Financial Derivatives PDF

APPENDIX TABLE 1 Course Title Financial Derivatives Credit 2 DURATION 30 hours (Including practical) Eligibility Anybody with a basic Interest for stock market in special context to der...

APPENDIX TABLE 1 Course Title Financial Derivatives Credit 2 DURATION 30 hours (Including practical) Eligibility Anybody with a basic Interest for stock market in special context to derivates. COURSE OBJECTIVE To orient students with basic knowledge of capital market and Investment Management. To understand concept of derivates and its types. To acquaint knowledge of forward future options. Course Outcome Understand emerging structure of derivates market in India. Describe the concept of financial future contracts. Compute call and put options payoffs. Course Content Unit 1: Introduction A. Introduction to Derivatives B. History of Indian Derivatives market. C. Factors influencing the growth of Derivatives market D. Types of Derivatives. Unit 2: Forward Contract A. Meaning of Forward Contract B. Features of Forward Contract C. Advantage of Forward Contract. Unit 3: Forward and Future contract A. Meaning of Future Contract B. Difference between Forward Contract and Future Contract C. Contract specification for Index future, Stock future, D. Pay offs for Future Contract Unit 4: Option contract: A. Meaning of Option Contract. B. European & American option contract, C. Open interest in relation to price & volume (concept), D. Contact specification for index option, stock option, E. In the money, At the Money, Out the money, intrinsic value and pay off, F. Factors determining Option Price. Reference Books 1. S. Kevin, Security Analysis and Portfolio Management, PHI EEE 2. E. Gordon K. Natarajan, Capital Market In India, Himalaya Publication 3. V. A. Avadhani, Investment Management – V.A. AVADHANI 4. V. K. Bhalla, Security Analysis And Portfolio Management, S. Chand 5. Vohra & Bagri, Futures and Options, Tata McGraw hill Latest Edition Financial Derivatives INDEX 1 : Introduction.................................................................................................................... 3 1.1 Introduction to Derivatives.......................................................................................... 3 1.2 History of Indian Derivatives market.......................................................................... 4 1.3 Factors influencing the growth of Derivatives market................................................ 7 1.4 Types of Derivatives................................................................................................. 10 2 : Forward Contract........................................................................................................ 14 2.1 Definition: Forward Contract.................................................................................... 14 2.2 Features/ Characteristics of Forward Contract.......................................................... 15 2.3 Advantages of Forward Contract.............................................................................. 16 2.4 Limitations of Forward Contract............................................................................... 17 3 : Forward and Future contract..................................................................................... 18 3.1 Definition: Future Contract....................................................................................... 18 3.2 Characteristics/ Features of Future Contract............................................................. 18 3.3 Difference between Forward Contract and Future Contract..................................... 19 3.4 Contract specification for Index future..................................................................... 21 3.5 Contract specification for Index future..................................................................... 21 3.6 Pay-offs for Future Contract..................................................................................... 22 4 : OPTION CONTRACT................................................................................................ 24 4.1 Option Contract......................................................................................................... 24 4.2 Features of Option Contract...................................................................................... 25 4.3 Terms used in Options............................................................................................... 26 4.4 Types of Options....................................................................................................... 26 4.4.1 Call option.......................................................................................................... 26 4.4.2 Put option........................................................................................................... 27 4.5 European & American option contract...................................................................... 28 4.6 Contact specification for index option...................................................................... 29 Dr. Boni Bhagat, DRB & NIM (BBA), Vesu, Surat Page 1 Financial Derivatives 4.7 Contact specification for stock option....................................................................... 29 4.8 Moneyness of Option................................................................................................ 30 4.8.1 In-the-money option........................................................................................... 31 4.8.2 At-the-money option.......................................................................................... 31 4.8.3 Out-of-the-money option................................................................................... 31 4.9 Intrinsic Value of Option........................................................................................... 31 4.10 Factors determining Option Price............................................................................. 31 4.11 Pay-off Profile for a Call Option............................................................................... 33 4.12 Pay-off Profile for a Put Option................................................................................ 35 4.13 Open interest in relation to price & volume (concept).............................................. 37 Dr. Boni Bhagat, DRB & NIM (BBA), Vesu, Surat Page 2 Financial Derivatives 1 : Introduction 1.1 Introduction to Derivatives – In general, derivatives are based upon all those major financial instruments which are explicitly traded like equities, debt instruments, forex instruments and commodity based contracts. When we talk about derivatives, we usually mean only financial derivatives, namely, forwards, futures, options, swaps etc. – The peculiar features of derivatives are: a) They can be designed in such a way so as to cater to the varied requirements of the users either by simply using any one of the above instruments or by using a combination of two or more such instruments. b) They can be designed and traded on the basis of the expectations regarding the future price movements of underlying assets. c) They are all off-balance sheet instruments and d) They are used as a device for reducing the risks of fluctuations in asset values.  Definition – Derivative is a contract or a product whose value is derived from value of some other asset known as underlying asset. – These underlying assets can be: a) Metals such as gold, silver, aluminum, copper, zinc, nickel, tin, lead etc. b) Energy resources such as oil (crude oil, products, cracks), coal, electricity, natural gas, etc. c) Agricultural commodities such as wheat, sugar, coffee, cotton, pulses etc. d) Financial assets such as shares, bonds and foreign exchange. – In the Indian context the Securities Contracts (Regulation) Act, 1956 [SC(R)A] defines "derivative" as: 1. A 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. – Since derivatives are securities under the SC(R)A their trading is governed by the regulatory framework under the SC(R)A. Dr. Boni Bhagat, DRB & NIM (BBA), Vesu, Surat Page 3 Financial Derivatives – The term derivative has also been defined in section 45U(a) of the RBI act 1934 as follows: – An instrument, to be settled at a future date, whose value is derived from change in interest rate, foreign exchange rate, credit rating or credit index, price of securities (also called “underlying”), or a combination of more than one of them and includes interest rate swaps, forward rate agreements, foreign currency swaps, foreign currency-rupee swaps, foreign currency options, foreign currency-rupee options or such other instruments as may be specified by RBI from time to time. – Another definition runs as follows: “Derivatives are instruments which make payments calculated using price of interest rates derived from on balance sheet or cash instruments, but do not actually employ those cash instruments to fund payments.” 1.2 History of Indian Derivatives market – Derivative Market in India have been in existence in one form or the other for a long time. In 1875, the Bombay cotton trade association started future trading way back then. – The government of India banned cash settlement and options trading.thus derivative trading shifted to informal forward market. In 1995, the introduction of financial derivative trading in India was promulgation on options in securities laws (amendment) ordinance. It provides for withdrawal of prohibition on options in securities. – Derivative trading commenced in India in June 2000 after SEBI granted the final approval to this effect in may 2001 on the recommendation of L.C.Gupta committee. SEBI permitted the derivative segments of 2 stock exchange NSE and BSE and their clearing house/ corporation to commence trading and settlement in approval derivative contracts.  Chronology of Financial Derivatives in India Dr. Boni Bhagat, DRB & NIM (BBA), Vesu, Surat Page 4 Financial Derivatives Dr. Boni Bhagat, DRB & NIM (BBA), Vesu, Surat Page 5 Financial Derivatives Dr. Boni Bhagat, DRB & NIM (BBA), Vesu, Surat Page 6 Financial Derivatives 1.3 Factors influencing the growth of Derivatives market – The growth of derivative markets is influenced by a variety of factors, including economic conditions, regulatory environment, market participants, technological advancements, and global trends. Here are some key factors that contribute to the growth of derivative markets: 1) Market Demand and Risk Management: As financial markets evolve, there is a growing demand for risk management tools. Derivatives provide a way for market participants to hedge against or speculate on price movements, interest rate changes, currency fluctuations, and other underlying assets. The need for effective risk management drives the demand for derivative products. Derivatives are widely used for risk management by businesses and investors. As the complexity of financial transactions and the need for risk mitigation increase, the demand for derivatives grows. Dr. Boni Bhagat, DRB & NIM (BBA), Vesu, Surat Page 7 Financial Derivatives 2) Market Volatility: Derivatives are widely used for risk management by businesses and investors. As the complexity of financial transactions and the need for risk mitigation increase, the demand for derivatives grows. 3) Globalization and Increased Trade: As international trade and investment continue to grow, the need to manage currency risks, interest rate exposures, and commodity price volatility also increases. Derivatives offer a way to manage these risks, thus driving their adoption. As financial markets become more interconnected globally, derivative markets can experience growth due to increased cross-border trading and investment opportunities. 4) Speculation and Investment Opportunities: Derivatives offer opportunities for traders and investors to speculate on price movements without directly owning the underlying assets. This speculative aspect can attract participants looking for potential high returns. 5) Liquidity and Market Efficiency: Liquid markets attract more participants as they provide ease of trading and narrow bid-ask spreads. Derivative markets can contribute to overall market efficiency by providing liquidity, enhancing price discovery, and reducing transaction costs. Higher market liquidity generally attracts more participants and encourages trading activity in derivative markets. Liquid markets provide easier entry and exit points for traders and investors. 6) Financial Innovation: Continuous financial innovation leads to the creation of new derivative products. These innovations cater to emerging needs in the market and attract participants seeking exposure to previously unavailable asset classes or risk profiles. The introduction of new and innovative derivative products can attract more participants to the market. These products might cater to specific needs or offer more efficient ways to manage risk. 7) Regulatory Framework: Regulatory policies play a crucial role in shaping the derivative market. Regulations that ensure transparency, stability, and investor protection can foster market growth by instilling confidence among participants. Regulatory changes can have a profound impact on derivative markets. Regulations that enhance transparency, reduce Dr. Boni Bhagat, DRB & NIM (BBA), Vesu, Surat Page 8 Financial Derivatives counterparty risk, and promote market integrity can lead to greater investor confidence and market growth. 8) Technological Advancements: Advances in technology have greatly facilitated derivative trading and risk management. Electronic trading platforms, algorithmic trading, and high-frequency trading have made derivatives more accessible and efficient, attracting a wider range of participants. Advances in trading technology, such as high- frequency trading, algorithmic trading, and electronic trading platforms, can increase the efficiency and accessibility of derivative markets, attracting more participants. 9) Diversification: Investors often seek diversification to spread risks across different assets. Derivatives enable exposure to a diverse range of underlying assets without needing to directly own them, thereby supporting portfolio diversification strategies. 10) Interest Rates and Monetary Policy: Central banks' decisions regarding interest rates can influence the demand for derivatives tied to interest rate movements. Changes in monetary policy can lead to increased interest in interest rate derivatives. 11) Macro-Economic Conditions: Economic indicators such as inflation, GDP growth, and employment rates impact various asset classes and, consequently, derivative markets. Economic uncertainty can drive the use of derivatives for risk mitigation. The overall economic environment, including GDP growth, interest rates, inflation, and global economic trends, can significantly affect derivative markets. In times of economic uncertainty, derivatives may be used for risk management or speculation, leading to increased trading activity. Certain macro-economic trends, such as shifts in demographics, consumer behaviour, and industry dynamics, can create opportunities and risks that drive derivative market activity. 12) Market Participants: The participation of various entities, including institutional investors, corporations, banks, and individual traders, contributes to the growth of derivative markets. A diverse set of participants can lead to increased trading volumes and product innovation. Growing interest from institutional investors, hedge funds, and Dr. Boni Bhagat, DRB & NIM (BBA), Vesu, Surat Page 9 Financial Derivatives retail traders can lead to higher trading volumes in derivative markets. Investor sentiment and confidence play a significant role in driving market growth. 13) Education and Awareness: As market participants become more educated about derivatives and their potential uses, the demand for these instruments may grow. Education helps dispel misconceptions and increase the responsible use of derivatives. Increased understanding of derivatives and their applications among investors and market participants can lead to more informed and active engagement in derivative markets. 14) Monetary Policy: Central bank actions and changes in monetary policy can influence interest rates and currency values, which in turn affect derivative markets, especially those related to interest rate and currency derivatives. 1.4 Types of Derivatives – There are many ways in which the derivatives can be categorized based on the markets where they trade, based on the underlying asset and based on the product feature etc. some ways of classification are following: 1) On the basis of linearity and non-linearity: – On the basis of this classification the financial derivatives can be classified into two big class namely linear and non-linear derivatives: (a) Linear derivatives: Those derivatives whose Over-the-counter (OTC) traded derivative: These values depend linearly on the underlying‟s value are called linear derivatives. They are (i) Forwards (ii) Futures (iii) Swaps (b) Non-linear derivatives: Those derivatives whose value is a non-linear function of the underlying are called non-linear derivatives. They are: (i) Options (ii) Convertibles (iii) Equity linked bonds (iv) Reinsurance Dr. Boni Bhagat, DRB & NIM (BBA), Vesu, Surat Page 10 Financial Derivatives (2) On the basis of financial and non-financial: On the basis of this classification the derivatives can be classified into two category namely financial derivatives and non-financial derivatives. (a) Financial derivatives: Those derivatives which are of financial nature are called financial derivatives. They are following: (i) Forwards (ii) Futures (iii) Options (iv) Swaps The above financial derivatives may be credit derivatives, forex, currency fixed-income, interest, insider trading and exchange traded. (b) Non-financial derivatives: Those derivatives which are not of financial nature are called non-financial derivatives. They are following: (i) Commodities (ii) Metals (iii) Weather (iv) Others Dr. Boni Bhagat, DRB & NIM (BBA), Vesu, Surat Page 11 Financial Derivatives (3) On the basis of market where they trade: On the basis of this classification, the derivatives can be classified into three categories namely; a) OTC traded derivatives: OTC derivative contracts are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. The OTC derivative market is the largest market for derivatives and largely unregulated with respect to disclosure of information between parties. They are following: (i) Swaps (ii) Forward rate agreements (iii) Exotic options (iv) Other exotic derivative b) Exchange-traded derivative: Those derivative instruments that are traded via specialized derivatives exchange of other exchange. A derivatives exchange is a market where individual trade standardized contracts that have been defined by the exchange. Derivative exchange act as an intermediary to all related transactions and takes initial margin from both sides of the trade to act as a guarantee. They may be followings: (i) Futures (ii) Options (iii) Interest rate (iv) Index product (v) Convertible (vi) Warrants Dr. Boni Bhagat, DRB & NIM (BBA), Vesu, Surat Page 12 Financial Derivatives (vii) Others c) Common derivative: These derivatives are common in nature/trading and classification. They are following: (i) Forwards (ii) Futures (iii) Options (iv) Binary options (v) Warrant (vi) Swaps Dr. Boni Bhagat, DRB & NIM (BBA), Vesu, Surat Page 13 Financial Derivatives 2 : Forward Contract 2.1 Definition: Forward Contract – Forward contract is an agreement made directly between two parties to buy or sell an asset at a predetermined price (decided today) on a specific date in the future. – Hence a forward contract consists of four major components- a) Asset: the underlying asset specified in the contract, which can be a commodity, currency, index, stock, etc. b) Quantity: It refers to the size of the contract, i.e. the specific amount of units of assets being bought and sold. c) Price: It is the price which will be paid at the expiration date. Also, it includes the currency of payment that will be rendered in. d) Expiration Date: This is the end date when the contract is settled and the asset is delivered and paid. – Forwards are the oldest of all the derivatives. – They are widely used in commodities, foreign exchange, equity and interest rate markets. – What is the basic difference between cash market and forwards? – Example: Assume on March 9, 2018 you wanted to purchase gold from a goldsmith. The market price for gold on March 9, 2018 was Rs. 70,425 for 10 gram and goldsmith agrees to sell you gold at market price. You paid him Rs. 70,425 for 10 gram of gold and took gold. This is a cash market transaction at a price (in this case Rs. 70,425) referred to as spot price. Now suppose you do not want to buy gold on March 9, 2018, but only after 1 month. Goldsmith quotes you Rs. 70,450 for 10 grams of gold. You agree to the forward price for 10 grams of gold and go away. Here, in this example, you have bought forward or you are long forward, whereas the goldsmith has sold forwards or short forwards. There is no exchange of money or gold at this point of time. After 1 month, you come back to the goldsmith pay him Rs. 70,450 and collect your gold. This is a forward, where both the parties are obliged to go through with the contract irrespective of the value of the underlying asset (in this case gold) at the point of delivery. – In a forward contract, a user (holder) who promises to buy the specified asset at an agreed price at a fixed future date is said to be in the „Long position‟. On the other hand, the user (holder) who promises to sell at an agreed price at a future date is said to be in „Short Dr. Boni Bhagat, DRB & NIM (BBA), Vesu, Surat Page 14 Financial Derivatives position‟. Thus, „long position‟ and „short position‟ take the form of „buy‟ and „sell‟ in a forward contract. 2.2 Features/ Characteristics of Forward Contract 1) Over the Counter Trading (OTC): – These contracts are purely privately arranged agreements and hence, they are not at all standardized ones. They are traded „over the counter‟ (OTC) and not in exchanges. – There is much flexibility since the contract can be modified according to the requirements of the parties to the contract. – Parties enter into this kind of contract on the basis of the custom, and hence, it is also called „customized contract‟. 2) No down Payment: – There must be a promise to supply or receive a specified asset at an agreed price at a future date. The contracting parties need not pay any down payment at the time of agreement. 3) Settlement at Maturity – The important feature of a forward contract is that no money or commodity changes hand when the contract is signed. Invariably, it takes place on the date of maturity only as given in the contract. 4) Linearity: – Another special feature of a forward rate contract is linearity. It means symmetrical gains or losses due to price fluctuation of the underlying asset. – When the spot price in future exceeds the contract price, the forward buyer stands to gain. The gain will be equal to spot price minus contract price. If the spot price in future falls below the contract price, he incurs a loss. The gain which one can get when the price moves in one direction will be exactly equal to the loss when the price moves in the other direction by the same amount. – It means that the loss of the forward buyers is the gain of the forward seller and vice versa. 5) No Secondary Market: – A forward rate contract is a purely private contract, and hence, it cannot be traded on an Dr. Boni Bhagat, DRB & NIM (BBA), Vesu, Surat Page 15 Financial Derivatives organized stock exchange. So, there is no secondary market for it. 6) Necessity of a Third Party: – There is a need for an intermediary to enable the parties to enter into a forward rate contract. This intermediary may be any financial institution like bank or any other third party. 7) Delivery: – The delivery of the asset which is the subject matter of the contract is essential on the date of the maturity of the contract. 2.3 Advantages of Forward Contract 1) Customization: Forward contracts are highly customizable. Parties can tailor the contract's terms to meet their specific needs, including the underlying asset, quantity, price, and settlement date. This flexibility allows parties to create contracts that closely align with their risk profiles and investment goals. 2) Price Certainty: Forward contracts provide price certainty for both parties involved. By agreeing on a fixed price at the outset, participants can lock in a future transaction price, mitigating the uncertainty associated with market fluctuations. 3) No Down payment: Unlike some other derivatives, like options, forward contracts generally don't require an down payment. This can make them more accessible for businesses and investors looking to hedge their positions or manage risk without an initial cash outlay. 4) Risk Management: Forward contracts are often used for risk management purposes. Businesses can use forward contracts to hedge against adverse price movements in commodities, currencies, interest rates, and other assets. This helps them manage their exposure to market volatility. 5) Private Transactions: Forward contracts are typically private agreements between two parties. This privacy can be advantageous for businesses that want to keep their hedging strategies and financial positions confidential. Dr. Boni Bhagat, DRB & NIM (BBA), Vesu, Surat Page 16 Financial Derivatives 6) Simplicity: The structure of forward contracts is relatively simple, making them easier to understand and use for participants with varying levels of financial expertise. 7) Long-Term Planning: Forward contracts can be useful for long-term planning and budgeting. Businesses can secure prices for future purchases or sales, allowing them to make more accurate financial projections. 8) Potential for Profit: If market conditions move in the favour of one party, they can benefit from the forward contract by securing a better price than what would have been available in the spot market at the time of contract initiation. 2.4 Limitations of Forward Contract 1) Default/ Counterparty Risk: since forward contracts are private arrangements, there‟s a risk that one of the parties might default on their obligations, leading to potential financial losses for the other party. 2) Lack of Liquidity: Forward contracts are not traded on organized exchanges, Risk which can lead to liquidity issues. It might be challenging to find counterparty willing to enter into a forward contract, especially for less common assets. 3) No Flexibility: Once a forward contract is established, both parties are obligated to fulfil the terms of the contract. This lack of flexibility can be limiting if circumstances change. 4) Opportunity Cost: By locking in a fixed price, parties might miss out on potential gains if market prices move significantly in their favour. 5) No Potential for Gains beyond Contract Terms: Unlike options or other derivatives, forward contracts don't provide the opportunity to profit beyond the agreed-upon terms of the contract. 6) Regulatory and Accounting Considerations: Depending on the jurisdiction and the nature of the contract, there might be regulatory requirements or accounting implications that need to be considered. Dr. Boni Bhagat, DRB & NIM (BBA), Vesu, Surat Page 17 Financial Derivatives 3 : Forward and Future contract 3.1 Definition: Future Contract – Future contract is an agreement between two parties made through a organized exchange to buy or sell an asset at a predetermined price on a specific date in the future – It is very similar to a forward contract in all respects excepting the fact that it is completely a standardised one. – Hence, it is rightly said that a futures contract is nothing but a standardised forward contract. It is legally enforceable and it is always traded on an organised exchange. – Clark has defined future trading "as a special type of futures contract bought and sold under the rules of organised exchanges". – The term 'future trading' includes both speculative transactions where futures are bought and sold with the objective of making profits from the price changes and also the hedging or protective transactions where futures are bought and sold with a view to avoiding unforeseen losses resulting from price fluctuations. – As in a forward contract, the trader who promises to buy is said to be in a 'Long Position' and the one who promises to sell is said to be in a 'Short Position' in futures also. 3.2 Characteristics/ Features of Future Contract 1) Highly Standardized – Futures are standardized and legally enforceable. Hence, they are traded only in organized Futures exchanges. It is also difficult to modify the agreement according to the needs of the contracting parties. – Once the agreement is entered into, the chances of modifying it are very rare. 2) Down Payment – The contracting parties need not pay any down payment at the time of agreement. However, they deposit a certain percentage of the contract price with the exchange and it is called initial margin. This gives a guarantee that the contract will be honoured. 3) Settlements – Though future contracts can be held till maturity, they are not so in actual practice. Dr. Boni Bhagat, DRB & NIM (BBA), Vesu, Surat Page 18 Financial Derivatives – Futures instruments are „marked to the market‟ and the exchange records profit and loss on them on daily basis. That is, once a futures contract is entered into, profits and losses to both the parties are calculated on a daily basis. – The difference between the futures price and the spot price on that day constitutes either profit and loss depending upon the prevailing spot prices. The spot price is nothing but the market price prevailing then. 4) Hedging of Price Risks – The main feature of a futures contract is to hedge against price fluctuations. The buyers of a futures contract hope to protect themselves from future spot price increases and the sellers from future spot price decreases. 5) Linearity – Parties to the contract get symmetrical gains or losses due to price fluctuation of the underlying asset on either direction. 6) Secondary Market – Futures are dealt in organized exchanges, and as such, they have secondary market too. 7) Non-delivery of the Asset – The delivery of the asset in question is not essential on the date of maturity of the contract. Generally, parties simply exchange the difference between the future and spot prices on the date of maturity. 3.3 Difference between Forward Contract and Future Contract – For all practical purpose, when a forward contract is standardized and dealt in an organized exchange, it becomes a futures contract. – Basically, they both seem to be one and the same. However, they differ from each other in the following respects. Sr. Parameter Forward Future No 1 Nature of the A forward contract is not at all a A futures contract is a highly Contract standardized one. It is tailor made standardized one where all the terms contract where quantity, price, date, of the contract are standardized and Dr. Boni Bhagat, DRB & NIM (BBA), Vesu, Surat Page 19 Financial Derivatives delivery conditions etc. are they cannot be altered to the negotiated between the parties requirements of parties to the according to their convenience. contract. 2 Existence of there is no secondary market for a Future contract can be traded on Secondary forward contract. organized exchanges (on NSE & Market BSE). Hence, it has a secondary market 3 Settlement A forward contract is always settled Future contract is always settled daily only on the date of maturity basis, irrespective of the maturity date 4 Third party Parties enter into a forward Future contracts are mainly facilitated requirement/ agreement with the help of some through organized exchange and Modus financial intermediary like bank hence requirement of third party does Operandi not exist. 5 Down In the case of a forward contract, the In the case of future contract, the Payment contracting parties need not pay any contracting parties have to deposit a down payment at the time of certain percentage of the contract agreement price as 'Margin Money' with the exchange. 6 Delivery of The delivery of the underlying asset Delivery of asset is not essential on the Asset is essential on the date of maturity of maturity date. The parties can merely forward contract. exchange the difference between the future and spot prices. Dr. Boni Bhagat, DRB & NIM (BBA), Vesu, Surat Page 20 Financial Derivatives 3.4 Contract specification for Index future 3.5 Contract specification for Index future Item Specification Underlying Ambuja Cement Underlying Symbol Ambujacem Lot Size 900 Tick Size Rs. 0.05 Price Bands Not applicable Contract Period 3 Serial Monthly Contract Trading Hours 9:15 AM to 3:30 PM Last Trading/ Expiration Day Last Thursday of expiry month or the preceding day if the last Thursday is holiday. Settlement Daily, in cash on T+1 basis Dr. Boni Bhagat, DRB & NIM (BBA), Vesu, Surat Page 21 Financial Derivatives 3.6 Pay-offs for Future Contract – Pay-off refers to profit or loss in a trade. A pay-off is positive if the investor makes a profit and negative if he makes a loss. – A pay-off diagram represents profit/loss in the form of a graph which has the stock price on the X axis and the profit/ loss on the Y axis. – Thus, from the graph an investor can calculate the profit or loss that his position can make for different stock price values. – Futures contracts have linear or symmetrical payoffs. It implies that the losses as well as profits for the buyer and the seller of a futures contract are unlimited. a) Payoff profile of Future buyer: Long Future – Suppose, a speculator buys ABC Future of two months expiry for Rs. 2220. The figure below shows the payoff for a long position on ABC Future. If the underlying share price goes up, the person in long future position will earn profits and if the share price falls, he will incur loss. Figure: Payoff for investor who went Long ABC Ltd. at Rs. 2220 b) Payoff profile for seller of asset: Short Future – Suppose, a speculator buys ABC Future of two months expiry for Rs. 2220. The figure below shows the payoff for a short position on ABC Future. If the underlying share price goes down, the person in short future position will earn profits and if the share price increases, he will incur loss. Dr. Boni Bhagat, DRB & NIM (BBA), Vesu, Surat Page 22 Financial Derivatives Figure: Payoff for investor who went Short ABC Ltd. at Rs. 2220 Dr. Boni Bhagat, DRB & NIM (BBA), Vesu, Surat Page 23 Financial Derivatives 4 : OPTION CONTRACT 4.1 Option Contract – An option is a derivative contract between a buyer and a seller, where one party (say First Party) gives to the other (say Second Party) the right, but not the obligation, to buy from (or sell to) the First Party the underlying asset on or before a specific day at an agreed-upon price. – Like forwards and futures, options are derivative instruments that provide the opportunity to buy or sell an underlying asset on a future date. – In return for granting the option, the party granting the option collects a payment from the other party. This payment collected is called the “premium” or price of the option. – The right to buy or sell is held by the “option buyer” (also called the option holder); the party granting the right is the “option seller” or “option writer”. – Options traded on the exchanges are backed by the Clearing Corporation thereby minimizing the risk arising due to default by the counter parties involved. Options traded in the OTC market however are not backed by the Clearing Corporation.  Illustration – Suppose A has “bought a call option” of 2000 shares of Hindustan Unilever Limited (HLL) at a strike price of Rs 260 per share at a premium of Rs 10. This option gives A, the buyer of the option, the right to buy 2000 shares of HLL from the seller of the option, on or before August 27, 2009 (expiry date of the option). The seller of the option has the obligation to sell 2000 shares of HLL at Rs 260 per share on or before August 27, 2009 (i.e. whenever asked by the buyer of the option). Suppose instead of buying a call, A has “sold a put option” on 100 Reliance Industries (RIL) shares at a strike price of Rs 2000 at a premium ofRs 8. This option is an obligation to A to buy 100 shares of Reliance Industries (RIL) at a price of Rs 2000 per share on or before August 27 (expiry date of the option) i.e., as and when asked by the buyer of the put option. It depends on the option buyer as to when he exercises the option. As stated earlier, the buyer does not have the obligation to exercise the option. Dr. Boni Bhagat, DRB & NIM (BBA), Vesu, Surat Page 24 Financial Derivatives 4.2 Features of Option Contract (i) Highly Standardised – On one hand, option contracts are highly standardized and so they can be traded only in organized exchanges. Such option instruments cannot be made flexible according to the requirements of the writer as well as the user. (ii) Down Payment – The option holder must pay a certain amount called „premium‟ for holding the right of exercising the option. If the option holder does not exercise his option, he has to forego this premium. (iii) Settlement – Settlement is made only when the option holder exercises his option. Suppose the option is not exercised till maturity, then the agreement automatically lapses and no settlement is required. (iv) Non-Linearity – An option contract does not possess linearity. It means that the option holder‟s profit, when the value of the underlying asset moves in one direction is not equal to his loss when its value moves in the opposite direction by the same amount. In short, profits and losses are not symmetrical under an option contract. (v) No Obligation to Buy or Sell – In all option contracts, the option holder has a right to buy or sell an underlying asset. He can exercise this right at any time during the currency of the contract. But, in no case, he is under an obligation to buy or sell. If he does not buy or sell, the contract will be simply lapsed. Dr. Boni Bhagat, DRB & NIM (BBA), Vesu, Surat Page 25 Financial Derivatives 4.3 Terms used in Options 1) Option Holder – An option holder is an individual who buys the option (holds the right to exercise an option contract) within its specified time frame. – A call option gives the holder the right (but no obligation) to buy an underlying asset. Whereas in put, the holder has the right to sell the underlying asset at a predetermined price, known as the strike price. 2) Option Writer – In an option contract, the seller is usually referred to as a "writer" since he is said to write the contract, It is similar to the seller who is said to be in 'Short position' in a forward contract – However, in a put option, the writer is in a different position. He is obliged to buy shares. In an option contract, the buyer has to pay a certain amount at the time of writing the contract for enjoying the right to buy or sell 3) Option Premium – In an option contract the option writer agrees to buy or sell an underlying asset at a future date for an agreed price from/to the option buyer/seller at his option. This contract like any other contract must be supported by consideration. The consideration for this contract is a sum of money called 'premium. – The premium is nothing but the price which is required to be paid for the purchase of 'right to buy or sell' 4.4 Types of Options 4.4.1 Call option – A call option is an option granting the right to the buyer of the option to buy the underlying asset on a specific day at an agreed upon price, but not the obligation to do so. It is the seller who grants this right to the buyer of the option. – It may be noted that the person who has the right to buy the underlying asset is known as the “buyer of the call option”. – The price at which the buyer has the right to buy the asset is agreed upon at the time of entering the contract. This price is known as the strike price of the contract (call option strike price in this case). Since the buyer of the call option has the right (but no obligation) to buy the Dr. Boni Bhagat, DRB & NIM (BBA), Vesu, Surat Page 26 Financial Derivatives underlying asset, he will exercise his right to buy the underlying asset if and only if the price of the underlying asset in the market is more than the strike price on or before the expiry date of the contract. 4.4.2 Put option – A put option is a contract granting the right to the buyer of the option to sell the underlying asset on or before a specific day at an agreed upon price, but not the obligation to do so. It is the seller who grants this right to the buyer of the option. – The person who has the right to sell the underlying asset is known as the “buyer of the put option”. The price at which the buyer has the right to sell the asset is agreed upon at the time of Dr. Boni Bhagat, DRB & NIM (BBA), Vesu, Surat Page 27 Financial Derivatives entering the contract. This price is known as the strike price of the contract (put option strike price in this case). – Since the buyer of the put option has the right (but not the obligation) to sell the underlying asset, he will exercise his right to sell the underlying asset if and only if the price of the underlying asset in the market is less than the strike price on or before the expiry date of the contract. – The buyer of the put option does not have the obligation to sell if he does not want to. 4.5 European & American option contract – In an Option contract, if the option can be exercised at any time between the writing of the contract and its expiration, it is called as an American option. On the other hand, if it can be exercised only at the time of maturity, it is termed as European option. – European Options: European options are securities that give the owner the right to buy a stock or an index at a certain price at a certain date. Notice the phrase "at a certain date" as opposed to the American style Options that can be exercised "by a certain date." – In other words, the difference between a European and American options is that the European style calls and puts can be exercised ONLY on the expiration date while the American style calls and puts can be exercised at any time PRIOR to their expiration date. – Most index options traded in the U.S. are European style. They also happen to be cash- settled since you can't actually buy 100 shares of an index. – Definition of an American Option: An American option or American Style Call is an option for the right to buy a stock or an index at a certain price at or prior to its expiration date. Notice the phrase "prior to a certain date." This "American Style Call" differs from the "European Style Call" in that the European Style Call can only be exercised "ON the expiration date. Dr. Boni Bhagat, DRB & NIM (BBA), Vesu, Surat Page 28 Financial Derivatives 4.6 Contact specification for index option 4.7 Contact specification for stock option Item Specification Underlying Ambuja Cement Underlying Symbol Ambujacem Lot Size 900 Tick Size Rs. 0.05 Strike Price Minimum of five strike prices (2 ITM, 1 ATM and 2 OTM) Contract Period 3 Serial Monthly Contract Trading Hours 9:15 AM to 3:30 PM Last Trading/ Expiration Day Last Thursday of expiry month or the preceding Dr. Boni Bhagat, DRB & NIM (BBA), Vesu, Surat Page 29 Financial Derivatives day if the last Thursday is holiday. Settlement Cash settlement based on closing price of underlying asset on day of expiry 4.8 Moneyness of Option – "Moneyness" of an option indicates whether an option is worth exercising or not i.e. if the option is exercised by the buyer of the option whether he will receive money or not. – "Moneyness" of an option at any given time depends on where the spot price of the underlying is at that point of time relative to the strike price. – The premium paid is not taken into consideration while calculating moneyness of an Option, since the premium once paid is a sunk cost and the profitability from exercising the option does not depend on the size of the premium. – Therefore, the decision (of the buyer of the option) whether to exercise the option or not is not affected by the size of the premium. The following three terms are used to define the moneyness of an option. Dr. Boni Bhagat, DRB & NIM (BBA), Vesu, Surat Page 30 Financial Derivatives 4.8.1 In-the-money option – An option is said to be in-the-money if on exercising the option, it would produce a cash inflow for the buyer. Thus, Call Options are in-the-money when the value of spot price of the underlying exceeds the strike price. On the other hand, Put Options are in-the- money when the spot price of the underlying is lower than the strike price. 4.8.2 At-the-money option – An at-the-money-option is one in which the spot price of the underlying is equal to the Strike price. It is at the stage where with any movement in the spot price of the underlying, the option will either become in-the-money or out-of-the-money. 4.8.3 Out-of-the-money option – An out-of-the-money option is an opposite of an in-the-money option. An option- holder will not exercise the option when it is out-of-the-money. A Call option is out-of-the-money when its strike price is greater than the spot price of the underlying and a Put option is out-of-the money when the spot price of the underlying is greater than the option's strike price. 4.9 Intrinsic Value of Option – Intrinsic value is the value that any given option would have if it were exercised today. – The intrinsic value is the amount by which the strike price of an option is profitable or in-the- money as compared to the stock's price in the market. – If the option is out-of-the-money or at-the-money, it isn't profitable to exercise it. In this case, the intrinsic value of option is considered as zero. – Hence, we can calculate intrinsic value of call as = Max [0, (spot-strike)] and – The intrinsic value of put will be = Max [0, (strike-spot)]. 4.10 Factors determining Option Price 1) Volatility – Option premiums deflect the personal beliefs of both buyers and sellers. – Buyers of options thrive on changes in stock prices and gladly pay premium for options on volatile stocks. The more stock prices fluctuate in the future, the better their chances, for making money. And the buyers' losses are limited to the amount of the premium. Dr. Boni Bhagat, DRB & NIM (BBA), Vesu, Surat Page 31 Financial Derivatives – On the other hand, sellers detest volatility, since it can only work against them. As a result, option sellers usually demand much higher prices for writing options on volatile stocks. The willingness of buyers to pay higher premiums combined with the reluctance of sellers to write them produces higher premium on options of more volatile stocks. 2) Expiration Date – The expiration date of the option also effects the premium. The odds of a stock making a profitable move increase with time. – The option buyer resembles a brand jumper. The longer the run, the better the chances of making a good jump. Because buyers benefit from the extended periods of time and sellers suffer, buyers or sellers agree to higher premiums for longer lasting options. For this reason, options are a wasting asset. – As time goes on, value of the option decreases, and decline usually occurs at a faster and faster pace. 3) Strike Prices – Strike prices add a further complication to the analysis of options. The striking price remains the same during the entire life of the option contract. – The nearer this strike price is to the market price of the underlying stock, the greater the buyer's chances of making money on the option. In effect the strike price serves as a hurdle placed in front of an investor sprinting after profits. – Higher hurdles or strike prices make it more difficult for option buyers to finish the race on time. In fact, many of the runners fall flat on their faces. No wonder calls with striking prices for above the current market prices sell for so little. 4) Dividends – Dividends also effect option premiums. Generally speaking, firms paying high dividends seldom increase very much in price. So, prospective call buyers avoid options on these stocks. Since options writers collect these dividends in addition to their premium income, they naturally prefer to write options on high dividend stocks. – Buyers and sellers compromise and agree to lower premiums for high-dividend paying stocks. Dr. Boni Bhagat, DRB & NIM (BBA), Vesu, Surat Page 32 Financial Derivatives When the Factor increases Call Price Put Price Current price of underlying stock Increase Decrease Strike price Decrease Increase Time to expiration of option Increase Increase Expected price volatility Increase Increase Short-term interest rate Increase Decrease Anticipated cash dividends Decrease Increase 5) Interest Rates – Interest rates have the opposite impact on premiums. At higher interest rates, options writers sacrifice considerable income by holding stocks instead of bonds. – As a result, they usually demand and get higher premiums for writing options during times of high interest rates. – The impact of each of these factors depends on whether (1) the option is a put or a call and (2) the option is an American option or a European option. A summary of the effect of each factor on put and call option prices is presented in the table below 4.11 Pay-off Profile for a Call Option a) Payoff profile for buyer of call options: Long call – A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option. – The profit/loss that the buyer makes on the option depends on the spot price of the underlying. If upon expiration, the spot price exceeds the strike price, he makes a profit. – Higher the spot price, more is the profit he makes. If the spot price of the underlying is less than the strike price, he lets his option expire un-exercised. His loss in this case is the premium he paid for buying the option. Dr. Boni Bhagat, DRB & NIM (BBA), Vesu, Surat Page 33 Financial Derivatives Figure: Payoff for buyer of call option – Figure gives the payoff for the buyer of a three month call option (often referred to as long call) with a strike of 2250 bought at a premium of 86.60. – As can be seen, as the spot Nifty rises, the call option is in-the-money. If upon expiration, Nifty closes above the strike of 2250, the buyer would exercise his option and profit to the extent of the difference between the Nifty-close and the strike price. The profits possible on this option are potentially unlimited. – However if Nifty falls below the strike of 2250, he lets the option expire. His losses are limited to the extent of the premium he paid for buying the option. b) Payoff profile for writer (seller) of call options: Short call – For selling the option, the writer of the option charges a premium. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. – Whatever is the buyer's profit is the seller's loss. If upon expiration, the spot price exceeds the strike price, the buyer will exercise the option on the writer. – As the spot price increases the writer of the option starts making losses. Higher the spot price, more is the loss he makes. If upon expiration the spot price of the underlying is less than the strike price, the buyer lets his option expire un-exercised and the writer gets to keep the premium. Dr. Boni Bhagat, DRB & NIM (BBA), Vesu, Surat Page 34 Financial Derivatives Figure: Payoff for writer of call option – The figure above gives the payoff for the writer of a three month call option (often referred to as short call) with a strike of 2250 sold at a premium of 86.60. – As the spot Nifty rises, the call option is in-the-money and the writer starts making losses. If upon expiration, Nifty closes above the strike of 2250, the buyer would exercise his option on the writer who would suffer a loss to the extent of the difference between the Nifty- close and the strike price. – The loss that can be incurred by the writer of the option is potentially unlimited, whereas the maximum profit is limited to the extent of the up-front option premium of Rs.86.60 charged by him. 4.12 Pay-off Profile for a Put Option a) Payoff profile for buyer of put options: Long put – A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option. – The profit/loss that the buyer makes on the option depends on the spot price of the underlying. If upon expiration, the spot price is below the strike price, he makes a profit. Lower the spot price, more is the profit he makes. – If the spot price of the underlying is higher than the strike price, he lets his option expire un- exercised. His loss in this case is the premium he paid for buying the option. Dr. Boni Bhagat, DRB & NIM (BBA), Vesu, Surat Page 35 Financial Derivatives Figure: Payoff for buyer of put option – The figure above gives the payoff for the buyer of a three month put option (often referred to as long put) with a strike of 2250 bought at a premium of 61.70. – As can be seen, as the spot Nifty falls, the put option is in-the-money. If upon expiration, Nifty closes below the strike of 2250, the buyer would exercise his option and profit to the extent of the difference between the strike price and Nifty-close. The profits possible on this option can be as high as the strike price. However if Nifty rises above the strike of 2250, he lets the option expire. His losses are limited to the extent of the premium he paid for buying the option. b) Payoff profile for writer (seller) of put options: Short put – A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option. For selling the option, the writer of the option charges a premium. – The profit/loss that the buyer makes on the option depends on the spot price of the underlying. Whatever is the buyer's profit is the seller's loss. If upon expiration, the spot price happens to be below the strike price, the buyer will exercise the option on the writer. – If upon expiration the spot price of the underlying is more than the strike price, the buyer lets his option un-exercised and the writer gets to keep the premium. Dr. Boni Bhagat, DRB & NIM (BBA), Vesu, Surat Page 36 Financial Derivatives Figure: Payoff for writer of put option – The figure above gives the payoff for the writer of a three month put option (often referred to as short put) with a strike of 2250 sold at a premium of 61.70. – As the spot Nifty falls, the put option is in-the-money and the writer starts making losses. If upon expiration, Nifty closes below the strike of 2250, the buyer would exercise his option on the writer who would suffer a loss to the extent of the difference between the strike price and Nifty close. – The loss that can be incurred by the writer of the option is a maximum extent of the strike price (Since the worst that can happen is that the asset price can fall to zero) whereas the maximum profit is limited to the extent of the up-front option premium of Rs.61.70 charged by him. 4.13 Open interest in relation to price & volume (concept) – Open interest (also known as open contracts or open commitments) refers to the total number of derivative contracts, like futures and options, that have not been settled for a specific underlying security. – A large open interest indicates more activity and liquidity for the contract. It can also be defined as the total number of futures contracts or option contracts that have not yet been exercised (squared off), expired, or fulfilled by delivery. – For some option traders, open interest indicates the intensity of trading in a financial instrument. – For each buyer of a futures/Option contract there must be a seller. From the time the buyer or seller opens the contract until the counter-party closes it, that contract is considered 'open'. – If open interest increases suddenly, it is likely that new information about the underlying security has been revealed, which may indicate a near-term rise in the underlying security's volatility. – However, neither an increase in volatility nor open interest necessarily indicate anything about the direction of future price movements. Dr. Boni Bhagat, DRB & NIM (BBA), Vesu, Surat Page 37 Financial Derivatives – Example: If the first trader to trade an option contract purchases 10 contracts, that trader is long 10 contracts and the open interest is 10, volume is also 10. Dr. Boni Bhagat, DRB & NIM (BBA), Vesu, Surat Page 38