Derivatives

Presentation by.Mohd Nazim Hussain

Mohd QasimNabeel AhmadNeeraj Gautam

Neha Vishwakarma

Definition of derivatives

A derivative is a contract designed in such

a way that its price is derived from the

price of an underlying asset.

Example- the price of a gold futures

contract for October maturity is derived

from the price of gold.

Features of derivatives

Future contract between two parties.

It is always derived from the value of an

underlying asset.

Underlying asset can be physical or non

physical.

Counter parties have specified obligation

under the derivative contract.

It is secondary market instrument.

Three types of participants in derivative market:

1. Hedgers:- hedgers are those person who

face risk associated with the price of an asset.

2. Speculators:- speculators are those who bet

on future movement in price of an asset.

3. Arbitrageurs:- arbitrageurs are one who

trades only to realise profit from

discrepancies in the market.

Forward Contracts

• Agreement to buy an asset on a specified

date for a specified price

• Normally traded outside stock exchanges

• Traded on OTC markets

Features :-

• Bilateral contracts

• Contract is customer designed

• Contract price generally not available in

public domain

• On expiration date, contract has to be

settled by delivery of assets

The Advantage/Disadvantage of A forward Contract

Advantage

• Both parties have limited their risk

Disadvantage• You must make or take

delivery of the commodity and settle on the deliver date and honor the contract as agreed upon

• The buyer and seller are dependent upon each other.

• In a forward contract, any profits or losses are not realized until the contract "comes due" on the predetermined date.

Futures Contract

A futures contract is an agreement between

two parties to buy or sell an asset at a

certain time in future, at a certain price.

Traded on an organised stock exchange.

Pricing Futures

When the deliverable asset exists in plentiful

supply then the price of a futures contract is

determined via arbitrage arguments. This is

typical for stock index futures, treasury bond

futures, and futures on physical commodities

when they are in supply (e.g. agricultural crops

after the harvest).

Contd...

However, when the deliverable commodity is

not in plentiful supply or when it does not yet

exist - for example on crops before the harvest

- the futures price cannot be fixed by arbitrage.

In this scenario there is only one force setting

the price, which is simple supply and demand

for the asset in the future, as expressed by

supply and demand for the futures contract.

Arbitrage arguments

Arbitrage arguments apply when the deliverable

asset exists in plentiful supply.

Assuming constant rates, for a simple, non-

dividend paying asset, the value of the future

price, F(t,T), will be found by compounding the

present value S(t) at time t to maturity T by the

rate of risk-free return r.

F(t,T) = S(t)*(1+R)^{(T-t)}

Pricing via expectation

When the deliverable commodity is not in plentiful supply (or when it does not yet exist) rational pricing cannot be applied, as the arbitrage mechanism is not applicable. Here the price of the futures is determined by today's supply and demand for the underlying asset in the future.

In a liquid market, supply and demand would be expected to balance out at a price which represents an unbiased expectation of the future price of the actual asset

Options (finance)

In finance, an option is a contract which gives

the buyer (the owner) the right, but not the

obligation, to buy or sell an underlying asset or

instrument at a specified strike price on or

before a specified date. The seller has the

corresponding obligation to fulfil the

transaction – that is to sell or buy – if the buyer

(owner) "exercises" the option.

Contd...

The buyer pays a premium to the seller for

this right. An option which conveys to the

owner the right to buy something at a

specific price is referred to as a call; an

option which conveys the right of the owner

to sell something at a specific price is

referred to as a put.

Types

1. According to the option rights• Call option• Put option2. According to the underlying assets• equity option• bond option• future option• index option• commodity option

Terminology1. Credit spread - It involves

simultaneously buying and selling (writing) options on the same security/index in the same month, but at different strike prices. (This is also a vertical spread)

2. Debit spread - results when an investor simultaneously buys an option with a higher premium and sells an option with a lower premium. The investor is said to be a net buyer and expects the premiums of the two options

Options Payoffs

A pay off for derivative contracts is the likely

profit/loss that would occur for the market

participant with change in the price of the

underlying asset.

Pricing options

An option buyer has the right but not the

obligation to exercise on the seller. The

worst that can happen to a buyer is the loss

of the premium paid by him.

Pricing stock options

The factors that affect option prices are as

follows:

1- The stock price

2- Time to expiration

3- Volatility

4- Risk free interest rate

5- Dividends

Derivative market in India

Proprietary traders contribute to the major

proportion of trading volumes in the derivative

segment. Foreign Institutional investors and

mutual funds are relatively small players in this

segment and so are corporate clients.

Thank you