What is Derivatives?

A derivative is a contract between two parties which derives its value/price from an underlying asset. The most
common types of derivatives are futures, options, forwards and swaps. It is a financial instrument having no
independent value but derives from underlying assets.
Underlying Assets:
Stocks
Commodities
Currency
Interest rate
Index
Weather

Wipro, Infosys
Gold , jeera,
GBP,USD
Labor,Mibor
Nifty

Types of derivatives:
A.
B.
C.
D.

Forwards
Futures,
Options, and
Swaps

A. Forwards
It is a type of derivative contract where the term and condition are agreed at (t=0) today and the performance
and execution takes place on the future date. It is an OTC. This transaction has done privately without the
interaction of Stock & commodities.
B. Futures
It is nothing but a forward contract done through exchange. futures contract (more colloquially, futures) is a
standardized contract between two parties to buy or sell a specified asset of standardized quantity and quality
for a price agreed upon today (the futures price) with delivery and payment occurring at a specified future date.

if you buy (go long) a futures contract and the price goes
up, you profit by the amount of the price increase times
the contract size; if you buy and the price goes down,
you lose an amount equal to the price decrease times the
contract size

Reflects the profit and loss potential of a short

futures position. If you sell (go short) a futures
contract and the price goes down, you profit by the
amount of the price decrease times the contract size;
if you sell and the price goes up, you lose an amount
equal to the price increase times the contract size.

Forward

Future

OTC

Exchange driven

Contract is customized

standardized contract

No. money margin ,no brokerages

Payment of money margin

Counter party risk are higher

No counter party risk

No regulation

Regulated by Stock exchanges

Contract date are fixed by Parties

Contract dates are fixed by Exchanges

C. Option Contract

An option is a contract between two parties giving the buyer the right, but not the obligation, either
to buy or to sell an underlying asset at a set price, on or before a predetermined date
Types of option Contract
1. Call Options
An Option contract that gives the holder the right to buy the underlying security at a specified price
for a certain, fixed period of time.
2. Put Options
An option contract that gives the holder the right to sell the underlying security at a specified price
for a certain fixed period of time.

According to the Payoff diagram of

Long Call Options strategy, it can be
seen that if the underlying asset price is
lower than the strike price, the call
options holders lose money which is
the equivalent of the premium value,
but if the underlying asset price is more
than the strike price and continually
increasing, the holders loss is
decreasing until the underlying asset
price reach the breakeven point, and
since then the call options holders
profit from their long call positions

More payoff examples of 4 main strategies of options investment

Long Call Options

A long call gives you the right to buy
the underlying stock at strike price A
Generally, the stock price will be at or
above strike A

Short Call Options

Selling the call obligates you to sell
stock at strike price A if the option is
assigned.

Generally, the stock price will be below

strike A

Long Put Options

A long put gives you the right to sell the
underlying stock at strike price A
Generally, the stock price will be at or
below strike A

Short Put Options

Selling the put obligates you to buy
stock at strike price A if the option is
assigned

Generally, the stock price will be above

strike A

D. Swaps

Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on changes in the
expected direction of underlying prices
Derivatives market participants:
Hedging

Corporate houses having exposes resort to hedging (currency risk hedging,

commodity price hedging, equity portfolio hedging)

Arbitrage

The practice of taking advantage of a price difference between two or more markets

Speculation

Traders bet on price movement (Bulls & Bears)

Margin money
Margin money is often used in the context of derivatives or commodities market. Margin money is taken
by stock exchanges or regulator from traders in order to ensure that in the event of loss to trader, the stock
exchange does not incur loss. There are different types of margin which are taken by stock exchanges,
lets look at some of them
I.

Initial Margin

Initial margin is taken by the stock exchanges from traders in order to cover the largest potential loss
which can happen in one day. Both buyer and seller have to deposit the initial margins. The initial margin
is deposited before the day opens and also before the traders takes the position in the market. Based on the
volatility of underlying the initial margin can be between 5 to 20 percent.
II.

Mark-to-market margin

All losses of the trader must be met by the trader by depositing further collateral known as mark to
market margin in to the stock exchange, and any profit is credited to the account of trader at the end of
trading day.
III.

Additional margin

In case of sudden higher than expected volatility, additional margin may be called for by the stock
exchange. This is generally imposed by the stock exchanges when the markets have become too volatile
as was the case in year 2008 when Lehman brother collapse happened.
IV.

Maintenance margin

Some exchanges work on the system of maintenance margin, which is set at a level slightly less than
initial margin. The margin is required to be replenished to the level of initial margin, only if the margin
level drops below the maintenance margin limit
V.

Delivery margin

It is a margin to be paid when expires of the contract arrives.

Short Note:
Option interest
Open interest represent the no of outstanding contract that are yet to be expired or yet to be
squared.
American option
In this case option can be exercised on or before the expiry date. Hence it gives more flexibility
binomial option price model helps to find option premium when the type of option is American.
European option
In this case option can be exercised only on the expiry date of the contract if doesnt provide
flexibility for the option buyer in this case the option premium is calculated on the basic of black
scholes model