DERIVATIVES

A Financial Instrument that derives its value from an underlying security. In other words, a derivative is a financial instrument that is derived from an underlying asset's value; rather than trade or exchange the asset itself, market participants enter into an agreement to exchange money, assets or some other value at some future date based on the underlying asset. Examples of assets could be anything from bars of gold, to a stock, or even an interest rate. A simple example is a futures contract: an agreement to exchange the underlying asset (or equivalent cash flows) at a future date. The exact terms of the derivative (the payments between the counterparties) depend on, but may or may not exactly correspond to, the behavior or performance of the underlying asset.

Why Derivatives?
The advantage of derivatives are two: leverage and liquidity The uses are three: speculation, hedging and arbitrage.

USAGES Insurance and hedging

One use of derivatives is as a tool to transfer risk. For example, farmers can sell futures contracts on a crop to a speculator before the harvest. The farmer offloads (or hedges) the risk that the price will rise or fall, and the speculator accepts the risk with the possibility of a large reward. The farmer knows for certain the revenue he will get for the crop that he will grow; the speculator will make a profit if the price rises, but also risks a loss if the price falls. It is not uncommon for farmers to walk away smiling when they have lost out in the derivatives market as the result of a hedge. In this case, they have profited from the real market from the sale of their crops. Contrary to popular belief, financial markets are not always a zero-sum game. This is an example of a situation where both parties in a financial markets transaction benefit.

Speculation and arbitrage

Of course, speculators may trade with other speculators as well as with hedgers. In most financial derivatives markets, the value of speculative trading is far higher than the value of true

hedge trading. As well as outright speculation, derivatives traders may also look for arbitrage opportunities between different derivatives on identical or closely related underlying securities. Derivatives such as options, futures, or swaps, generally offer the greatest possible reward for betting on whether the price of an underlying asset will go up or down. Other uses of derivatives are to gain an economic exposure to an underlying security in situations where direct ownership of the underlying is too costly or is prohibited by legal or regulatory restrictions, or to create a synthetic short position. In addition to directional plays (i.e. simply betting on the direction of the underlying security), speculators can use derivatives to place bets on the volatility of the underlying security. This technique is commonly used when speculating with traded options.

Types of Derivatives

Forwards Futures
Options

FORWARDS : A forward contract is an agreement between two parties to buy or sell an asset (which can be of any kind) at a pre-agreed future point in time. Therefore, the trade date and delivery date are separated. It is used to control and hedge risk, for example currency exposure risk (e.g. forward contracts on USD or EUR) or commodity prices (e.g. forward contracts on oil). One party agrees to sell, the other to buy, for a forward price agreed in advance. In a forward transaction, no actual cash changes hands. If the transaction is collaterised, exchange of margin will take place according to a pre-agreed rule or schedule. Otherwise no asset of any kind actually changes hands, until the maturity of the contract. The forward price of such a contract is commonly contrasted with the spot price, which is the price at which the asset changes hands (on the spot date, usually two business days). The difference between the spot and the forward price is the forward premium or forward discount.A standardized forward contract that is traded on an exchange is called a futures contract. The forward price of such a contract is commonly contrasted with the spot price, which is the price at which the asset changes hands (on the spot date, usually two business days). The difference between the spot and the forward price is the forward premium or forward discount.

Futures A standardized forward contract that is traded on an exchange is called a futures

contract.

What It Is:
Futures are financial contracts giving the buyer an obligation to purchase an asset (and the seller an obligation to sell an asset) at a set price at a future point in time. The assets often traded in futures contracts include commodities, stocks, and bonds. Grain, precious metals, electricity, oil, beef, orange juice, and natural gas are traditional examples of commodities, but foreign currencies, emissions credits, bandwidth, and certain financial instruments are also part of today's commodity markets.There are two kinds of futures traders: HEDGERS AND SPECULATORS Hedgers do not usually seek a profit by trading commodities futures but rather seek to stabilize the revenues or costs of their business operations. Their gains or losses are usually offset to some degree by a corresponding loss or gain in the market for the underlying physical commodity. Speculators are usually not interested in taking possession of the underlying assets. They essentially place bets on the future prices of certain commodities. Thus, if you disagree with the consensus that wheat prices are going to fall, you might buy a futures contract. If your prediction is right and wheat prices increase, you could make money by selling the futures contract (which is now worth a lot more) before it expires (this prevents you from having to take delivery of the wheat as well). Speculators are often blamed for big price swings, but they also provide liquidity to the futures market. Futures contracts are standardized, meaning that they specify the underlying commodity's quality, quantity, and delivery so that the prices mean the same thing to everyone in the market. For example, each kind of crude oil (light sweet crude, for example) must meet the same quality specifications so that light sweet crude from one producer is no different from another and the buyer of light sweet crude futures knows exactly what he's getting. Futures exchanges depend on clearing members to manage the payments between buyer and seller. They are usually large banks and financial services companies. Clearing members guarantee each trade and thus require traders to make good-faith deposits (called margins) in order to ensure that the trader has sufficient funds to handle potential losses and will not default

on the trade. The risk borne by clearing members lends further support to the strict quality, quantity, and delivery specifications of futures contracts. REGULATION: The Commodity Futures Trading Commission (CFTC) regulates commodities futures trading through its enforcement of the Commodity Exchange Act of 1974 and the Commodity Futures Modernization Act of 2000. The CFTC works to ensure the competitiveness, efficiency, and integrity of the commodities futures markets and protects against manipulation, abusive trading, and fraud. FUTURES EXCHANGE: There are several futures exchanges. Common ones include The New York Mercantile Exchange, the Chicago Board of Trade, the Chicago Mercantile Exchange, the Chicago Board of Options Exchange, the Chicago Climate Futures Exchange. Why It Matters: Futures are a great way for companies involved in the commodities industries to stabilize their prices and thus their operations and financial performance. Futures give them the ability to "set" prices or costs well in advance, which in turn allows them to plan better, smooth out cash flows, and communicate with shareholders more confidently. Futures trading is a zero-sum game; that is, if somebody makes a million dollars, somebody else loses a million dollars. Because futures contracts can be purchased on margin, meaning that the investor can buy a contract with a partial loan from his or her broker, futures traders have an incredible amount of leverage with which to trade thousands or millions of dollars worth of contracts with very little of their own money. These are similar to forwards in length of time. However, profits and losses are recognized at the close of business daily, Mark-tomarket. Transactions go through a clearinghouse to reduce default risk. 90% of all futures contracts are delivered to someone other than the original buyer.

OPTIONS
Options are types of derivative contracts, including call options and put options, where the future payoffs to the buyer and seller of the contract are determined by the price of another security, such as a common stock. More specifically, a call option is an agreement in which the buyer (holder) has the right (but not the obligation) to exercise by buying an asset at a set price (strike price) on (for a European style option) or not later than (for an American style option) a future

date (the exercise date or expiration); and the seller (writer) has the obligation to honor the terms of the contract. A put option is an agreement in which the buyer has the right (but not the obligation) to exercise by selling an asset at the strike price on or before a future date; and the seller has the obligation to honor the terms of the contract. Since the option gives the buyer a right and the writer an obligation, the buyer pays the option premium to the writer. The buyer is considered to have a long position, and the seller a short position. For every open contract there is a buyer and a seller. An Option is the right, not the obligation to buy or sell an underlying instrument.

OPTION TERMS

Put: the right to sell @ a certain price Call: the right to buy @ a certain price Long: to purchase the option Short: to sell or write the option Bullish: feel the value will increase Bearish: feel the value will decrease
Strike/Exercise Price: Price the option can be bought or sold.

Important terms in options

1. Strike Price - This is the stated price per share for which an underlying stock may be

purchased (for a call) or sold (for a put) upon the exercise of the option contract.
2. Expiry Date - This is the termination date of an option contract. 3. Volume - This indicates the total number of options contracts traded for the day. 4. Bid - This indicates the price someone is willing to pay for the options contract. 5. Ask - This indicates the price at which someone is willing to sell an options contract. 6. Open Interest - This is the number of options contracts that are open; these are contracts

that have neither expired nor been exercised.

7. Underlying Security- An equity option's underlying security is the stock that will change

hands when the option is exercised. An option is classified as a derivative security because its value is derived from the value and characteristics of this underlying stock

8. Unit of Trade- An option's unit of trade (which is sometimes referred to as its contract

size) is simply the number of shares that change hands when its holder chooses to exercise the contract. Generally this unit is a standardized 100 shares of the option's underlying stock.

Opportunities for Investors in Options

1. Flexibility. Options can be used in a wide variety of strategies, from conservative to high-risk, and can be tailored to more expectations than simply "the stock will go up" or "the stock will go down." 2. Leverage. An investor can gain leverage in a stock without committing to a trade. 3. Limited Risk and unlimited returns. Risk is limited to the option premium (except when writing options for a security that is not already owned). 4. Hedging. Options allow investors to protect their positions against price fluctuations when it is not desirable to alter the underlying position. Risks for Investors in Options Trading 1. Costs: The costs of trading options (including both commissions and the bid/ask spread) is significantly higher on a percentage basis than trading the underlying stock, and these costs can drastically eat into any profits. 2. Liquidity: With the vast array of different strike prices available, some will suffer from very low liquidity making trading difficult. 3. Complexity: Options are very complex and require a great deal of observation and maintenance. 4. Time decay: The time-sensitive nature of options leads to the result that most options expire worthless. This only applies to those traders that purchase options - those selling collect the premium but with unlimited risk some option positions, such as writing uncovered options, are accompanied by unlimited risk.

Option are two types ie. calls and put

Calls : A call option is a financial contract between two parties, the buyer and theseller of this
type of option. Often it is simply labeled a "call". The buyer of the option has the right, but not

the obligation to buy an agreed quantity of a particular commodity or financial instrument (the underlying instrument) from the seller of the option at a certain time (the expiration date) for a certain price (the strike price). The seller (or "writer") is obligated to sell the commodity or financial instrument should the buyer so decide. The buyer pays a fee (called a premium) for this right. The buyer of a call option wants the price of the underlying instrument to rise in the future; the

seller either expects that it will not, or is willing to give up some of the upside (profit) from a price rise in return for (a) the premium (paid immediately) plus (b) retaining the opportunity to make a gain up to the strike price (see below for examples). Call options are most profitable for the buyer when the underlying instrument is moving up, making the price of the underlying instrument closer to the strike price. When the price of the underlying instrument surpasses the strike price, the option is said to be "in the money". The initial transaction in this context (buying/selling a call option) is not the supplying of a physical or financial asset (the underlying instrument). Rather it is the granting of the right to buy the underlying asset, in exchange for a fee - the option price or premium. Exact specifications may differ depending on option style. A European call option allows the holder to exercise the option (i.e., to buy) only on the option expiration date. An American call option allows exercise at any time during the life of the option. Call options can be purchased on many financial instruments other than stock in a corporation options can be purchased on futures on interest rates, for example (see interest rate cap) - as well as on commodities such as gold or crude oil. A tradeable call option should not be confused with either Incentive stock options or with a warrant. An incentive stock option, the option to buy stock in a particular company, is a right granted by a corporation to a particular person (typically executives) to purchase treasury stock. When an incentive stock option is exercised, new shares are issued. Incentive stock options are not traded on the open market. In contrast, when a call option is exercised, the underlying asset is transferred from one owner to another.

Buy a call: buyer expects that the price may go up.

Pays a premium that buyer will never get back. Buyer has the right to exercise the option at the strike price.

Write a call: writer receives the premium..

if buyer decides to exercise the option, writer has to sell the stock at the strike price. Example of a call option on a stock: An investor buys a call on a stock with a strike price of 50 and an option expiration date of June 16, 2006 and pays a premium of 5 for this call option. The current price is 40. Assume that the share price (the spot price) rises, and is 60 on the strike date. The investor would exercise the option (i.e., buy the share from the counter-party), and could then hold the share, or sell it in the open market for 60. The profit would be 10 minus the fee paid for the option, 5, for a net profit of 5. The investor has thus doubled his money, having paid 5 and ending up with 10. If however the share price never rises to 50 (that is, it stays below the strike price) up through the exercise date, then the option would expire as worthless. The investor loses the premium of 5. Thus, in any case, the loss is limited to the fee (premium) initially paid to purchase the stock, while the potential gain is theoretically unlimited (consider if the share price rose to 100).From the viewpoint of the seller, if the seller thinks the stock is a good one, (s)he is better (in this case) by selling the call option, should the stock in fact rise. However, the strike price (in this case, 50) limits the seller's profit. In this case, the seller does realize the profit up to the strike price (that is, the 10 rise in price, from 40 to 50, belongs entirely to the seller of the call option), but the increase in the stock price thereafter goes entirely to the buyer of the call option. Prior to exercise, the option value, and therefore price, varies with the underlying price and with time. The call price must reflect the "likelihood" or chance of the option "finishing in-themoney". The price should thus be higher with more time to expiry (except in cases when a significant dividend is present) and with a more volatile underlying instrument. The buyer and seller must agree on the initial value (the premium), otherwise the exchange (buy/sell) of the option will not take place.(Option Premium)

Fig.3.4 call option graph

Buying a call option : This is a graphical interpretation of the payoffs and profits generated by a call option as seen by the buyer. A higher stock price means a higher profit. Eventually, the price of the underlying security will be high enough to fully compensate for the price of the option.

fig.3.5 call option graph

Writing a call option - This is a graphical interpretation of the payoffs and profits generated
by a call option as seen by the writer of the option. Profit is maximized when the strike price exceeds the price of the underlying security, because the option expires worthless and the writer keeps the premium.

Long a call. Person buys the right (a contract) to buy an asset at a cretin price. They feel that
the price in the future will exceed the strike price. This is a Bullish position.

Short a Call. Person sells the right (a contract) to someone that allows them to buy a asset at a
cretin price. The writer feels that the asset will devalue over the time period of the contract. This person is Bearish on that asset.

PUTS : A put option (sometimes simply called a "put") is a financial contract between two
parties, the buyer and the writer (seller) of the option. The put allows the buyer the right but not the obligation to sell a commodity or financial instrument (the underlying instrument) to the writer (seller) of the option at a certain time for a certain price (the strike price). The writer (seller) has the obligation to purchase the underlying asset at that strike price, if the buyer exercises the option. Note:That the writer of the option is agreeing to buy the underlying asset if the buyer exercises the option. In exchange for having this option, the buyer pays the writer (seller) a fee (the premium). (Note: Although option writers are frequently referred to as sellers, because they initially sell the option that they create, thus taking a short position in the option, they are not the only sellers. An option holder can also sell his long position in the option. However, the difference between the two sellers is that the option writer takes on the legal obligation to buy the underlying asset at the strike price, whereas the option holder is merely selling his long position, and is not contractually obligated by the sold option.) Exact specifications may differ depending on option style. A European put option allows the holder to exercise the put option for a short period of time right before expiration. An American put option allows exercise at any time during the life of the option. The most widely-known put option is for stock in a particular company. However, options are traded on many other assets: financial - such as interest rates (see interest rate floor) - and physical, such as gold or crude oil. The put buyer either believes its likely the price of the underlying asset will fall by the exercise date, or hopes to protect a long position in the asset. The advantage of buying a put over shorting the asset is that the risk is limited to the premium. The put writer does not believe the price of the

underlying security is likely to fall. The writer sells the put to collect the premium. Puts can also be used to limit portfolio risk, and may be part of an option spread

Buy a Put: Buyer thinks price of a stock will decrease.

Pay a premium which buyer will never get back. The buyer has the right to sell the at strike price.

Write a put: Writer receives a premium, if buyer exercises the Option, writer will buy the
stock at strike price, If buyer does not exercise the option, Writers profit is premium

Example of a put option on a stock I purchase a put contract to sell 100 shares of XYZ Corp. for 50. The current price is 55, and I pay a premium of 5. If the price of XYZ stock falls to 40 per share right before expiration, then I can exercise my put by buying 100 shares for 4,000, then selling it to a put writer for 5,000. My total profit would equal 500 (5,000 from put writer - 4,000 for buying the stock - 500 for buying the put contract of 100 shares at 5 per share, excluding commissions). If, however, the share price never drops below the strike price (in this case, 50), then I would not exercise the option. (Why sell a stock to someone at 50, the strike price, if it would cost me more than that to buy it?) My option would be worthless and I would have lost my whole investment, the fee (premium) for the option contract, 500 (5 per share, 100 shares per contract). My total loss is limited to the cost of the put premium plus the sales commission to buy it. This example illustrates that the put option has positive monetary value when the underlying instrument has a spot price (S) below the strike price (K). Prior to exercise, the option value, and therefore price, varies with the underlying price and with time. The put price must reflect the "likelihood" or chance of the option "finishing in-themoney". The price should thus be higher with more time to expiry, and with a more volatile underlying instrument. The buyer and seller must agree on this value initially.

Buying a put option - This is a graphical interpretation of the payoffs and profits generated
by a put option as seen by the buyer of the option. A lower stock price means a higher profit.

Eventually, the price of the underlying security will be low enough to fully compensate for the price of the option.

fig.3.6 :buy option graph

Writing a put option - This is a graphical interpretation of the payoffs and profits generated
by a put option as seen by the writer of the option. Profit is maximized when the price of the underlying security exceeds the strike price, because the option expires worthless and the writer keeps the premium. Long a Put. Buy the right to sell an asset at a pre-determined price. You feel that the asset will devalue over the time of the contract. Therefore you can sell the asset at a higher price than is the current market value. This is a bearish position.

Short a Put. Sell the right to someone else. This will allow them to sell the asset at a specific
price. They feel the price will go down and you do not. This is a bullish position.

What is the difference between a futures contract and a contract

forward

Both a futures contract and a forward contract are used to hedge investments. They trade securities, currencies, or commodities contracts that settle on a future date. Since the trading is of contracts and not the actual instruments these trades are referred to as derivative trading. In the confusing world of derivative trading it is important to know exactly what you are investing in and how. Although very similar a futures contract and a forward contract have some distinct differences.A futures contract is a type of financial contract where two

parties come to an agreement on a future transaction. The buyer of the futures contract agrees to buy a commodity at a certain future date for a specific price. Most futures contracts do not actually end with a transfer of the physical commodity. Futures contracts, like most derivatives, are often used to hedge an investment. The accounts are settled daily in the cash market. The potential for gain is virtually unlimited but so is the potential for loss. For example, suppose you believe that this year Hawaii will produce a poor crop of coffee. Currently on the commodities market coffee is trading at 5 dollars a pound. You agree to buy 1000 pounds of coffee in two months at 5 dollars a pound, 5000 dollars. The coffee grower agrees to sell you those 1000 pounds in two months. Fifteen days later ideal conditions lead investors to believe there will be a bumper crop, the price of coffee drops. What happened? You agreed to buy at 5 dollars; coffee is now trading at 3 dollars. Your account, which is settled daily, has been debited 2 dollars a pound, 2000 dollars. You could call it quits and settle, loosing the 2000 dollars or you could await the end of the contract and hope a hurricane comes and ruins the crop driving up prices. A forward contract is very similar. It allows for a buyer to contract to buy at a later date at a specific price. In contrast, however, the forward contract is not traded on an exchange, which means that it is not settled in cash daily. Returning to our example, on that fifteenth day you, the buyer, would not see a decline in your cash account of 2000 dollars. You would simply be anxiously hoping for a recovery of the price of coffee so that on day 30 you can make a profit.Futures are common in the FOREX market where companies and organizations use currency futures to hedge against the change in a currencies value. For example, if you have agreed to accept payment in Yen on a day two months in the future you may purchase a future contract on the Japanese Yen. You would want to be guaranteed that you could sell those Yen for a specific USD amount. Whether the value of the Yen rises or falls you now have the guarantee that you will not make any less than the value of your contract.Commodity futures trading and forward contracts can be very risky. The assistance of commodity futures brokers can be invaluable. Commodity trading using futures and forwards are not for novice investors.

BSE SENSEX 30 FUTURE HOW TO PURCHASES

Step 1 You feel that the Sensex will close at 5000 on the last Thursday of July (all the contracts whether for one month, two month or three month expire on the last Thursday of the month) for the one month contract. Then, you have to choose the minimum quantity of transaction akin to market lot in the spot market. In the case of the Sensex, it is fixed at 50 times the index. In other words, you are required to buy a minimum of 50 contracts of Sensex futures.

Step 2 At this stage, you have to calculate what is called the Tick size which is nothing but the minimum movement of the Sensex futures. This is taken at 0.1 percent which is equivalent to Rs.5. That is to say, the price of each contract is Rs.5. Step 3 You decide to buy 50 July contracts of Sensex futures. With the Sensex futures for July pegged at 5000, your contract value is Rs.12.5 lacks (5000 x 50 (contracts) x Rs.5) Step 4 You are not required to pay the entire money now as all that is needed from you is the initial margin which is fixed at 5 percent. i.e., Rs.62,500 on the total value of the contract of Rs.12.5 lacks. Step 5 On the next trading day, if the Sensex rises to 5200, your July futures contract will have gained 200 points and you will have made a profit of Rs.50, 000 (200 x 50 x 5) which the seller will pay you. On the other hand, if the Sensex falls by a similar margin, you are obliged to pay the seller a similar sum. Step 6 This kind of transaction can be undertaken on a daily basis till the July contract expires. Alternatively, you can carry on in this fashion till the final settlement is done. Step 7 When the final settlement falls due, one fact must be borne in mind. On this day, the actual Sensex is related to the Sensex futures of the preceding day, which is the last Thursday of July. Even if the actual Sensex is at 5400 while the Sensex futures is fixed at 5200, you stand to gain Rs.50, 000 (200 x 50 x 5), this being the sum payable by the seller