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Introduction
The primary objectives of any investor are to

maximise
returns
and
minimise
risks.
Derivatives are contracts that originated from
the need to minimise risk.
The

word
'derivative'
originates
from
mathematics and refers to a variable, which
has been derived from another variable.

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Introduction
Derivatives are specialised contracts which

signify an agreement or an option to buy or

sell the underlying asset of the derivate up to
a certain time in the future at a prearranged
price, the exercise price.
The contract also has a fixed expiry period.

The value of the contract depends on the

expiry period and also on the price of the
underlying asset.
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Why Derivatives?
Options trading will be of interest to those
who wish to :
Participate in the market without trading or

holding a large quantity of stock.

Protect their portfolio by paying small
premium amount

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Why Derivatives.?
Benefits of trading in Futures and Options.
Able to transfer the risk to the person who is

willing to accept them

Incentive to make profits with minimal
amount of risk capital
Provides liquidity, enables price discovery in
underlying market
Derivatives market are lead economic
indicators.
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Features of Derivative:
(1)

(2)

Nature of Contract: Three imp. Contracts

- Forward & Futures
- Options
- Swaps
Underlying Assets:
- Foreign exchange
- Interest bearing financial assets
- Commodities
- Equities
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Classification of Derivative:
One form of classification of derivative:
(a) Commodity derivatives : Futures, Forward
and Options on gold, sugar, jute, pepper
etc.
(b) Financial derivatives: Futures, Options or
Swaps on currencies, securities, interest
rate, stock market indices etc.

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Derivatives Instruments:
Forwards Contract:

A forward contract is a customised contract

between two entities, where settlement
takes place on a specific date in the future
at todays pre-agreed price.

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Features:
-

Over the counter trading (not in

exchange)
No down payment
Settlement at maturity only
No secondary market
Necessity of third party
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Long & Short Positions:

Long Positions: The person who agrees to

buy the underlying asset in such contracts is

known as the Long.
Short positions: The counter party who

agrees to sell the underlying asset as per the

contract is known as Short.

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Pay-off: (P & L for the two parties)

Symbolically, let ST be the Spot price of
the asset at the date of maturity and E be
the delivery price (Exercise Price) agreed
upon in the contract,

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IF
E

ST > E

ST = E

ST <

Pay-off for Long

position : ST E

Gain

Break even

Loss

Pay-off for Short

Position : E ST

Loss

Break even

Gain

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Derivatives Instruments ..
Futures Contract : Is an agreement between

two parties to buy or sell an asset at a

certain time in the future at a perdetermined
price.

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Futures Contract
Features:
- Contract is often entered through an
intermediary.
- There is a standard amount of contract to a
market lot in stock exchange, which is fixed
by the stock exchange.
- There is a pre-determined grade(s) of the
commodity.
- Trading is required margin payment and
daily settlement.
- Positions can be closed easily.
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Initial Margins: The clearing house collects small

payment known as initial margin both from the
buyer and the seller, which is typically 5 to 10
percent of the value of the contract.
Marking to Market:

Daily profit and losses are

paid between buyer and seller and a final

payment

is

made

at

delivery.

The

daily

calculation of profits and losses as netted against

the initial margin is known as Marking to Market.
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Maintenance Margin:

To wipe out negative

balance in initial margin, investor is required to

ensure maintenance margin, which is threefourths of the initial margin.
Margin Call:

In the process of marking to

market, if the balance in the margin account

falls

below

the

maintenance

margin,

the

investor receives a margin call and is required

to deposits additional funds.

The extra funds

deposited are
called variation margin.
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Foreign currency futures:

Contract
: Long Position in a pound
Contract Day : Monday Morning
Maturity Day : Wednesday afternoon
Agreed price : $1.70 for 62,000
Close price :
Monday : $1.72
Tuesday : $1.71
Find out Profit / Loss if the investor takes delivery
of the pounds at the prevailing price of $1.71.
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Difference between Forwards Vs.

Futures
Features Forward Futures
Type of
Informal agreement Standardized
contract
Maturity Any maturity day
Few maturity dates
Contract size Large
Small
Cash flows No cash flows until Daily settlement
delivery
Default risk If party become
risk is small, cleared
by
default
exchanges
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Difference between Futures Vs.

Options
-

Futures Options
Obligation - both the
- Only the seller (writer)
parties of the contract
is obliged
No premium is paid
- The buyer pays
Holder of the contract
- The buyers loss is
restricted
is exposed to the entire
to downside risk to the
spectrum of downside risk
premium paid.
Contract must perform at
- The buyer can exercise
settlement date. Not
option at any time prior to
obliged to perform before
the expiry date.
the date.
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Short Selling:
- It is one arbitrage strategies used in F & O.
- It implies selling the securities which are not owned
by the seller and buying them back at a later date.
- If the price increases the short seller stands to
loose.
- Short position holders required to pay minimum
margin to the broker (25% mkt value)
- Short Squeezed: If the short seller doesnt borrow
the shares, the broker may call investor to close out
the position.

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