Understanding Derivatives

Introduction

Derivatives..

Derivative is a product/contract which does not have any value on its own i.e. it derives its value from some underlying. Leverage is key element in a derivative contract.

Forward contracts..
Forward contract is one to one bi-partite contract, to be performed in the future, at the terms decided today. (E.g. forward currency market in India) Forward contracts offer tremendous flexibility to the parties to design the contract in terms of the price, quantity, quality (in case of commodities), delivery time and place. Forward contracts suffer from poor liquidity and default risk.

Futures contracts..

Futures contracts are organised/ standardised contracts, which are traded on the exchanges. These contracts, being standardised and traded on the exchanges are very liquid in nature. In futures market, clearing corporation/ house provides the settlement guarantee. Every futures contract is a forward

Forward / Futures Contracts

Features Operational Mechanism Contract Specifications Counterparty Risk Forward Contract Not traded on exchange Differ from trade to trade. Exists Futures Contract Traded on exchange Contracts are standardised contracts. Exists, but assumed by Clearing Corporation/ house. Very high Liquidity as contracts are standardised contracts. Better; as fragmented markets are brought to the common platform.

Liquidation Profile

Price Discovery

Poor Liquidity as contracts are tailor maid contracts. Poor; as markets are fragmented.

Exchange traded vs. OTC products

Exchanged Traded Products

Standard Contracts Limited term Fixed contract sizes Limited product range of futures, calls and puts Broker account (standardized documentation). Daily revaluations and margin calls

OTC Products Flexible customized contracts Maturities up to 10/15 years Size as desired by client Versatile product range. Exotics available Customized documentation, periodic credit reviews, generally no margining

Exchange bid/offer spreads Transparent commission revenues Credit risk assumed by the exchange/clearing corporation High Liquidity Better information dissemination Transparent and competitive market

Dealer bid/offer spreads Non transparent revenues as weaved in bid-offer Counterparties assume credit risk Low liquidity Low level of information dissemination Less transparent and less competitive market

Understanding futures

Contract Cycles Contract Month - The month in which the contract expires. Expiry Day - The last day on which the contract is available for trading. Contract size Tick size - It is the minimum difference between two quotes of similar nature. MTM settlement on daily basis Final settlement in cash or through delivery

Option..
Option is a right given by option seller to the option buyer to buy or sell a specific asset at a specific price on or before a specific date.

Option..

Option Seller - One who gives/writes the option. He has an obligation to perform, in case option buyer desires to exercise his option.

Option Buyer - One who buys the option. He has right to exercise the option but no obligation.

Option..

Call Option - Option to buy. Put Option - Option to sell. American Option - An option which can be exercised anytime on or before the expiry date. European Option - An option which can be exercised only on expiry date.

Evolution of options
Forward Contract X Bring to the exchange X Futures Contract Attach right to the contract Option European

Right to buy (Call)

Right to sell (put) Attach the flexibility of any time exercise

American Option

Option terminology..

Strike Price/ Exercise Price - Price at which the option is to be exercised. Expiration Date - Date on which the option expires. Exercise Date - Date on which the option gets exercised by the option holder/buyer. Option Premium - The price paid by the option buyer to the option seller for granting the option.

Frequently used terms in derivatives market..

Positions:

Long position- Outstanding/unsettled purchase position at any point of time. Short position - Outstanding/ unsettled sales position at any point of time. Open position -

Frequently used terms in derivatives market..

Open interest - Total outstanding long or short positions in the market at any specific point in time. Volume - No. of contracts traded during a specific period of time. During a day, during a week or during a month.

Settling a derivatives position..

Physical delivery - Open position at the expiry of the contract is settled through delivery of the underlying.

Cash settlement - Open position at the expiry of the contract is settled in cash. These contracts are designated as cash settled contracts.

Why some contracts are essentially cash settled..

Delivery is not possible or very cumbersome. Unwillingness of the exchange to indulge itself in the process. Lack of infrastructure at the exchanges end to handle the delivery. Regulatory requirement to avoid price manipulation and short

Participants in the derivatives market..

View based trading (Speculators) Participants, who intentionally take risk from hedgers in pursuit of profit. Hedgers - Participants, who want to transfer a risk component of their portfolio. Arbitrageurs Participants, who operate in different markets simultaneously, in pursuit of profit.

What makes a contract click..

Risk in the underlying market. Presence of both hedgers and speculators in the system.

Right product specifications. Proper margining.

Pay-off of futures contract buyer

Traders right - Nil. Traders obligation - Accept underlying at contract price/ Pay settlement difference.

Premium paid or received - Nil. Margin requirement - Yes. Risk profile - Unlimited*, if prices go down. Profit potential - Unlimited, if prices go up

* Practically loss potential is limited as price of the asset

can not go below zero (Maximum loss = buy price).

Pay-off of futures contract seller

Traders right - Nil. Traders obligation - Deliver underlying at contract price/ Pay settlement difference. Premium paid or received - Nil. Margin requirement - Yes. Risk profile - Unlimited, when prices go up. Profit potential - Unlimited*, if prices go down.

* Practically profit potential is limited as price of the asset can not go below zero (Maximum profit = sell price).

Pay-off of futures contracts

100

50

Gain / Loss

Profit
0 50 -50 75 100 125 150

Buyer Seller

Loss
Price

-100

Pay-off of Call option buyer

Traders right - Buy underlying at strike price. Traders obligation - Nil. Premium paid or received - Paid. Margin requirement - No. Risk profile - Limited, to the extent of premium paid. Profit potential - Unlimited, if prices go up.

Pay-off of Call option seller

Traders right - Nil. Traders obligation - Sell underlying at strike price. Premium paid or received - Received. Margin requirement - Yes. Risk profile - Unlimited, if prices go up. Profit potential - Limited , to the extent of the premium received. Breakeven point - Strike price + Premium.

Pay-off of Call options

Strike 100 Premium 5
20 15 10 5 0 -5 -10 -15 -20

Profit/Loss

90

95

100

105

110

115

120

Buyer Writer

Price

Pay-off of Put option buyer

Traders right - Sell underlying at strike price. Traders obligation - Nil. Premium paid or received - Paid. Margin requirement - No. Risk profile - Limited, to the extent of premium paid. Profit potential - Unlimited*, if prices go down (BEP = Strike price - Premium).

* Practically, Put option buyers profit is limited as price of the asset can not go

Pay-off of Put option seller

Traders right - Nil. Traders obligation - Buy underlying at strike price. Premium paid or received - Received. Margin requirement - Yes. Risk profile - Unlimited*, if prices go down. Profit potential - Limited, to the extent of premium received (BEP = Strike price Premium)

* Practically, Put option sellers risk is limited as price of the asset can not go below zero

Pay-off of Put options

Strike 100 Premium 5
15 10 Profit/Loss 5 0 -5 -10 -15 Price 85 90 95 100 105 110 115 Buyer Writer

General notations used....

Notations used in the presentation are as follows:

Call option price ( C ) Put option price ( P ) Current asset price (S) Asset price at the time t (St ) Strike price (K) Volatility of underlying asset price ( ) Time to expiration (t) Interest rate (r )

Value of option (Premium)

Value of an option is sum of its Intrinsic value and Time value.
Intrinsic Value of option Intrinsic value of an option is the value to the extent an option is in the money (at any point in time). Intrinsic value of call option at time t is Max. (0, St - K)

Intrinsic value of put option at time t is Max. (0, K - St )

Value of option (Premium)

At the money calls and puts Out of the money puts 35 40 45 50 In the money puts 55 60 65

35

40

45

50

55

60

65

In the money calls Cash price = 50

Out of the money calls

Intrinsic value and types of options

Market Scenarios
Market price > strike price Market price = strike price Market price < Strike price

Call option
In the money

Put options
Out of the money

At the money *

At the money*

Out of the money

In the money

* When market price is very near to the strike price, option is called near the money option. * Only in the money options have intrinsic value.

Value of option (Premium)

Time Value of option

The magnitude of the options time value reflects the potential of option to gain intrinsic value during its life.

Value of option (Premium)

P R E M I U M 40 45 50 Stock Price 55 60 Strike Price 5 Maximum Time Value Premium 10 Intrinsic Value Call option price curve

Value of option (Premium)

P R E M I U M
Time value premium is maximum when stock price and strike price are the same. When stock price is far above or below the strike price, option sells for nearly its intrinsic value.

9 months curve

6 months curve 3 months curve Strike Price

Behavior of time value of option

Time Value Premium Time to maturity 3 2 1 0 Rate of decay of option time value is not linear. Time value premium decreases at an accelerated rate as the option approaches maturity.

Determinants of options value

Effect of an increase in each pricing factor on the option value, holding other factors constant Sl. No. 1. 2. 3. 4. 5. Pricing Factors Current Asset Price (S) Strike price (K) Call option Increase Decrease Put option Decrease Increase Increase Increase Decrease

Volatility of Increase underlying price () Time to expiration (t) Increase Interest rate ( r ) Increase

Let us see whether.

Long call option position is riskier than the equivalent long underlying position. Long put option position is riskier than the equivalent short underlying position. Short call option position is riskier than the equivalent short underlying position.

Synthetic futures

Long futures position

Long on call + Short on put (Ensures upward profit potential) + (Creates downside risk)

Short futures position

Long on put + Short on call (Ensures downside profit potential) + (Creates upside risk)

Synthetic call options

Long Call option

Long on underlying/futures +Long on put option (upward profit potential + downside risk) + (This contains the downside risk)

Short Call option

Short on underlying/futures + Short on put option (downward profit potential + upside risk) + (downside risk)

Synthetic put options

Long Put options

Short on underlying/futures + Long on call option (downside profit potential and upside risk) + (this contains the upside risk)

Short Put Options

Long on underlying/futures + Short on call option (upside profit potential and downside risk) + (upside risk)

Why do we go for synthetic options and futures

Non-availability of readymade products.

Flexibility of synthetic products. For price discovery and arbitrage.

Profit/Loss dimensions of the trading

Risk/Loss Profit Trade spreads and arbitrage I II III IV Buy options Unlimited Sell options Limited Unlimited

Limited

Buy/ sell underlying and futures

Risk management

MTM (Mark-To-Market) Margin: Mark-to-market losses on outstanding settlement obligations of the Member. VaR Margins: Value at risk margins to cover potential losses for 99% of the days. Extreme Loss Margins: Margins to cover the expected loss in situations that lie outside the coverage of VaR margins. Base Minimum Capital: Capital required for all risks other than the market risk (for example, operational risk and client claims). Special Margin : Special margin collected as a surveillance measure.

Thank you

Please feel free to reach me at manish@valueadvisors.co.in +91 98924 86751