Derivatives

Dr Roshna Varghese

Outline of the lectures

Session 1
Investment and securities Introduction to Derivatives Options

Session 2
Futures Stock , Commodity, currency futures

Session 3
Swaps Stock exchange regulations

Investment
Investment is a commitment of funds made in the expectation of some positive rate of return. Investment
Savings, , if Income > expenditure Expectation of return Tangible Asset Physical ass- E.g. Land, machinery, work of art Dealt in product market Intangible Asset Financial Assets - shares, bonds, derivatives, mutual funds, Dealt in Financial market

Characteristics of investment
Return Risk Marketability Safety

Investment Avenues
Corporate Securities
Equity shares Preference shares Debentures/Bonds GDRs/ADRs

Derivatives Govt and semi govt Securities Money market instruments Mutual fund schemes Deposits in banks and non banking companies Post office Savings/Life insurance policies Provident fund schemes Real assets Real estate, precious objects

Securities
Definition of Security Securities include shares, bonds, debentures or other marketable securities like securities of incorporated companies or other body corporates or government.

Securities Contract Regulation Act 1956

Securities Market
Money Market
Debt instruments having a maturity of less than one year are dealt in money market. T- bill market, Ready forward contracts (Repo) market, Call money market, Commercial Paper market

Capital Market
Securities with maturities of more than one year are bought and sold in the capital market. Equity Market; Debt Market ; Derivatives market Primary or Secondary market

Derivatives

Derivatives
Instruments that derive value from underlying assets. Changes in price of the underlying asset affect the price of the derivative security.

Derivatives Underlying assets

Commodities
including grain, coffee .. Precious metal like gold and silver

Securities
stock, Bonds and other debt instruments

Foreign Exchange rate Interest rate Index of prices Weather, .

Types of Derivatives
Options Futures Complex Derivatives
Swaps Credit Derivatives

Derivatives permitted in India

Derivatives

Equity

Debt

Forex

Commoditi es

Index futures & Options Single stock options & futures

Interest rate futures & forwards Interest rate swaps

Currency futures Currency options Forwards Cross currency swaps

Forwards Futures

What are futures and options?

A contract to make or take delivery of a product in the future, at a price set in the present In formalized futures and options trading on exchanges, standardized agreements specify price, quantity, and month of delivery Started in agriculture, but have expanded to a wide range of products

Derivatives - History
Not a modern invention
First option transaction by Greek Philosopher Thales from Miletus (624 BC 546 BC) Evolved from commodity markets

Establishment of Chicago Board of Trade (CBoT) in 1848 Publication of Black Scholes Option pricing model in 1973 In India
First organised futures market in 1875 in Bombay After independence, prohibited derivatives trading Reintroduction in 2000

Options
Option is the right to either buy or sell something, at a specified price within a specified period of time.

Is a contract in which the writer of the option grants the buyer of the option the right to purchase from or sell to the writer a designated instrument at a specific price within a specified period of time.

Options
The writer grants the right to the buyer for a certain sum of money option premium. The price at which the buyer can exercise the option Exercise price/ strike price/ striking price. Call option & Put option American option and European Option

Call option & Put option

Call option :
An option that grants the buyer the right to purchase a designated instrument.

Put option :
An option that grants the buyer the right to sell the designated instrument.

Options Terminology American option & European option American option :

can be exercised on or before the expiration date.

European option :
can be exercised only on the expiration date.

Return and risk of Buyer and seller of Option contract

Seller has an obligation and buyer has a right in option agreement Buyer
Limited amount of risk (max loss is premium paid) Return (profit) potential in unlimited

Seller
Unlimited risk Limited return potential

Options Underlying Assets

Financial options
Stock Indices Treasury Bonds, debentures Forex rate

Commodity options
Agricultural commodities Industrial commodities

In India, option trading in all commodities is prohibited by Forwards Contracts (Regulation) Act, 1952

A std option contract : allows the buyer to buy or sell . shares of stock at a specific price. Call option & Put option Expiration date : date on which the option contract expires. Exercise price / Striking price Premium : Synonymous with price

` `

Buyer (holder). original seller is called writer. Seller is not the same as writer for an existing option. Option Buyer is in Long position Option Writers is in short position Writing calls covered : Writing call options against the shares owned by the writer Uncovered call options : Writing call options without owning the underlying shares.

At any time

, option maybe: Call ExP = MP ExP < MP ExP > MP Put ExP = MP ExP > MP ExP < MP

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At the money : In the money : Out of the money:

Why buy options

A Call option is cheaper than the underlying shares. Buying a call rather than shares will reduce the his profit by the amount of premium if the share price advances, but it will limit his loss to the amount of the premium if it declines. Put option is used for by the buyer as safer way of betting on decline in stock price.

Why buy options

Expiration / Exercise Price April /15 April /20 April/25 Price of option (premium) 7 2 0.5 Stock price

21 21 21

Why sell options

Sold by conservative investors who want additional income. Earn premium

Payoff Diagram on a Call

Net Payoff On a call

Strike Price

Price of underlying asset

Payoff Diagram on Put Option

Net Payoff On Put

Strike Price

Price of underlying asset

Trading in derivatives
Trading in options on index and stocks commenced on NSE and BSE in 2001 Currency options in NSE and USE in October 2010

Financial Options
Single stock options
Trading in options on individual securities commenced from July , 2001. Option contracts are European style and cash settled and are available on 223 securities stipulated by the Securities & Exchange Board of India (SEBI). The value of the option contracts on individual securities may not be less than Rs. 2 lakhs at the time of introduction for the first time at any exchange Options contracts expire on the last Thursday of the expiry month.
If the last Thursday is a trading holiday, the contracts expire on the previous trading day.

Financial Options
Index Options
NSE introduced trading in index options on June 4, 2001. The options contracts are European style and cash settled The value of the option contracts on Nifty may not be less than Rs. 2 lakhs at the time of introduction Nifty Index contract multiplier is 100 BSE Senses contract multiplier is 50

Trading cycle
S&P CNX Nifty options contracts have
3 consecutive monthly contracts On expiry of the near month contract, new contracts (monthly/quarterly/ half yearly contracts as applicable) are introduced at new strike prices for both call and put options, on the trading day following the expiry of the near month contract.

ET Reading - Options

ET reading of options
Open interest
Number of outstanding contracts at a particular point of time, typically at the end of the trading day. Total no of long positions will always be equal to the total number of short positions, only one side of the contract will be counted

Contracts

Determinants of option value

Determining factors 1 Current stock price 2 Striking price 3 Time to expiration 4 Stock volatility 5 Interest rates 6 Cash dividends
Effect of increase holding others constant
Put Call

Decreases Increases Increases Increases Decreases Increases

Increases Decreases Increases Increases Increases Decreases

Option value
Rate of change in option price due to change in price of the underlying asset is known as Delta. Rate of change in option price due to time left to expiration is known as Theta. Rate of change in option price due to change in volatility of the underlying asset is known as Vega. Rate of change in option price due to change in interest rate is known as Rho.

Option Pricing Black Scholes Option Pricing Model

By Black and Scholes in 1973. Pc = Ps N(d1) Pe e-rT N (d2)

Pc = Market value of the call option Ps = Current market price of the underlying asset N(d1) & N(d2) = cumulative normal distribution function of d1 and d2 respectively. Pe = Exercise price, e = Exponential constant 2.71828 r = Risk free interest rate, T = Time to expiration (in years) d1 = [ln (Ps/Pe) + (r + 0.5 2)T] / T d2 = d1 ( T)

Black Scholes Option Pricing Model Assumptions

The stock underlying the call option provides no dividends during the option s life. There are no transaction costs involved in buying and selling the option. The risk free interest is assumed to be constant during the life of the option. The call option can be exercised only on its expiration date. The movement of stock prices is taken to be random.

Combinations of Put and Call Options or Option Strategies

Straddle Strip Strap Strangle Spread

Options Strategies Straddle

A straddle is a put and a call option on the same security at the same exercise price and for the same time period.

Also called double option or put- and- call option.

Options Strategies Strip

A strip is two puts and one call at the same exercise price for the same period. Buyer of a strip believes that the security s price is more likely to fall than to rise.

Options Strategies Strap

A strap is two calls and one put at the same contracted exercise price and for the same period.

Buyer of a strap believes that the security s price is more likely to rise than to fall.

Options Strategies -Strangle

Buying a put and a call option with the same expiration date but with different exercise prices. Profit can be made if stock price is lower than price of put or stock price exceeds price of call.

Options Strategies Spread

A spread means combining 2 or more call options (or 2 or more put options) on the same stock with different exercise prices or different expiration dates. Time spread : options have same exercise price but different expiration dates. Price spread : Expiration date same, Exercise prices different

Futures

Futures
A futures is a firm legal commitment between a buyer and a seller in which they agree to exchange something at a specified price at the end of a designated period of time. Exchange traded futures are standardized as to quantity, quality, time and place of delivery.

Features - Futures
All futures contracts are traded on the futures (derivatives) section of the stock exchange and commodity exchanges.

The futures contract will be settled at the prevailing spot price of the asset
Although these contracts cannot be liquidated before their expiry date, you can sell them on the exchange.
In other words, a futures contract is bought and sold regularly on the market till its expiry.

Types of Futures
Financial futures
A futures contract in a financial instrument like equity shares, stock market indices, debt securities or foreign currencies.

Stock futures Index futures Currency futures Interest rate futures

Commodity Futures
Agro based commodities Industry based commodities

Pricing a futures contract

The fair price of futures contracts depends upon the spot price and the cost of carry. Cost of carry is the sum of all costs that you would have to bear if you purchased the underlying asset now from the stock market and held on to it until the time of maturity of the futures contract, less any dividends received in this period. The cost typically includes interest costs. Example: Suppose you purchased stock futures of Company ABC when its price was Rs 1,000. Let's assume that no dividends are expected and that the one-month cost of carry is 1.5 per cent. The fair price for Company ABC's stock futures contract that expires after a month is Rs 1,015 (the current price plus interest). Apart from the theoretical value, the actual value may vary depending on the present demand and supply of the underlying asset and expectations about the future.

Futures Terminology
The basis
The difference between the price of the underlying asset in the spot market and futures market is known as the basis.
Although both these prices generally move in line with each other, the basis is not constant. Generally, the basis will decrease with time and on expiry, the basis will become zero and the price of the underlying asset in both the markets will become the same.

Futures Terminology
Contango and Backwardation

Under normal market conditions, the price of the underlying asset in the futures market exceeds its price in the spot market. This is known as the 'Contango Market'. The reverse situation is called 'Backwardation'.

Types of Futures
Financial futures
A futures contract in a financial instrument like equity shares, stock market indices, debt securities or foreign currencies.

Stock futures Index futures Currency futures Interest rate futures

Commodity Futures
Agro based commodities Industry based commodities

Stock and Index futures

There are two kinds of actively traded futures - index futures and stock futures. Index futures are derivative contracts, which have the index value (NSE Nifty, the BSE Sensex, etc.) as the underlying asset. Stock futures are derivative contracts that have an equity share as the underlying asset. Each index/stock future contract has a 'market lot' or a certain pre-determined number of index units/shares that constitute one contract. Both these derivative products work in the same manner. The only difference is the underlying asset.

Futures on individual stocks

Introduced in India in 2001. List of securities permitted as specified by SEBI. 3 month trading cycle.

Working of a futures contract Example of buying a futures contract

You expect the price of Company ABC to move up from the present level of Rs 100 to Rs 150 in the cash market. To profit from such a scenario, you buy a futures contract of Company ABC. The futures contract will be settled at the prevailing spot price of the shares of Company ABC in the cash market at the time of expiry of the contract. That there is no delivery of shares that take place. Presently, the futures contract (1 future contract =100 shares) of Company ABC is quoting at Rs 12,000 in the futures market. This means 1 share of Company ABC is valued at Rs 120 in the futures market. The share is valued at a higher price in the futures market (vis--vis the cash market) because it includes the cost of carry and also accounts for the market sentiment.

Example of buying a futures contract

If the share price of Company ABC reaches Rs 150 in the cash market on expiry of the contract, your futures contract will be settled at Rs 15,000 (spot price in cash market of Rs 150 x 100 shares). Your profit would be Rs 3,000 (futures contract value at the time of settlement i.e. Rs 15,000 - futures contract value at the time of purchase i.e. Rs 12,000). In any case, you will earn profit on the futures contract on shares of Company ABC if the price of the share at the time of expiry in the cash market is above your cost price of Rs 120. However, if the price of Company ABC is below your cost of Rs 120 per share at the time of expiry of the futures contract, you have incurred a loss on the Contract.

Example of selling a futures contract

You expect the price of Company ABC to fall from the present value of Rs 100 to Rs 70 in the cash market. To profit from such a scenario, you sell a futures contract of Company ABC. The futures contract will be settled at the prevailing spot price of the shares of Company ABC in the cash market at the time of expiry of the contract. Keep in mind though, that there is no delivery of shares that take place. Presently, the futures contract (1 future contract = 100 shares) of Company ABC is quoting at Rs 10,500 in the futures market. This means that 1 share of Company ABC is valued at Rs 105 in the futures market. The share is valued at a higher price in the futures market (vis--vis the cash market) because it includes the cost of carry and also accounts for the market sentiment.

Example of selling a futures contract (contd.)

If the share price of Company ABC reaches Rs 70 in the cash market on expiry of the contract, your futures contract will be settled at Rs 7,000 (spot price in cash market of Rs 70 x 100 shares). Your profit would be Rs 3,500 (futures contract value at the time of sale i.e. Rs 10,500 - futures contract value at the time of settlement i.e. Rs 7,000). On settlement, your broker will refund your margin after reducing relevant charges and pay you your profit. In any case, you will earn profit on the futures contract on shares of Company ABC if the price of the share at the time of expiry in the cash market is below your selling price of Rs 105. However, if the price of Company ABC is above your selling price of Rs 105 per share at the time of expiry of the futures contract, you have incurred a loss on the contract.

When to buy and sell a futures contract?

If you expect the price of the underlying asset to rise in the cash market, you could buy a futures contract on that underlying asset. If you expect the price of the underlying asset to fall in the cash market, you could sell a futures contract on that underlying asset.

Stock Index futures

A stock index future is an obligation to deliver at settlement an amount of cash equal to a certain times the difference between the stock index value at the last trading day of the contract and the price at which the futures contract was originally struck. (Buyer gets money if the index moves up and buyer has to give money to seller if the index moves down). Index futures are settled in cash NSE S&P CNX Nifty Futures, BSE Sensex Futures

Futures vs Options
Futures Options
1. In case of options the buyer enjoys 1. In case of futures, both the the right and not the obligation, to buyer and seller are buy or sell the underlying asset. obligated to buy/sell the 2. In case of options, the buyer faces underlying asset. a limited amount of risk (extent of 2. In case of futures contracts, premium paid) while the seller i.e. both the parties - the buyer the option writer, faces unlimited and the seller -face the same risk. level of risk. 3. The prices of options are 3. Futures contract prices are affected by the prices of the affected mainly by the prices underlying asset, time remaining of the underlying asset in the for expiry of the contract and cash market. volatility of the underlying asset.

Trading in derivatives
Trading in index futures began on NSE and BSE in 2000 Trading on single stock futures began on NSE and BSE in 2002 Introduction of interest rate futures on NSE and commodity futures in 2003 Currency futures was launched in NSE, BSE and MCX in August 2008

Other Types of futures

Financial Derivatives
Foreign currency futures :
Futures contract in foreign currencies.

Interest rate futures :

Futures on interest bearing securities like bills, bonds and debentures.
Treasury bill futures 10 year bonds futures

Commodity Futures

Currency futures
Agreement between two parties to exchange one currency for another at a specified date in future in an exchange rate being fixed at the time the agreement is entered into. Currency Futures are standard contracts of a specified quantity to exchange one currency for another at a specified date in the future called settlement date at a price that is fixed on the purchase date called futures price.

Currency futures in Indian stock exchanges

`

Currency futures was launched in NSE, BSE and MCX in August 2008
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Only US Dollar ($) futures is being traded against the Indian Rupee (INR) when introduced in Aug 2008. The contract for say the month of September will be called USDSEP2010.

RBI allowed futures trading in three more currencies the euro, the pound sterling and the yen - in Jan 2010. There are 12 near calendar months contract available for trading.

USD/INR - Quote/trade
On BSE-CDX, the underlying value is the rate of exchange between one unit of foreign currency and Indian Rupee. USD is the base currency and the variable currency is INR. One unit of USD (One Dollar) is priced in terms of INR. E.g. 1USD = INR 48.8525/8550 The minimum Lot Size/Contract Size is USD 1,000 (and in multiples of USD 1,000 thereafter).

Buying currency futures

Importer, one who has to pay in dollars on 31.03.11 Risk Rupee depreciation (50/$ becomes 55/$) Eg :X has a payment obligation of 1,000 USD on Mar 2011 . Buy a currency futures to buy 1000 USD at 1USD = INR 50 (i) On the settlement date, if spot rate is Rs 55 his gain Rs 5,000. (ii) If spot rate is Rs 45, his loss will be Rs 5,000.

Selling currency futures

Exporter/ one who will get certain amount in dollars Risk Rupee appreciation (50/$ becomes 45/$) Eg : X is expecting a receipt of 1,000 USD on Mar 2009. Sell a currency futures 1,000 USD at 1USD = INR 50 (i) On the settlement date, if spot rate is Rs 45 his gain Rs 5,000. (ii) If spot rate is Rs 55, his loss will be Rs 5,000.

BSE and currency derivatives

For providing state-of-the-art infrastructure and trading base for Currency derivatives, BSE has strategically partnered with United Stock Exchange of India Ltd. (USE), India s newest stock exchange. USE represents the commitment of ALL 21 Indian public sector banks, prestigious private banks and elite corporate houses to build an institution that symbolizes India s modern financial markets.

Interest Rate futures

An interest rate futures contract is an agreement to buy or sell a package of debt instruments at a specified future date at a price that is fixed today. The underlying assets of an interest rate futures contract are different interest bearing instruments like Treasury Notes, Treasury Bills, Treasury Bonds, deposits and so on.

Interest rate futures

The maturity: one to three months contracts. The underlying:
the 10 year bonds and the 91-day Treasury bill.

The mode of settlement:

cash settlement w.r.t. the price of the bonds prevailing on expiration date.

Example
On 1/1/2011, 10-year bond was priced at Rs.95.43. Lot size 2,000 You believe the interest rate will go up, so you sell three futures contracts (6,000 bonds) @ Rs.98. On 31/1/2011, the 10-year bond is at Rs.88. You have a profit of Rs.10/bond or Rs.60,000 overall.

Example 2
On January 2011, 10-year bond was at Rs.92. March futures were trading at Rs.93. You thought interest rates would go down, so you purchased two futures contracts (4000 bonds) @ Rs.93. Interest rates went up! On expiration, the bond was at Rs. 83. A loss of Rs.40,000.

Commodity Futures
Commodity futures contract is a contractual agreement between two parties to buy or sell a specified quantity and quality of commodity at a certain time in future at a certain price agreed at the time of entering into the contract on the commodity exchange. The kinds of commodities being traded are:
Agriculture based commodities such as rice, wheat, sugar, Soybean, soya Oil, Chana, Palm Oil, Jeerra, Pepper, Turmeric, Chilli, Cardamon, Guar Gum, Guar Seed, Mentha Oil, RM seed. Mineral-based commodities such as gold, platinum, aluminum, copper, zinc, etc Energy Crude oil etc

Commodity Exchanges
Globally
New York Mercantile Exchange (NYMEX) Chicago Board of Trade (CBOT) Chicago Mercantile Exchange (CME) London Metal Exchange (LME)

In India
Multi Commodity Exchange of India (MCX) (2003), Mumbai National Commodity and Derivative Exchange (NCDEX) (2003), Mumbai National Multi Commodity Exchange of India (NMCE), (2003) Indian Commodity Exchange (ICEX)

Commodity Future contracts e.g.

Cotton
COTJ34BTD is Cotton J34 grade Bhatinda location COTLSCKDI is Long Staple Cotton grade Kadi location.

Rubber
FUT-RBRRS4KTM-20-Jan-2006

Cash Versus Physical Settlement

Cash or physical delivery depends on the intention of buyer & seller and varies on the type of contracts. On the expiry day, the contracts are cash settled.
Participants square off their positions before maturity.

Further, in respect of physical delivery, the exchange offers three types of delivery options viz. Seller's option for delivery, Compulsory delivery and Intention Matching option for delivery.

Forwards
FCRA defines forward contract as a contract for the delivery of goods and which is not a ready delivery contract Ready delivery contract is one which provides for delivery of goods and payment of price either immediately or within such period not exceeding 11 days after the date of the contract. Requires physical delivery of goods.

Forwards vs Futures
Feature Deals are done on Price risk Futures Organised exchanges Eliminated Forwards OTC market Eliminated Present Low Customised (negotiable)

Performance/credit Eliminated risk Liquidity Generally high

Terms & conditions, viz. contract size, Standardised delivery date

ET Reading - Futures

Session 3
MARGIN REQUIREMENTS; TYPES OF ORDERS; WEATHER & ELECTRICITY DERIVATIVES; SWAPS

Futures trading Margin Requirements

Initial Margin Maintenance margin Mark to Market Margin (MTM)

Margin Requirements
Initial Margin:
The margin that is required to be deposited to the clearing house of the exchange at the time of entering into the contract. A certain percentage of the contract value. Based on SPAN (Standard Portfolio Analysis of Risk)

Maintenance margin :
If margin money is reduced below the maintenance level, the member is expected to bring in additional amount and restore the margin at least to the initial level.

Margin Requirements
Marking to market :
The process of revaluing the contract based on the ruling price of the contracts is known as marking to market. With reference to the closing price of the underlying stock.

Margins - E.g.
For an options contract the initial margin and maintenance margin prescribed be Rs 4,000 and 3,000 respectively. Future price 75 Share price: Day 1 Rs 74 Day 2 Rs 73 Day 3 Rs 72 Day 4 Rs 76

Margins - Eg
Future price Rs 75 Contact value 7500

Particulars Share price Contract value Margin money a/c of Buyer 1 opening balance 2 Amt to be adjusted 3. Adjusted Balance 5 Closing balance Margin money a/c of seller 1 opening balance 2 Amt to be adjusted 3. Adjusted Balance 5 Closing balance

Day 1 74 7400 4,000 - 1000 3,000 3,000 4,000 1000 5,000 4,000

Day 2 72 7,200 3,000 -2,000 1,000 3,000 4,000 4,000 2,000 6,000 -2,000 4,000

Day 3 73 7,200 4,000 1,000 5,000 -1,000 4,000 4,000 -1,000 3,000 --3,000

Day 4 76 7,600 4,000 3,000 7,000 -3,000 4,000 3,000 -3,000 --4,000 4,000

4 Amt deposited/withdrawn -

4 Amt deposited/withdrawn -1,000

An order in a market is an instruction from customers to brokers to buy or sell on the exchange.

Types of orders
Market order Limit order Stop loss order Time order
Good till day Good till date Good till cancelled

Types of Orders
Market order
is a buy or sell order to be executed immediately at current market prices. The order is filled at the best price available at the relevant time.

Limit order
is an order to buy a security at not more, or sell at not less, than a specific price. A buy limit order can only be executed at the limit price or lower; A sell limit order can only be executed at the limit price or higher.

Stop loss order (Stop order)

is an order to buy (or sell) a security once the price of the security has climbed above (or dropped below) a specified stop price.

Types of Orders
Time order
Good till day
order that is in force from the time the order is submitted to the end of the day's trading session

Good till date

Order that is in force till a specific date mentioned

Good till cancelled

order requires a specific cancelling order. It can persist indefinitely (although brokers may set some limits, for example, 90 days).

Weather derivatives
Weather derivatives are financial instruments
to reduce risk associated with adverse or unexpected weather conditions. the underlying asset (rain/temperature/snow) has no direct value to price the weather derivative.

Players
Farmers can use - to hedge against poor harvests caused by drought or frost; theme parks -to insure against rainy weekends during peak summer seasons; and power companies A sports event managing company - to hedge the loss because if it rains the day of the sporting event, fewer tickets will be sold.

Weather derivatives
Chicago Mercantile Exchange introduced the first exchange-traded weather futures ( & options), in 1999 Heating Degree Days (HDD) or Cooling Degree Days (CDD) contracts Weather contracts on U.S. cities for the winter months are tied to an index of heating degree day (HDD) values. These values represent temperatures for days on which energy is used for heating. The contracts for U.S. cities in the summer months are geared to an index of cooling degree day (CDD) values, which represent temperatures for days on which energy is used for air conditioning. Both HDD and CDD values are calculated according to how many degrees a day's average temperature varies from a baseline of 65 Fahrenheit.

Weather derivatives
The baseline temperature is fixed; it is 65o Fahrenheit in the U.S and 18o Celsius in Europe. The Earth Satellite Corporation, an independent entity, calculates HDD and CDD index ensuring transparency and independence in the benchmark.

Weather derivatives
Measuring Daily Index Values An HDD value equals the number of degrees the day's average temperature is lower than 65 F. For example, a day's average temperature of 40 F would give you an HDD value of 25 (65 - 40). If the temperature exceeded 65 F, the value of the HDD would be zero. This is because in theory there typically would be no need for heating on a day warmer than 65. Measuring Daily Index Values An HDD value equals the number of degrees the day's average temperature is lower than 65 F. For example, a day's average temperature of 40 F would give you an HDD value of 25 (65 - 40). If the temperature exceeded 65 F, the value of the HDD would be zero. This is because in theory there typically would be no need for heating on a day warmer than 65. Measuring Monthly Index Values A monthly HDD or CDD index value is simply the sum of all daily HDD or CDD value recorded that month The value of a CME weather futures contract is determined by multiplying the monthly HDD or CDD value by $20.

Electricity Futures
Electricity future contracts represent the obligation to buy or sell a fixed amount of electricity at a prespecified contract price, known as the forward price, at certain time in the future (called maturity or expiration time). In other words, electricity futures are contracts between a buyer and a seller, where the buyer is obligated to take power and the seller is obligated to supply. Introduced in MCX on Jan 2009 and banned on Dec 2010

Swap
Recent origin since 1981. An agreement by two parties to exchange a series of cash flows in the future Types :
Foreign currency Swap Interest rate Swap

other kinds- commodity swap, equity swap

Foreign currency Swap

An agreement between two parties to exchange payments or receipts in one currency for payments or receipts in another.

Foreign currency Swap -Eg

Firm A in New York needs GBP 1 million which it can repay in 3 years. Firm B in London needs similar value in US dollars. The rate at which companies can borrow is: Company Firm A in New York Firm B in London Interest rates Dollars (%) Pound Sterling (%) 6% 8% 9% 7%

If both companies raise the needed funds in the market, then A has to pay 9% and firm B 8%. So it would be to their mutual advantage that if firm A raises the loan in dollars at 6% and firm B in Pound sterling and they exchange their liabilities. The arrangement would be

Foreign currency Swap -Eg

On the date of contract, firm A raises a loan of USD 1.6 million (assuming spot rate GBP 1 = USD 1.6) and remit the amount to B. Firm B raises a loan of GBP1 million and remits this to firm A. Periodically, say every 6 moths, firm A calculates interest on sterling as 7% and remits the amount to Firm B to enable it to pay the interest on sterling loan. Similarly firm B remits interest in dollars to firm A at 6%. On maturity firm A remits GBP 1 million to firm B to repay the loan raised by the latter. Similarly, firm B remits USD 1.6 million to firm A

Interest rate Swap

An agreement between two parties to exchange a fixed interest rate for floating interest rate on a principal sum.

Interest rate Swap - Eg

Two British companies both wish to borrow 10 million pounds. Company A is a giant company with an excellent credit rating. Company B is a medium sized company of ten years standing with a lower credit rating. Both companies have the option of borrowing either at fixed rates or at floating rates. Company A would prefer to raise loan under the fixed rate loan while company B w prefer to floating rate. The quoted rates of interest to the companies are as follows:Company A B Quoted interest rates Fixed (%) 7.5 9.0 Floating (%) LIBOR + 0.5% LIBOR + 3.5%

Interest rate Swap - Eg

B s cost of funds is higher than A on both floating and fixed. For fixed B s extra cost is 1.5% (9 7.5) For Floating B extra cost is 3%. Thus B has a comparative advantage in fixed rate market. C Ltd, a broker arranges a swap. Under this, A actually borrows 10 million pounds from a bank at LIBOR + 0.5% and B borrows 10 million pounds from a bank at 9% fixed rate . As a separate transaction (which constitutes Swap) A, B and C agree as follows
fixed 7% A
floating LIBOR + 0.5% Bank - LIBOR +0.5% fixed 6.5%

C
floating LIBOR +0.5%

Bank Fixed 9%

Interest rate Swap - Eg

Total outflow A =(LIBOR +0.5%) -(LIBOR +0.5%) 7% = 7%. B = -(LIBOR +0.5%) - 9% + 6.5% =(LIBOR + 3%) C = 0.5%
Each one gets a benefit of 0.5%. Interest differential between fixed and floating is 3 -1.5 = 1.5%. This 1.5% is distributed among the three. It should be noted that Swap is independent of the initial borrowings and the banks which lent the funds. Only the interest rate obligations are exchanged, not the underlying loan.

LIBOR & MIBOR

LIBOR (London Inter-bank Offer rate) is the interest rate charged by banks in London on short term loans to each other. It is taken as a benchmark for market interest rate, and non-bank floating rate borrowers are quoted a rate based on LIBOR plus a margin reflecting their credit worthiness. LIBOR is the most widely used "benchmark" or reference rate for short term interest rates. It is compiled by the British Bankers Association as a free service and released to the market at about 11.00[London time] each day. MIBOR - Mumbai Inter-bank Offer Rate.

Major derivatives Exchanges

Exchange Chicago Board Options Exchange (CBOE) Chicago Board of Trade (CBOT) Chicago Mercantile Exchange (CME) London International Financial Futures & Options Exchange (LIFFE) Major underlying asset
commodities, stocks, stock indices, currencies, T bonds, T notes Commodities , Precious metals, S&P Index Commodities Currencies, FTSE index, equities

London Commodity Exchanges (LCE) Futures - Commodities like coffee,

Cocoa, sugar

London Metal Exchange (LME) London Futures and Options Commodities Exchange (FOX)

Futures- Metals like Al, Copper, Zn Commodities

Derivatives Exchanges in India

Both NSE and BSE have options and futures trading stock, index, interest rate and currency derivatives Commodity exchanges in IndiaAt present there are national and regional commodity exchanges.

List of Commodity Exchanges in India

1. Bhatinda Om & Oil Exchange Ltd., Batinda. 2. The Bombay Commodity Exchange Ltd., Mumbai 3. The Rajkot Seeds oil & Bullion Merchants` Association Ltd 4. The Kanpur Commodity Exchange Ltd., Kanpur 5. The Meerut Agro Commodities Exchange Co. Ltd., Meerut 6. The Spices and Oilseeds Exchange Ltd. 7. Ahmedabad Commodity Exchange Ltd. 8. Vijay Beopar Chamber Ltd., Muzaffarnagar 9. India Pepper & Spice Trade Association, Kochi 10. Rajdhani Oils and Oilseeds Exchange Ltd., Delhi 11. National Board of Trade, Indore 12. The Chamber Of Commerce, Hapur 13. The East India Cotton Association, Mumbai

List of Commodity Exchanges in India

14. The Central India Commercial Exchange Ltd., Gwalior 15. The East India Jute & Hessian Exchange Ltd. 16. First Commodity Exchange of India Ltd, Kochi 17. Bikaner Commodity Exchange Ltd., Bikaner 18. The Coffee Futures Exchange India Ltd, Bangalore 19. Esugarindia Limited 20. National Multi Commodity Exchange of India Limited 21. Surendranagar Cotton oil & Oilseeds Association Ltd 22. Multi Commodity Exchange of India Ltd 23. National Commodity & Derivatives Exchange Ltd 24. Haryana Commodities Ltd., Hissar 25. e-Commodities Ltd

Regulation of forward Trading

Forward Contracts (Regulation) Act, 1952. Forward Markets Commission (FMC) established under the above Act

Uses of Derivatives
Risk Management
Risk Transfer Hedging

Income Generation Financial Engineering

Participants in Derivative Market

Hedging (Hedger) Speculation (Speculator) Arbitrage (Arbitrageur)

Trading in derivatives
Forward rate agreement and Swaps permitted by RBI in 1999 Trading in index futures began on NSE and BSE in 2000 Trading in options on index and stocks commenced on NSE and BSE in 2001 Trading on single stock futures began on NSE and BSE in 2002 Introduction of interest rate futures on NSE and commodity futures in 2003 Currency futures was launched in NSE, BSE and MCX in August 2008 Currency options in NSE and USE in October 2010

References
S.S.S. Kumar(2007). Financial Derivatives. New Delhi : Prentice Hall India. John C. Hull. (2005). Options, Futures and Other Derivatives (6th Ed.). New Delhi : Prentice Hall Robert A. Strong. (2006). Derivatives : An Introduction. Singapore : Thomson Learning Bansal & Bansal. (2007). Derivatives and Financial Innovations. New Delhi : McGraw Hill. Websites
NSE, BSE, MCX, NCDEX