Introduction to Derivatives

1
What will we be covering today?
• A brief introduction on Derivatives
• Exchange Traded Vs Over the Counter Markets
• Forward Contract
• Futures Contract
• Forward Vs Future Contract
• MTM Calculation in Futures
• Margin Call, Maintenance Margin and Initial Margin
• Short Selling
• Call Option
• Put Option
• In the Money, At the Money and Out of Money Options
• Option Chains – Interpretation
• Swaps
• Interest Rate Swaps 2

• Credit Default Swaps

Excel Sheets To Be Used For This Training

Interest Rate
Derivatives Swaps

3
What do we mean by Derivatives?
▪ Financial instruments whose value depends upon the
value of other underlying variables/Derives its value
from underlying Asset

▪ Underlying assets can be stocks, bonds, currencies,

interest rates etc.

▪ Settlement at a predetermined future date

▪ Important Tool for Risk Management (Lock in prices,

Hedge against unfavorable movements in rates,
diversify the portfolio)

▪ Cons – Complicated to understand, chances of

counterparty’s default in OTC derivatives
4
Types of Derivatives
▪ Futures Contract

▪ Forwards Contract

▪ Options – Call and Put

▪ Swaps – Interest rate and Credit Default Swaps

5
Exchange Traded Vs Over the Counter Markets

▪ Exchange Traded: markets where individuals trade standardized contracts

defined by the exchange

▪ Over The Counter: Telephonic and computerized network of dealers. Trades

are done over the phone between two financial institutions or between
financial institution and one of the client

▪ In OTC terms of contracts are not specified by exchange.

▪ Market participants can negotiate freely any attractive deal

▪ Some amount of credit risk in OTC

▪ Forward contracts vs Future contracts

6
Real Life Example to Understand Forward Contract

Farmer ITC Ltd.

▪ Consider a farmer growing wheat on yearly basis and selling it to ITC Ltd.
▪ Today’s Wheat Price – INR 10 per Kg. Assuming demand and supply of
wheat is fluctuating due to the ongoing pandemic, resulting in its price
fluctuations in coming months
▪ In the current scenario the farmer does not have the complete product
ready. Wheat will be ready in 2 months
▪ Expected Production – 1,00,000 Kg
▪ After 2 months if the price of wheat remains INR 10 – there isn’t any
problem for both the counterparties
7
Real Life Example to Understand Forward Contract

Farmer ITC Ltd.

Scenario 1 - After 2 months Wheat Price – INR 8/Kg
▪ Revenue for the farmer after selling the wheat at current market price – INR
8,00,000(1,00,000 x 8)
▪ Revenue loss of INR 2,00,000 to the farmer since the initial price of wheat was INR
10/Kg
▪ Profitable for ITC since its paying a lesser amount/cost saving to purchase wheat( had it
bought the wheat for INR 10/Kg instead of INR 8/Kg, it would have payed INR 2,00,000
more)
Scenario 2 – After 2 months Wheat Price – INR 12/Kg
▪ Revenue for the farmer after selling the wheat at current market price – INR 12,00,000
▪ Revenue Gain of INR 2,00,000 to the farmer since the initial price of wheat was INR
10/Kg and he sold it at INR 12/Kg
▪ Loss of ITC as it is paying more to buy same quantity of wheat 8
Real Life Example to Understand Forward Contract

Farmer ITC Ltd.

Scenario 1 – Wheat price – INR 8/Kg Scenario 2 – Wheat price – INR 12/Kg
after 2 months after 2 months

▪ Wheat Price – INR 8/Kg ▪ Wheat Price – INR 12/Kg

▪ Farmer – Revenue Loss (2L) ▪ Farmer – Revenue Gain (2L)
▪ ITC Ltd. – Cost Savings (2L) ▪ ITC Ltd. – Additional Cost (2L)

9
Real Life Example to Understand Forward Contract

▪ How to eliminate this uncertainty in revenue? Enter into a forward contract

▪ ITC will buy 1,00,000 Kg of wheat from farmer at INR 10/Kg after 2 months

▪ Both the parties will benefit from this agreement(because the market is uncertain).In the
absence of this contract, if the market price of wheat decreases farmer will lose his revenue.
On the other hand, if market price of wheat increases ITC will have to incur more cost to buy
the wheat at a higher price

▪ Both the parties have now eliminated their risk via this contract. Irrespective of whatever the
future market price of wheat will be, both the parties have already fixed the price at which
they will buy/sell wheat after 2 months

▪ In this case Revenue of Farmer and Cost of ITC will be same in case of any price fluctuation
i.e., INR 10,00,000

10
Forward Contract
▪ An agreement between 2 parties to buy or sell an asset on a certain future
date/future time for a certain price

▪ Long position in a forward contract – Party that will agree to buy the underlying
asset on a certain future date for a specific price

▪ Short position in a forward contract – The other party that agrees to sell the
asset on the same date for same price

▪ No Standard Contract Size. Not traded on exchange

▪ Liquidity is very low

▪ Customized Contract based on requirements of all the involved parties. Used by

institutional investors. Settlement date can be any Future date as agreed by the
parties
11
Futures Contract
▪ An agreement between 2 parties to buy or sell an asset on a certain future date/future time
for a certain price

▪ Long position in futures contract – Party that will agree to buy the underlying asset on a
certain future date for a specific price

▪ Short position in a futures contract – The other party that agrees to sell the asset on the
same date for same price

▪ Traded on an exchange. Exchange monitored

▪ Standard Contract Size

▪ Highly Liquid

▪ Trade today, settlement at a predetermined future date. Generally monthly expiries

▪ No need to pay full contract value (Pay only margin money and take full advantage of the
contract
12
Forward Vs Future Contracts
Basic Differences
Forward Contract Futures Contract
OTC Traded Exchange Traded

Customized Expiry date and Lot/Contract Standard Contract size and Fixed
Size Expiry date

Not regulated by market or Exchange Market regulated

Illiquid Contract Liquid Contract

Lesser chances of default by

Higher chances of Counterparty Risk
counterparty

No collateral is required Initial payment/margin is required

13
Mark To Market, Initial Margin and Maintenance Margin
▪ In futures contact it refers to daily settlement of profit & loss arising due to change in market
value of security till it is held

▪ Calculation of MTM is done after trading hours based on closing price of the day

▪ P&L is settled on same day in the trading account and is nor reflected in the positions next
day

▪ Initial Margin is the amount a trader must deposit with broker to start a trading position.
Maintenance Margin is the amount of money a trader must have in their accounts to
continue holding the position

▪ If funds in the margin account drop below the maintenance margin level, the trader will
receive a margin call to immediately add funds to bring the account back to the initial margin
level. If he fails to do so his position will be squared off

▪ Suppose if someone is trading in a gold futures contract with initial margin of $1000,
maintenance margin of $750, if on day 1 the balance in traders account falls to $725, then he
will immediately have to deposit $275 in his account to bring it back to the initial margin
14
level
Short Selling
▪ It involves borrowing shares/securities from a brokerage firm, selling them in market and
repurchasing them at a lower price later to repay the amount borrowed/ initial amount and
pocket in the difference as profit

▪ Bearish strategy – when you expect the prices of shares to fall

▪ Suppose you borrow 100 shares of a stock trading at $50 per share and you sell them at
$5000. Now when price of the share declines to $25, you will buy 100 shares at $2500 and
replace the 100 shared borrowed. However, you have made a profit of $2500 in this bargain

▪ To borrow shares, you will have to first set up a margin account with the broker and give
your own stock/cash/bond/mutual fund as collateral

▪ You will also be charged an interest on the value of outstanding shares, until they are
returned. Once you have opened and funded the margin account, you can short sell

▪ Risk in short selling – If you own a stock the maximum amount that you can lose is 100% of
the money you invested. The downside risk is limited. However, when you short a stock, your
losses are limitless. The price of stock can keep on rising and the amount you will pay to 15
replace the borrowed share can be limitless
Call Option

▪ Options are financial derivatives that give buyers the right, but not the obligation, to
buy or sell an underlying asset at an agreed-upon price and date

▪ Call option – is a contract between 2 parties to exchange a stock at a certain price by a

predetermined date. The date specified in the contract is known as expiration date or
maturity date. The price specified in the contract is called as the strike price or
exercise price.

▪ Exercised when value of stock/ asset will increase in future

▪ Has 2 parties – Option holder/buyer and option seller/writer

▪ Option Holder/buyer – right but not obligation to buy the asset at a certain date for a
certain price from option seller

▪ Option Seller/writer – obligated to sell if the option buyer exercises his right. Receives
16
option premium
Call Option Explained – Real life Scenario/Story
Scenario-1
Scenario-2
Scenario-3
Another Example of Call option
▪ Consider a stock is trading at $50 and you
think it is going up to $60, you might buy a
$55 call option for 20 cents
▪ If the stock rose to $60, that would allow
you to buy the stock at $55 even if it is
priced at $60, netting a $4.80 profit on each
share
▪ On the other hand, the person who sold
you a call option will be obligated to sell
you the stock at $55 at a loss of $4.80
▪ If the stock never rises above $55 by
expiration date, the call option expires
worthless, and the call buyer is out of 20
cents and the call seller keeps the 20 cents
Put Option

▪ Put option – is a contract between 2 parties to exchange a stock at a certain price by a

predetermined date. The date specified in the contract is known as expiration date or
maturity date. The price specified in the contract is called as the strike price or
exercise price.

▪ Exercised when value of stock/ asset will decrease in future

▪ Has 2 parties – Option holder/buyer and option seller/writer

▪ Option Holder/buyer – right but not obligation to sell the asset at a certain date for a
certain price from option seller

▪ Option Seller/writer – obligated to buy the stock/asset if the option buyer exercises
his right. Receives option premium

22
Put Option Explained
Scenario-1
Scenario-2
Scenario-3
Another Example of Put option
▪ Consider a stock is trading at $50 and you
think it will go down to $40, you might buy a
$45 put option for 20 cents
▪ If the stock dropped to $40, that would
allow you to sell the stock at $45 even if it is
priced at $40, netting a $4.80 profit on each
share
▪ On the other hand, the person who sold you
a put option will be obligated to buy the
stock from you at $45 at a loss of $4.80
▪ If the stock never drops below $45 by
expiration date, the put option expires
worthless, and the put buyer is out of 20
cents and the put seller keeps the 20 cents
In The Money, At The Money and Out
of Money Options
▪ At The Money Option - When the strike price is available for the rate going on

▪ In the Money Option - The strike price in which the option will be certainly exercised
considering the current market price are called ITM Options

▪ Out Of Money Option - Options on strike price which will certainly not be exercised taking
base of current market price

▪ A call option is in the money if strike price is lesser than the current market price and out
of money if strike price is more than the current market price

▪ A put option is in the money if strike price is more than the current market price and out
of money if the strike price is less than the current market price

▪ Refer to the Excel for further details

Interpretation of Option Chains from
NSE site
▪ Refer to the Excel for further details
SWAPS
▪ A swap is an over-the-counter agreement between 2 companies to exchange cash flows in
future
▪ The agreement defines the dates when the cash flows are to be paid and the way in which
they will be calculated
▪ A forward contract can be viewed as a simple example of a swap.
▪ Whereas a forward contract is equivalent to the exchange of cash flows on just one future
date, swaps lead to cash flow exchanges on several future dates
▪ Types – Interest Rate Swaps, Credit default Swaps
Interest Rate Swaps
▪ An interest rate swap is a forward contract in which one stream of future interest
payments is exchanged for another based on a specified principal amount

▪ Interest rate swaps usually involve the exchange of a fixed interest rate for a floating rate,
or vice versa, to reduce or increase exposure to fluctuations in interest rates or to obtain a
marginally lower interest rate than would have been possible without the swap

▪ The agreement defines the dates when the cash flows are to be paid and the way in which
they will be calculated

▪ Whereas a forward contract is equivalent to the exchange of cash flows on just one future
date, swaps lead to cash flow exchanges on several future dates

▪ Also called plain vanilla swaps, since they are the simplest such swap instruments

▪ IRS Excel to explain a real-life scenario

Credit Default Swaps

▪ Derivatives contract between 2 counterparties

▪ Protection buyer and Protection Seller
▪ Buyer will keep on paying small premium to seller to
ensure that in case of default by a bond or an
underlying instrument, seller can pay off/compensate
buyer and take complete ownership of the asset
▪ A Credit Default Swap is a type of insurance that
protects a party against payment defaults
▪ Anybody who doesn’t have any direct insurable interest
can also buy a CDS
▪ In the 2008 financial crisis, AIG lost $99.2 billion. $30
billion of the losses were due to the collapse of CDS
32
Credit Default Swaps – Scenario 1

$1B given
Pension Fund Company B

Pays 10% interest

Assigns AAA rating

AIG Insurance Moody’s

33
Credit Default Swaps – Scenario 1
▪ Consider a pension fund that can invest in AAA or AA rated bonds only as per
government regulations. Finds company B attractive and wants to invest in it but
cannot do the same as it is BB rated

▪ AIG insurance enjoys AAA rating by Moody’s

▪ Pension fund and AIG agree on an agreement/enter a CDS in which the pension fund
will give 1 B to company B and will pay 1% of interest it will receive from company B
as premium to AIG insurance

▪ AIG in return will issue a CDS and pay back the agreed amount ($1B) to Pension Fund
if company B defaults

▪ Risks – AIG is insuring multiple clients. No regulation to check if it has sufficient assets
to pay off the debt. Accumulation of enormous debt
34
Credit Default Swaps – Scenario 2

$ 2 B given
Pension Fund A Company A

Pays 20% interest

Pays 10% interest on $12 B after

buying CDS for Company A Hedge Fund A
Insurer 2

35
Credit Default Swaps – Scenario 2
▪ Pension Fund A and Insurer 2 enter an agreement in which the pension fund A will give
$2B loan to company A and will pay 12% of interest it will receive from company A as
premium to insurer 2

▪ Insurer 2 in return will issue a CDS and pay back the agreed amount ($2B) to Pension Fund
A if company A defaults

▪ Hedge fund A buys CDS (insured at $12B) from insurer 2 on company A ( worth $2B). It
pays 10% of interest on $12 B as premium to company A

▪ Worst Case scenario – Company A goes bankrupt. Insurer 2 will now have to pay $12 B
which is way more than $2B(actual amount) to Hedge fund A and goes undercapitalized.
Its rating will be downgraded by Moody’s

▪ Since pension fund A also got insurance from Insurer 2, now that transaction will unwind
(because insurer 2’s rating is now downgraded)

▪ Hence series of chain events will start which are riskier and might end up impacting the
economy to a large extent
36
37