derivatives and valn

8/6/2019 Derivatives and Valn

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DerivativesDr Roshna Varghese



Outline of the lectures

Session 1 Investment and securities

Introduction to Derivatives

Options

Session 2 Futures

Stock , Commodity, currency f utures

Session 3 Swaps

Stock exchange regulations



Investment

Investment is a commitment of f unds made in theexpectation of some positive rate of return.

Investment

Savings, , if Income > expenditure

Expectation of return

Tangible Asset

Physical ass- E.g. Land, machinery, work of art

Dealt in product market

Intangible Asset

Financial Assets - shares, bonds, derivatives, mutual f unds,

Dealt in Financial market



Characteristics of investment

Return

Risk

Marketability

Safety



Investment Avenues

Corporate Securities Equity shares Preference shares

Debentures/Bonds

GDRs/ADRs

Derivatives Govt and semi govt Securities

Money market instruments

Mutual f und schemes

Deposits in banks and non banking companies Post off ice Savings/Life insurance policies

Provident f und schemes

Real assets Real estate, precious objects



Securities

Def inition of Security -

Securities include shares, bonds, debentures or

other marketable securities like securities of

incorporated companies or other body corporates orgovernment.

Securities Contract Regulation Act 1956



Securities Market

Money Market Debt instruments having a maturity of less than

one year are dealt in money market.

T- bill market, Ready forward contracts (Repo)

market, Call money market, Commercial Paper

market

Capital Market

Securities with maturities of more than one yearare bought and sold in the capital market.

Equity Market; Debt Market ; Derivatives market

Primary or Secondary market



Derivatives



Derivatives

Instruments that derive value from

underlying assets.

Changes in price of the underlying

asset affect the price of the derivativesecurity.



Derivatives Underlying assets

Commodities including grain, coffee ..

Precious metal like gold and silver

Securities stock, Bonds and other debt instruments

Foreign Exchange rate Interest rate

Index of prices

Weather,.



Types of Derivatives

Options

Futures

Complex DerivativesSwaps

Credit Derivatives



Derivatives permitted in India

Derivatives

Equity

Index f utures& Options

Single stockoptions &f utures

Debt

Interest ratef utures &forwards

Interest rateswaps

Forex

Currency f utures

Currency options

Forwards

Cross currency swaps

Commoditi

es

Forwards

Futures



What are f utures and options?

A contract to make or take delivery of a product

in the f uture, at a price set in the present

In formalized f utures and options trading on

exchanges, standardized agreements specif y

price, quantity, and month of delivery

Started in agriculture, but have expanded to a

wide range of products



Derivatives - History

Not a modern invention First option transaction by Greek Philosopher Thales from

Miletus (624 BC 546 BC)

Evolved from commodity markets

Establishment of Chicago Board of Trade (CBoT) in1848

Publication of Black Scholes Option pricing model in1973

In India First organised f utures market in 1875 in Bombay

Af ter independence, prohibited derivatives trading

Reintroduction in 2000



Options

Option is the right to either buy or sell something, at a specif ied price within a specif ied period of time.

Is a contract in which the writer of the option grantsthe buyer of the option the right to purchase from orsell to the writer a designated instrument at a

specif ic price within a specif ied period of time.



Options

The writer grants the right to the buyer for acertain sum of money option premium.

The price at which the buyer can exercise theoption Exercise price/ strike price/ strikingprice.

Call option & Put option

American option and European Option



Call option & Put option

Call option :

An option that grants the buyer the right to

purchase a designated instrument.

Put option :

An option that grants the buyer the right to sell

the designated instrument.



Options Terminology

American option & European option

American option :

can be exercised on or before the expirationdate.

European option : can be exercised only on the expiration

date.



Return and risk of Buyer and seller of

Option contract

Seller has an obligation and buyer has a right inoption agreement

Buyer

Limited amount of risk (max loss is premium paid)

Return (prof it) potential in unlimited

Seller

Unlimited risk

Limited return potential



Options Underlying Assets

Financial options Stock

Indices

Treasury Bonds, debentures

Forex rate

Commodity options Agricultural commodities

Industrial commodities

In India, option trading in all commodities is prohibitedby Forwards Contracts (Regulation) Act, 1952



` A std option contract : allows the buyer to buy or sell«. shares of stock at a specific price.

` Call option & Put option

` Expiration date : date on which the option contractexpires.

` Exercise price / Striking price

` Premium : Synonymous with price



` Buyer (holder).

` original seller is called writer. Seller is not the same

as writer for an existing option.

` Option Buyer ± is in Long position

Option Writers ± is in short position

` Writing calls covered : Writing call options against

the shares owned by the writer

` Uncovered call options : Writing call options

without owning the underlying shares.



At any time , option maybe:

Call Put

` At the money : ExP = MP ExP = MP

` In the money : ExP < MP ExP > MP

`

Out of the money: ExP > MP ExP < MP



Why buy options

A Call option is cheaper than the underlyingshares.

Buying a call rather than shares will reducethe his prof it by the amount of premium if theshare price advances, but it will limit his lossto the amount of the premium if it declines.

Put option is used for by the buyer as saferway of betting on decline in stock price.



Why sell options

Sold by conservative investors who want

additional income.

Earn premium



Payoff Diagram on a Call

Price of

underlying asset

Strike Price

Net Payoff

On a call



Payoff Diagram on Put Option

Price of underlying

asset

Strike

Price

Net Payoff

On Put



Trading in derivatives

Trading in options on index and stocks

commenced on NSE and BSE in 2001

Currency options in NSE and USE in October

2010



Financial Options

Single stock options

Trading in options on individual securities commencedfrom July , 2001.

Option contracts are European style and cash settledand are available on 223 securities stipulated by the

Securities & Exchange Board of India (SEBI). The value of the option contracts on individual

securities may not be less than Rs. 2 lakhs at the timeof introduction for the f irst time at any exchange

Options contracts expire on the last Thursday of theexpiry month.

If the last Thursday is a trading holiday, the contracts expireon the previous trading day.



Financial Options

Index Options

NSE introduced trading in index options on

June 4, 2001.

The options contracts are European style andcash settled

The value of the option contracts on Nif ty may

not be less than Rs. 2 lakhs at the time of

introduction

Nif ty Index contract multiplier is 100

BSE Senses contract multiplier is 50



Trading cycle

S&P CNX Nif ty options contracts have

3 consecutive monthly contracts

On expiry of the near month contract, new

contracts (monthly/quarterly/ half yearly contracts

as applicable) are introduced at new strike prices

for both call and put options, on the trading day following the expiry of the near month contract.



ET Reading - Options



ET reading of options

Open interest

Number of outstanding contracts at a particular

point of time, typically at the end of the trading

day.

Total no of long positions will always be equal to

the total number of short positions, only one side

of the contract will be counted

Contracts



Determinants of option value

Determiningfactors

Effect of increase holdingothers constant

Put Call

1 Current stock price Decreases Increases

2 Striking price Increases Decreases

3 Time to expiration Increases Increases

4 Stock volatility Increases Increases

5 Interest rates Decreases Increases

6 Cash dividends Increases Decreases



Option value

Rate of change in option price due to change in priceof the underlying asset is known as Delta.

Rate of change in option price due to time lef t toexpiration is known as Theta.

Rate of change in option price due to change in

volatility of the underlying asset is known as Vega.

Rate of change in option price due to change ininterest rate is known as Rho.



Option Pricing

Black Scholes Option Pricing Model

By Black and Scholes in 1973.

Pc = Ps N(d1) Pe e-rTN (d2) Pc = Market value of the call option

Ps = Current market price of the underlying asset

N(d1) & N(d2) = cumulative normal distribution f unction of d1 andd2 respectively.

Pe = Exercise price,

e = Exponential constant 2.71828

r = Risk free interest rate, T = Time to expiration (in years)

d1 = [ln (Ps/Pe) + (r + 0.52)T] / T

d2 = d1 (T)



Black Scholes Option Pricing Model -

Assumptions

The stock underlying the call option provides nodividends during the options life.

There are no transaction costs involved in buying andselling the option.

The risk free interest is assumed to be constant duringthe life of the option.

The call option can be exercised only on its expirationdate.

The movement of stock prices is taken to be random.



Combinations of Put and Call Options or Option

Strategies

� Straddle

� Strip

� Strap

� Strangle

� Spread



Options Strategies Strip

A strip is two puts and one call at the same

exercise price for the same period.

Buyer of a strip believes that the securitys

price is more likely to fall than to rise.



Options Strategies Strap

A strap is two calls and one put at the same

contracted exercise price and for the same

period.

Buyer of a strap believes that the securitys

price is more likely to rise than to fall.



Options Strategies -Strangle

Buying a put and a call option with the same

expiration date but with different exercise prices.

Prof it can be made if stock price is lower than priceof put or stock price exceeds price of call.



Futures



Futures

A f utures is a f irm legal commitment between

a buyer and a seller in which they agree to

exchange something at a specif ied price at the

end of a designated period of time.

Exchange traded f utures are standardized as

to quantity, quality, time and place of delivery.



Features - Futures

All f utures contracts are traded on the f utures(derivatives) section of the stock exchange andcommodity exchanges.

The f utures contract will be settled at the prevailingspot price of the asset

Although these contracts cannot be liquidated before

their expiry date, you can sell them on the exchange. In other words, a f utures contract is bought and sold

regularly on the market till its expiry.



Types of Futures

Financial f utures A f utures contract in a f inancial instrument like equity

shares, stock market indices, debt securities or foreigncurrencies.

Stock f utures

Index f utures

Currency f utures

Interest rate f utures

Commodity Futures Agro based commodities

Industry based commodities



Pricing a f utures contract

�The fair price of f utures contracts depends upon the spot price andthe cost of carry. Cost of carry is the sum of all costs that you would

have to bear if you purchased the underlying asset now from the

stock market and held on to it until the time of maturity of the

f utures contract, less any dividends received in this period. The

cost typically includes interest costs.

� Example: Suppose you purchased stock futures of Company ABC

when its price was Rs 1,000. Let's assume that no dividends are

expected and that the one-month cost of carry is 1.5 per cent. Thefair price for Company ABC's stock f utures contract that expires

af ter a month is Rs 1,015 (the current price plus interest). Apart

from the theoretical value, the actual value may vary depending on

the present demand and supply of the underlying asset and

expectations about the f uture.



Futures Terminology

� The basis The difference between the price of the underlying

asset in the spot market and f utures market is known

as the basis. Although both these prices generally move in line with

each other, the basis is not constant.

Generally, the basis will decrease with time and on expiry,

the basis will become zero and the price of the underlyingasset in both the markets will become the same.



Futures Terminology

� Contango and Backwardation

Under normal market conditions, the price of

the underlying asset in the f utures market

exceeds its price in the spot market. This is

known as the 'Contango Market'.

The reverse situation is called 'Backwardation'.



Types of Futures

Financial f utures A f utures contract in a f inancial instrument like equity

shares, stock market indices, debt securities or foreigncurrencies.

Stock f utures

Index f utures

Currency f utures


Commodity Futures Agro based commodities

Industry based commodities



Futures on individual stocks

Introduced in India in 2001.

List of securities permitted as specif ied by SEBI.

3 month trading cycle.



Working of a futures contract

Example of buying a futures contract

� You expect the price of Company ABC to move up from the present

level of Rs 100 to Rs 150 in the cash market. To prof it from such a

scenario, you buy a f utures contract of Company ABC. The f utures

contract will be settled at the prevailing spot price of the shares of

Company ABC in the cash market at the time of expiry of thecontract. That there is no delivery of shares that take place.

� Presently, the f utures contract (1 f uture contract =100 shares) of

Company ABC is quoting at Rs 12,000 in the f utures market. Thismeans 1 share of Company ABC is valued at Rs 120 in the f utures

market. The share is valued at a higher price in the f utures market

(vis-à-vis the cash market) because it includes the cost of carry and

also accounts for the market sentiment.



Example of buying a futures contract

� If the share price of Company ABC reaches Rs 150 in the cashmarket on expiry of the contract, your f utures contract will besettled at Rs 15,000 (spot price in cash market of Rs 150 x 100shares). Your prof it would be Rs 3,000 (f utures contract value at the time of settlement i.e. Rs 15,000 - f utures contract value at the time of purchase i.e. Rs 12,000). In any case, you will earnprof it on the f utures contract on shares of Company ABC if theprice of the share at the time of expiry in the cash market isabove your cost price of Rs 120.

� However, if the price of Company ABC is below your cost of Rs120 per share at the time of expiry of the f utures contract, you have incurred a loss on the Contract.



Example of selling a futures contract

� Y

ou expect the price of Company ABC to fall from the present value of Rs 100 to Rs 70 in the cash market. To prof it from

such a scenario, you sell a f utures contract of Company ABC.

The f utures contract will be settled at the prevailing spot price

of the shares of Company ABC in the cash market at the time

of expiry of the contract. Keep in mind though, that there isno delivery of shares that take place.

� Presently, the f utures contract (1 f uture contract = 100 shares)

of Company ABC is quoting at Rs 10,500 in the f utures market.� This means that 1 share of Company ABC is valued at Rs 105 in

the f utures market. The share is valued at a higher price in the

f utures market (vis-à-vis the cash market) because it includes

the cost of carry and also accounts for the market sentiment.



Example of selling a futures contract (contd.)

� If the share price of Company ABC reaches Rs 70 in the cash

market on expiry of the contract, your f utures contract will be

settled at Rs 7,000 (spot price in cash market of Rs 70 x 100

shares). Your prof it would be Rs 3,500 (f utures contract value at

the time of sale i.e. Rs 10,500 - f utures contract value at the

time of settlement i.e. Rs 7,000). On settlement, your brokerwill ref und your margin af ter reducing relevant charges and pay

you your prof it. In any case, you will earn prof it on the f utures

contract on shares of Company ABC if the price of the share at

the time of expiry in the cash market is below your selling price

of Rs 105.

� However, if the price of Company ABC is above your selling price

of Rs 105 per share at the time of expiry of the f utures contract,

you have incurred a loss on the contract.



Stock Index f utures

A stock index f uture is an obligation to deliver at settlement an amount of cash equal to a certain

times the difference between the stock index value

at the last trading day of the contract and the price

at which the f utures contract was originally struck.

(Buyer gets money if the index moves up and buyer

has to give money to seller if the index moves down).

Index f utures are settled in cash

NSE S&P CNX Nif ty Futures, BSE Sensex Futures



Futures vs OptionsFutures

1. In case of f utures, both the

buyer and seller are

obligated to buy/sell the

underlying asset.

2. In case of f utures contracts,

both the parties - the buyer

and the seller -face the same

level of risk.

3. Futures contract prices areaffected mainly by the prices

of the underlying asset in the

cash market.

Options1. In case of options the buyer en joys

the right and not the obligation, to

buy or sell the underlying asset.

2. In case of options, the buyer faces

a limited amount of risk (extent of premium paid) while the seller i.e.

the option writer, faces unlimited

risk.

� 3. The prices of options are

affected by the prices of the

underlying asset, time remaining

for expiry of the contract and

volatility of the underlying asset.




Trading in index f utures began on NSE and BSE in2000

Trading on single stock f utures began on NSE and

BSE in 2002

Introduction of interest rate f utures on NSE andcommodity f utures in 2003

Currency f utures was launched in NSE, BSE andMCX in August 2008



Other Types of f utures

Financial Derivatives Foreign currency f utures :

Futures contract in foreign currencies.

Interest rate f utures : Futures on interest bearing securities like bills, bonds

and debentures.

Treasury bill f utures

10 year bonds f utures

Commodity Futures



Currency f utures

Agreement between two parties to exchange onecurrency for another at a specif ied date in f uturein an exchange rate being f ixed at the time theagreement is entered into.

Currency Futures are standard contracts of aspecif ied quantity to exchange one currency for

another at a specif ied date in the f uture calledsettlement date at a price that is f ixed on thepurchase date called f utures price.



Currency f utures in Indian stock exchanges

` Currency f utures was launched in NSE, BSE and MCX inAugust 2008

` Only US Dollar ($) f utures is being traded against the Indian

Rupee (INR) when introduced in Aug 2008.

` The contract for say the month of September will be calledUSDSEP2010.

` RBI allowed f utures trading in three more currencies

the euro, the pound sterling and the yen - in Jan 2010.

` There are 12 near calendar months contract available

for trading.



USD/INR - Q uote/trade

On BSE-CDX, the underlying value is the rate of exchange between one unit of foreign currency

and Indian Rupee.

USD is the base currency and the variable currency

is INR. One unit of USD (One Dollar) is priced in

terms of INR.

E.g. 1USD = INR 48.8525/8550

� The minimum Lot Size/Contract Size is USD 1,000

(and in multiples of USD 1,000 thereaf ter).



Buying currency f utures

Importer, one who has to pay in dollars on 31.03.11

Risk Rupee depreciation (50/$ becomes 55/$)

Eg :X has a payment obligation of 1,000 USD on Mar2011 . Buy a currency f utures to buy 1000 USD at

1USD = INR 50

(i) On the settlement date, if spot rate is Rs 55 his gain

Rs 5,000.

(ii) If spot rate is Rs 45, his loss will be Rs 5,000.



Selling currency f utures

Exporter/ one who will get certain amount in dollarsRisk Rupee appreciation (50/$ becomes 45/$)

Eg : X is expecting a receipt of 1,000 USD on Mar2009. Sell a currency f utures 1,000 USD at 1USD =INR 50

(i) On the settlement date, if spot rate is Rs 45 hisgain Rs 5,000.

(ii) If spot rate is Rs 55, his loss will be Rs 5,000.



BSE and currency derivatives

For providing state-of-the-art infrastructure andtrading base for Currency derivatives, BSE hasstrategically partnered with United Stock

Exchange of India Ltd. (USE), Indias newest stockexchange.

USE represents the commitment of ALL 21 Indian

public sector banks, prestigious private banks andelite corporate houses to build an institution that symbolizes Indias modern f inancial markets.



Interest Rate f utures

An interest rate f utures contract is anagreement to buy or sell a package of debt instruments at a specif ied f uture date at a

price that is f ixed today.

The underlying assets of an interest ratef utures contract are different interest bearinginstruments like Treasury Notes, Treasury Bills,Treasury Bonds, deposits and so on.




The maturity: one to three monthscontracts.

The underlying:the 10 year bonds and the 91-day Treasury bill.

The mode of settlement:cash settlement w.r.t. the price of the bondsprevailing on expiration date.



Example

On 1/1/2011, 10-year bond was priced at Rs.95.43. Lot size 2,000

You believe the interest rate will go up, so you sell three f utures contracts (6,000 bonds) @ Rs.98.

On 31/1/2011, the 10-year bond is at Rs.88.

You have a prof it of Rs.10/bond or Rs.60,000overall.



d



Commodity Futures Commodity f utures contract is a contractual agreement

between two parties to buy or sell a specif ied quantity and quality of commodity at a certain time in f uture at

a certain price agreed at the time of entering into the

contract on the commodity exchange.

The kinds of commodities being traded are:

Agriculture based commodities such as rice, wheat, sugar,

Soybean, soya Oil, Chana, Palm Oil, Jeerra, Pepper, Turmeric,

Chilli, Cardamon, Guar Gum, Guar Seed, Mentha Oil, RMseed.

Mineral-based commodities such as gold, platinum,

aluminum, copper, zinc, etc

Energy Crude oil etc



Commodity Exchanges

Globally New York Mercantile Exchange (NYMEX)

Chicago Board of Trade (CBOT)

Chicago Mercantile Exchange (CME)

London Metal Exchange (LME)

In India Multi Commodity Exchange of India (MCX) (2003), Mumbai

National Commodity and Derivative Exchange (NCDEX) (2003),

Mumbai National Multi Commodity Exchange of India (NMCE), (2003)

Indian Commodity Exchange (ICEX)



Commodity Future contracts e.g.

Cotton

COTJ34BTD is Cotton J34 grade Bhatinda location

COTLSCKDI is Long Staple Cotton grade Kadi

location.

Rubber

FUT-RBRRS4KTM-20-Jan-2006



Forwards

FCRA def ines forward contract as a contract for the delivery of goods and which is not aready delivery contract

Ready delivery contract is one which providesfor delivery of goods and payment of priceeither immediately or within such period not exceeding 11 days af ter the date of thecontract. Requires physical delivery of goods.



ET Reading - Futures



M

ARG

IN REQU

IREME

NTS; TYPE

S OF

ORDERS;WEATHER & ELECTRICITY

DERIVATIVES; SWAPS

Session 3

Futures trading



Futures trading

Margin Requirements

Initial Margin

Maintenance margin

Mark to Market Margin (MTM)

M i R i t



Margin Requirements

Initial Margin: The margin that is required to be deposited to theclearing house of the exchange at the time of entering into the contract. A certain percentage of the contract value.

Based on SPAN (Standard Portfolio Analysis of Risk)

Maintenance margin : If margin money is reduced below the

maintenance level, the member is expected tobring in additional amount and restore the margin

at least to the initial level.



Margin Requirements

Marking to market :

The process of revaluing the contract based on the

ruling price of the contracts is known as marking

to market.

With reference to the closing price of the

underlying stock.

M i E



Margins - E.g.

For an options contract the initial margin andmaintenance margin prescribed be Rs 4,000 and

3,000 respectively.

Future price 75

Share price:

Day 1 Rs 74

Day 2 Rs 73

Day 3 Rs 72

Day 4 Rs 76

Margins - Eg



Margins Eg

Particulars Day 1 Day 2 Day 3 Day 4

Share price 74 72 73 76Contract value 7400 7,200 7,200 7,600

Marginmoney a/c of Buyer

1 opening balance 4,000 3,000 4,000 4,000

2 Amt to be ad justed - 1000 -2,000 1,000 3,000

3. Ad justed Balance 3,000 1,000 5,000 7,000

4 Amt deposited/withdrawn - 3,000 -1,000 -3,000

5 Closing balance 3,000 4,000 4,000 4,000

Marginmoney a/c of seller

1 opening balance 4,000 4,000 4,000 3,000

2 Amt to be ad justed 1000 2,000 -1,000 -3,000

3. Ad justed Balance 5,000 6,000 3,000 ---

4 Amt deposited/withdrawn -1,000 -2,000 --- 4,000

5 Closing balance 4,000 4,000 3,000 4,000

Future price Rs 75 Contact value 7500



`

Anorder

in a market is an instruction fromcustomers to brokers to buy or sell on the

exchange.

�Types of orders

� Market order � Limit order

� Stop loss order

�

Time order � Good till day

� Good till date

� Good till cancelled

T f O d



Types of Orders

Market order is a buy or sell order to be executed immediately at

current market prices. The order is f illed at the best price available at the relevant time.

Limit order is an order to buy a security at not more, or sell at not

less, than a specif ic price.

A buy limit order can only be executed at the limit price or lower; A sell limit order can only be executed

at the limit price or higher. Stop loss order (Stop order) is an order to buy (or sell) a security once the price of

the security has climbed above (or dropped below) aspecif ied stop price.



Types of Orders

Time order

Good till day

order that is in force from the time the order is

submitted to the end of the day's trading session Good till date

Order that is in force till a specif ic date mentioned

Good till cancelled

order requires a specif ic cancelling order. It can persist

indef initely (although brokers may set some limits, for

example, 90 days).

Weather derivatives



Weather derivatives

Weather derivatives are f inancial instruments

to reduce risk associated with adverse or unexpectedweather conditions.

the underlying asset (rain/temperature/snow) has nodirect value to price the weather derivative.

Players

Farmers can use - to hedge against poor harvestscaused by drought or frost;

theme parks -to insure against rainy weekends duringpeak summer seasons; and power companies

A sports event managing company - to hedge the lossbecause if it rains the day of the sporting event, fewer

tickets will be sold.

Weather derivatives



Weather derivatives Chicago Mercantile Exchange introduced the f irst exchange-traded

weather f utures ( & options), in 1999 Heating Degree Days (HDD) or Cooling Degree Days (CDD) contracts

Weather contracts on U.S. cities for the winter months are tied

to an index of heating degree day (HDD) values. These values

represent temperatures for days on which energy is used for

heating.

The contracts for U.S. cities in the summer months are geared to

an index of cooling degree day (CDD) values, which represent

temperatures for days on which energy is used for air

conditioning.

Both HDD and CDD values are calculated according to how many

degrees a day's average temperature varies from a baseline of

65° Fahrenheit.



Weather derivatives

The baseline temperature is f ixed; it is 65o

Fahrenheit in the U.S and 18o Celsius inEurope.

The Earth Satellite Corporation, anindependent entity, calculates HDD and CDDindex ensuring transparency and

independence in the benchmark.

Weather derivatives



� Measuring Daily Index ValuesAn HDD value equals the number of degrees the day's averagetemperature is lower than 65° F. For example, a day's averagetemperature of 40° F would give you an HDD value of 25 (65 - 40). If the temperature exceeded 65° F, the value of the HDD would be zero.This is because in theory there typically would be no need for heatingon a day warmer than 65°.

�Measuring Daily Index ValuesAn HDD value equals the number of degrees the day's averagetemperature is lower than 65° F. For example, a day's averagetemperature of 40° F would give you an HDD value of 25 (65 - 40). If the temperature exceeded 65° F, the value of the HDD would be zero.This is because in theory there typically would be no need for heatingon a day warmer than 65°.

� Measuring Monthly Index ValuesA monthly HDD or CDD index value is simply the sum of all daily HDDor CDD value recorded that month

� The value of a CME weather f utures contract is determined by

multiplying the monthly HDD or CDD value by $20.



Swap

Recent origin since 1981.

An agreement by two parties to exchange a

series of cash f lows in the f uture

Types :

Foreign currency Swap

Interest rate Swap

other kinds- commodity swap, equity swap



Foreign currency Swap

An agreement between two parties to

exchange payments or receipts in one

currency for payments or receipts in

another.

Foreign currency Swap -Eg



Foreign currency Swap Eg

Firm A in New York needs GBP 1 million which it can repay in 3

years. Firm B in London needs similar value in US dollars. Therate at which companies can borrow is:

If both companies raise the needed f unds in the market, then

A has to pay 9% and f irm B 8%. So it would be to their mutual advantage that if f irm A raises the loan in dollars at 6% andf irm B in Pound sterling and they exchange their liabilities.The arrangement would be

Company Interest rates

Dollars (%) Pound Sterling (%)

Firm A in New York 6% 9%

Firm B in London 8% 7%

Foreign currency Swap Eg



Foreign currency Swap -Eg

On the date of contract, f irm A raises a loan of USD 1.6million (assuming spot rate GBP 1 = USD 1.6) and remit the amount to B. Firm B raises a loan of GBP1 million andremits this to f irm A.

Periodically, say every 6 moths, f irm A calculates interest on sterling as 7% and remits the amount to Firm B toenable it to pay the interest on sterling loan. Similarly f irm B remits interest in dollars to f irm A at 6%.

On maturity f irm A remits GBP 1 million to f irm B torepay the loan raised by the latter. Similarly, f irm B remitsUSD 1.6 million to f irm A

Interest rate Swap



Interest rate Swap

An agreement between two parties to

exchange a f ixed interest rate for f loating

interest rate on a principal sum.

Interest rate Swap Eg



Interest rate Swap - Eg� Two British companies both wish to borrow 10 million

pounds. Company A is a giant company with an excellent

credit rating. Company B is a medium sized company of

ten years standing with a lower credit rating. Both

companies have the option of borrowing either at f ixed

rates or at f loating rates. Company A would prefer toraise loan under the f ixed rate loan while company B w

prefer to f loating rate. The quoted rates of interest to the

companies are as follows:-

Company Q uoted interest rates

Fixed (%) Floating (%)

A 7.5 LIBOR + 0.5%

B 9.0 LIBOR + 3.5%

Interest rate Swap - Eg



Interest rate Swap - Eg Bs cost of f unds is higher than A on both f loating and f ixed.

For f ixed Bs extra cost is 1.5% (9 7.5) For Floating B extra cost is 3%.

Thus B has a comparative advantage in f ixed rate market.

C Ltd, a broker arranges a swap. Under this, A actually borrows 10 million pounds from a bank at LIBOR + 0.5% and Bborrows 10 million pounds from a bank at 9% f ixed rate . As aseparate transaction (which constitutes Swap) A, B and Cagree as follows

fixed 7% fixed 6.5%A C B

floating LIBOR + 0.5% floating LIBOR +0.5%

Bank - LIBOR +0.5% Bank Fixed 9%

Interest rate Swap Eg



Interest rate Swap - Eg Total outf low

A =(LIBOR +0.5%) -(LIBOR +0.5%) 7% = 7%. B = -(LIBOR +0.5%) - 9% + 6.5% =(LIBOR + 3%)

C = 0.5%

Each one gets a benef it of 0.5%.

Interest differential between f ixed and f loating is 3 -1.5 =1.5%. This 1.5% is distributed among the three.

It should be noted that Swap is independent of the initial borrowings and the banks which lent the f unds. Only theinterest rate obligations are exchanged, not the underlyingloan.

&



LIBOR & MIBOR

LIBOR (London Inter-bank Offer rate) is the interest ratecharged by banks in London on short term loans to eachother. It is taken as a benchmark for market interest rate, andnon-bank f loating rate borrowers are quoted a rate based onLIBOR plus a margin ref lecting their credit worthiness.

LIBOR is the most widely used "benchmark" or reference ratefor short term interest rates. It is compiled by the BritishBankers Association as a free service and released to themarket at about 11.00[London time] each day.

MIBOR - Mumbai Inter-bank Offer Rate.

Ma jor derivatives Exchanges



j gExchange Major underlying asset

Chicago Board Options Exchange(CBOE)

commodities, stocks, stock indices,currencies, T bonds, T notes

Chicago Board of Trade (CBOT) Commodities , Precious metals,

S&P Index

Chicago Mercantile Exchange (CME)Commodities

London International Financial

Futures & Options Exchange (LIFFE)

Currencies, FTSE index, equities

London Commodity Exchanges (LCE) Futures - Commodities like coffee,

Cocoa, sugar

London Metal Exchange (LME) Futures- Metals like Al, Copper, Zn

London Futures and Options

Commodities Exchange (FOX)

Commodities

D i i E h i I di



Derivatives Exchanges in India

Both NSE and BSE have options and f utures

trading stock, index, interest rate and

currency derivatives

Commodity exchanges in India-

At present there are national and regional

commodity exchanges.

List of Commodity Exchanges in India



y g

1. Bhatinda Om & Oil Exchange Ltd., Batinda.

2. The Bombay Commodity Exchange Ltd., Mumbai

3. The Ra jkot Seeds oil & Bullion Merchants` Association Ltd

4. The Kanpur Commodity Exchange Ltd., Kanpur

5. The Meerut Agro Commodities Exchange Co. Ltd., Meerut

6. The Spices and Oilseeds Exchange Ltd.

7. Ahmedabad Commodity Exchange Ltd.

8. Vijay Beopar Chamber Ltd., Muzaffarnagar

9. India Pepper & Spice Trade Association, Kochi

10. Ra jdhani Oils and Oilseeds Exchange Ltd., Delhi

11. National Board of Trade, Indore

12. The Chamber Of Commerce, Hapur

13. The East India Cotton Association, Mumbai

Li t f C dit E h i I di



List of Commodity Exchanges in India

14. The Central India Commercial Exchange Ltd., Gwalior15. The East India Jute & Hessian Exchange Ltd.

16. First Commodity Exchange of India Ltd, Kochi

17. Bikaner Commodity Exchange Ltd., Bikaner

18. The Coffee Futures Exchange India Ltd, Bangalore19. Esugarindia Limited

20. National Multi Commodity Exchange of India Limited

21. Surendranagar Cotton oil & Oilseeds Association Ltd

22. Multi Commodity Exchange of India Ltd23. National Commodity & Derivatives Exchange Ltd

24. Haryana Commodities Ltd., Hissar

25. e-Commodities Ltd

R l ti f f d T di



Regulation of forward Trading

Forward Contracts (Regulation) Act, 1952.

Forward Markets Commission (FMC)

established under the above Act

U f D i ti



Uses of Derivatives

Risk Management

Risk Transfer

Hedging

Income Generation

Financial Engineering

P ti i t i D i ti M k t



Participants in Derivative Market

Hedging (Hedger)

Speculation (Speculator)

Arbitrage (Arbitrageur)





Forward rate agreement and Swaps permitted by RBI in1999

Trading in index f utures began on NSE and BSE in 2000

Trading in options on index and stocks commenced onNSE and BSE in 2001

Trading on single stock f utures began on NSE and BSEin 2002

Introduction of interest rate f utures on NSE andcommodity f utures in 2003

Currency f utures was launched in NSE, BSE and MCX inAugust 2008

Currency options in NSE and USE in October 2010



References



S.S.S. Kumar(2007). Financial Derivatives. New Delhi :

Prentice Hall India.

John C. Hull. (2005). Options, Futures and OtherDerivatives (6th Ed.). New Delhi : Prentice Hall

Robert A. Strong. (2006). Derivatives : An Introduction.Singapore : Thomson Learning

Bansal & Bansal. (2007). Derivatives and Financial

Innovations. New Delhi : McGraw Hill.

Websites NSE, BSE, MCX, NCDEX

derivatives and valn

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