Presented By
Debasis Mohanty
What are Derivatives?
A derivative is a financial instrument whose value is derived
from the value of another asset, which is known as the
underlying.
When the price of the underlying changes, the value of the
derivative also changes.
 A Derivative is not a product. It is a contract that derives its
value from changes in the price of the underlying.
Example :
The value of a gold futures contract is derived from the
value of the underlying asset i.e. Gold.
TerminologyLong position – Buying
Short position – selling
Spot price – Price of the asset in the spot market.(market price)
Delivery/forward price – Price of the asset at the delivery date.
Strike Price — the price at which the holder of an option may exercise his right to buy (in
the case of a call) or sell (in the case of a put) the underlying futures contract. Also
known as exercise price.
Maintenance Margin — a sum, usually smaller than the initial margin, which must be held
on deposit at all times. If a customer’s equity falls below this margin level, the broker
must issue a “margin call” for the amount of money required to restore the customer’s
equity in the account to the original margin level.
Initial Margin — money which must be deposited with the broker for each futures
contract as a guarantee of fulfillment of the contract. Also known as a security deposit,
initial margin or performance bond. Buyers of options do not have to post margins since
their risk is limited to the option premium.
Open Interest — total number of futures or options(puts and calls) contracts outstanding
on a given commodity.
Spread — a market position that is simultaneously long and short equivalent amounts of the same or
related commodities
Marking to Market-This is the practice of periodically adjusting the margin account by adding or
subtracting funds based on changes in market value to reflect the investor’s gain or loss.
Expiration Date — the last day on which an option/future may be exercised. Options expire on a specified
date preceding delivery. Options for cash settled commodities expire the same time as the underlying
futures contract.
Delivery — the transfer of the cash /commodity from the
seller of a futures contract to the buyer of a futures
Contract
A bid -price is the highest price that a buyer (i.e., bidder) is willing to
pay for a good. It is usually referred to simply as the "bid." In bid
and ask, the bid price stands in contrast to the ask price or "offer",
and the difference between the two is called the bid–ask spread
lot size- A measure or quantity increment acceptable to or specified by
the party offering to buy or sell. Used also as an alternative term for
lot quantity.
Contract cycle – The period for which a contract trades.
The futures on the NSE have one (near) month, two (next) months,
three (far) months expiry cycles.
Types of OrderAn order is an instruction to buy or sell on a trading venue such as a stock market,
bond market, commodity market, or financial derivative market. These instructions can be
simple or complicated, and can be sent to either a broker or directly to a trading venue via
direct market access. There are some standard instructions for such orders.
Price in force
 Market order
A market order is a buy or sell order to be executed immediately at current market prices. As
long as there are willing sellers and buyers, market orders are filled. Market orders are
therefore used when certainty of execution is a priority over price of execution.
 Limit order
A limit order is an order to buy a security at no more than a specific price, or to sell a security at
no less than a specific price (called "or better" for either direction). This gives the trader
(customer) control over the price at which the trade is executed; however, the order may
never be executed ("filled").Limit orders are used when the trader wishes to control price
rather than certainty of execution.
Time in force
 A day order or good for day order (GFD) (the most common) is a market or limit order that is
in force from the time the order is submitted to the end of the day's trading session. For stock
markets, the closing time is defined by the exchange. For the foreign exchange market, this is
until 5 p.m. EST/EDT for all currencies except the New Zealand Dollar.
 Good-till-cancelled (GTC) orders require a specific cancelling order, which can persist
indefinitely (although brokers may set some limits, for example, 90 days).
 An immediate or cancel (IOC) orders are immediately executed or cancelled by the exchange.
Unlike FOK orders, IOC orders allow for partial fills.
 Fill or kill(FOK) orders are usually limit orders that must be executed or cancelled
immediately. Unlike IOC orders, FOK orders require the full quantity to be executed.
Conditional orders
A conditional order is any order other than a limit order which
is executed only when a specific condition is satisfied.
Stop orders
A stop order, also referred to as a stop-loss order, is an order
to buy or sell a stock once the price of the stock reaches a
specified price, known as the stop price. When the stop price
is reached, a stop order becomes a market order. A buy–stop
order is entered at a stop price above the current market
price. Investors generally use a buy stop order to limit a loss
or to protect a profit on a stock that they have sold short. A
sell–stop order is entered at a stop price below the current
market price. Investors generally use a sell–stop order to
limit a loss or to protect a profit on a stock that they own.
Traders in Derivatives Market
There are 3 types of traders in the Derivatives Market :
HEDGER
A hedger is someone who faces risk associated with price
movement of an asset and who uses derivatives as means of
reducing risk.
They provide economic balance to the market.
SPECULATOR
A trader who enters the futures market for pursuit of profits,
accepting risk in the endeavor.
They provide liquidity and depth to the market.
ARBITRAGEUR
A person who simultaneously enters into transactions in two
or more markets to take advantage of the discrepancies
between prices in these markets.
 Arbitrage involves making profits from relative mispricing.
Arbitrageurs also help to make markets liquid, ensure
accurate and uniform pricing, and enhance price stability
They help in bringing about price uniformity and discovery.
Economic benefits of derivatives
Reduces risk
Enhance liquidity of the underlying asset
Lower transaction costs
Enhances liquidity of the underlying asset
Enhances the price discovery process.
Portfolio Management
Provides signals of market movements
Facilitates financial markets integration
Types of Derivative Instruments:
Derivative contracts are of several types. The most common types are forwards,
futures, options and swap.
Forward Contracts
A forward contract is an agreement between two parties – a buyer and a seller
to purchase or sell something at a later date at a price agreed upon today.
Forward contracts, sometimes called forward commitments , are very common
in everyone life. Any type of contractual agreement that calls for the future
purchase of a good or service at a price agreed upon today and without the right
of cancellation is a forward contract.
Future Contracts
A futures contract is an agreement between two parties – a buyer and a seller –
to buy or sell something at a future date. The contact trades on a futures
exchange and is subject to a daily settlement procedure. Future contracts
evolved out of forward contracts and possess many of the same characteristics.
Unlike forward contracts, futures contracts trade on organized exchanges, called
future markets. Future contacts also differ from forward contacts in that they
are subject to a daily settlement procedure. In the daily settlement, investors
who incur losses pay them every day to investors who make profits.
Options Contracts
Options are of two types – calls and puts. Calls give the buyer the right
but not the obligation to buy a given quantity of the underlying asset, 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 the underlying
asset at a given price on or before a given date.
Swaps
Swaps are private agreements between two parties to exchange cash
flows in the future according to a prearranged formula. They can be
regarded as portfolios of forward contracts. The two commonly used
swaps are interest rate swaps and currency swaps.
Interest rate swaps: These involve swapping only the interest related
cash flows between the parties in the same currency.
Currency swaps: These entail swapping both principal and interest
between the parties, with the cash flows in one direction being in a
different currency than those in the opposite direction.
What is a Forward?
A forward is a contract in which one party commits to
buy and the other party commits to sell a specified
quantity of an agreed upon asset for a pre-determined
price at a specific date in the future.
It is a customized contract, in the sense that the terms of
the contract are agreed upon by the individual parties.
Hence, it is traded OTC.
Forward Contract Example
I agree to sell
500kgs wheat at
Rs.40/kg after 3
months.
I agree to sell
500kgs wheat at
Rs.40/kg after 3
months.
Farmer Bread
Maker
3 months Later
Farmer
Bread
Maker
500kgs wheat
Rs.20,000
Risks in Forward Contracts
Credit Risk – Does the other party have the means to
pay?
Operational Risk – Will the other party make delivery?
Will the other party accept delivery?
Liquidity Risk – Incase either party wants to opt out of
the contract, how to find another counter party?
What are Futures?
A future is a standardised forward contract.
It is traded on an organised exchange.
Standardisations-
- quantity of underlying
- quality of underlying(not required in financial futures)
- delivery dates and procedure
- price quotes
Futures Contract Example
AA
BB CC
L Rs10
S Rs12
S Rs10
L Rs14
L Rs12
S Rs14
Profit Rs2
Loss Rs4 Profit Rs2
Market
Price/Spot Price
D1 Rs10
D2 Rs12
D3 Rs14
Market
Price/Spot Price
D1 Rs10
D2 Rs12
D3 Rs14
Types of Futures Contracts
Stock Futures Trading (dealing with shares)
Commodity Futures Trading (dealing with commodities)
Index Futures Trading (dealing with stock market indices)
Currency Future(deals with currency)
Closing a Futures Position
Most futures contracts are not held till expiry, but closed
before that.
If held till expiry, they are generally settled by delivery.
(2-3%)
By closing a futures contract before expiry, the net
difference is settled between traders, without physical
delivery of the underlying.
COMPARISON FORWARD
FUTURES
• Trade on organized exchanges No Yes
• Use standardized contract terms No Yes
• Use associate clearinghouses to
guarantee contract fulfillment No Yes
• Require margin payments and daily
settlements No Yes
• Markets are transparent No Yes
• Marked to market daily No Yes
• Closed prior to delivery No
Mostly
What are Options?
Contracts that give the holder the option to buy/sell
specified quantity of the underlying assets at a
particular price on or before a specified time period.
The word “option” means that the holder has the
right but not the obligation to buy/sell underlying
assets.
Types of Options
Options are of two types – call and put.
Call option give the buyer the right but not the
obligation to buy a given quantity of the underlying
asset, at a given price on or before a particular date
by paying a premium.
 Puts give the buyer the right, but not obligation to
sell a given quantity of the underlying asset at a given
price on or before a particular date by paying a
premium.
Types of Options (cont.)
The other two types are – European style options
and American style options.
European style options can be exercised only on the
maturity date of the option, also known as the expiry
date.
American style options can be exercised at any time
before and on the expiry date.
Call Option Example
Right to buy 100
Reliance shares at
a price of Rs.300
per share after 3
months.
Right to buy 100
Reliance shares at
a price of Rs.300
per share after 3
months.
CALL OPTION
Strike Price
Premium =
Rs.25/share
Amt to buy Call
option = Rs.2500
Current Price = Rs.250
Suppose after a month,
Market price is Rs.400, then
the option is exercised i.e.
the shares are bought.
Net gain = 40,000-30,000-
2500 = Rs.7500
Suppose after a month, market
price is Rs.200, then the option is
not exercised.
Net Loss = Premium amt
= Rs.2500
Expiry
date
Put Option Example
Right to sell 100
Reliance shares at
a price of Rs.300
per share after 3
months.
Right to sell 100
Reliance shares at
a price of Rs.300
per share after 3
months.
PUT OPTION
Strike Price
Premium =
Rs.25/share
Amt to buy Call
option = Rs.2500
Current Price = Rs.250
Suppose after a month,
Market price is Rs.200, then
the option is exercised i.e.
the shares are sold.
Net gain = 30,000-20,000-
2500 = Rs.7500
Suppose after a month, market
price is Rs.300, then the option is
not exercised.
Net Loss = Premium amt
= Rs.2500
Expiry
date
Features of Options
A fixed maturity date on which they expire. (Expiry date)
The price at which the option is exercised is called the exercise
price or strike price.
The person who writes the option and is the seller is referred
as the “option writer”, and who holds the option and is the
buyer is called “option holder”.
The premium is the price paid for the option by the buyer to
the seller.
A clearing house is interposed between the writer and the
buyer which guarantees performance of the contract.
Options Terminology
Underlying: Specific security or asset.
Option premium: Price paid.
Strike price: Pre-decided price.
Expiration date: Date on which option expires.
Exercise date: Option is exercised.
Open interest: Total numbers of option contracts
that have not yet been expired.
Option holder: One who buys option.
Option writer: One who sells option.
Options Terminology (cont.)
Option class: All listed options of a type on a
particular instrument.
Option series: A series that consists of all the options
of a given class with the same expiry date and strike
price.
Put-call ratio: The ratio of puts to the calls traded in
the market.
Options Terminology (cont.)
Moneyness: Concept that refers to the potential
profit or loss from the exercise of the option. An
option maybe in the money, out of the money, or at
the money.
In the money
At the money
Out of the
money
Call Option Put Option
Spot price > strike
price
Spot price = strike
price
Spot price < strike
price
Spot price < strike
price
Spot price = strike
price
Spot price > strike
price
What are SWAPS?
In a swap, two counter parties agree to enter into a
contractual agreement wherein they agree to exchange
cash flows at periodic intervals.
Most swaps are traded “Over The Counter”.
Some are also traded on futures exchange market.
Types of Swaps
There are 2 main types of swaps:
Plain vanilla fixed for floating swaps
or simply interest rate swaps.
Fixed for fixed currency swaps
or simply currency swaps.
What is an Interest Rate Swap?
A company agrees to pay a pre-determined fixed
interest rate on a notional principal for a fixed number of
years.
In return, it receives interest at a floating rate on the
same notional principal for the same period of time.
The principal is not exchanged. Hence, it is called a
notional amount.
Floating Interest Rate
LIBOR – London Interbank Offered Rate
It is the average interest rate estimated by leading banks
in London.
It is the primary benchmark for short term interest rates
around the world.
Similarly, we have MIBOR i.e. Mumbai Interbank Offered
Rate.
It is calculated by the NSE as a weighted average of
lending rates of a group of banks.
Co.A Co.BSWAPS
BANK
SWAPS
BANK
Bank ABank A
Fixed 7%
Variable LIBOR
Bank BBank B
Fixed 10%
Variable LIBOR + 1%
Aim - VARIABLE Aim - FIXED
LIBOR LIBOR
8% 8.5%
7%5m 5m LIBOR
+ 1%
Notional Amount =
£ 5 million
Using a Swap to Transform a Liability
Firm A has transformed a fixed rate liability into a
floater.
A is borrowing at LIBOR – 1%
A savings of 1%
Firm B has transformed a floating rate liability into a
fixed rate liability.
B is borrowing at 9.5%
A savings of 0.5%.
Swaps Bank Profits = 8.5%-8% = 0.5%
What is a Currency Swap?
It is a swap that includes exchange of principal and
interest rates in one currency for the same in another
currency.
It is considered to be a foreign exchange transaction.
It is not required by law to be shown in the balance
sheets.
The principal may be exchanged either at the beginning
or at the end of the tenure.
However, if it is exchanged at the end of the life of the
swap, the principal value may be very different.
It is generally used to hedge against exchange rate
fluctuations.
Direct Currency Swap Example
Firm A is an American company and wants to borrow
€40,000 for 3 years.
Firm B is a French company and wants to borrow $60,000
for 3 years.
Suppose the current exchange rate is €1 = $1.50.
Firm A Firm B
Bank A Bank B
€ 6%
$ 7%
€ 5%
$ 8%
Aim - EURO
Aim - DOLLAR
7%
5%
7% 5%$60th €40th
Comparative Advantage
Firm A has a comparative advantage in borrowing
Dollars.
Firm B has a comparative advantage in borrowing Euros.
This comparative advantage helps in reducing borrowing
cost and hedging against exchange rate fluctuations.

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Financial Derivative

  • 2. What are Derivatives? A derivative is a financial instrument whose value is derived from the value of another asset, which is known as the underlying. When the price of the underlying changes, the value of the derivative also changes.  A Derivative is not a product. It is a contract that derives its value from changes in the price of the underlying. Example : The value of a gold futures contract is derived from the value of the underlying asset i.e. Gold.
  • 3. TerminologyLong position – Buying Short position – selling Spot price – Price of the asset in the spot market.(market price) Delivery/forward price – Price of the asset at the delivery date. Strike Price — the price at which the holder of an option may exercise his right to buy (in the case of a call) or sell (in the case of a put) the underlying futures contract. Also known as exercise price. Maintenance Margin — a sum, usually smaller than the initial margin, which must be held on deposit at all times. If a customer’s equity falls below this margin level, the broker must issue a “margin call” for the amount of money required to restore the customer’s equity in the account to the original margin level. Initial Margin — money which must be deposited with the broker for each futures contract as a guarantee of fulfillment of the contract. Also known as a security deposit, initial margin or performance bond. Buyers of options do not have to post margins since their risk is limited to the option premium. Open Interest — total number of futures or options(puts and calls) contracts outstanding on a given commodity. Spread — a market position that is simultaneously long and short equivalent amounts of the same or related commodities Marking to Market-This is the practice of periodically adjusting the margin account by adding or subtracting funds based on changes in market value to reflect the investor’s gain or loss. Expiration Date — the last day on which an option/future may be exercised. Options expire on a specified date preceding delivery. Options for cash settled commodities expire the same time as the underlying futures contract.
  • 4. Delivery — the transfer of the cash /commodity from the seller of a futures contract to the buyer of a futures Contract A bid -price is the highest price that a buyer (i.e., bidder) is willing to pay for a good. It is usually referred to simply as the "bid." In bid and ask, the bid price stands in contrast to the ask price or "offer", and the difference between the two is called the bid–ask spread lot size- A measure or quantity increment acceptable to or specified by the party offering to buy or sell. Used also as an alternative term for lot quantity. Contract cycle – The period for which a contract trades. The futures on the NSE have one (near) month, two (next) months, three (far) months expiry cycles.
  • 5. Types of OrderAn order is an instruction to buy or sell on a trading venue such as a stock market, bond market, commodity market, or financial derivative market. These instructions can be simple or complicated, and can be sent to either a broker or directly to a trading venue via direct market access. There are some standard instructions for such orders. Price in force  Market order A market order is a buy or sell order to be executed immediately at current market prices. As long as there are willing sellers and buyers, market orders are filled. Market orders are therefore used when certainty of execution is a priority over price of execution.  Limit order A limit order is an order to buy a security at no more than a specific price, or to sell a security at no less than a specific price (called "or better" for either direction). This gives the trader (customer) control over the price at which the trade is executed; however, the order may never be executed ("filled").Limit orders are used when the trader wishes to control price rather than certainty of execution. Time in force  A day order or good for day order (GFD) (the most common) is a market or limit order that is in force from the time the order is submitted to the end of the day's trading session. For stock markets, the closing time is defined by the exchange. For the foreign exchange market, this is until 5 p.m. EST/EDT for all currencies except the New Zealand Dollar.  Good-till-cancelled (GTC) orders require a specific cancelling order, which can persist indefinitely (although brokers may set some limits, for example, 90 days).  An immediate or cancel (IOC) orders are immediately executed or cancelled by the exchange. Unlike FOK orders, IOC orders allow for partial fills.  Fill or kill(FOK) orders are usually limit orders that must be executed or cancelled immediately. Unlike IOC orders, FOK orders require the full quantity to be executed.
  • 6. Conditional orders A conditional order is any order other than a limit order which is executed only when a specific condition is satisfied. Stop orders A stop order, also referred to as a stop-loss order, is an order to buy or sell a stock once the price of the stock reaches a specified price, known as the stop price. When the stop price is reached, a stop order becomes a market order. A buy–stop order is entered at a stop price above the current market price. Investors generally use a buy stop order to limit a loss or to protect a profit on a stock that they have sold short. A sell–stop order is entered at a stop price below the current market price. Investors generally use a sell–stop order to limit a loss or to protect a profit on a stock that they own.
  • 7. Traders in Derivatives Market There are 3 types of traders in the Derivatives Market : HEDGER A hedger is someone who faces risk associated with price movement of an asset and who uses derivatives as means of reducing risk. They provide economic balance to the market. SPECULATOR A trader who enters the futures market for pursuit of profits, accepting risk in the endeavor. They provide liquidity and depth to the market.
  • 8. ARBITRAGEUR A person who simultaneously enters into transactions in two or more markets to take advantage of the discrepancies between prices in these markets.  Arbitrage involves making profits from relative mispricing. Arbitrageurs also help to make markets liquid, ensure accurate and uniform pricing, and enhance price stability They help in bringing about price uniformity and discovery.
  • 9. Economic benefits of derivatives Reduces risk Enhance liquidity of the underlying asset Lower transaction costs Enhances liquidity of the underlying asset Enhances the price discovery process. Portfolio Management Provides signals of market movements Facilitates financial markets integration
  • 10. Types of Derivative Instruments: Derivative contracts are of several types. The most common types are forwards, futures, options and swap. Forward Contracts A forward contract is an agreement between two parties – a buyer and a seller to purchase or sell something at a later date at a price agreed upon today. Forward contracts, sometimes called forward commitments , are very common in everyone life. Any type of contractual agreement that calls for the future purchase of a good or service at a price agreed upon today and without the right of cancellation is a forward contract. Future Contracts A futures contract is an agreement between two parties – a buyer and a seller – to buy or sell something at a future date. The contact trades on a futures exchange and is subject to a daily settlement procedure. Future contracts evolved out of forward contracts and possess many of the same characteristics. Unlike forward contracts, futures contracts trade on organized exchanges, called future markets. Future contacts also differ from forward contacts in that they are subject to a daily settlement procedure. In the daily settlement, investors who incur losses pay them every day to investors who make profits.
  • 11. Options Contracts Options are of two types – calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, 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 the underlying asset at a given price on or before a given date. Swaps Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are interest rate swaps and currency swaps. Interest rate swaps: These involve swapping only the interest related cash flows between the parties in the same currency. Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction.
  • 12. What is a Forward? A forward is a contract in which one party commits to buy and the other party commits to sell a specified quantity of an agreed upon asset for a pre-determined price at a specific date in the future. It is a customized contract, in the sense that the terms of the contract are agreed upon by the individual parties. Hence, it is traded OTC.
  • 13. Forward Contract Example I agree to sell 500kgs wheat at Rs.40/kg after 3 months. I agree to sell 500kgs wheat at Rs.40/kg after 3 months. Farmer Bread Maker 3 months Later Farmer Bread Maker 500kgs wheat Rs.20,000
  • 14. Risks in Forward Contracts Credit Risk – Does the other party have the means to pay? Operational Risk – Will the other party make delivery? Will the other party accept delivery? Liquidity Risk – Incase either party wants to opt out of the contract, how to find another counter party?
  • 15. What are Futures? A future is a standardised forward contract. It is traded on an organised exchange. Standardisations- - quantity of underlying - quality of underlying(not required in financial futures) - delivery dates and procedure - price quotes
  • 16. Futures Contract Example AA BB CC L Rs10 S Rs12 S Rs10 L Rs14 L Rs12 S Rs14 Profit Rs2 Loss Rs4 Profit Rs2 Market Price/Spot Price D1 Rs10 D2 Rs12 D3 Rs14 Market Price/Spot Price D1 Rs10 D2 Rs12 D3 Rs14
  • 17. Types of Futures Contracts Stock Futures Trading (dealing with shares) Commodity Futures Trading (dealing with commodities) Index Futures Trading (dealing with stock market indices) Currency Future(deals with currency)
  • 18. Closing a Futures Position Most futures contracts are not held till expiry, but closed before that. If held till expiry, they are generally settled by delivery. (2-3%) By closing a futures contract before expiry, the net difference is settled between traders, without physical delivery of the underlying.
  • 19. COMPARISON FORWARD FUTURES • Trade on organized exchanges No Yes • Use standardized contract terms No Yes • Use associate clearinghouses to guarantee contract fulfillment No Yes • Require margin payments and daily settlements No Yes • Markets are transparent No Yes • Marked to market daily No Yes • Closed prior to delivery No Mostly
  • 20. What are Options? Contracts that give the holder the option to buy/sell specified quantity of the underlying assets at a particular price on or before a specified time period. The word “option” means that the holder has the right but not the obligation to buy/sell underlying assets.
  • 21. Types of Options Options are of two types – call and put. Call option give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a particular date by paying a premium.  Puts give the buyer the right, but not obligation to sell a given quantity of the underlying asset at a given price on or before a particular date by paying a premium.
  • 22. Types of Options (cont.) The other two types are – European style options and American style options. European style options can be exercised only on the maturity date of the option, also known as the expiry date. American style options can be exercised at any time before and on the expiry date.
  • 23. Call Option Example Right to buy 100 Reliance shares at a price of Rs.300 per share after 3 months. Right to buy 100 Reliance shares at a price of Rs.300 per share after 3 months. CALL OPTION Strike Price Premium = Rs.25/share Amt to buy Call option = Rs.2500 Current Price = Rs.250 Suppose after a month, Market price is Rs.400, then the option is exercised i.e. the shares are bought. Net gain = 40,000-30,000- 2500 = Rs.7500 Suppose after a month, market price is Rs.200, then the option is not exercised. Net Loss = Premium amt = Rs.2500 Expiry date
  • 24. Put Option Example Right to sell 100 Reliance shares at a price of Rs.300 per share after 3 months. Right to sell 100 Reliance shares at a price of Rs.300 per share after 3 months. PUT OPTION Strike Price Premium = Rs.25/share Amt to buy Call option = Rs.2500 Current Price = Rs.250 Suppose after a month, Market price is Rs.200, then the option is exercised i.e. the shares are sold. Net gain = 30,000-20,000- 2500 = Rs.7500 Suppose after a month, market price is Rs.300, then the option is not exercised. Net Loss = Premium amt = Rs.2500 Expiry date
  • 25. Features of Options A fixed maturity date on which they expire. (Expiry date) The price at which the option is exercised is called the exercise price or strike price. The person who writes the option and is the seller is referred as the “option writer”, and who holds the option and is the buyer is called “option holder”. The premium is the price paid for the option by the buyer to the seller. A clearing house is interposed between the writer and the buyer which guarantees performance of the contract.
  • 26. Options Terminology Underlying: Specific security or asset. Option premium: Price paid. Strike price: Pre-decided price. Expiration date: Date on which option expires. Exercise date: Option is exercised. Open interest: Total numbers of option contracts that have not yet been expired. Option holder: One who buys option. Option writer: One who sells option.
  • 27. Options Terminology (cont.) Option class: All listed options of a type on a particular instrument. Option series: A series that consists of all the options of a given class with the same expiry date and strike price. Put-call ratio: The ratio of puts to the calls traded in the market.
  • 28. Options Terminology (cont.) Moneyness: Concept that refers to the potential profit or loss from the exercise of the option. An option maybe in the money, out of the money, or at the money. In the money At the money Out of the money Call Option Put Option Spot price > strike price Spot price = strike price Spot price < strike price Spot price < strike price Spot price = strike price Spot price > strike price
  • 29. What are SWAPS? In a swap, two counter parties agree to enter into a contractual agreement wherein they agree to exchange cash flows at periodic intervals. Most swaps are traded “Over The Counter”. Some are also traded on futures exchange market.
  • 30. Types of Swaps There are 2 main types of swaps: Plain vanilla fixed for floating swaps or simply interest rate swaps. Fixed for fixed currency swaps or simply currency swaps.
  • 31. What is an Interest Rate Swap? A company agrees to pay a pre-determined fixed interest rate on a notional principal for a fixed number of years. In return, it receives interest at a floating rate on the same notional principal for the same period of time. The principal is not exchanged. Hence, it is called a notional amount.
  • 32. Floating Interest Rate LIBOR – London Interbank Offered Rate It is the average interest rate estimated by leading banks in London. It is the primary benchmark for short term interest rates around the world. Similarly, we have MIBOR i.e. Mumbai Interbank Offered Rate. It is calculated by the NSE as a weighted average of lending rates of a group of banks.
  • 33. Co.A Co.BSWAPS BANK SWAPS BANK Bank ABank A Fixed 7% Variable LIBOR Bank BBank B Fixed 10% Variable LIBOR + 1% Aim - VARIABLE Aim - FIXED LIBOR LIBOR 8% 8.5% 7%5m 5m LIBOR + 1% Notional Amount = £ 5 million
  • 34. Using a Swap to Transform a Liability Firm A has transformed a fixed rate liability into a floater. A is borrowing at LIBOR – 1% A savings of 1% Firm B has transformed a floating rate liability into a fixed rate liability. B is borrowing at 9.5% A savings of 0.5%. Swaps Bank Profits = 8.5%-8% = 0.5%
  • 35. What is a Currency Swap? It is a swap that includes exchange of principal and interest rates in one currency for the same in another currency. It is considered to be a foreign exchange transaction. It is not required by law to be shown in the balance sheets. The principal may be exchanged either at the beginning or at the end of the tenure.
  • 36. However, if it is exchanged at the end of the life of the swap, the principal value may be very different. It is generally used to hedge against exchange rate fluctuations.
  • 37. Direct Currency Swap Example Firm A is an American company and wants to borrow €40,000 for 3 years. Firm B is a French company and wants to borrow $60,000 for 3 years. Suppose the current exchange rate is €1 = $1.50.
  • 38. Firm A Firm B Bank A Bank B € 6% $ 7% € 5% $ 8% Aim - EURO Aim - DOLLAR 7% 5% 7% 5%$60th €40th
  • 39. Comparative Advantage Firm A has a comparative advantage in borrowing Dollars. Firm B has a comparative advantage in borrowing Euros. This comparative advantage helps in reducing borrowing cost and hedging against exchange rate fluctuations.