FINANCIAL DERIVATIVES

INTRODUCTION
Derivatives

What Is a Derivative?
Derivatives actually started as financial instruments to mitigate risk.
A derivative is a financial contract that derives its value from an underlying asset.
The buyer agrees to purchase the asset on a specific date at a specific price.
● Derivatives are financial contracts.
● The value of financial derivatives is dependent on the underlying asset. The
assets can be stocks, bonds, commodities, currencies, etc.
● The value of the underlying asset changes with the market movements.
● The key motives of a derivative contract are to speculate on the underlying
asset prices in the future and to guard against the price volatility of an
underlying asset or commodity.
Derivatives actually started as financial instruments to mitigate risk.
Let us consider an example:
It is raining heavily. If I go for a walk, there is a 5% chance that I will slip, fall &
break my leg. Most of us would happily accept this risk & say, “Oh, that’s fine, then.
Only 5% chance of damage”. God forbid, if I do fall & break my leg, will I break it
5%, or will I break it 100%? It is imperative for us to understand not just a
probability and an expected risk/return, but also, our ability to face this risk, should
the worst happen.
There can only be a derivative contract in existence, if there is a buyer and a seller,
and both consent to the price, executing the trade. Every single contract that exists,
has both, a buyer and a seller. If both close their positions, then the net derivative
position becomes ZERO.
E.g. If there is a future contract on the exchange, on Reliance Industries, i.e.,shares
of Reliance Industries.
The company has issued equity shares and the total outstanding equity is Rs. 3,238
crore (media release, Reliance Industries Ltd, 16th October, 2015). This translates
into a total of 323. 8 crore equity shares of Rs. 10/ each, fully paid-up These shares
exist, even if no fresh buyers or sellers transact. In other words, the market cannot
change the outstanding equity base of Reliance Industries, no matter how many
trades there are. The market can increase or decrease the quantity of derivatives
contracts outstanding, depending on number of trades.
What are the underlying assets?
● Underlying asset are the financial assets upon which a derivative’s price is based.
● Knowing the value of an underlying asset helps traders determine the appropriate action
(buy, sell, or hold) with their derivative.
● Most common -
● Stocks
● Bonds
● Commodities
● Currencies
● Interest Rates
Which are the Common Financial Derivatives?
● Forwards
● Futures
● Options
● Swaps
WHY DERIVATIVES?
Scenario 1
Consider a farmer, whose fresh crop of corn will be harvested in three months from
now. He is unsure about the price he will receive at that time. Will he get a buyer
when he is in the market to sell corn, three months later? Uncertain again.
A derivative contract will enable him to enter into a firm contract today, to sell a
fixed quantity of corn, of an agreed upon quality, at a mutually agreed price, at the
time specified (in his case, three months).
So the farmer now knows how much demand there is for his corn for delivery after
three months (when he is ready with his harvest) and he also knows what price he
will receive for his produce. Uncertainty removed.
Scenario 2
An IT company will receive its payment in US$, a month later. It is unsure about the
rupee value of this receipt, at that time.
Derivatives can enable this company to sell the receivables in US$ today, to lock
into the prevailing US$/INR rate for one month.
Once again, the company has mitigated uncertainty. It has an assured buyer for the
revenue flow in US$, more importantly, it is assured of an exchange rate today, to
enable sound planning.
Scenario 3
A long-term investor has a blue chip portfolio, which she is unwilling to liquidate.
She does feel that the market may fall in the near future, thus affecting her
investments, negatively.
She can use derivatives today, sell now and buy later, amount linked to her
portfolio value, to take advantage of any fall in market values, while at the same
time, retaining her portfolio to continue participating in all corporate benefits
therefrom.
There are infinite possibilities, for buying or selling (sometimes, a combination of
both) using derivatives to hedge risk.
The Securities Contracts (Regulation) Act 1956 defines “derivative” as under:

“Derivative” includes

1. Security derived from a debt instrument, share, loan whether secured or unsecured, risk
instrument or contract for differences or any other form of security.

2. A contract which derives its value from the prices, or index of prices of underlying
securities or assets.
Features of Financial Derivatives

1. A derivative instrument relates to the future contract between two parties. It means
there must be a contract-binding on the underlying parties and the same to be
fulfilled in future. The future period may be short or long depending upon the nature of
contract, for example, short term interest rate futures and long term interest rate futures
contract.

2. Normally, the derivative instruments have the value which derived from the values
of other underlying assets, such as agricultural commodities, metals, financial
assets, intangible assets, etc. Value of derivatives depends upon the value of underlying
instrument and which changes as per the changes in the underlying assets. Hence, they
are closely related.
3. In general, the counter parties have specified obligation under the derivative
contract. Obviously, the nature of the obligation would be different as per the type of
the instrument of a derivative. For example, the obligation of the counter parties, under
the different derivatives, such as forward contract, future contract, option contract and
swap contract would be different.

4. The derivatives contracts can be undertaken directly between the two parties or
through the particular exchange like financial futures contracts. The exchange
traded derivatives are quite liquid and have low transaction costs in comparison
to tailor-made contracts. Example of exchange traded derivatives are Dow Jones,
S&P 500, Nikkei 225, NIFTY option, S&P Junior that are traded on New York Stock
Exchange, Tokyo Stock Exchange, National Stock Exchange, Bombay Stock Exchange
and so on.
5. Usually, in derivatives trading, the taking or making of delivery of underlying
assets is not involved; rather underlying transactions are mostly settled by taking
offsetting positions in the derivatives themselves. There is, therefore, no effective limit
on the quantity of claims, which can be traded in respect of underlying assets.
6. Derivatives are also known as deferred delivery or deferred payment instrument.
It means that it is easier to take short or long position in derivatives in comparison to
other assets or securities. Further, it is possible to combine them to match specific, i.e.,
they are more easily amenable to financial engineering.
7. Derivatives are mostly secondary market instruments and have little usefulness in
mobilizing fresh capital by the corporate world.
8. Although in the market, the standardized, general and exchange-traded
derivatives are being increasingly evolved, however, still there are so many privately
negotiated customized, over-the-counter (OTC) traded derivatives are in existence.
They expose the trading parties to operational risk, counter-party risk and legal risk.
Further, there may also be uncertainty about the regulatory status of such derivatives.
Classification of derivatives
Derivatives can be broadly divided into two distinct groups:

Over the Counter (OTC): The OTC derivative market is the largest market for
derivatives. Here, the derivatives are traded privately without an exchange. Products
such as swaps, Options, and forward rate agreements are traded between highly
sophisticated financial entities such as hedge funds and banks in private.

Exchange-traded derivative contracts (ETD): ETDs are derivative instruments that

are traded in a derivatives exchange. This exchange acts as an intermediary in all
related transactions. As a guarantee, an initial margin is submitted by both the buyer
and the seller of the contract.
Purpose / Functions of derivatives
1.Enable Price Discovery
First, the derivatives and their market increase the competitiveness of the market as it
encourages more number of participants with varying objectives of hedging,
speculation, and arbitraging. With broadening of the market the changes in the price
of the product are watched by many who trade on the slightest of reasons. Even a
minor variation in price prompts action on the part of speculators. Active participation
by large number of buyers and sellers ensures fair price. The derivative markets,
therefore, facilitate price discovery of assets due to increased participants, increased
volumes, and increased sensitivity of participants to react to smallest of price changes.
By increased depth in the market, faster and smooth dissemination of information
among different participants, the process of discovery of price becomes more
efficient.
2.Facilitate Transfer of Risk
Hedgers amongst themselves could eliminate risk if two parties face risk from
opposite movement of price. As seen earlier, the wheat farmer needing to sell his
produce faced a risk from the fall in price, while the flour mill needing to buy wheat
was worried about the rise in price. Since risk was emanating from opposing
directions of price movement, the convergence of the two was possible. If both the
farmer and the flour mill wanted to hedge against price rise the two would not meet.
When speculators enter the market they discharge an important function and help
transfer of risk from those wanting to eliminate to those wanting to assume risk.
3. Other Benefits

The function of leveraging and risk transfer helps in efficient portfolio management.
With a smaller fund at disposal, better diversification can be achieved with part of the
fund allocation to derivatives assets. Derivatives provide a much wider menu to
portfolio managers who constantly seek better risk return trade off. The range of
choices would be far more restricted in the absence of derivatives.
4 . Provide Leveraging
Taking position in derivatives involves only fractional outlay of capital when
compared with the position in the underlying asset in the spot market.
Assume a speculator is convinced that price of wheat will be ` 16 per kg in six months
and a farmer agrees to sell at ` 15.50 per kg. To take advantage the speculator will
have to pay the full price of ` 15.50 now and realize ` 16.00 six months later. Instead,
if a mechanism is available by which he can absolve himself of making the full
payment, he will be too glad to enter into a contract. Derivatives, as products, and
their markets provide such exit route by letting him first enter into a contract and then
permitting him to neutralize position by booking an opposite contract at a later date.
This magnifies the profit manifolds with the same resource base. This also helps build
volumes of trade, further helping the price discovery process.
Therefore, by virtue of risk management, short selling, price discovery, and
improved liquidity, derivatives make the markets more efficient.
Forward Contract
“An agreement to buy or sell an asset with a pre-specified price and date”.

● A forwards contract is a specific agreement by two parties to purchase or sell an

asset at a particular price on a future date. The two parties agree to conduct the
said transaction in the future, hence the term ‘forward’.
● The value of the forward contract is derived from the underlying asset’s value, such
as stocks, commodities, currencies, etc. This is why a forward contract acts as a
derivative. However, unlike an options contract, the two parties involved in a
forwards derivative contract are obligated to fulfil the specified transaction and take
the delivery of the underlying asset.
● Forward contracts are not traded on a centralised exchange, which is why they
are essentially considered over-the-counter or OTC derivatives. Furthermore,
since forward contracts are negotiated privately and without an intermediary,
they are more customisable than standard derivative contracts.
Example of a forward contract

An Indian company buys Automobile parts from USA with payment of one million dollar
due in 90 days. The importer, thus, is short of dollar that is, it owes dollars for future
delivery. Suppose present price of dollar is ` 48. Over the next 90 days, however, dollar
might rise against ` 48. The importer can hedge this exchange risk by negotiating a 90 days
forward contract with a bank at a price 50. According to forward contract in 90 days the
bank will give importer one million dollar and importer will give the bank 50 million
rupees hedging a future payment with forward contract. On the due date importer will
make a payment of 50 million to bank and the bank will pay one million dollar to
importer, whatever rate of the dollar is after 90 days. So this is a typical example of
forward contract on currency.
Features of a Forward contract
1. Forward contracts are bilateral contracts, and hence, they are exposed to counterparty
risk. There is risk of non-performance of obligation either of the parties, so these are
riskier than to futures contracts.
2. Each contract is custom designed, and hence, is unique in terms of contract size,
expiration date, the asset type, quality, etc.
3. In forward contract, one of the parties takes a long position by agreeing to buy the
asset at a certain specified future date. The other party assumes a short position by
agreeing to sell the same asset at the same date for the same specified price. A party with
no obligation offsetting the forward contract is said to have an open position. A party
with a closed position is, sometimes, called a hedger.
4. The specified price in a forward contract is referred to as the delivery price. The forward
price for a particular forward contract at a particular time is the delivery price that would
apply if the contract were entered into at that time. It is important to differentiate between
the forward price and the delivery price. Both are equal at the time the contract is entered
into. However, as time passes, the forward price is likely to change whereas the delivery
price remains the same.

5. In the forward contract, derivative assets can often be contracted from the combination
of underlying assets, such assets are oftenly known as synthetic assets in the forward
market. 6. In the forward market, the contract has to be settled by delivery of the asset on
expiration date. In case the party wishes to reverse the contract, it has to compulsory go to
the same counter party, which may dominate and command the price it wants as being in a
monopoly situation.
7. Forward contracts are very popular in foreign exchange market as well as interest rate
bearing instruments. Most of the large and international banks quote the forward rate
through their ‘forward desk’ lying within their foreign exchange trading room. Forward
foreign exchange quotes by these banks are displayed with the spot rates.

8. As per the Indian Forward Contract Act- 1952, different kinds of forward contracts can
be done like hedge contracts, transferable specific delivery (TSD) contracts and
non-transferable specify delivery (NTSD) contracts. Hedge contracts are freely
transferable and do not specific, any particular lot, consignment or variety for delivery.
Transferable specific delivery contracts are though freely transferable from one party to
another, but are concerned with a specific and predetermined consignment. Delivery is
mandatory. Non-transferable specific delivery contracts, as the name indicates, are not
transferable at all, and as such, they are highly specific.
How Is Forward Trading Done?
The two parties typically enter into a forward contract because of their opposing views on
a particular asset’s future price. One party believes that the price of a particular asset is set to
rise in the future and therefore wishes to purchase it at a lower, predetermined price to make
profits based on the price difference. Hence, this party offers to be the buyer. On the other
hand, the other party believes that the asset’s price will fall in the near future and therefore
wishes to cut their losses by locking in a predetermined price. This party, therefore, offers to
be the seller.

Based on how the market performs and the price of the asset changes, the actual result of the
forward contract can typically go in three different ways:

1. The Price Of The Asset Rises In The Future

In this scenario, the buyer’s prediction comes true, and they can sell the asset at a higher
price. They take the delivery of the asset by paying the lower predetermined price of the
forwards’ contract and sell it on the open market.Example Of a Forwards Contract
The profit made by the buyer in this scenario is the difference between the actual current
price of the asset and the locked-in price at which the buyer bought it.

2.The Price Of The Asset Falls In The Future

In this scenario, the seller’s prediction is correct, providing benefits from the sale made
through the forward contract. Even though the price of the asset has fallen, the seller gets to
sell it at a price higher than its current value. The profit made by the seller in this scenario
is the difference between the price at which the seller sells the asset and the actual current
price of the asset.

3.The Price Of The Asset Remains Unchanged In The Future

In this scenario, the prediction of neither the buyer nor the seller is proven correct.
Therefore, the transaction results in no profit made or loss incurred by either party.
Basic terms used in Forward Contracts
● Underlying Asset: This is the underlying asset that is mentioned in the contract.
This underlying asset can be commodity, currency, stock, and so on.
● Quantity: This mainly refers to the size of the contract, in units of the asset that is
being bought and sold.
● Price: This is the price that will be paid on the expiration date must also be
specified.
● Expiration Date: This is the date when the agreement is settled and the asset is
delivered and paid.
Forward Price

Forward price is the predetermined delivery price for an underlying commodity, currency,
or financial asset as decided by the buyer and the seller of the forward contract, to be paid
at a predetermined date in the future. At the inception of a forward contract, the forward
price makes the value of the contract zero, but changes in the price of the underlying will
cause the forward to take on a positive or negative value.
Forward price is based on the current spot price of the underlying asset, plus any
carrying costs such as interest, storage costs, foregone interest or other costs or
opportunity costs.

Although the contract has no intrinsic value at the inception, over time, a contract may
gain or lose value. Offsetting positions in a forward contract are equivalent to a zero-sum
game. For example, if one investor takes a long position in a pork forward agreement and
another investor takes the short position, any gains in the long position equals the losses
that the second investor incurs from the short position. By initially setting the value of the
contract to zero, both parties are on equal ground at the inception of the contract.
Forward Price Calculation
When the underlying asset in the forward contract does not pay any dividends, the
forward price can be calculated using the following formula:
F=S×e(r×t)
where:
F=the contract’s forward price
S=the underlying asset’s current spot price
e=the mathematical irrational constant approximated by 2.7183
r=the risk-free rate that applies to the life of the forward contract
t=the delivery date in years
Delivery Price
The delivery price is the price at which one party agrees to deliver the underlying
commodity and at which the counter-party agrees to accept delivery. The delivery
price is defined in a futures contract traded on a registered exchange or in an
over-the-counter forward agreement. The delivery price is set in advance in the
contract. It is agreed on the day the futures or forward contract is entered, not on the
day in the future when the commodity is actually delivered. Delivery price can also
refer to a stock's selling price in options contracts.
FUTURE CONTRACTS
A futures contract is a legal agreement to buy or sell a particular commodity asset, or
security at a predetermined price at a specified time in the future. Futures contracts are
standardized for quality and quantity to facilitate trading on a futures exchange.
The buyer of a futures contract is taking on the obligation to buy and receive the
underlying asset when the futures contract expires. The seller of the futures contract is
taking on the obligation to provide and deliver the underlying asset at the expiration date.
● Futures contracts are financial derivatives that oblige the buyer to purchase some
underlying asset (or the seller to sell that asset) at a predetermined future price and
date.
● A futures contract allows an investor to speculate on the direction of a security,
commodity, or financial instrument, either long or short, using leverage.
● Futures are also often used to hedge the price movement of the underlying asset to
help prevent losses from unfavorable price changes.
Example of Futures Contracts
Futures contracts are used by two categories of market participants: hedgers and
speculators. Producers or purchasers of an underlying asset hedge or guarantee the price
at which the commodity is sold or purchased, while portfolio managers and traders may
also make a bet on the price movements of an underlying asset using futures.
An oil producer needs to sell its oil. They may use futures contracts to do it. This way
they can lock in a price they will sell at, and then deliver the oil to the buyer when the
futures contract expires. Similarly, a manufacturing company may need oil for making
widgets. Since they like to plan ahead and always have oil coming in each month, they
too may use futures contracts. This way they know in advance the price they will pay for
oil (the futures contract price) and they know they will be taking delivery of the oil once
the contract expires.

Futures are available on many different types of assets. There are futures contracts on
stock exchange indexes, commodities, and currencies.
Mechanics of a Futures Contract
Imagine an oil producer plans to produce one million barrels of oil over the next year. It
will be ready for delivery in 12 months. Assume the current price is $75 per barrel. The
producer could produce the oil, and then sell it at the current market prices one year from
today.

Given the volatility of oil prices, the market price at that time could be very different
than the current price. If the oil producer thinks oil will be higher in one year, they may
opt not to lock in a price now. But, if they think $75 is a good price, they could lock in a
guaranteed sale price by entering into a futures contract.
A mathematical model is used to price futures, which takes into account the current spot
price, the risk-free rate of return, time to maturity, storage costs, dividends, dividend
yields, and convenience yields. Assume that the one-year oil futures contracts are priced
at $78 per barrel. By entering into this contract, in one year the producer is obligated to
deliver one million barrels of oil and is guaranteed to receive $78 million. The $78 price
per barrel is received regardless of where spot market prices are at the time.

Contracts are standardized. For example, one oil contract on the Stock Exchange is for
1,000 barrels of oil. Therefore, if someone wanted to lock in a price (selling or buying)
on 100,000 barrels of oil, they would need to buy/sell 100 contracts. To lock in a price
on one million barrels of oil/they would need to buy/sell 1,000 contracts.
Difference Between Forward and Futures Contract
BASIS FOR
FORWARD CONTRACT FUTURES CONTRACT
COMPARISON
Meaning Forward Contract is an agreement A contract in which the parties
between parties to buy and sell the agree to exchange the asset for
underlying asset at a specified date cash at a fixed price and at a
and agreed rate in future. future specified date, is known
as future contract.
What is it? It is a tailor made contract. It is a standardized contract.
Traded on Over the counter, i.e. there is no Organized stock exchange.
secondary market.
Risk High Low

Default As they are private agreement, the chances No such probability.

of default are relatively high.

Size of contract Depends on the contract terms. Fixed

Collateral Not required Initial margin required.

Maturity As per the terms of contract. Predetermined date

Regulation Self regulated By stock exchange

Liquidity Low High

Settlement On maturity date. On a daily basis.

Options

The term option refers to a financial instrument that is based on the value of underlying
securities such as stocks. An options contract offers the buyer the opportunity to buy or
sell—depending on the type of contract they hold—the underlying asset. Unlike futures,
the holder is not required to buy or sell the asset if they decide against it. Each
contract will have a specific expiration date by which the holder must exercise their
option. The stated price on an option is known as the strike price. Options are typically
bought and sold through online or retail brokers.
● 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 options and put options form the basis for a wide range of option strategies
designed for hedging, income, or speculation.
Options are versatile financial products. These contracts involve a buyer and seller,
where the buyer pays a premium for the rights granted by the contract.

● Call options allow the holder to buy the asset at a stated price within a specific
timeframe.
● Put options, on the other hand, allow the holder to sell the asset at a stated
price within a specific timeframe.
● Each call option has a bullish buyer and a bearish seller while put options have
a bearish buyer and a bullish seller.

Traders and investors buy and sell options for several reasons. Options speculation
allows a trader to hold a leveraged position in an asset at a lower cost than buying shares
of the asset. Investors use options to hedge or reduce the risk exposure of their
portfolios.
American options can be exercised any time before the expiration date of the option,
while European options can only be exercised on the expiration date or the exercise date.
Exercising means utilizing the right to buy or sell the underlying security.
Important points

Options contracts usually represent 100 shares of the underlying security. The buyer pays a
premium fee for each contract.

For example, if an option has a premium of 35 cents per contract, buying one option costs
$35 ($0.35 x 100 = $35). The premium is partially based on the strike price or the price for
buying or selling the security until the expiration date.

Another factor in the premium price is the expiration date. The expiration date indicates the
day the option contract must be used. The underlying asset will determine the use-by date.
Some of the essential terms that are often used in options are:

● Lot Size:This refers to the standard quantity or units of the underlying asset that is
included in the options contract.
● Strike Prize:Also known as exercise price, this is the price of the asset at which the two
parties agree to buy or sell the underlying asset.
● Premium:This refers to the amount that the buyer pays to the seller of the options
contract and the underlying asset to avail the benefits of the options contract. It is the
market price of the options contract itself.
● Expiration Date:This refers to the future date until which an options contract can be
exercised by the investor. Beyond the expiration date, the options contract will expire
worthlessly.
Example of an Option
Suppose that Microsoft shares trade at $108 per share and you believe they will increase
in value. You decide to buy a call option to benefit from an increase in the stock's price.
You purchase one call option with a strike price of $115 for one month in the future for
37 cents per contact. Your total cash outlay is $37 for the position plus fees and
commissions (0.37 x 100 = $37).

If the stock rises to $116, your option will be worth $1, since you could exercise the
option to acquire the stock for $115 per share and immediately resell it for $116 per
share. The profit on the option position would be 63 cents since you paid 37 cents and
earned $1—that's much higher than the 7.4% increase in the underlying stock price from
$108 to $116 at the time of expiry.

In other words, the profit in dollar terms would be a net of 63 cents or $63 since one
option contract represents 100 shares [($1 - 0.37) x 100 = $63].

If the stock fell to $100, your option would expire worthlessly, and you would be out $37
premium. The upside is that you didn't buy 100 shares at $108, which would have
resulted in an $8 per share, or $800, total loss. As you can see, options can help limit
your downside risk.
Types of Options
Call Option
A call option is a type of options contract that gives the holder the right, but not the
obligation to buy the asset at the agreed-upon strike price before the expiration date.
The call option can be bought by the investor by paying a premium upfront to the
seller, also called the Options writer. The option holders, therefore, make a profit if the
value of the asset rises in the future. This is because the call option allows them to buy
the asset at a much lower price and then sell in the market for its current higher price.

For example, suppose you purchase a call option for stock at a strike price of Rs 200
and the expiration date is in two months. If within that period, the stock price rises to
Rs 240, you can still buy the stock at Rs 200 due to the call option and then sell it to
make a profit of Rs 240-200 = Rs 40.
Put Option
A put option is a type of options contract that gives the options holders the right, but not
the obligation to sell the asset at the set strike price any time before the expiration date.
If the value of the asset falls in the future, the put option gives holders the choice to sell
the asset at the agreed-upon higher price, thereby minimising overall risk.

For example, let’s assume you purchase a put option for stock at a strike price of Rs 200
and the expiration date is in a month. If within that period, the stock price falls to Rs
180, you can still choose to sell the stock at Rs 200. On the other hand, if the price of
the stock rises above Rs 200, you can choose between exercising the contract or not.
Writing an Option
Writing an option refers to selling an options contract in which a fee, or premium, is
collected by the writer in exchange for the right to buy or sell shares at a future price and
date.

● Traders who write an option receive a fee, or premium, in exchange for giving the
option buyer the right to buy or sell shares at a specific price and date.
The buyer of a call option has the right, but not the obligation, to buy the number of shares
covered in the contract at the strike price. Put buyers, on the other hand, have the right, but
not the obligation, to sell the shares at the strike price specified in the contract.

● The fee, or premium, received when writing an option depends upon several factors,
such as the current price of the stock and when the option expires.
● Writing an option can involve losing more than the premium received.
Risk of Writing an Option
Even though an option writer receives a fee, or premium for selling their option contract,
there’s the potential to incur a loss. For example, let’s say David thinks Apple Inc. (AAPL)
shares will stay flat until the end of the year due to a lackluster launch of the tech company's
iPhone 11, so he decides to write a call option with a strike price of $200 that expires on Dec.
20.

Unexpectedly, Apple announces that it plans on delivering a 5G capability iPhone sooner

than expected, and its stock price closes at $275 on the day the option expires. David still has
to deliver the stock to the option buyer for $200. That means he will lose $75 per share as he
has to buy the stock on the open market for $275 to deliver to his options buyer for $200.
Advantages of Options to an investor

1. Cost-Efficiency
Options have great leveraging power. As such, an investor can obtain an option position
similar to a stock position, but at huge cost savings. For example, to purchase 200 shares of an
$80 stock, an investor must pay out $16,000. However, if the investor were to purchase two
$20 calls (with each contract representing 100 shares), the total outlay would be only $4,000
(2 contracts x 100 shares/contract x $20 market price). The investor would then have an
additional $12,000 to use at his or her discretion.

2. Less Risk (If Used Properly)

There are situations in which buying options is riskier than owning equities, but there are also
times when options can be used to reduce risk. It really depends on how you use them.
Options can be less risky for investors because they require less financial commitment than
equities, and they can also be less risky due to their relative imperviousness to the potentially
catastrophic effects of gap openings. Options are the most dependable form of hedge, and this
also makes them safer than stocks.
3. Higher Potential Returns
You don't need a calculator to figure out if you spend less money and make almost the same
profit, you'll have a higher percentage return. When they pay off, that's what options typically
offer to investors.
Disadvantages of options:
Less Liquidity:
Some stock options have lower liquidity which makes it very difficult for a trader to make
entry and exit from the trade.
High Commissions:
Option trading is more expensive as compared to future or stock trading. However, there
are some discount brokers that give the opportunity to traders to trade on lower
commissions. But most of the full-service brokers charge higher fees for trading in options.
Time Decay:
Time decay is a worse thing while trading options. The value of your option premium
decreases by some percentages each day irrespective of movement in the underlying.
Non Availability of All Stock Options:
All the stocks registered with exchanges do not have options contracts. This makes it
difficult for a trader to hedge his position with options strategies.
Swaps

A swap is a derivative contract through which two parties exchange the cash
flows or liabilities from two different financial instruments.
Most swaps involve cash flows based on a notional principal amount such as a
loan or bond, although the instrument can be almost anything.
Usually, the principal does not change hands. Each cash flow comprises one leg
of the swap. One cash flow is generally fixed, while the other is variable and based
on a benchmark interest rate, floating currency exchange rate, or index price.
Swaps offer great flexibility in designing and structuring contracts based on
mutual agreement.
The most common kind of swap is an interest rate swap. Swaps do not trade on
exchanges, and retail investors do not generally engage in swaps.
Rather, swaps are over-the-counter (OTC) contracts primarily between
businesses or financial institutions that are customized to the needs of both parties.
The objective of a swap is to change one scheme of payments into another one of a
different nature, which is more suitable to the needs or objectives of the parties, who
could be retail clients, investors, or large companies.

● An individual client could, for example, decide to make a swap to exchange the
variable payments on a mortgage, which are linked to the Euribor (Euro
Interbank Offered Rate), for payments at a fixed interest rate. In this way, the
risk of unexpected increases in monthly payments would be averted.
● Large companies finance themselves by issuing debt bonds, on which they pay
a fixed interest rate to investors. On many occasions, they contract a swap to
transform those fixed payments into variable rate payments, which are
linked to market interest rates. The reasons for doing so are many, and are
generally intended to optimize the company’s debt structure.
● Likewise, a swap can also be useful for a company that has issued bonds in a
foreign currency and wants to convert those payments into local currency by
contracting a cross-currency swap. Currency swaps may be made because a
company receives a loan or revenues in a foreign currency, which must be
changed into local currency, or vice-versa.
Types Of Swaps
1.Interest Rate Swaps:
The idea behind an interest rate swap is to switch the cash flows from a fixed interest
rate to a floating interest rate. In such a swap, Party A agrees to pay a fixed rate of
interest to Party B on a notional principal for a specified period and on predetermined
intervals.
The most popular types of swaps are plain vanilla interest rate swaps. They allow
two parties to exchange fixed and floating cash flows on an interest-bearing
investment or loan.
Businesses or individuals attempt to secure cost-effective loans but their selected
markets may not offer preferred loan solutions. For instance, an investor may get a
cheaper loan in a floating rate market, but they prefer a fixed rate. Interest rate swaps
enable the investor to switch the cash flows, as desired.
Assume For Example :

Paul prefers a fixed rate loan and has loans available at a floating rate (LIBOR+0.5%)
or at a fixed rate (10.75%). Mary prefers a floating rate loan and has loans available at a
floating rate (LIBOR+0.25%) or at a fixed rate (10%). Due to a better credit rating,
Mary has the advantage over Paul in both the floating rate market (by 0.25%) and in the
fixed rate market (by 0.75%). Her advantage is greater in the fixed rate market so she
picks up the fixed rate loan. However, since she prefers the floating rate, she gets into a
swap contract with a bank to pay LIBOR and receive a 10% fixed rate.

Paul borrows at floating (LIBOR+0.5%), but since he prefers fixed, he enters into a
swap contract with the bank to pay fixed 10.10% and receive the floating rate.
Benefits of the Interest rate Swaps:

Paul pays (LIBOR+0.5%) to the lender and 10.10% to the bank, and receives LIBOR
from the bank. His net payment is 10.6% (fixed). The swap effectively converted his
original floating payment to a fixed rate, getting him the most economical rate.
Similarly, Mary pays 10% to the lender and LIBOR to the bank and receives 10% from
the bank. Her net payment is LIBOR (floating). The swap effectively converted her
original fixed payment to the desired floating, getting her the most economical rate. The
bank takes a cut of 0.10% from what it receives from Paul and pays to Mary.
2.Currency Swaps
● A currency swap, sometimes referred to as a Cross-currency swap, involves the
exchange of interest—and sometimes of principal—in one currency for the same in
another currency. Interest payments are exchanged at fixed dates through the life of
the contract.
● Currency Swaps, useful for hedging interest rate risk, is an agreement between the
two parties for exchanging notional amount in one currency with that of another
currency and its interest rate can be fixed or floating rates denominated in two
currencies.
● Such agreements are valid for the specified period only and could range up to a
period of ten years depending upon the terms and conditions of the contract.
● As exchange of the payments takes place in the two different types of currencies so,
spot rate prevailing at that time is used for calculating the amount of payment.
● A currency swap involves the exchange of interest—and sometimes of principal—in
one currency for the same in another currency.
● Companies doing business abroad often use currency swaps to get more favorable
loan rates in the local currency than if they borrowed money from a local bank.
● Considered to be a foreign exchange transaction, currency swaps are not required by
law to be shown on a company's balance sheet.
 Examples of Currency Swap
Suppose there is an Australian company named A ltd., who is thinking of setting up the
business in another country, i.e., the UK, and for that, it requires GBP 5 million when the
exchange rate AUD/GBP is at 0.5. So that the total required amount in AUD comes to
AUD 10 million. At the same time, there is a company U Ltd based out of the UK, who
wants to set up a business in Australia, and for that, it requires AUD 10 million. Both the
companies need loans for the six-monthly repayments. In both countries, there is high
loan cost for foreign companies as compared with the local companies, and at the same
time, it is also difficult to take a loan by the foreign companies due to the extra
procedural requirements.
The cost of a loan in the UK for foreigners is 10%, and for locals, it is 6%, whereas in
Australia, the cost of the loan for foreigners is 9% and for locals is 5%. Since both the
companies can take the loan in their home countries at a low cost and easily, both
decided to execute the currency swap agreement where A ltd took a loan of AUD 10
million in Australia, and U ltd took a loan of GBP 5 million in the UK and gave their
amount of loan received to each other which enabled both of the firms to start their
business in another country.
Now, after every six months,
An ltd. will pay the interest portion to U ltd for the loan taken in the UK by U ltd
which is calculated as follows:
U Ltd. will pay the interest portion to A ltd for the loan taken in Australia by A ltd, which is calculated as
follows:

Like this payment against the interest will continue till the end of the currency swap
agreement when both of the parties give back to other parties, their original foreign currency
amounts are taken.
Types of Currency Swap
The classification can be done on the basis of different types of leg involved in the contract;
the most common types are listed below
1 Fixed vs. Float
In this type, one leg represents the stream of payments for the fixed interest, while another leg
represents the stream of payments for the floating interest.
2 Float vs. Float (Basis Swap)
This type is also known as the basis swap, where both legs of the swap represent the payments
of floating interest.
3 Fixed vs. Fixed
In this type, both the stream of the swap represents the payments of fixed interest.

● Currency swaps are important financial instruments used by banks, investors, and
multinational corporations.
● Pricing is usually expressed as London Interbank Offered Rate (LIBOR), plus or
minus a certain number of points
Benefits :
By getting into a swap, both firms were able to secure low-cost loans and hedge against
interest rate fluctuations. Variations also exist in currency swaps, including fixed vs.
floating and floating vs. floating. In sum, parties are able to hedge against volatility in
forex rates, secure improved lending rates, and receive foreign capital.
India and Japan signed a bilateral currency swap agreement worth $75 billion in
October 2018 to bring stability to forex and capital markets in India.
India and Japan in March 2022 renewed their bilateral swap arrangements to the extent
of $75 billion. The Bank of Japan, acting as an agent for the Minister of Finance Japan,
and the RBI signed the amendment agreement of the bilateral swap agreement (BSA).
Japan and India believe that the BSA, which aims to strengthen and complement other
financial safety nets, will further deepen financial cooperation between the two
countries and contribute to regional and global financial stability.
Essentially, BSA is a two-way arrangement where both authorities can swap their
local currencies in exchange for dollars.

This means, India can acquire dollars from Japan in exchange for rupees. And,
conversely, Japan can also seek dollars from India in exchange for yen.
The BSA was negotiated between India and Japan during the Indian prime minister’s
visit to Japan in 2018. Consequently, the swap arrangement was signed to the tune of
$75 billion in October 2020, to bring greater stability to foreign exchange.
3. Commodity Swaps

Commodity swaps are common among individuals or companies that use raw materials to
produce goods or finished products. Profit from a finished product may suffer if
commodity prices vary, as output prices may not change in sync with commodity prices.
A commodity swap allows receipt of payment linked to the commodity price against a
fixed rate.

A commodity swap is a type of derivative contract where two parties agree to exchange cash
flows dependent on the price of an underlying commodity. A commodity swap is usually used
to hedge against price swings in the market for a commodity, such as oil and livestock.
Commodity swaps allow for the producers of a commodity and consumers to lock in a set
price for a given commodity.
Commodity swaps are not traded on exchanges. Rather, they are customized deals that
are executed.
Example
● Let us now work through an example. An airline has entered into a contract to pay a
fixed rate of $5.00/gallon for a proportion of its fuel needs. If at the payment period,
the price of fuel is $5.20/gallon, how much has the airline saved, given the contract
is for 200,000 gallons of fuel?
● Here we see that the airline company wants to pay a fixed rate of $5.00 per gallon of
fuel. At this point in time, the difference would be $5.20/gallon – $5.00/gallon =
$0.20/gallon.
● In total, the other party would pay the airline company 200,000 gallons x
$0.20/gallon = $40,000
● This $40,000 would offset the increase in the price of fuel paid by the airline. If the
airline had to pay $5.20/gallon for 200,000 gallons of fuel, this would cost them
$1,040,000. However, due to the swap contract the net amount is: $1,040,000 –
$40,000 = $1,000,000.
● If the price had been $5.00/gallon, the airline company would have paid
$5.00/gallon x 200,000 gallons = $1,000,000.
● We can see that through the swap contract, the airline company is able to ensure a
price of $5.00 per gallon for the specified 200,000 gallons of fuel.
Benefits of the Commodity Swaps:

The first party has locked in the price of the commodity by using a commodity swap,
achieving a price hedge. Commodity swaps are effective hedging tools against variations
in commodity prices or against variation in spreads between the final product and raw
material prices.

On the commodity-Producer side, this will guarantee a stable selling price for them. On
the End-user side, this will guarantee a stable buying price for them. For example,
airline companies have significant fuel costs. They are highly exposed to swings in the
price of oil. A commodity swap is one way for them to reduce this exposure.
4. Credit Default Swaps
The term credit default swap (CDS) refers to a financial derivative that allows an investor to
swap or offset their credit risk with that of another investor. To swap the risk of default, the
lender buys a CDS from another investor who agrees to reimburse the lender in the case the
borrower defaults. Most CDS contracts are maintained via an ongoing premium payment
similar to the regular premiums due on an insurance policy. A lender who is worried about a
borrower defaulting on a loan often uses a CDS to offset or swap that risk.
● Credit default swaps are credit derivative contracts that enable investors to swap credit risk
on a company, a country, or another entity with a different counterparty.
● Lenders purchase CDSs from investors who agree to pay the lender if the borrower ever
defaults on its obligation(s).
● CDSs are traded over-the-counter and are often used to transfer credit exposure on fixed
income products in order to hedge risk.
● There are normally three parties involved in a CDS: the debt issuer, the buyer, and the
seller of the CDS.
● Contracts are customized between the counterparties involved, which makes them opaque,
illiquid, and hard to track for regulators.
CDSs require at least three parties:
● The first party is the institution that issues the debt. This party is also known as the
borrower.
● The debt buyer is the second party, who will also be the CDS buyer if the parties decide
to engage in the contract.
● The CDS seller is the third entity involved in the CDS. This entity is most often a large
bank or insurance company that guarantees the underlying debt between the issuer and
the buyer.
Debt securities often have longer terms to maturity, making it harder for investors to estimate
the risk of the investment. That's why these contracts are an extremely popular way to
manage risk. The buyer makes payments to the seller until the contract's maturity date. In
return, the seller agrees that (in the event that the debt issuer defaults or experiences another
credit event) the seller will pay the buyer the security's value as well as all interest payments
that would have been paid between that time and the maturity date.
Credit default swaps are traded over-the-counter (OTC), which means they are
non-standardized and not verified by an exchange. That's because they are complex and often
bespoke.
Example

Assume Peter bought a 15-year long bond issued by ABC, Inc. The bond is worth $1,000 and
pays annual interest of $50 (i.e., 5% coupon rate). Peter worries that ABC, Inc. may default so
he executes a credit default swap contract with Paul. Under the swap agreement, Peter (CDS
buyer) agrees to pay $15 per year to Paul (CDS seller). Paul trusts ABC, Inc. and is ready to
take the default risk on its behalf. For the $15 receipt per year, Paul will offer insurance to
Peter for his investment and returns. If ABC, Inc. defaults, Paul will pay Peter $1,000 plus
any remaining interest payments. If ABC, Inc. does not default during the 15-year long bond
duration, Paul benefits by keeping the $15 per year without any payables to Peter.

Benefits: The CDS works as insurance to protect lenders and bondholders from
borrowers’ default risk.
DERIVATIVE TRADING
Participants in the Derivatives Market
On the basis of their trading motives, participants in the derivatives markets can be segregated
into four categories – hedgers, speculators, margin traders and arbitrageurs.
1.Hedgers:
Traders, who wish to protect themselves from the risk involved in price movements,
participate in the derivatives market. They are called hedgers. This is because they try to
hedge the price of their assets by undertaking an exact opposite trade in the derivatives
market. Thus, they pass on this risk to those who are willing to bear it. They are so keen
to rid themselves of the uncertainty associated with price movements that they may even
be ready to do so at a predetermined cost.
For example, let's say that you possess 200 shares of a company – ABC Ltd., and the
price of these shares is hovering at around Rs. 110 at present. Your goal is to sell these
shares in six months. However, you worry that the price of these shares could fall
considerably by then. At the same time, you do not want to liquidate your investment
today, as the stock has a possibility of appreciation in the near-term.
You are very clear about the fact that you would like to receive a minimum of Rs. 100
per share and no less. At the same time, in case the price rises above Rs. 100, you would
like to benefit by selling them at the higher price. By paying a small price, you can
purchase a derivative contract called an 'option' that incorporates all your above
requirements. This way, you reduce your losses, and benefit, whether or not the share
price falls. You are, thus, hedging your risks, and transferring them to someone who is
willing to take these risks.
2.Speculators:
As a hedger, you passed on your risk to someone who will willingly take on risks from
you. But why someone do that? There are all kinds of participants in the market.
Some might be averse to risk, while some people embrace them. This is because, the
basic market idea is that risk and return always go hand in hand. Higher the risk, greater
is the chance of high returns. Then again, while you believe that the market will go up,
there will be people who feel that it will fall. These differences in risk profile and market
views distinguish hedgers from speculators. Speculators, unlike hedgers, look for
opportunities to take on risk in the hope of making returns.
Let's go back to our example, wherein you were keen to sell the 200 shares of company
ABC Ltd. after one month, but feared that the price would fall and eat your profits. In
the derivative market, there will be a speculator who expects the market to rise.
Accordingly, he will enter into an agreement with you stating that he will buy shares
from you at Rs. 100 if the price falls below that amount. In return for giving you relief
from this risk, he wants to be paid a small compensation. This way, he earns the
compensation even if the price does not fall and you wish to continue holding your
stock.
This is only one instance of how a speculator could gain from a derivative product. For
every opportunity that the derivative market offers a risk-averse hedger, it offers a
counter opportunity to a trader with a healthy appetite for risk.
In the Indian markets, there are two types of speculators – day traders and the
position traders.
● A day trader tries to take advantage of intra-day fluctuations in prices. All their
trades are settled by by undertaking an opposite trade by the end of the day. They
do not have any overnight exposure to the markets.
● On the other hand, position traders greatly rely on news, tips and technical
analysis – the science of predicting trends and prices, and take a longer view, say
a few weeks or a month in order to realize better profits. They take and carry
position for overnight or a long term.
3.Margin traders: Many speculators trade using of the payment mechanism unique to
the derivative markets. This is called margin trading. When you trade in derivative
products, you are not required to pay the total value of your position up front. . Instead,
you are only required to deposit only a fraction of the total sum called margin. This
is why margin trading results in a high leverage factor in derivative trades.
● With a small deposit, you are able to maintain a large outstanding position. The
leverage factor is fixed; there is a limit to how much you can borrow. The
speculator to buy three to five times the quantity that his capital investment would
otherwise have allowed him to buy in the cash market. For this reason, the
conclusion of a trade is called ‘settlement’ – you either pay this outstanding
position or conduct an opposing trade that would nullify this amount.

For example, let's say a sum of Rs. 1.8 lakh fetches you 180 shares of ABC Ltd.
in the cash market at the rate of Rs. 1,000 per share. Suppose margin trading in
the derivatives market allows you to purchase shares with a margin amount of
30% of the value of your outstanding position. Then, you will be able to purchase
600 shares of the same company at the same price with your capital of Rs. 1.8
lakh, even though your total position is Rs. 6 lakh.
If the share price rises by Rs. 100, your 180 shares in the cash market will deliver a profit of
Rs. 18,000, which would mean a return of 10% on your investment. However, your payoff
in the derivatives market would be much higher. The same rise of Rs. 100 in the derivative
market would fetch Rs. 60,000, which translates into a whopping return of over 33% on
your investment of Rs. 1.8 lakh. This is how a margin trader, who is basically a speculator,
benefits from trading in the derivative markets.
4.Arbitrageurs: Derivative instruments are valued on the basis of the underlying asset’s
value in the spot market. However, there are times when the price of a stock in the cash
market is lower or higher than it should be, in comparison to its price in the derivatives
market.
Arbitrageurs exploit these imperfections and inefficiencies to their advantage. Arbitrage
trade is a low-risk trade, where a simultaneous purchase of securities is done in one
market and a corresponding sale is carried out in another market. These are done
when the same securities are being quoted at different prices in two markets.
● In the earlier example, suppose the cash market price is Rs. 1000 per share, but is
quoting at Rs. 1010 in the futures market. An arbitrageur would purchase 100
shares at Rs. 1000 in the cash market and simultaneously, sell 100 shares at Rs.
1010 per share in the futures market, thereby making a profit of Rs. 10 per share.