1. Nuts and Bolts
of
Derivatives

2. Understanding
Derivatives

3. Derivatives Defined
Derivatives are instruments whose
value is ‘derived’, in whole or in part,
from the value of one or more underlying
assets.
*Financial Market

4. The Underlying in a Derivative
Commodity
The value of the
derivative instrument is
Bond DERIVED from the Stock
underlying asset
An Exchange Rate An Index Another Derivative

5. Key features of Derivatives
The value of a derivative instrument is derived from
the value of the underlying
A derivative contract is priced separately from the
asset
The derivative contract is traded not the underlying
asset
No ownership rights associated with the asset sold

6. Classification of Derivatives
Based on the underlying:
Commodity Derivatives
Financial Derivatives

7. Origin of Derivatives
Originated as hedging devices against fluctuation in
commodity prices
Chicago Mercantile Exchange
Chicago Board of Trade
Financial derivatives emerged post 1970
Volatility of financial market an important reason
Index based and stock based are most popular today
Today the volumes of financial derivatives trade is many times
more than volumes in commodity derivatives trade.

8. Derivatives in India
In India, derivative trading commenced on Jun 09, 2000
(BSE) & Jun 12, 2000 (NSE) with index futures and
subsequently index options (Jun 2001), stock options
(Jul 2001) and stock futures (Nov 2001) were introduced
Commodity derivatives started much later in 2003 and
are also popular but the market is smaller in comparison
Futures & Options are the more popular forms
Separate segment for derivatives (NEAT- F&O on NSE
and DTSS on BSE)
Today the trading volumes on derivative segment are in
excess of INR 15,000 crores per day
In 2004-05, 77+ crores trades with volumes of 25 lakh-
crores were done.

9. Popularity of Derivatives
Derivative markets have attained an overwhelming popularity for a
variety of reasons...
To hedge or insure risks; i.e., shift risk.
• Interest rate volatility
Hedging: • Stock price volatility
• Exchage rate volatility
• Commodity prices volatility
VOLATILITY

10. Popularity of Derivatives
Derivative markets have attained an overwhelming popularity for a
variety of reasons...
To reflect a view on the future direction of the market,
i.e., to speculate.
• Leverage opportunity
Speculation: • Huge returns
EXTREMELY RISKY

11. Popularity of Derivatives
Derivative markets have attained an overwhelming popularity for a
variety of reasons...
To lock in an profit on the basis of price differential in
the market i.e. an arbitrage opportunity
Arbitrage: • Take advantage of price differential
by taking offsetting positions
PRICE DIFFERENTIAL

12. !STOP!!CHECK!
The following could be an underlying in a derivative?
ITC Stock
Coffee
USD/GBP rate
All the above
The price of a derivate is separate from but dependent on the price of the underlying
TRUE
FALSE
While Commodity based derivatives started before financial derivatives, the trading volumes
in financial derivatives across the world are higher than commodity derivatives
TRUE
FALSE
Which of the following was the 1st financial derivative traded in India?
a. Index Option
b. Index Future
c. Stock Future
d. Stock option
The strategy that involves taking advantage of price differential between two markets is
called:
Hedging
Speculating
Arbitraging
Diversifying

13. Types of Derivatives
Futures
Types of Derivative
Forwards Instruments Options
Swaps

14. Types of Derivatives
The owner of a future has the OBLIGATION to sell or buy
Future something in the future at a predetermined price. A future
contract has standardized conditions.
The owner of a forward has the OBLIGATION to sell or buy
something in the future at a predetermined price. The difference
Forward to a future contract is that forwards are customized, not
standardized. These are bilateral contracts between 2
private parties.
The owner of an option has the OPTION to buy or sell
Option something at a predetermined price on or before a
predetermined date.
A swap is an agreement between two parties to
Swap exchange a sequence of cash flows.

15. OTC vs. Exchange-Traded Derivatives
Primarily, Forwards and Swaps are OTC
derivatives
Considered risky because:
– There is no formal margining system
– These are not settled on a clearing house
– These do no follow any formal rules or
mechanisms
Futures and Options are exchange-
traded, a safer option.

16. !STOP!!CHECK!
If I commit to sell gold to you in the month of Dec and we agree to a price of Rs. 12,000
per 10 gm, we have just entered into a:
Future contract
Option contract
Forward contract
Swap agreement
All derivatives are obligatory on both buyer and seller, except:
Futures
Forwards
Options
Swaps
The following are OTC derivatives, hence have higher element of risk involved:
Swaps and options
Options and futures
Futures and forwards
Swaps and forwards
The following is not true about exchange-traded derivatives?
There is a settlement mechanism
There is a margining system
there is no loss of margin money ever
There are formal rules or mechanism

17. Understanding
Futures

18. Future Contract
Future The owner of a future contract
has the OBLIGATION to sell or
buy something in the future at
a predetermined price.

19. Future Contract
Standardized Items in Future
Quantity of the underlying
Quality of the underlying
The date and month of delivery
Location of settlement

20. Future Contract
Future Terminology
Spot Price
Future Price
Contract Cycle
Expiry Date
Contract Size
Basis
Cost of Carry
Initial Margin
Marking to Market
Maintenance Margin

21. Futures Terminology
Spot Price – the price at which an asset trades in the spot
market
Future Price – the price at which the future contract trades in
the futures market
Contract Cycle – the period over which the contract trades.
The index futures contracts on the NSE have a one-month, two-
month and three-month expiry cycles which expire on the last
Thursday of the month. On the Friday following the last Thursday,
a new contract having a three-month expiry is introduced for
trading.
Expiry Date – the date specified in the futures contract.
Contract Size – the amount of asset that has to be delivered
under one contract. For instance, the contract size on NSE futures
market is 100 Nifties.

22. Futures Terminology
Basis – the future price minus the spot price. There will be a
different basis for each delivery month for each contract. In a
normal market, basis will be positive. This reflects that future
prices normally exceed spot prices.
Cost of Carry – the storage cost plus the interest that is paid
to finance the asset less the income earned on the asset.
Initial Margin – the amount that must be deposited in the
margin account at the time the future contract is first entered into
Marking to Market – the adjustment made at the end of
each trading day to the investor’s margin account to reflect the
investor’s gain or loss depending upon the future closing price.
Maintenance Margin – somewhat lower than the initial
margin; the balance in the margin account must never become
negative and in case it does, the investor receives a margin call
who must top-up the account to the initial margin level before
trade commences the following day

23. A long position is an agreement
to buy
LONG => BUY
A short position is an agreement
to sell
SHORT => SELL

24. Futures Payoffs
Future contracts have linear pay-offs –
unlimited profits or losses
Payoff for buyer of future: long future
An obligation to take delivery at a future
date
– Similar to that of a person who holds an asset
– Example - A speculator buys a two-month nifty index
futures contract when the nifty stands at 3250. when
the index starts moving up, the long futures position
makes profits and when the index moves down the
future starts making losses.

25. Long Future
Profit
3250
NIFTY
Loss

26. Futures Payoffs
Future contracts have linear pay-offs –
unlimited profits or losses
Payoff for seller of future: short future
An obligation to give/make delivery at a
future date
– Similar to that of a person who sells/shorts an asset
– Example - A speculator sells a two-month nifty index
futures contract when the nifty stands at 3250. when
the index starts moving down, the short futures
position makes profits and when the index moves up
the future starts making losses.

27. Short Future
Profit
3250
NIFTY
Loss

28. Futures Payoffs
Bought
Future
Gain Gain
Profit
Profit
Loss Loss
Sold
Future
Current Current
Price Price
Purchase Price Purchase Price
of Contract of Contract
Gain/Loss = Gain/Loss =
Sale Price – Purchase Price Purchase Price - Sale Price

29. Futures Contracts
General Rule for Hedgers:
• If you are going to sell something in the near future but
want to lock in a secured price, you take a short position.
• If you are going to receive/buy something in the future but
want to lock in a secured price, you take a long position.
The Role of Speculators:
• As the name implies, speculators are involved in
price betting and take the risk of price movements
against them.

30. Application of Futures
Hedging – a risk management tool
long security, short future
Example – an investor holds a security but gets
uncomfortable with the movements in the short run. Sees
prices falling from 450 to 390. in the absence of stock
futures, he either live with it or sells the security.
With security futures he can minimize the price risk. He
can enter into an off-setting short futures position.
Assuming spot price is 390. He sells a two-months future
for 400, for which he pays an initial margin. If prices fall,
so does the price of futures. As a result, his short futures
position starts making profits. The loss incurred on the
security will be made up by the profit on his short futures
position.
N.B. Hedging does not always make money! It removes
unwanted exposure i.e. unnecessary risk.

31. Application of Futures
Speculation – bullish security, buy (long) future
Case 1 – a speculator believes a security at 1000 is
undervalued; in the absence of a deferred product, he has
to buy it and hold on to it till his hunch proves correct.
assume he buys 100 shares which cost him one lakh
rupees. Two-months later, say the security closes at 1010.
He makes a profit of 1000 on an investment of 100,000 for
a period of two-months. This works out to be an annual
return of 6% .
Case 2 – the security trades at 1000 and the two-month
future at 1006. for the sake of comparison, assume the
minimum contract value is 100,000. he buys 100 security
futures for which he pays a margin of Rs. 20,000. two
months later, the security closes at 1010. Assuming, on the
date of expiration, the future price converges to the spot
price, he makes a profit of Rs. 400 on an investment of Rs.
20,000. this works out to an annual return of 12 percent.
There lies the power of leverage.

32. Application of Futures
Speculation – bearish security, Sell (Short) future
Example – take a trader who expects to see a fall in
price of X. he sells one two-month contract of futures
on X at Rs. 240 (each contract for 100 underlying
shares). He pays a small margin on the same, say
48,000. Two months later, when the futures contract
expires, X closes at Rs. 220. on the day of expiration,
the spot and futures price converge. He has made a
clean profit of Rs. 20 per share. For the one contract
that he bought, this works out to Rs. 2000.

33. Application of Futures
Arbitrage
Overpriced futures: buy (long) spot, sell (short) future
Cash-and-carry arbitrage opportunity
The cost-of-carry ensures that futures price stay in tune with
the spot price. Whenever futures price deviates from its fair
value, arbitrage opportunities arise.
Say X trades at 1000. one month future trades at 1025 and
seems overpriced. As an arbitrageur, you can enter into the
following trade to make riskless profit:
– Borrow funds to buy the security in cash/spot market for 1000.
– Take delivery of the security and hold for a month.
– Simultaneously, sell the security future for 1025.
– On futures expiration date, spot and future prices converge.
Unwind the position.
– Say the security closes at 1015. sell the security.
– Futures position expires with a profit of Rs. 10
– The result is also a riskless profit of Rs. 15 on the spot position.
– Return the borrowed funds.

34. Application of Futures
Arbitrage
Underpriced futures – buy (long) future, sell (short) spot
A reverse cash-and-carry arbitrage – where the riskless
return is more than the arbitrage trades
A security X trades at 1000. a one-month future trades at 965
and seems underpriced. You can make riskless profit by
entering into the following transaction.
– on day 1, sell the security in cash/spot for 1000.
– make delivery of the security.
– simultaneously, buy the futures on the security at 965.
– on the futures expiration date, the spot and the future prices
converge. Now unwind the position.
– say, the security closes at 975.
– buy back the security. the result is a riskless profit of Rs. 25 on
the spot position
– And, the futures position expires with a profit of Rs. 10.

35. Index Arbitrage
- Buy NIFTY Futures
- Sell Stock Futures on the
composition stocks

36. Open Interest
Open
INFY Buyer1 B2 B3 Seller1 S2 S3 Interest
Day 1 100 -100 100
Day 2 -25 50 -10 -15
75 50 -110 -15 125
Day 3 50 -75 100 -45 20 -50
125 -25 100 -155 5 -50 230
The outstanding open long or short positions in
the market

37. !STOP!!CHECK!
Ram sold a Nov ABB futures contract at Rs. 1000. Each contract is for delivery of 200
shares. Current Spot Price is Rs. 995. On future expiry date the spot price has slipped to
Rs. 950. Ram’s profit/loss in the transaction is:
Profit of Rs. 5,000
Loss of Rs. 5,000
Profit of Rs. 10,000
Loss of Rs. 10,000
Ganesh bought a Dec ITC futures at Rs. 650. Each contract is for delivery of 400 shares.
Current Spot is Rs. 660. on Futures expiry date, ITC has moved down to 625. Ganesh’s
profit/loss on the transaction is:
Profit of Rs. 10,000
Profit of Rs. 7,000
Loss of Rs. 10,000
Loss of Rs. 7,000
The adjustments made to the margin account at the end of each trading day to reflect the
investor’s gain/loss is called:
Maintenance margin
Marking to market
Margin call
Initial margin
Hedge using futures involves:
Have underlying, buy futures
Have underlying, sell futures
Sell underlying, buy futures
Sell underlying, sell futures

38. Understanding
Options

39. Options Contracts
Option The owner of an option has the OPTION
to buy or sell something at a
predetermined price
Right to BUY – CALL OPTION
Right to SELL – PUT OPTION

40. Options Contracts
Option Terminology
Stock options
Buyer of an option
Writer of an option
Call Option
Put Option
Option price/premium
Expiration date
Strike Price
American Options
European options
In-The-Money Option (ITM)
At-The-Money (ATM)
Out-Of-The-Money Option (OTM)

41. Options Contracts
Option Terminology
Stock options – options on individual stocks. A contract
gives the buyer the right to buy or sell shares at the specified
price
Buyer of an option – the one who by paying price
(premium) buys the right but not the obligation to exercise
his/her option on the seller/writer
Writer of an option – the one who by receiving premium,
is obliged to sell/buy the asset if the buyer exercises on him
Call Option – gives the buyer the right but not the
obligation to buy an asset by a certain date for a certain price
Put Option – gives the buyer the right but not the
obligation to sell an asset by a certain date for a certain price

42. Options Contracts
Option Terminology
Option price/premium – the price that the buyer pays to
the seller/writer
Expiration date – the date specified in the options
contract; also called exercise date or strike date or maturity
date
Strike Price – the price specified in the options contract;
also called exercise price
American Options – options that can be exercised at any
time upto the expiration date. Most exchange-traded options
are American
European options – options that can be exercised only on
the expiration date

43. Options Contracts
In-The-Money Option (ITM) – an option that would lead to
a positive cash-flow to the holder if it were exercised
immediately.
A call option on the index is said to be ITM if the current index
stands higher than the strike price (Spot Price > Strike Price).
A put option is ITM if the index is below the Strike price (Spot
Price < Strike Price).
At-The-Money (ATM) – an option that would lead to zero
cash flows to the holder if it were exercised immediately.
Out-Of-The-Money Option (OTM) – an option that would
lead to a negative cash-flow to the holder if it were
exercised immediately.
A call option on the index is said to be OTM if the current index
stands at a level which is less than the strike price (Spot Price <
Strike Price).
A put option is OTM if the index is above the Strike price (Spot
Price > Strike Price).

44. Options Contracts
The option premium has two components – intrinsic
value and time value.
The intrinsic value of an option - is the amount the
option is ITM, if it is ITM. If the call is OTM, its intrinsic
value is zero.
– Intrinsic value of a call is Max [0, (St – K)]
– Intrinsic value of a put is Max [0, (K – St )]
where, K= Strike Price and St = spot price
Time value of an option – the difference between the
option premium and its intrinsic value. Both calls and
puts have time value. An option that is ATM or OTM only
has time value. Usually, the maximum time value exists
when option is ATM. The longer the expiration, the
greater the time value of an option, all else being equal.
At expiration, an option should have no time value.

45. Options Contracts
Call Option Contracts
A call option is a contract that gives the owner of the call
option the right, but not the obligation, to buy an
underlying asset, at a fixed price (K), on (or sometimes
before) a pre-specified day, which is known as the expiration
day.
The seller of a call option, the call writer, is obligated to
deliver, or sell, the underlying asset at a fixed price, K on (or
sometimes before) expiration day (T).
The fixed price, K, is called the strike price, or the exercise
price.
Because they separate rights from obligations, call
options have value.

46. Options Contracts
Put Option Contracts
A put option is a contract that gives the owner of the put
option the right, but not the obligation, to sell an
underlying asset, at a fixed price, on (or sometimes before)
a pre-specified day, which is known as the expiration day
(T).
The seller of a put option, the put writer, is obligated to
take delivery, or buy, the underlying asset at a fixed price
(K), on (or sometimes before) expiration day.
The fixed price, K, is called the strike price, or the exercise
price.
Because they separate rights from obligations, put
options have value.

47. Options Contracts
The four basic positions:
Write (SHORT)
Call Option
Buy (LONG)
Write (SHORT)
Put Option
Buy (LONG)

48. Profit Diagram for a Long Call
Position, at Expiration
Profit
0
call premium K ST

49. Profit Diagram for a Short Call
Position, at Expiration
Profit
Call premium
0
K S
T

50. Covered Call
- Your Short call position is
covered if you have the
underlying asset

51. Profit Diagram for a Long Put
Position, at Expiration
Profit
0
K put premium S
T

52. Protective Put
- Your Long Put Position is
protective if you have the
underlying asset

53. Profit Diagram for a Short Put
Position, at Expiration
Profit
0
K S
T

54. Call Option Payoffs
Out of In
the Money the Money
Payoff
Payoff
Price Price
Current Option
Stock Exercise
Price Price
Stock Payoffs Call Option Payoffs
Call Option Payoff = Max[ 0 , S - X ]

55. Put Option Payoffs
In Out of
the Money the Money
Payoff
Payoff
Price Price
Current Option
Stock Exercise
Price Price
Stock Payoffs Put Option Payoffs
Put Option Payoff = Max[ 0 , X - S ]

56. Application of Options
Hedging – have underlying, buy (go LONG on) puts
(Protective Puts)
One way to protect your portfolio from potential
downside due to market drop is to buy insurance
using put options
Buy the right no. of puts at the right exercise price –
when the stock prices fall, your stock will lose value and
the put options bought by you will gain, effectively
ensuring that the portfolio value does not fall below a
particular level.
Portfolio insurance by buying put options is a hedging
tool for funds who own well-diversified portfolios
By buying puts, funds can limit the downside in case of a
market fall.

57. Application of Options
Speculation – bullish security, buy (LONG) calls or sell
(SHORT) puts
Buying a call option
The downside is limited to the option premium
The upside is potentially unlimited
Selling a Put Option
The upside is the option premium
The downside is potentially unlimited

58. !STOP!!CHECK!
A call writer could have:
Limited profit; unlimited losses
Unlimited profit, unlimited losses
Unlimited profit, limited losses
Limited profit, limited losses
Spot S&P CNX Nifty is Rs. 3200. An investor bought a one-month S&P CNX 3220 call
option for a premium of Rs.10. As on date the option is:
In the money
At the money
Out of the money
None of these
In a rising market, the right strategy would be to go:
long puts and/or long calls
long puts and/or short calls
Short puts and/or short calls
Short puts and/or long calls
When Spot<Strike, which of the following positions will be ITM?
a. Long Call and Short Put
b. Long Call and Long Put
c. Short Call and Long Put
d. Short Call and Short Put

59. Futures vs. Options
Purchasers of options have rights but no obligations
and Sellers have obligations, no rights. Whereas, both
purchasers and sellers of futures have obligations.
Options also lock in a future price, but do not have to
be exercised. Futures lock in prices and must be
executed at specified future date.
To enter into a future contract one must maintain a
margin, while option buying requires an up-front
payment (premium).

60. Futures vis-à-vis Options
Futures Options
Exchange traded Same as futures
Exchange defines the product Same as futures
Price is zero, strike price moves Strike price is fixed, price moves
Price is zero Price is always positive
Linear payoff Non-linear payoff
Both long and short at risk Only short at risk

61. Remember
• Future and Option markets have a short-term
investment horizon ONLY.

62. Thank You!

63. Pivot Training Pvt Ltd
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