreed upon
• Example:
A trader agrees to sell 100 barrels of oil at $50 per barrel in 3
months.
o If the market price of oil after 3 months is $40 per barrel, the
trader gains: 50−40=1050 - 40 = 1050−40=10 per barrel.
o If the market price is $55 per barrel, the trader loses:
50−55=−550 - 55 = -550−55=−5 per barrel.
Risks Involved in Forward Contracts
1. Counterparty Risk (Credit Risk):
Since forward contracts are private agreements, there is a chance
that one party might not fulfill their obligation. For example, the
seller might fail to deliver the agreed asset, or the buyer may not
have the required funds to pay. This risk arises because there is no
intermediary or clearinghouse to guarantee the transaction.
2. Liquidity Risk:
Forward contracts are not traded on public exchanges, meaning
they are illiquid. Once the contract is signed, it is difficult for either
party to exit or sell it to someone else before the agreed date. This
can be challenging if one party wants to back out of the contract
due to changes in market conditions or financial needs.
3. Market Risk (Price Risk):
The value of the underlying asset can change over time. If the
market price moves against the agreed forward price, one party
will face a financial loss. For example, if you agreed to buy gold at
$2,000 per ounce, but the market price drops to $1,800, you must
still purchase it at the higher price, resulting in a loss.
4. Settlement Risk:
At the settlement date, one party might fail to deliver the asset or
make payment as promised. This could be due to operational
failures, financial problems, or unforeseen events. Settlement can
involve either physical delivery of the asset or cash payment, and
any failure in this process creates settlement risk.
5. Regulatory and Operational Risk:
Forward contracts are over-the-counter (OTC) instruments,
meaning they are not regulated or standardized like futures
contracts. This can result in operational issues, such as unclear
terms, miscommunication between the parties, or documentation
errors. These risks can lead to unexpected delays or conflicts.
6. Mark-to-Market Risk:
The value of the forward contract fluctuates as market prices
change, which can create accounting challenges. Companies
 using forward contracts for hedging might need to adjust their
financial statements to reflect these changes, impacting their
reported profits and performance.
7. Legal Risk:
Since forward contracts are customized agreements, poorly written
contracts may lead to conflicts or disputes. If terms such as
delivery date or quality of the asset are not clearly defined, both
parties may interpret the contract differently, leading to potential
legal action.

Types of Forward Contracts Based on Underlying Assets

Forward contracts are categorized according to the type of asset or
commodity involved. Below are the common types:
1. Commodity Forwards: These forward contracts involve physical
goods such as agricultural products, metals, or energy resources. They
help producers, traders, and buyers manage price risks associated with
these commodities.
Examples:
• Agricultural Commodities: Wheat, corn, rice, coffee, or sugar.
• Metals: Gold, silver, copper, and other industrial metals.
• Energy: Crude oil, natural gas, and coal.
2. Currency (Forex) Forwards: Currency forward contracts involve the
exchange of two different currencies at a predetermined rate on a future
date. They are primarily used by companies engaged in international
trade to hedge against foreign exchange rate risks.
Example: A company that expects to receive payment in euros three
months from now can enter a forward contract to lock in the current
exchange rate for euros against the U.S. dollar.
3. Interest Rate Forwards (Forward Rate Agreements): These
contracts are used to hedge or speculate on interest rate movements.
The parties agree on an interest rate to be paid on a notional amount at
a specific future date.
Example: A business expecting to take a loan in the future may use a
forward rate agreement (FRA) to lock in the interest rate today,
protecting itself from potential increases in interest rates.
4. Equity Forwards: Equity forwards involve an agreement to buy or sell
stocks or equity indices at a specified future date and price. These are
useful for investors who want exposure to stock price movements
without buying the stock immediately.
Example: An investor enters a forward contract to purchase 1,000
shares of a company at $50 per share in six months, regardless of the
market price at that time.
5. Credit Forwards: Credit forwards involve a credit-related asset such
as a loan or bond. These contracts allow parties to manage risks
associated with changes in credit spreads or credit ratings. They are
often used by financial institutions to hedge against default risks.
Example: A bank enters a credit forward to protect itself from the risk of
a borrower’s credit rating deteriorating over the contract period.
 UNIT-3 FUTURE CONTACTS

Basic Features of Future Contracts

A futures contract is a standardized financial instrument that obligates
two parties to buy or sell an underlying asset at a predetermined price
on a specified future date. Below are the key features that distinguish
futures contracts from other derivatives like forwards:
1. Standardization
• Futures contracts are standardized in terms of quantity, quality,
and delivery date to facilitate trading on organized exchanges.
• This makes them easier to trade compared to forward contracts,
which are customized and private.
2. Exchange-Traded
• Futures contracts are traded on formal exchanges like the
Chicago Mercantile Exchange (CME) or the National Stock
Exchange (NSE).
• Exchanges act as intermediaries, providing transparency and
ensuring fair trade practices.
3. Mark-to-Market Settlement
• The value of futures contracts is marked-to-market daily. This
means that profits and losses are settled at the end of each trading
day, rather than at the maturity of the contract.
4. Margin Requirements
• Both buyers and sellers are required to deposit a margin (initial
collateral) with the exchange.
• There is also a maintenance margin that must be maintained
throughout the contract’s life to cover potential losses.
5. Clearinghouse and Reduced Counterparty Risk
• The exchange’s clearinghouse guarantees the performance of
futures contracts, reducing the counterparty risk present in
forward contracts.
• If one party defaults, the clearinghouse steps in to fulfill the
contract.
6. Highly Liquid
• Futures contracts are more liquid than forward contracts because
they are actively traded on exchanges, making it easy for
participants to enter or exit positions.
7. Leverage
• Futures contracts provide leverage, allowing traders to control
large positions with a relatively small amount of capital (the
margin).
• However, leverage also magnifies potential losses.
8. Obligation to Buy or Sell
• Both parties to a futures contract are legally obligated to either
buy or sell the underlying asset at the agreed price, regardless of
market movements at the time of settlement.
9. Delivery or Cash Settlement
• Some futures contracts require physical delivery of the
underlying asset, while others are cash-settled, meaning the
difference between the agreed price and the market price is paid in
cash.
10. Speculation, Hedging, and Arbitrage
• Futures contracts are widely used for speculation (to profit from
price movements), hedging (to protect against price risks), and
arbitrage (to exploit price differences between markets).
Types of Futures Contracts
Futures contracts are classified based on the type of underlying asset.
Each type helps participants manage risks or speculate on price
movements in different markets. Below are the main types of futures
contracts:
1. Commodity Futures: These contracts involve physical
commodities like agricultural products, energy resources, or metals.
They help producers, traders, and businesses manage risks associated
with commodity price fluctuations.
• Examples:
o Agricultural Futures: Wheat, corn, soybeans, coffee,
cotton, etc.
o Energy Futures: Crude oil, natural gas, gasoline, coal.
o Metal Futures: Gold, silver, copper, aluminum.
2. Currency (Forex) Futures: Currency futures involve the exchange of
one currency for another at a predetermined rate on a future date. They
are widely used by businesses and investors involved in international
trade to hedge against exchange rate fluctuations.
• Examples:
o USD/EUR futures (exchange rate between U.S. dollar and
euro).
o JPY/USD futures (Japanese yen vs. U.S. dollar).
3. Interest Rate Futures: These contracts are based on interest rates
and are used to hedge against the risk of changing interest rates.
Financial institutions, such as banks, use these futures to lock in future
interest rates.
• Examples:
o U.S. Treasury bond futures.
o Eurodollar futures.
o Indian government bond futures.
4. Stock Index Futures: Stock index futures are based on the
performance of a specific stock market index, such as the S&P 500
or Nifty 50. They allow investors to speculate on the overall direction of
the market or hedge portfolio risks.
• Examples:
o S&P 500 futures.
o NASDAQ futures.
o Nifty 50 futures (India).
5. Equity Futures (Single Stock Futures): These futures involve the
purchase or sale of an individual stock at a specified price on a future
date. They allow investors to speculate on the future price of a stock or
hedge their positions.
• Examples:
o Reliance Industries futures (India).
o Apple Inc. futures (U.S.).
o Tesla futures (U.S.).
Difference between Forward and Futures Contracts
Concept of Daily Settlement in Futures Contracts (Mark-to-Market)
In futures contracts, daily settlement, also known as mark-to-market,
refers to the process of adjusting the value of the contract at the end of
each trading day based on the market price. This ensures that gains and
losses are realized daily, reducing the risk of default by either party at
the end of the contract.
How Daily Settlement Works
1. Initial Margin:
o When a futures contract is entered, both the buyer and seller
are required to deposit an initial margin with the exchange.
This acts as collateral to cover potential losses.
2. Mark-to-Market (Daily Profit or Loss):
o At the end of each trading day, the exchange compares the
settlement price of the contract (closing market price) with
the previous day’s price.
o The difference in prices is credited or debited to the margin
account of the trader based on whether the position gained
or lost value.
3. Maintenance Margin:
o If the balance in a trader’s margin account falls below the
maintenance margin level due to daily losses, the trader
must deposit additional funds (a margin call) to bring the
account back to the required level.
4. Daily Payouts:
o Profits are immediately credited to the trader’s margin
account, and losses are debited on the same day. This
ensures both parties meet their obligations as the market
value of the contract changes.
Margin in Futures Trading and Types of Margins
In futures trading, margin is a security deposit that both buyers and
sellers must maintain to ensure they fulfill their obligations. It ensures the
stability of the market by covering potential losses due to price
movements.

Types of Margins in Futures Trading

1. Initial Margin
• This is the amount of money required to open a futures position. It
acts as collateral to enter the trade and is set by the exchange.
2. Maintenance Margin
• This is the minimum balance that must be maintained in the
margin account to keep the position active. If the margin falls
below this level, the trader will receive a margin call.
3. Variation Margin (Mark-to-Market Margin)
• This reflects the daily adjustment of profits or losses based on the
changes in the market price. At the end of each trading day, the
margin account is updated to reflect gains or losses.
4. Margin Call
• A margin call occurs when the margin account falls below the
maintenance margin. The trader must deposit additional funds to
bring the account back to the required level to avoid the position
being closed by the broker.
Payoffs for Short and Long Positions in Futures Contracts
The payoff in a futures contract refers to the profit or loss realized by the
buyer or seller at the time of contract settlement. The payoff for a long
position differs from that of a short position, depending on the
movement of the asset’s market price.
1. Long Position Payoff in Futures Contracts
A trader holding a long position agrees to buy the underlying asset at a
specified price (the futures price) on the contract’s settlement date. The
payoff depends on the difference between the market price of the asset
at settlement and the agreed futures price.
Payoff Formula for Long Position:
Payoff (Long)=ST−F0\text{Payoff (Long)} = S_T - F_0Payoff (Long)=ST
−F0
Where:
• STS_TST = Spot price (market price at settlement)
• F0F_0F0 = Futures price (agreed price)
• If ST>F0S_T > F_0ST>F0: The trader makes a profit, as the
market price is higher than the agreed purchase price.
• If ST<F0S_T < F_0ST<F0: The trader incurs a loss, as the market
price is lower than the agreed price.
Example of Long Position Payoff:
• A trader enters a futures contract to buy gold at $1,800 per ounce.
o If the market price rises to $1,900, the payoff is
1,900−1,800=1001,900 - 1,800 = 1001,900−1,800=100
(profit).
o If the market price falls to $1,700, the payoff is
1,700−1,800=−1001,700 - 1,800 = -1001,700−1,800=−100
(loss).
2. Short Position Payoff in Futures Contracts
A trader holding a short position agrees to sell the underlying asset at
the agreed futures price. The payoff depends on the difference between
the market price at settlement and the agreed futures price.
Payoff Formula for Short Position:
Payoff (Short)=F0−ST\text{Payoff (Short)} = F_0 - S_TPayoff (Short)=F0
−ST
Where:
• STS_TST = Spot price (market price at settlement)
• F0F_0F0 = Futures price (agreed price)
• If ST<F0S_T < F_0ST<F0: The trader makes a profit, as they can
sell the asset at the higher agreed price, despite the market price
being lower.
• If ST>F0S_T > F_0ST>F0: The trader incurs a loss, as they must
sell at the lower agreed price, despite the market price being
higher.

Basic Concept of Lot Size and Expiry in Futures Contracts

1. Lot Size in Futures Contracts
• Definition:
Lot size refers to the standard quantity of the underlying asset
specified in a futures contract. Every futures contract is traded in
multiples of this lot size, ensuring uniformity and ease of trading on
exchanges. Standardizing the lot size ensures that all participants
trade in equal-sized contracts, improving liquidity and reducing
confusion in the market.
• Examples of Lot Sizes:
o Gold Futures: 100 troy ounces per contract.
o Crude Oil Futures: 1,000 barrels per contract.
o Stock Futures (Reliance Industries on NSE): 250 shares
per contract.
 • Impact:
The lot size determines the exposure of the trader. A larger lot
size means higher exposure and requires a larger margin deposit,
while smaller lot sizes offer more flexibility and lower exposure.
2. Expiry of Futures Contracts
• Definition:
Expiry refers to the last date on which a futures contract can be
traded or settled. After this date, all open positions must be either
settled or rolled over to the next available contract.
• Expiry Cycle:
o Futures contracts are typically available in monthly,
quarterly, or yearly cycles, depending on the underlying
asset and exchange.
o Example: Stock futures on the National Stock Exchange
(NSE) expire on the last Thursday of each month.
• Settlement on Expiry:
o Physical Delivery: Some contracts (like commodity futures)
require the actual delivery of the underlying asset at expiry.
o Cash Settlement: Many financial futures (like stock index
futures) are settled in cash, where the difference between
the contract price and the market price is paid.
• Rollover:
If a trader wishes to maintain their position beyond the current
contract's expiry, they need to roll over their position by closing
the current contract and entering a new one for the next expiry
period.
 UNIT-4 OPTION CONTRACTS

Option Contracts
An option contract is a financial derivative that gives the holder the
right, but not the obligation, to buy or sell an underlying asset at a
specified price (strike price) before or on a specific date (expiry). The
buyer pays a premium to the seller (writer) for this right.
Types of Option Contracts
Option contracts are primarily categorized into two types based on the
direction of the trade:
1. Call Option
• A call option gives the holder the right, but not the obligation, to
buy the underlying asset at the strike price before or on the
expiration date. Investors buy call options when they expect the
price of the underlying asset to rise.
• Example:
o If the strike price of a call option on a stock is $100, and the
stock's market price rises to $120, the option holder can buy
the stock at $100 and profit from the difference.
2. Put Option
• A put option gives the holder the right, but not the obligation, to
sell the underlying asset at the strike price before or on the
expiration date. Investors buy put options when they expect the
price of the underlying asset to fall.
• Example:
o If the strike price of a put option on a stock is $100, and the
stock’s market price drops to $80, the option holder can sell
the stock at $100, profiting from the price difference.
Long and Short Positions in Call and Put Options with Payoffs
Options contracts involve two types of participants: buyers (holders)
and sellers (writers). The buyer takes a long position, and the seller
takes a short position. Below is a detailed breakdown of the payoffs
for long and short positions in call and put options.
1. Call Options
A call option gives the buyer the right to buy the underlying asset at
the strike price. The payoffs differ for the long (buyer) and short (seller)
positions.
1.1 Long Call Position (Buyer of the Call Option)
• The buyer pays a premium to acquire the right to buy the asset at
the strike price.
• Payoff Formula for Long Call:
Payoff (Long Call)=max(ST−K,0)−Premium
Where:
o STS_TST = Spot price at expiry
o KKK = Strike price
• Payoff Explanation:
o Profit if ST> K: The buyer exercises the option to buy at the
lower strike price and benefits from the price difference.
o Loss if ST≤ K: The option expires worthless, and the buyer
loses the premium paid.

1.2 Short Call Position (Seller of the Call Option)

• The seller receives a premium from the buyer but is obligated to
sell the asset at the strike price if the buyer exercises the option.
• Payoff Formula for Short Call:
Payoff (Short Call)=Premium−max(ST−K,0)
 • Payoff Explanation:
o Profit if ST≤ K: The option expires worthless, and the seller
keeps the premium.
o Loss if ST> K: The seller incurs a loss as they must sell the
asset at the lower strike price, missing out on market gains.
2. Put Options
A put option gives the buyer the right to sell the underlying asset at the
strike price. The payoffs differ for the long (buyer) and short (seller)
positions.
2.1 Long Put Position (Buyer of the Put Option)
• The buyer pays a premium to acquire the right to sell the asset at
the strike price.
• Payoff Formula for Long Put:
Payoff (Long Put)=max(K−ST,0)−Premium
• Payoff Explanation:
o Profit if ST<K: The buyer benefits from selling the asset at
the higher strike price.
o Loss if ST≥K: The option expires worthless, and the buyer
loses the premium paid.

2.2 Short Put Position (Seller of the Put Option)

• The seller receives a premium from the buyer but is obligated to
buy the asset at the strike price if the buyer exercises the option.
• Payoff Formula for Short Put:
Payoff (Short Put)=Premium−max(K−ST,0)
• Payoff Explanation:
• • Profit if ST≥K: The option expires worthless, and the seller keeps
the premium.
• • Loss if ST<K: The seller incurs a loss by buying the asset at the
higher strike price.
Concept of Premium and Price Decay (Theta) in Option Contracts
1. Option Premium: The premium is the price paid by the buyer of
an option to acquire the right (but not the obligation) to buy or sell an
underlying asset at a specific strike price. It is paid upfront to the seller
(writer) of the option, and this premium compensates the seller for the
risk taken.
• Components of Option Premium:
1. Intrinsic Value:
The difference between the current spot price of the
underlying asset and the strike price (only if favorable to the
holder). Intrinsic Value (Call)=max(S0−K,0)
Intrinsic Value (Put)=max(K−S0,0)
Where:
§ S0S_0S0 = Current spot price of the underlying asset
§ KKK = Strike price
2. Time Value:
The portion of the premium that reflects the time left until
expiration and the expected volatility of the asset. Even if
the option is currently out-of-the-money, it may still have
value due to the possibility of favorable price changes before
expiry.

2. Price Decay (Theta) in Option Contracts

• Definition of Theta:
Theta is a measure of the time decay of an option’s value. It
represents how much the option’s premium decreases per day as
it approaches its expiration date, assuming all other factors (like
volatility and underlying asset price) remain constant.
• How Theta Works:
o Options lose value as they get closer to expiry, especially the
time value portion of the premium.
 o At-the-money (ATM) options experience the most rapid time
decay since they have high time value.
o Out-of-the-money (OTM) options lose time value faster near
expiry, often becoming worthless if the underlying price does
not move favorably.
• Theta Example:
If an option has a Theta of -0.05, the premium will decline by
$0.05 each day, assuming no change in other factors. A higher
Theta means faster time decay.

Key Points about Time Decay (Theta):

• Theta is Negative:
For buyers of both calls and puts, Theta is negative because time
decay works against them—every passing day reduces the
premium they paid.
• Theta is Positive for Sellers:
Option sellers (writers) benefit from time decay, as the value of the
option decreases over time, making it less likely the buyer will
exercise it profitably.
• Impact Near Expiry:
Time decay accelerates as the option approaches its expiration
date. The rate of decline is slow initially and becomes more
pronounced in the last few days before expiration.
Concept of Chart-Pattern Analysis: Candles
Candlestick: Candlestick charts depict the open, closing, high, and low
prices of a security over a designated time. The shape can shrink or
enlarge depending on the relationship between these prices. The color of
the wide part of the candlestick indicates whether the stock closed higher
or lower than the previous period
As you can see, there are several horizontal bars or candles that form this
chart. Each candle has three parts:
1. The Body
2. Upper Shadow
3. Lower Shadow

Also, the body is colored either Red or Green. Each candle is a

representation of a time period and the data corresponds to the trades
executed during that period.
A candle has four points of data:
1. Open – the first trade during the period specified by the candle
2. High – the highest traded price
3. Low – the lowest traded price
4. Close – the last trade during the period specified by the candle
How to Analyze Candlestick Chart
The body of the candle represents the opening and closing price of the
trading done during the period. Knowing this is important for candlestick
trading. Hence, traders can see the price range of the said stock for the
said period immediately. Also, the color of the body can tell them if the
stock price is rising or falling. So, if a candlestick chart for one month with
each candle representing a day has more consecutive reds, then traders
know that the price is falling.
Above and below the body are vertical lines called wicks or shadows that
show the lows and highs of the traded price of the stock. Here is a
scenario:
• If the upper wick on a red candle is short, then it indicates that the
stock opened near the high of the day.
• On the other hand, if the upper wick on a green candle is short, then
it indicates that the stock closed near the high of the day.
Hence, a candlestick graph displays the relationship between the high,
low, opening, and closing price of a stock. The body can be long or short
and red or green. Also, shadows can be long or short. A combination of
these displays the sentiment of the market towards the said stock. These
details are important to know to understand how to read a candle chart.
Candlestick Chart Patterns
Candle chart patterns are an excellent way of understanding investor
sentiment and the relationship between demand and supply, bears and
bulls, greed and fear, etc.
Traders must remember that while an individual candle provides sufficient
information, patterns can be determined only by comparing one candle
with its preceding and next candles. To benefit from them, it is important
that traders understand patterns in candlestick charts.
For better understanding let’s divide the patterns into two sections:
1. Bullish patterns
2. Bearish patterns
Both patterns are essential for candlestick chart analysis.
1. Bullish Patterns
- Hammer Pattern
This is a candle with a short body and a long lower wick. It is usually
located at the bottom of a downward trend. It indicates that despite selling
pressures, a strong buying surge pushed the prices up. If the body is
green, it indicates a stronger bull market than a red body.
- Inverse Hammer Pattern
This is a candle with a short body and a long upper wick. It is usually
located at the bottom of a downward trend too. It indicates buying
pressure followed by selling pressure. It also indicates that buyers will
soon have control.

- Bullish Engulfing Pattern

This is a pattern of two candlesticks where the first candle is a short red
one engulfed by a large green candle. It indicates a bullish market that
pushes the price up despite opening lower than the previous day.
- Piercing Line Pattern
This is a two-candle pattern having a long red candle followed by a long
green candle. Also, the closing price of the second candle must be more
than half-way up the body of the first candle. This indicates strong buying
pressure.

- Morning Star Pattern

This is a three-candle pattern that has one candle with a short body
between one long red and a long green candle. There is usually no overlap
between the short and the long candles. This is an indication of the
reduction of the selling pressure and the onset of a bull market
- Three White Soldiers Pattern
This is a three-candle pattern that has three green candles with small
wicks. These candles open and close higher than the previous day. After
a downtrend, this is a strong indication of an upcoming bull trend.

2. Bearish Patterns
- Hanging Man Pattern
This is a candle with a short body and a long lower wick. It is usually
located at the top of an upward trend. It indicates that the selling pressures
were stronger than the buying thrust. It also indicates that bears are
gaining control of the market.
- Shooting Star Pattern
This is a candle with a short body and a long upper wick. It is usually
located at the top of an upward trend too. Usually, the market opens higher
than the previous day and rallies a bit before crashing like a shooting
star. It indicates selling pressure taking over the market.

- Bearish Engulfing Pattern

In candlestick chart analysis, this is a pattern of two candlesticks where
the first candle is a short green one engulfed by a large red candle. It
usually occurs at the top of an upward trend. It indicates a slowdown in
the market rise and an upcoming downtrend. If the red candle is lower, the
downtrend is usually more significant.
- Evening Star Pattern
This is a three-candle pattern that has one candle with a short body
between one long red and a long green candle. There is usually no overlap
between the short and the long candles. This is an indication of the
reversal of an upward trend. This is more significant if the third candle
overcomes the gains of the first candle.

- Three Black Crows Pattern

This is a three-candle pattern that has three consecutive red candles with
short wicks. These candles open and close lower than the previous
day. After an upward trend, this is a strong indication of an upcoming bear
market.
Chart patterns are an important component of how to read a candle chart.
There are several other patterns that can be followed to understand trends
and sentiment of the markets. You can consider this blog as a starting
point to understand how to analyse candlestick chart and dive deeper into
these patterns to understand market movements.

Heiken-Ashi, Support, and Resistance Levels

1. Heiken-Ashi Candlesticks
• Definition: Heiken-Ashi (meaning "average bar" in Japanese) is a
charting technique that smooths out price data to create a clearer
picture of market trends. Unlike traditional candlestick charts,
Heiken-Ashi uses averaged data to reduce noise, making trends
easier to identify.
• Characteristics:
o Green/White Candles (uptrend): No lower shadows (wicks)
indicate strong bullish momentum.
o Red Candles (downtrend): No upper shadows show strong
bearish momentum.
o Doji-like Candles (small bodies): Indicate market indecision
or potential reversal.
• Uses:
o Heiken-Ashi helps traders identify trends and trend reversals
more easily than standard candlesticks.
o It is often used to stay in trends longer by filtering out minor
fluctuations and noise.
2. Support and Resistance Levels
• Definition:
Support and resistance levels are key price points on a chart
where the asset tends to experience buying or selling pressure,
preventing it from moving further in that direction.
Support Level:
• A support level is a price point where the demand for the asset is
strong enough to prevent it from falling further.
• Psychology: Buyers enter the market at this level, expecting the
price to rebound.
• Example: If a stock frequently drops to $50 but bounces back, $50
becomes a support level.
Resistance Level:
• A resistance level is a price point where selling pressure
prevents the price from rising further.
• Psychology: Sellers dominate at this level, expecting the price to
fall back.
• Example: If a stock frequently rises to $100 but fails to break
through, $100 becomes a resistance level.
How Support and Resistance Levels Work
• Trend Reversal: If the price breaks through a support or
resistance level, it may indicate a trend reversal.
o Support Broken: When a support level is broken, it can act
as new resistance.
o Resistance Broken: When a resistance level is broken, it
can act as new support.
• Range-Bound Market: In some markets, the price moves
between a support and resistance level, forming a range. Traders
often buy at support and sell at resistance in such scenarios.
• Identifying Support and Resistance:
o Horizontal Levels: Based on previous highs and lows.
o Trendlines: Dynamic support or resistance based on a
sloping line connecting multiple highs or lows.
o Moving Averages: Can act as support or resistance when
the price interacts with a moving average line.
 UNIT-5 SWAP CONTRACTS
Introduction to Swap Contracts
A swap contract is a financial agreement between two parties to
exchange cash flows or financial instruments over a set period.
These contracts are commonly used by businesses and financial
institutions to hedge risks, manage cash flows, or reduce borrowing
costs. The most common swaps involve interest rates, currencies, or
commodities.
Types of Swap Contracts
1. Interest Rate Swaps
o Involves the exchange of interest rate payments between
two parties, usually switching between fixed and floating
interest rates.
o Used to manage exposure to interest rate fluctuations.
2. Currency Swaps
o Involves the exchange of principal and interest payments
in different currencies between two parties.
o Used to manage foreign exchange rate risk in international
trade or investments.
3. Commodity Swaps
o Involves the exchange of cash flows based on the price of a
commodity, like oil or natural gas.
o Helps companies hedge against commodity price
fluctuations.
4. Credit Default Swaps (CDS)
o Provides insurance-like protection against default by a
borrower.
o One party pays a premium in return for compensation if a
credit event (default) occurs.
5. Equity Swaps
o Involves the exchange of returns on equity investments,
such as stock indices or individual stocks, for fixed or floating
rate cash flows.
 Basic Features of Swap Contracts
• Customization: Swaps are typically over-the-counter (OTC)
contracts, meaning they are customized to meet the specific needs
of the parties involved.
• Notional Principal: The amount on which the exchanged interest
or cash flows are based, though it is not exchanged directly.
• Maturity Period: Swaps usually have a specific time frame, such
as 2 to 10 years.
• Counterparty Risk: Since swaps are OTC contracts, there is a
risk of one party defaulting on its obligations.
• Settlement Frequency: Payments are exchanged at regular
intervals (e.g., quarterly or semi-annually).
Mechanism of Interest Rate Swap
In an interest rate swap, one party agrees to pay a fixed interest rate
and receive a floating interest rate (or vice versa) on the same notional
principal. The purpose is to manage exposure to interest rate changes.
• Example:
o Party A: Borrows with a floating rate loan (e.g., LIBOR +
2%).
o Party B: Borrows with a fixed rate loan (e.g., 5%).
o Swap: Party A agrees to pay 5% (fixed) to Party B, and in
return, Party B pays LIBOR + 2% (floating) to Party A.
• Net Settlement: Only the net difference in interest payments is
exchanged, rather than the full amounts.
Mechanism of Currency Swap
In a currency swap, two parties exchange principal amounts in
different currencies at the beginning of the contract and re-
exchange them at the end. During the contract, they also
exchange interest payments in those currencies.
• Example:
o Company A (in the U.S.) borrows $10 million.
o Company B (in Europe) borrows €9 million.
o Swap: Company A agrees to pay interest in euros, and
Company B pays interest in dollars.
o At the end of the swap, the principal amounts ($10 million
and €9 million) are re-exchanged.