Derivatives in general refer to contracts that derive from another - whose value depends on another contract or asset.

Derivatives are essentially devised as a hedging device to insulate a business from risks over which a business has no or little control, but in practice, they are also used as yield-kickers. Where there are risks, there are derivatives to strip the risk and transfer it. As derivatives are essentially devices of transferring risks, their types and applications differ based on the type of risk facing a business. Take, for instance, the following sources of risk and the derivatives to protect a business against such risks:

Interest rate risk: Banks and financial institutions face the risk of changes in interest rates. If a bank has liabilities carrying floating costs and assets having fixed rates, it faces the risk of an adverse movement, that is, a decline in interest rates. This risk can be sheltered by writing an interest rate swap - that is, swapping the floating rate for fixed rates. Associated with interest rate movements is the basis risk, that is risk of unpredicted changes in the basis on which interest rates float. Let us say, a business has loans which are floating with reference to the LIBOR or EURIBOR, whereas the assets of the business are floating with reference to US treasuries. To cushion against this risk, the business may like to swap the basis by entering into a basis swap. Foreign exchange risk: If a business has assets or liabilities denominated in foreign currency, there is a risk of adverse changes in exchange rates. This risk is sheltered by foreign exchange futures or forward covers.

Commodity risks: A business having any position on commodities faces risk of changes in commodity prices. Such risks are also sheltered by futures and forwards in commodities. Risk on capital market instruments: If someone holds equity shares, there is a risk that prices of equity shares will move up or down. To manage this risk, there are various futures and options available. Credit risk: Yet another risk in all financial transactions is credit risk. Credit derivatives are used to hedge against credit risk. Weather risk: Even something like risk of changes in weather is hedged and transferred. There is a variety of weather derivatives, that is, instruments that pay off based on weather changes.

A derivative is a financial instrument that derives its value from an underlying asset. This underlying asset can be stocks, bonds, currency, commodities, metals and even intangible, pseudo assets like stock indices. Derivatives can be of different types like futures, options, swaps, caps, floor, collars etc. The most popular derivative instruments are futures and options. There are newer derivatives that are becoming popular like weather derivatives and natural calamity derivatives. These are used as a hedge against any untoward happenings because of natural causes.

derives its value from an asset: What the phrase means is that the derivative on its own does not have any value. It is considered important because of the importance of the underlying. When we say an Infosys future or an Infosys option, these carry a value only because of the value of Infosys.

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Financials

Derivatives

Commodities

Basic

Complex

Forward s

Futures

Options

Warrants & Convertibl es

Swaps

Exotic (Nonstandard)

Financial derivatives are instruments that derive their value from financial assets. These assets can be stocks, bonds, currency etc. These derivatives can be forward rate agreements, futures, options swaps etc. As stated earlier, the most traded instruments are futures and options.

Derivatives will find use for the following set of people: 1. Speculators: An investor who is willing to take a risk by taking futures position with the expectation to make profits. Usually trade in futures market to earn profit on the basis of difference in spot and future prices of the underlying asset Can be classified in 3 categories: fundamental analyst, technical analyst, & local speculator For example, if you will the stock price of Reliance is expected to go up to Rs.400 in 1 month, one can buy a 1 month future of Reliance at Rs 350 and make profits

2. Hedgers: People who buy or sell to minimize their losses. Use the futures markets for avoiding exposure to adverse movements in the price of the asset. Hedging strategy can be undertaken in all markets like futures, forwards, options, swap, etc with a different modus operandi. For example, an importer has to pay US $ to buy goods and rupee is expected to fall to Rs 50 /$ from Rs 48/$, then the importer can minimize his losses by buying a currency future at Rs 49/$

3.Arbitrageurs: People who buy or sell to make money on price differentials in different markets. Tries to earn riskless profits from discrepancies between futures and spot prices and among different future prices Arbitrage trading helps to make market liquid, ensue accurate pricing and enhance price stability. It involves making profits from relative mis-pricing For example, a futures price is simply the current price plus the interest cost. If there is any change in the interest, it presents an arbitrage opportunity.

By Speculator
Perception Bearish

Bullish

Long Call

Short Put

Long Put

Short Call

By Hedger: If in Cash Market, Long Security That means, bearish in derivatives market i.e. Long Put And Short Call If in Cash Market, Short Security That means bullish in derivatives market i.e. Long Call And Short Put

Derivatives have been a recent development in the Indian financial markets. But there have been derivatives in the commodities market. There is Cotton and Oilseed futures in Mumbai, Soya futures in Bhopal, Pepper futures in Cochin, Coffee futures in Bangalore etc. But the players in these markets are restricted to big farmers and industries, who need these as an input to protect themselves from the vagaries of agriculture sector. Globally too, the first derivatives started with the commodities, way back in 1894. Financial derivatives are a relatively late development, coming into existence only in the 1970s. The first exchange where derivatives were traded is the Chicago Board of Trade (CBOT). In India, the first derivatives were introduced by National Stock Exchange (NSE) in June 2000. The first derivatives were index futures. The index used was Nifty. Option trading was started in June 2001, for index as well as stocks. In November 2001, futures on stocks were allowed. Currently, there are 30 stocks on which derivative trading is allowed.

Insurance is nothing but transfer of risk. An insurance company sells you risk cover and buys your risk and you sell your risk and buy a risk cover. The risk involved in life insurance is the death of the policyholder. The insurance companies bet on your surviving and hence agree to sell a risk cover for some premium. There is a transfer of risk here for a financial cost, i.e. the premium. In this sense, a derivative instrument can be compared to insurance, as there is a transfer of risk at a financial cost.

Derivatives also work well on the concept of mutual insurance. In mutual insurance, two people having opposite risks can enter into a contract and reduce their risk. The most classic example is that of an importer and exporter. An importer buys goods from country A and has to pay in dollars in 3 months. An exporter sells goods to country A and has to receive payment in dollars in 3 months. In case of an importer, the risk is of exchange rate moving up. In case of an exporter, the risk is of exchange rate moving down. They can cover each others risk by entering into a forward rate after 3 months.

Futures Forwards Options Swap

The following are the basic types of derivatives: Forwards: A forward is a contract to buy a thing or security at a prefixed future date. The typical usage of a forward would be something like this: a business having its assets in a local currency has taken a loan repayable in a foreign currency 6 months hence. There is an exchange rate risk here: if the local currency suffers against the foreign currency, the business has to write a loss. To cover against this risk, the business enters into a forward contract - that is, it agrees today to buy the foreign currency 6 months hence at prices prevailing today, against a pre-fixed premium. Obviously, if the perceptions of the seller and the buyer as to future prices of the foreign currency differ, both will strike what they perceive is a win-win deal. Forwards are also quite common in commodities, and can be used either for speculation or for hedging. Say, XYZ has an order to ship 10000 tons of steel 6 months hence at a prefixed price of say USD 1000 per ton. And XYZ expects the price of steel to go up. So, to hedge against the price risk, XYZ enters into a forward purchase agreement, for 10000 tons 6 months hence. XYZ's position is now fully hedged: if the price of steel goes up as expected, XYZ will either claim a delivery from the forward seller, or a net settlement. If the price comes down, XYZ will be obliged to settle by making a payment for the price difference to the forward seller, but will be fully offset by the pre-fixed price it gets from its own forward sale contract.

A forward rate agreement is one in which a buyer and a seller enter into a contract at a specified quantity of an asset at a specified price on a specified date. An example for this is the exporters getting into forward rate agreements on currencies with banks. But there is always a risk of one of the parties defaulting. The buyer may not pay up or the seller may not be able to deliver. There may not be any redressal for the aggrieved party as this is a negotiated contract between two parties.

A future is similar to a forward rate agreement, except that it is not a negotiated contracted but a standard instrument. A future is a contract to buy or sell an asset at a specified future date at a specified price. These contracts are traded on the stock exchanges and it can change many hands before final settlement is made. The advantage of a future is that it eliminates counterparty risk. Since there is an exchange involved in between, and the exchange guarantees each trade, the buyer or seller does not get affected with the opposite party defaulting.

There are two kinds of futures traded in the market- index futures and stock futures. There are three types of futures, based on the tenure. They are 1, 2 or 3 month future. They are also known as near and far futures depending on the tenure.

Futures are traded on a stock Exchange Futures are contracts having standard terms and conditions No default risk as the exchange provides a counter guarantee Exit route is provided because of high liquidity on the stock exchange Highly regulated with strong margining and surveillance systems

Forwards are non tradable, negotiated instruments Forwards are contracts customized by the buyer and seller High risk of default by either party No exit route for these contracts No such systems are present in a forward market.

Futures

Forwards

Spot Price: The current market price of the scrip/index Future Price: The price at which the futures contract trades in the futures market Tenure: The period for which the future is traded Expiry date: The date on which the futures contract will be settled Basis : The difference between the spot price and the future price

As seen earlier, futures are derivative instruments where one can take a position for an asset to be delivered at a future date. But there is also an obligation as the seller has to make delivery and buyer has to take delivery. Options are one better than futures. In option, as the name indicates, gives one party the option to take or make delivery. But this option is given to only one party in the transaction while the other party has an obligation to take or make delivery. The asset can be a stock, bond, index, currency or a commodity But since the other party has an obligation and a risk associated with making good the obligation, he receives a payment for that. This payment is called as premium

The party that had the option or the right to buy/sell enjoys low risk. The cost of this low risk is the premium amount that is paid to the other party. Thus option is a derivative that gives one party a right and the other party an obligation to buy /sell at a specified price for a specified quantity. The buyer of the right is called the option holder. The seller of the right (and buyer of the obligation) is called the option writer. The cost of this transaction is the premium. For example, a railway ticket is an option in daily life. Using the ticket, a passenger has an option to travel. In case he decides not to travel, he can cancel the ticket and get a refund. But he has to pay a cancellation fee, which is analogous to the premium paid in an option contract. The railways, on the other hand, have an obligation to carry the passenger if he decides to travel and refund his money if he decides not to travel. In case the passenger decides to travel, the railways get the ticket fare. In case he does not, they get the cancellation fee. The passenger on the other hand, by booking a ticket, has hedged his position in case he has to travel as anticipated. In case the travel does not materialize, he can get out of the position by canceling the ticket at a cost, which is the cancellation fee.

Call option Put option

The money made in an option is called as the option pay off. There can be two pay off for options, for put and call option Call option: A call option gives the holder a right to buy shares. The option holder will make money if the spot price is higher than the strike price. The pay off assumes that the option holder will buy at the strike price and sell immediately at the spot price. But if the spot price is lower than the strike, the option holder can simply ignore the option. It will be cheaper to buy from the market. The option holder loss is to the extent of premium he has paid. But if the spot price increases dramatically then he can make wind fall profits. Thus the profits for an option holder in a call option is unlimited while losses are capped to the extent of the premium. Conversely, for the writer, the maximum profit he can make is the premium amount. But the losses he can make are unlimited.

Put option The put option gives the right to sell. The option holder will make money if the spot price is lower than the strike price. The pay off assumes that the option holder will buy at spot price and sell at the strike price But if the spot price is higher than the strike, the option holder can simply ignore the option. It will be beneficial to sell to the market. The option holder loss is to the extent of premium he has paid. But if the spot prices falls dramatically then he can make wind fall profits. Thus the profits for an option holder in a put option is unlimited while losses are capped to the extent of the premium. This is a theoretical fallacy as the maximum fall a stock can have is till zero, and hence the profit of a option holder in a put option is capped. Conversely, the maximum profit that an option writer can make in this case is the premium amount. But in the above pay off, we had ignored certain costs like premium and brokerage. These are also important, especially the premium. So, in a call option for the option holder to make money, the spot price has to be more than the strike price plus the premium amount. If the spot is more than the strike price but less than the sum of strike price and premium, the option holder can minimize losses but cannot make profits by exercising the option. Similarly, for a put option, the option holder makes money if spot is less than the strike price less the premium amount. If the spot is less than the strike price but more than the strike price less premium, the option holder can minimize losses but cannot make profits by exercising the option.

If the spot is more than the strike price but less than the sum of strike price and premium, the option holder can minimize losses but cannot make profits by exercising the option. Similarly, for a put option, the option holder makes money if spot is less than the strike price less the premium amount. If the spot is less than the strike price but more than the strike price less premium, the option holder can minimize losses but cannot make profits by exercising the option.

These are universal terminologies and mean the same everywhere. a. Option holder : The buyer of the option who gets the right b. Option writer : The seller of the option who carries the obligation c. Premium: The consideration paid by the buyer for the right d. Exercise price: The price at which the option holder has the right to buy or sell. It is also called as the strike price. e. Call option: The option that gives the holder a right to buy f. Put option : The option that gives the holder a right to sell g. Tenure: The period for which the option is issued h. Expiration date: The date on which the option is to be settled i. American option: These are options that can be exercised at any point till the expiration date j. European option: These are options that can be exercised only on the expiration date k. Covered option: An option that an option writer sells when he has the underlying shares with him.

l.Naked option: An option that an option writer sells when he does not have the underlying shares with him m.In the money: An option is in the money if the option holder is making a profit if the option was exercised immediately n. Out of money: An option is in the money if the option holder is making a loss if the option was exercised immediately o. At the money: An option is in the money if the option holder evens out if the option was exercised immediately

Swaps are arrangements between two counterparts to exchange cash flows over time two basic types are interest-rate swaps currency swaps.

In a swap, both the parties exchange recurring payments with the idea of exchanging one stream of payments for another. A typical usage is a swap of fixed interest rates with floating rates, or rates floating with reference to one basis to another basis. In credit derivatives market, there are swaps based on the total return from a particular credit asset against total return on a reference asset.

1. 2. 3. 4.

Currency swaps are swaps of obligations to pay cash flows in one currency for obligations to pay in another currency Uses: To convert a loan in one currency into a loan in another currency To convert an investment in one currency into an investment in another currency To take the advantage of lower interest rate on a loan To take the advantage of higher interest rate on an investment

A swap in which one party agrees to pay to the another party cash flow a equal to interest at a floating rate on a notional principal for the number of years . To the same time another party agrees to pay to the first party cash flows equal to interest at a fixed rate of interest on the same notional principle for the same period of time.

Caps, floors and collars are essentially options designed to shift the risk of an upward and/or downward movement in variables such as interest rates. These are normally linked to a notional amount and a reference rate. For example, if some one wants to transfer the risk of interest rates going up, one will enter into a cap on a notional amount of say, USD 100 million, with the interest rate of 5.5%. Now if the interest rate increases to 6%, the cap holder will be able to claim a settlement from the cap seller, for the differential rate of 0.5% on the notional amount. If the interest does not go up, or rather declines, the option holder would have paid the premium, and there is no settlement. On the other hand, if some one expects the interest rate to go down which spells a risk to him, he would enter into a floor, which would allow him to claim a settlement if the interest rate falls below a particular strike rate. Interest rate collar is the fixation of both a cap and floor, so that the payment will be triggered if the rate goes above the collar and below the floor.

A swaption is an option on a swap. The option provides the holder with the right to enter into a swap at a specified future date at specified terms. This derivative has characteristics of an option and a swap.

A return from a contract or investment is said to be symmetric when it can either give a profit or incur a loss. Returns from forwards and futures are symmetrical: if you enter into a forward at a particular price, the price might either go up or come down, and so, you might either make a profit or a loss. However, options have an asymmetric return profile: an option is an option with one party. The option will be exercised only when the purchaser of the option is in-the-money. Therefore, the only loss in an option is the cost of writing and carrying the option. Hence, options have an asymmetric return profile. On the other hand, the option-seller only makes returns by way of fees or premium for selling the option, against which he takes the risk of being out-of-money. If the option is not exercised, he makes his fees, but if the option is exercised, he might lose substantially.

The system allows the trading members to enter orders with various conditions attached to them as per their requirements These conditions are broadly divided in to following categoriesTime conditions Price conditions other conditions .

Day Order Good Till cancelled(GTC) Good Till Days/Date(GTD) Immediate or cancelled(IOC)

Stop Loss

Market Price Trigger Price Limit Price Pro CLI