Derivatives

Futures & Options

 Derivatives
• Derivative is a product whose value is
derived from the value of one or more
basic variables called bases (i.e. underline)
– Stock
– Index
– Commodity
– Currencies
– Interest Rates
 Why Derivatives ?
• Prices in an organized derivative market
reflect the perception of market participants
about the future and lead the prices of
underlying to perceived future level.

• Derivative market helps to transfer risks from

those who have them but may not like them
to those who have an appetite for them
 Why Derivatives ? (Cont…)
• Derivatives, due to their inherent nature, are
linked to the underlying cash markets. (high
Volume)

• Speculative trades shift to a more controlled

environment of derivative market. (benefit of
organized market)

• Derivative acts as a catalyst for new

entrepreneurial activity.
 Types of Derivatives
• Forward:
A forward contract is a customized
contract between two entities where
settlement takes place on a specific date in
the future at today’s pre-agreed price.

• Futures:
A 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.
 Types of Derivatives (Cont…)
• Options:
Options are two types - calls and puts.

– Calls give the buyer the right but not the obligation
to buy a given quantity of underlying assets, at a
given price on or before a given future date.

– Puts give the buyer the right but not the obligation
to sell a given quantity of underlying assets, at a
given price on or before a given future date.
 Types of Derivatives (Cont…)
• Warrants:
Longer dated options are called warrants
and are generally traded over-the-counter.

• LEAPS (Long-Term Equity Anticipation

Securities)
These are options having a maturity of
upto three years.
 Types of Derivatives (Cont…)
• Baskets:
Baskets options are options on portfolios of
underlying assets. Equity index options are a
form of basket options.

• Swaps:
They can be regarded as portfolios of
forward contracts. Two commonly used
swaps are: interest rate and currency.
 Types of Derivatives (Cont…)
• Swaptions:
Swaptions are options to buy or sell a
swap that will become operative at the
expiry of the options.
 Difference Between Futures &
Forwards
FUTURES FORWARDS
Trade on an organized OTC in the nature
exchange
Standardized Contract Customized Contract
Terms Terms
More Liquid Less Liquid
Requires Margin No Margin Payment
Payments
Follows daily settlement Settlement happens at
the end of period
 Difference Between Futures &
FUTURES
Forwards OPTIONS
Futures contract is an agreement to In options the buyer enjoys the right
buy or sell specified quantity of the and not the obligation, to buy or sell
underlying assets at a price agreed the underlying asset
upon by the buyer and seller, on or
before a specified time. Both the
buyer and seller are obliged to
buy/sell the underlying asset.
Unlimited upside & downside for Limited downside (to the extent of
both buyer and seller. premium paid) for buyer and
unlimited upside. For seller (writer)
of the option, profits are limited
whereas losses can be unlimited.
Futures contracts prices are affected Prices of options are however,
mainly by the prices of the underlying affected by a)prices of the
asset underlying asset, b)time remaining
for expiry of the contract and
FUTURE
S
 Futures Terminology
• Spot Price : (S)
The prices at which an assets trades in the
spot market.
• Future Price: (F)
The price at which the futures contract
trades in the futures market.
• Contract Cycle:
The period over which a contract trades.
 Futures Terminology (Cont…)
• Expiration Date: (T)
It is the date specified in the future contract.
• Contract Size:
The quantity to be traded in a contract.
• Basis:
Future Price – Spot Price
Normally , basis will be positive.
 Futures Terminology (Cont…)
• Cost of Carry: (CoC)
The relationship between future and spot price
is known as cost of carry.
• Initial Margin:
Amount to be deposited at the time of future
transactions.
• Marking - to – Market: (M2M)
At the end of day gain or loss is adjusted by
settlement price daily.
Pay-off for the long assets (future)
• The figure shows the profits/losses from a long position on ABC
Ltd.. The investor bought ABC Ltd. at Rs. 2220. If the share price
goes up, he profits. If the share price falls he loses.
Pay-off for the short assets (future)
• The figure shows the profits/losses from a short position on ABC
Ltd.. The investor sold ABC Ltd. at Rs. 2220. If the share price falls,
he profits. If the share price rises, he loses.
 Pricing Futures
• The Cost of Carry Model:
F=S+C
F = S (1+ r)T
Where,
r cost of financing
T time to expiration

F = SerT e = 2.71828
 Participants in Futures
• Speculators

• Hedgers

• Arbitragers
– Spreader (Basis Trading)
OPTIONS
 Options Terminology
• Index options:
These options have the index as the underlying.
In India, they have a European style settlement.
Eg. Nifty options, Mini Nifty options etc.
• Stock options:
Stock options are options on individual stocks.
A stock option contract gives the holder the
right to buy or sell the underlying shares at the
specified price. They have an American style
settlement.
 Options Terminology (Cont…)
• 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 / seller of an option:
The writer / seller 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.
 Options Terminology (Cont…)
• Call option:
A call option gives the holder the right but not
the obligation to buy an asset by a certain date
for a certain price.

• Put option:
A put option gives the holder the right but not
the obligation to sell an asset by a certain date
for a certain price.
 Options Terminology (Cont…)
• Option price/premium:
Option price 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.
 Options Terminology (Cont…)
• 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 upto the expiration date.
• European options:
European options are options that can be
exercised only on the expiration date itself.
`
 Options Terminology (Cont…)
• In-the-money option:
An in-the-money (ITM) option is an option
that would lead to a positive cashflow 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). If the index is much higher than the
strike price, the call is said to be deep ITM. In
the case of a put, the put is ITM if the index is
below the strike price.
 Options Terminology (Cont…)
• At-the-money option:
An at-the-money (ATM) option is an
option that would lead to zero cashflow 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).
 Options Terminology (Cont…)
• Out-of-the-money option: An out-of-the-
money (OTM) option is an option that would
lead to a negative cashflow 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. In the case of a put, the put is OTM
if the index is above the strike price.
 Options Terminology (Cont…)
• Intrinsic value of an option:
The option premium can be broken down into two
components - intrinsic value and time value. The
intrinsic value of a call is the amount the option is
ITM, if it is ITM. If the call is OTM, its intrinsic
value is zero. Putting it another way, the intrinsic
value of a call is Max[0, (St — K)] which means the
intrinsic value of a call is the greater of 0 or (St —
K). Similarly, the intrinsic value of a put is Max
[0,K — St],i.e. the greater of 0 or (K — St). K is the
strike price and St is the spot price.
 Options Terminology (Cont…)
• 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.
 Pay-off for the buyer of call
• options
The figure shows the profits/losses for the buyer of a three-month Nifty
2250 call option. As can be seen, as the spot Nifty rises, the call option is in-
the-money. If upon expiration, Nifty closes above the strike of 2250, the
buyer would exercise his option and profit to the extent of the difference
between the Nifty-close and the strike price. The profits possible on this
option are potentially unlimited. However if Nifty falls below the strike of
2250, he lets the option expire. His losses are limited to the extent of the
premium he paid for buying the option.
 Pay-off for the writer of call
• options
The figure shows the profits/losses for the seller of a three-month Nifty
2250 call option. As the spot Nifty rises, the call option is in-the-money and
the writer starts making losses. If upon expiration, Nifty closes above the
strike of 2250, the buyer would exercise his option on the writer who would
suffer a loss to the extent of the difference between the Nifty-close and the
strike price. The loss that can be incurred by the writer of the option is
potentially unlimited, whereas the maximum profit is limited to the extent
of the up-front option premium of Rs.86.60 charged by him.
 Pay-off for the buyer of put options
• The figure shows the profits/losses for the buyer of a three-month Nifty
2250 put option. As can be seen, as the spot Nifty falls, the put option is in-
the-money. If upon expiration, Nifty closes below the strike of 2250, the
buyer would exercise his option and profit to the extent of the difference
between the strike price and Nifty-close. The profits possible on this option
can be as high as the strike price. However if Nifty rises above the strike of
2250, he lets the option expire. His losses are limited to the extent of the
premium he paid for buying the option.
 Pay-off for the writer of put options
• The figure shows the profits/losses for the seller of a three-month Nifty
2250 put option. As the spot Nifty falls, the put option is in-the-money
and the writer starts making losses. If upon expiration, Nifty closes below
the strike of 2250, the buyer would exercise his option on the writer who
would suffer a loss to the extent of the difference between the strike price
and Nifty close. The loss that can be incurred by the writer of the option
is a maximum extent of the strike price (Since the worst that can happen
is that the asset price can fall to zero) whereas the maximum profit is
limited to the extent of the up-front option premium of Rs.61.70 charged
by him.
 Factors affecting option price
• Stock price
• Strike price
• Time to expiration
• Volatility
• Risk-free interest
• Dividend
 Participants in Options
• Buyers

• Writers

• Sellers???
 Trading,
Clearing &
Settlement
 Trading
• Contract Specification : Index future

Underlying index S & P CNX nifty

Exchange of trading NSE (Trading Hours : 9.00 a.m. to 3.30 p.m.)
Security Descriptor N FUTIDX NIFTY
Contract Size 50 (Min value 2.5 lacs)
Price steps Re 0.05
Price Bands Not Applicable
Trading Cycle 3 months, new contract will be introduced on the next day
trading day following the expiry of near month contract.
Margin Specified by the exchange time-to-time
Requirement
Expiry Day Last Thursday of the month or previous trading day if last
Thursday is trading holiday.
Settlement basis Mark to market and final settlement will be cash settled on
T+1 basis
Settlement Price Daily settlement price will be the closing price of the future
contracts for the trading day and final settlement price
shall be the closing value of the underlying index on the last
 Trading
• Contract Specification : Index option
Underlying index S & P CNX nifty
Exchange of trading NSE (Trading Hours : 9.00 a.m. to 3.30 p.m.)
Security Descriptor N OPTIDX NIFTY
Contract Size 50 (Min value 2.5 lacs)
Price steps Re 0.05
Price Bands Not Applicable
Trading Cycle 3 months, new contract will be introduced on the next day
trading day following the expiry of near month contract.
Expiry Day Last Thursday of the month or previous trading day if last
Thursday is trading holiday.
Settlement basis cash settled on T+1 basis
Style of option European
Strike price interval
Daily Settlement Premium value (net)
Price
Final Settlement Price Closing value of index on the last trading day
 Trading
• Contract Specification : Stock future

Underlying index Individual securities

Exchange of trading NSE (Trading Hours : 9.00 a.m. to 3.30 p.m.)
Security Descriptor N FUTSTK ________
Contract Size 50 (Min value 2.5 lacs)
Price steps Re 0.05
Price Bands Not Applicable
Trading Cycle 3 months, new contract will be introduced on the next day
trading day following the expiry of near month contract.
Margin Requirement Specified by the exchange time-to-time
Expiry Day Last Thursday of the month or previous trading day if last
Thursday is trading holiday.
Settlement basis Mark to market and final settlement will be cash settled on
T+1 basis
Settlement Price Daily settlement price will be the closing price of the future
contracts for the trading day and final settlement price shall
be the closing value of the underlying index on the last
 Trading
• Contract Specification : Stock option
Underlying index Individual Securities
Exchange of trading NSE (Trading Hours : 9.00 a.m. to 3.30 p.m.)
Security Descriptor N OPTSTK _______
Contract Size 50 (Min value 2.5 lacs)
Price steps Re 0.05
Price Bands Not Applicable
Trading Cycle 3 months, new contract will be introduced on the next day
trading day following the expiry of near month contract.
Expiry Day Last Thursday of the month or previous trading day if last
Thursday is trading holiday.
Settlement basis cash settled on T+1 basis
Style of option European
Strike price interval
Daily Settlement Premium value (net)
Price
Final Settlement Closing value of index on the last trading day
 Clearing & Settlement
• Clearing Mechanism:
The clearing mechanism essentially
involves working out open positions and
obligations of clearing members.

• Settlement Mechanism:
All futures and options contracts are cash
settled, i.e. through exchange of cash.
 Settlement of Futures Contracts
• M2M Settlement:
• Final Settlement:
• Settlement Price for Futures:
Daily settlement price on a trading day is
the closing price of the respective future
on such day. Final settlement price is the
closing price of the relevant underlying
index/security in the spot market.
Closing price is arrived at by calculating
last half an hour weighted average price
 Settlement of Options Contracts
• Daily Premium Settlement:
• Exercise Settlement:
– Interim exercise settlement
– Final exercise settlement