6th SEMESTER B.

COM FINANCE
CALICUT UNIVERSITY

FINANCIAL DERIVATIVES
2018 ADMISSION
SEMESTER NOTE

Prepared by
ILLYAS.K.P
Assistant professor
Department of commerce & management

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 SYLLABUS
BCM6B15 FINANCIAL DERIVATIVES
Lecture hours: 5, Credits: 5
Internal: 20, External: 80, Examination 3 Hours

• To acquire knowledge about financial derivatives and their features.

• To know about various risks associated with derivatives.

Module I
Financial Derivatives: Introduction – Meaning – Types of financial derivatives: Forwards –
Futures – Options – Swaps – Economic functions of derivative contracts. (12 Hours, 10 marks)

Module II
Derivative Markets: History of financial derivative market – Participants in a derivative market –
Cash market Vs derivative market – Stock market derivatives in India – Other derivatives in India –
The regulatory frame work for derivatives trading in India.
(15 Hours, 20 marks)

Module III
Forward Contracts: Features – Limitations of forward markets – Introduction to Futures –
Meaning and definition – Features of futures – Difference between forwards and futures –
Futures – terminology – Types of future contracts – Financial futures – Stock futures –
Currency futures – Interest rate futures – Index futures – Commodity futures – Futures pay offs –
Trading strategies in stock futures. (20 Hours, 20 marks)

Module IV
Options: Meaning – Definition – Need – Difference between options and futures –
Fundamental option strategies – Types of options contracts – Call – Put – options – Intrinsic value Vs
Time value of options – Trading strategies in stock options.
(20 Hours, 20 marks)

Module V
Swaps: Meaning – Definition – Features of swaps – Terms used in swaps – Types of swaps:
Interest rate swap – Currency swap – Commodity swap – Equity swap – Difference between
Swaps and Futures. (13 Hours, 10 marks)

Reference Books:
1. Hull John. C, Options, Futures and Other Derivatives, Pearson Educations Publishers,
New Delhi (Latest Edition).
2. S.L.Gupta, Prentice Hall of India Private Ltd, New Delhi.
3. L.M Bhole, Financial Institutions and Markets – Structure, Growth and Innovations,
Tata Mc Graw Hill Publishing Co. Ltd. New Delhi.
4. D.C. Patwari&A.Bhargava, Options and Futures, an Indian Perspective, JAICO
Publishing

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MODULE 1
INTRODUCTION TO FINANCIAL DERIVATIVES
The objective of an investment decision is to get required rate of return with minimum risk.
To achieve this objective, various instruments, practices and strategies have been devised and
developed in the recent past. With the opening of boundaries for international trade and business, the
world trade gained momentum in the last decade, the world has entered into a new phase of global
integration and liberalisation. The integration of capital markets world-wide has given rise to
increased financial risk with the frequent changes in the interest rates, currency exchange rate and
stock prices. To overcome the risk arising out of these fluctuating variables and increased
dependence of capital markets of one set of countries to the others, risk management practices have
also been reshaped by inventing such instruments as can mitigate the risk element. These new
popular instruments are known as financial derivatives which, not only reduce financial risk but also
open us new opportunity for high risk takers.
Definition of derivatives
Literal meaning of derivative is that something which is derived. Now question arises as to
what is derived? From what it is derived? Simple one line answer is that value/price is derived from
any underlying asset. The term ‘derivative’ indicates that it has no independent value, i.e., its value is
entirely derived from the value of the underlying asset. The underlying asset can be securities,
commodities, bullion, currency, livestock or anything else. The Securities Contracts (Regulation) Act
1956 defines ‘derivative’ as under:
‘Derivative’ includes–
Security derived from a debt instrument, share, loan whether secured or unsecured, risk
instrument or contract for differences or any other form of security. A contract which derives its
value from the prices, or index of prices of underlying securities. There are two types of derivatives.
Commodity derivatives and financial derivatives. Firstly derivatives originated as a tool for managing
risk in commodities markets. In commodity derivatives, the underlying asset is a commodity. It can
be agricultural commodity like wheat, soybeans, rapeseed, cotton etc. or precious metals like gold,
silver etc. The term financial derivative denotes a variety of financial instruments including stocks,
bonds, treasury bills, interest rate, foreign currencies and other hybrid securities. Financial
derivatives include futures, forwards, options, swaps, etc. Futures contracts are the most important
form of derivatives, which are in existence long before the term ‘derivative’ was coined. Financial
derivatives can also be derived from a combination of cash market instruments or other financial
derivative instruments. In fact, most of the financial derivatives are not new instruments rather they
are merely combinations of older generation derivatives and/or standard cash market instruments.
Features of financial derivatives
1. It is a contract: Derivative is defined as the future contract between two parties. It means there
must be a contract-binding on the underlying parties and the same to be fulfilled in future. The future
period may be short or long depending upon the nature of contract, for example, short term interest
rate futures and long term interest rate futures contract.
2. Derives value from underlying asset: Normally, the derivative instruments have the value which
is derived from the values of other underlying assets, such as agricultural commodities, metals,
financial assets, intangible assets, etc. Value of derivatives depends upon the value of underlying

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instrument and which changes as per the changes in the underlying assets, and sometimes, it may be
nil or zero. Hence, they are closely related.
3.
4.
5. Specified obligation: In general, the counter parties have specified obligation under the derivative
contract. Obviously, the nature of the obligation would be different as per the type of the instrument
of a derivative. For example, the obligation of the counter parties, under the different derivatives,
such as forward contract, future contract, option contract and swap contract would be different.
6.
7.
8. Direct or exchange traded: The derivatives contracts can be undertaken directly between the
two parties or through the particular exchange like financial futures contracts. The exchange-traded
derivatives are quite liquid and have low transaction costs in comparison to tailor-made contracts.
Example of exchange traded derivatives are Dow Jons, S&P 500, Nikki 225, NIFTY option, S&P
Junior that are traded on New York Stock Exchange, Tokyo Stock Exchange, National Stock
Exchange, Bombay Stock Exchange and so on
9. Related to notional amount: In general, the financial derivatives are carried off-balance
sheet. The size of the derivative contract depends upon its notional amount. The notional amount
is the amount used to calculate the payoff. For instance, in the option contract, the potential loss
and potential payoff, both may be different from the value of underlying shares, because the
payoff of derivative products differs from the payoff that their notional amount might suggest.
10. Delivery of underlying asset not involved: Usually, in derivatives trading, the taking or
making of delivery of underlying assets is not involved; rather underlying transactions are mostly
settled by taking offsetting positions in the derivatives themselves. There is, therefore, no effective
limit on the quantity of claims, which can be traded in respect of underlying assets.
11. May be used as deferred delivery: Derivatives are also known as deferred delivery or deferred
payment instrument. It means that it is easier to take short or long position in derivatives in
comparison to other assets or securities. Further, it is possible to combine them to match specific,
i.e., they are more easily amenable to financial engineering.
12. Secondary market instruments: Derivatives are mostly secondary market instruments and
have little usefulness in mobilizing fresh capital by the corporate world, however, warrants and
convertibles are exception in this respect.
13. Exposure to risk: Although in the market, the standardized, general and exchange-traded
derivatives are being increasingly evolved, however, still there are so many privately negotiated
customized, over-the-counter (OTC) traded derivatives are in existence. They expose the trading
parties to operational risk, counter-party risk and legal risk. Further, there may also be uncertainty
about the regulatory status of such derivatives.
14. off balance sheet item: Finally, the derivative instruments, sometimes, because of their off-
balance sheet nature, can be used to clear up the balance sheet. For example, a fund manager who
is restricted from taking particular currency can buy a structured note whose coupon is tied to the
performance of a particular currency pair.
Classification of Derivatives (Types of Derivatives)
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 a. On the basis of nature of payoff or nature of contract
b. On the basis of underlying assets
c. On the basis of trading mechanism
On the basis of nature of payoff or nature of contract

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 It may be classified into forwards, futures, options and swaps
Forwards: A forward contract is a customised contract between two entities, where settlement takes
place on a specific date in the future at today’s pre-agreed price. It is a bilateral agreement. Forward
contracts are unstandardized. They are not traded on stock exchanges they are generally traded on
over the counter (OTC).
Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain
time in the future at a certain price. Futures contracts are special types of forward contracts traded on
stock exchanges. The exchange guarantees and ensures the execution of the contract by both the
parties. The contract value is adjusted according to market movements till the expiration date.
Options: An option refers to the right (but not the obligation) to buy or sell a security or other assets
during a given time for a specified price. The specified price is called strike price. Options are of two
types– calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of
the underlying asset, at a given price on or before a given future date. Puts give the buyer the right,
but not the obligation to sell a given quantity of the underlying asset at a given price on or before a
given date.
Swaps: Swaps are private agreements between two parties to exchange cash flows in the future
according to a prearranged formula. They can be regarded as portfolios of forward contracts. The
cash flows are based on a notional principal amount agreed between both the parties without
exchanging principal amount. The amount of cash flows is based on a rate of interest. One cash flow
is generally fixed and the other is variable. Swaps are not traded on stock exchanges.
On the basis of underlying assets
They can be classified into two, namely, commodity derivatives and financial derivatives.
1. Commodity Derivatives: In a commodity derivative, the underlying instrument is a
commodity which may be wheat, cotton, pepper, sugar, jute, turmeric, corn, soyabeans,
crude oil, natural gas, gold, silver, copper and so on.
2. Financial Derivatives: In a financial derivative, the underlying instrument may be treasury
bills, stocks, bonds, foreign exchange, stock index, gilt-edged securities, cost of living index,
etc.
Difference between commodity derivatives and financial derivatives
In a commodity derivative, the underlying instrument is a commodity which may be wheat,
cotton, pepper, sugar, jute, turmeric, corn, soyabeans, crude oil, natural gas, gold and silver. : In a
financial derivative, the underlying instrument may be financial instrument such as bonds, stocks,
stock indices and currencies.
A financial derivative is fairly standard and there are no quality issues whereas in commodity
derivative, the quality may be the underlying matter.
In the case of financial derivatives, most of the contracts are cash-settled. Even in the case of
physical settlement, financial assets are not bulky. They do not need special facility for storage. But
in the case of commodity derivatives, generally the underlying assets are bulky. Due to the bulky
nature of the underlying assets, physical settlement in commodity derivatives creates the need for
warehousing.

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On the basis of trading mechanism
According to the markets or places the derivatives are traded, they can be classified into two –
Exchange Traded Derivatives and Over The Counter Derivatives.

1. Over the Counter Derivatives: (OTC) derivatives or off-exchange trading is to trade

financial instruments such as stocks, bonds, commodities or derivatives directly between
two parties without going through an exchange or other intermediary.
■ The contract between two parties are privately negotiated.
■ The contract can be tailor-made to the two parties’ liking.
■ OTC markets are uncontrolled, unregulated and have very few laws. It is more like a
free fall.
Merits of OTC Derivatives:
a. Limitless flexibility in contract design
b. These are customised to the requirements of contracting parties
c. The underlying asset can be anything, the size of the contract can be of any amount, and the
delivery can be made at any time and at any location.
Demerits of OTC Derivatives
a. It is difficult to find matching parties
b. There is credit risk. It means that one of the parties to the contract may fail to honour
the obligations.
c. There is skewed pricing as two parties are not equally strong.
d. Transaction cost is high.

2. Exchange Traded Derivatives: Exchange Traded derivative contracts are those

derivative instruments that are traded via specialized Derivative exchange or other
exchanges. A derivatives exchange is a market where individuals trade standardized
contracts that have been defined by the exchange.
■ The world’s largest derivative exchange (by number of transactions) is the Korea
Exchange
■ There is a very visible and transparent market price for the derivatives
Merits of Exchange Traded Derivatives:
a. Free from counter party risk
b. Transaction cost is transparent and nominal
c. Investors can enter and exit from derivative positions very conveniently as trading takes
place continuously.
Demerits of Exchange Traded Derivatives
a. Less flexible
b. These are not customised to the requirements of the contracting parties. They have to
accept the rules and regulations of the exchange.

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 .
Difference between Exchange Traded and OTC Derivatives

Exchange Traded Derivatives OTC Derivatives

1. Do not have any counter party risk 1. Counter party risk is present
2. Contracts that traded on an 2. OTC derivatives result from agreements
organised exchange between two parties
3. Transaction costs are less 3. Transaction costs are more
4. The contracts have standardised terms 4. Contracts are customised to the
set by the exchange or clearing house requirements of the counter party
5. Prices are publicly available 5. Prices are not available(kept confidential)
6. Market traders do not know each other 6. Market players are known to each other

FINANCIAL DERIVATIVES
Financial derivatives constitute the largest segment in derivatives. A financial derivative is a
financial contract that derives its value from an underlying asset. The underlying asset may be stocks
or bonds or interest rates or currencies. The seller of the contract doesn’t have to own the underlying
asset. Financial derivatives are also known as common derivatives.
Features of financial derivatives
1. It is a financial instrument or a financial contract.
2. It is a future contract between two parties.
3. Its value depends on the value of the financial instruments.
4. It can be undertaken directly between the two parties or through the particular exchange.
5. The trading results through financial derivatives are not shown in the financial statements.
6. Usually in financial derivatives, the taking or making delivery of underlying asset is
not involved.
Types of Financial Derivatives
a. Currency Derivatives: Exchange rates between various currencies can form the basis of
derivatives. The currencies can be US Dollar, Canadian Dollar, Singapore Dollar, Euro, Yen
etc. Currency derivatives came into existence only after 1972 when the fixed exchange rate
regime under Bretton Woods System came to an end. The first derivative on financial asset
was traded on currencies (currency futures) in the International Monetary Market of the
Chicago Mercantile Exchange, USA in 1972.
b. Interest Rate Derivatives: In the case of interest rate derivatives, the underlying asset is
interest rates. Most common interest rates on which derivatives are traded are London Inter
Bank Offer Rate(LIBOR), or instruments whose value is dependent upon interest rate such
as T-bills and Treasury bonds.
c. Equity Derivatives: The most popular derivatives are equity derivatives. Here the underlying
assets are equity stocks. Futures and options are very widely traded derivatives on equity
stocks.
d. Stock Indices Derivatives: Derivatives on various stock indices in the stock markets are
more popular now-a-days. This is because of their ability to provide protection from
market risks. Futures and options on stock indices exist all over the world in all major stock
exchanges. In the case of stock index derivatives, delivery of the asset is not possible.
e. Credit Derivatives: These are derivatives that are based on the credit rating or credit risk
of cash flows such as instalment on loans or other forms of receivables. There are six credit
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 derivatives commonly used. They are (1) credit default swaps, (2) total return swaps, (3)
credit-linked notes, (4) credit spread options, (5) credit basket swaps and (6) collateralised
loan obligations. These products transfer credit risk without the transfer of ownership.
Thus, credit derivatives include a range of products designed to manage credit risk or
default risk.
f. Other Types of Financial Derivatives:
i. Warrants: Options generally have lives of up to one year, the majority of options
traded on options exchanges having maximum maturity of nine months. Longer-dated
options are called warrants and are generally traded over-the-counter.
ii. LEAPS: The acronym LEAPS means Long term Equity Anticipation Securities.
These are options having a maturity of up to three years.
iii. Baskets: Basket options are options on portfolios of underlying assets. The
underlying asset is usually a moving average of a basket of assets. Equity index
options are a form of basket options.
iv. Convertibles: These are hybrid securities. They combine the basic attributes of fixed
interest and variable return securities. E.g.:- convertible bonds, convertible
debentures, convertible preference shares. These are also called equity derivative
securities. They can be fully or partly converted into equity shares of the issuing
company at predetermined terms.
(Financial derivatives may also be classified into forwards, futures, options, swaps, warrants,
convertibles, swaptions, etc.)
USES OF DERIVATIVES
Derivatives are supposed to provide the following services:
1. Risk aversion tools: One of the most important services provided by the derivatives is to
control, avoid, shift and manage efficiently different types of risks through various strategies like
hedging, arbitraging, spreading, etc. Derivatives assist the holders to shift or modify suitably the
risk characteristics of their portfolios. These are specifically useful in highly volatile financial
market conditions like erratic trading, highly flexible interest rates, volatile exchange rates and
monetary chaos.
2. Prediction of future prices: Derivatives serve as barometers of the future trends in prices
which result in the discovery of new prices both on the spot and futures markets. Further, they help in
disseminating different information regarding the futures markets trading of various commodities and
securities to the society which enable to discover or form suitable or correct or true equilibrium
prices in the markets. As a result, they assist in appropriate and superior allocation of resources in the
society.
3. Enhance liquidity: As we see that in derivatives trading no immediate full amount of the
transaction is required since most of them are based on margin trading. As a result, large number of
traders, speculators arbitrageurs operate in such markets. So, derivatives trading enhance liquidity
and reduce transaction costs in the markets for underlying assets
4. Assist investors: The derivatives assist the investors, traders and managers of large pools
of funds to devise such strategies so that they may make proper asset allocation increase their
yields and achieve other investment goals.
5. Integration of price structure: It has been observed from the derivatives trading in the
market that the derivatives have smoothen out price fluctuations, squeeze the price spread,
integrate price structure at different points of time and remove gluts and shortages in the markets.
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 6. Catalyse growth of financial markets: The derivatives trading encourage the
competitive trading in the markets, different risk taking preference of the market operators like
speculators, hedgers, traders, arbitrageurs, etc. resulting in increase in trading volume in the country.
They also attract young investors, professionals and other experts who will act as catalysts to the
growth of financial markets.
7. Brings perfection in market: Lastly, it is observed that derivatives trading develop the
market towards ‘complete markets’. Complete market concept refers to that situation where no
particular investors can be better off than others, or patterns of returns of all additional securities
are spanned by the already existing securities in it, or there is no further scope of additional
security.
ECONOMIC FUNCTIONS OF DERIVATIVE CONTRACTS
Derivative contracts perform a number of economic functions. Important functions may be outlined
as below:-
1. Risk management functions
This is the primary function of derivatives. Derivatives shift the risk from the buyer of the
derivative product to the seller. Thus, derivatives are very effective risk management tools. Most
of the world’s 500 largest companies use derivates to lower risk.
2. Price discovery function:-
This refers to the ability to achieve and disseminate price information. Without price
information, investors, consumers, and producers cannot make informed decisions. They cannot
direct their capital to efficient uses. Derivatives are exceptionally well suited for providing price
information. They are the tools that assist everyone in the market place to determine value. The
wider the use of derivatives, the wider the distribution of price information.
3. Liquidity function
Derivatives contract improve the liquidity of the underlying instruments. They provide better
avenues for raising money. They contribute sustainability to increasing the depth of the markets.
Derivative markets often have greater liquidity than the spot markets; this higher liquidity is at
least partly due to the smaller amount of capital required for participation in derivative markets.
Since the capital required is less, more participants will operate in the market. This leads to
increased volume of trade and liquidity.
4. Efficiency function
Derivatives significantly increase market liquidity, as a result, transactional costs are lowered,
the efficiency in doing business is increased, the cost of raising capital investment is expanded.
5. Portfolio management function
Derivatives help in efficient portfolio management. With a smaller fund at disposal,
better diversification can be achieved. Derivatives provide much wider menu to portfolio
managers who constantly seek better risk return trade off.
6. Economic development function
Bright, creative, well educated people with an entrepreneurial attitude will be attracted
towards the derivative markets. Derivative markets energise other to create new businesses, new
products and new employment opportunities. Derivative markets help increase savings and
investment in the long run.

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DISADVANTAGES OF DERIVATIVES
1. High volatility: Since the value of derivatives is based on certain underlying things such as
commodities, metals and stocks etc., they are exposed to high risk. Most of the derivatives are traded
on open market. And the prices of these commodities metals and stocks will be continuously
changing in nature. So the risk that one may lose their value is very high.
2. Requires expertise: In case of mutual funds or shares one can manage with even a limited
knowledge pertaining to his sector of trading. But in case of derivatives it is very difficult to
sustain in the market without expert knowledge in the field.
3. Contract life: The main problem with the derivative contracts is their limited life. As the time
passes the value of the derivatives will decline and so on. So one may even have chances of losing
completely within that agreed time frame
4. Increased bankruptcies
5. Increased regulatory burden
6. Enhancement of risk
7. Speculative and gambling motives
8. Instability of the financial system
RISK INVOLVED IN DERIVATIVES
1. Counterparty Risk: This is the risk which arises when one of the parties involved in a derivative
trade (buyer or seller or dealer) makes default on the contract. It is also called credit risk or default
risk.
2. Market risk: It arises due to adverse movements in the price of a financial asset or commodity.
In short, market risk refers to the general risk in any investment
3. Basis risk: It is a type of market risk. It refers to the difference between the spot market price
of the asset being hedged and the derivative’s price.
4. Interconnection risk: One market can greatly affect what happens to another market, and that
market affects another market, and so on. If an investor is in this situation, it is possible for him to
lose his whole investment.
5. Operation risk: It arises when internal systems are not capable of managing the transaction.
6. Liquidity risk: Most derivatives are customised instruments. Hence, investors may not be able
to close out (or finish) a trade prior to maturity.

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MODULE 2
DERIVATIVE MARKETS
The derivatives are most modern financial instruments for hedging risk. The individuals and
firms who wish to avid or reduce risk can deal with the others who are willing to accept the risk for a
price. A common place where such transactions take place is called the derivative market.
Meaning and definition of derivative markets
Initially, derivative started in an unorganized market. But, now, there exists an organized
market as well. Organized market does not mean undeveloped market. It refers to over the counter
market, in which the buyers and sellers come in contract directly with each other or through an
intermediary. They mutually decide about all the terms and conditions of the contract and both
commit to fulfil and abide by the set of terms. Thus derivative market is a market in which
derivatives are traded. In short, it is a market for derivatives. The traders in the derivative markets are
hedgers, speculators and arbitrageurs.
Importance of derivative markets
1. It increases the volume of transactions
2. Transaction costs are lower
3. The risk of holding underlying assets is lower
4. It gives increased liquidity for investors.
5. Leads to faster execution of transactions.
6. Enhances the price discovery process.
7. Facilitates the transfer of risk from risk-averse investors (hedgers) to risk takers(speculators).
8. Increases the savings and investments in the economy.
Role or functions of Derivative Markets
1. Discovery of prices
2. Management of risk
3. Provision of liquidity.
4. Portfolio management
5. Trading catalyst
6. Smoothening out the seasonable price variations
7. Promoting savings and investment.
Major players or participants in the Derivative Markets
The participants in the derivative markets can be banks, foreign institutional investors,
corporates, brokers, individuals etc. All of them can be classified into four depending upon their
motives. They are: hedgers, speculators, arbitrageurs and spreaders. They have different
motives.
1. Hedgers
A hedger is someone who faces risk associated with price movement of an asset and who uses
derivatives as means of reducing risk. They provide economic balance to the market.
Functions of hedgers:
a. To eliminate the price risk of contracting parties
b. To help to increase the trading volume

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c. To attract more people into the derivative market.

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2. Speculators
A trader who enters the futures market for pursuit of profits, accepting risk in the endeavour.
They provide liquidity and depth to the market.
There are three types of speculation (based on duration)
a. Scalpers(hold for very short time-in minutes
b. Day traders ( one trading day), and
c. Position traders (long period- week, month, a year)
Functions of Speculators:
a. To contribute to market efficiency
b. To conduct fundamental analysis and/or technical analysis and collect information to predict
price movements.
c. To provide liquidity to the market.
d. To find matching parties for the contract and help hedgers.
e. To make the market competitive
f. To reduce transaction costs and
g. To expand the market size.
3. Arbitrageurs
Arbitrage is the process of simultaneous purchase of securities or derivatives in one market at
a low price and sale of the same in another market at a relatively higher price. Arbitrageur is a person
simultaneously enters into transactions in two or more markets to take advantage of the discrepancies
between prices in these markets.
Arbitrage involves making profits from relative mispricing. Arbitrageurs also help to make markets
liquid, ensure accurate and uniform pricing, and enhance price stability. They help in bringing
about price uniformity and discovery.
Functions of arbitrageurs
1. To provide a link between the derivatives market and the cash market by synchronising prices
in the two.
2. To make markets efficient by taking riskless positions in the different markets.
3. To restore the balance and consistency among the different markets.
4. To render competitiveness to the market and help in the price discovery process.
4. Spreaders
Spreading is a specific trading activity in which offsetting position is involved (i.e.,
simultaneous long and short positions on the same derivative). A spreader is a person who believes in
lower expected return at the reduced risk.
Difference between Hedging and Speculation

Hedging Speculation
1. Transfer of price risk faced by a person 1. Buying and selling of financial
or organisation to others who are willing instruments and derivatives in the hope of
to bear the risk for windfall profit. a profit from anticipated changes in the
price of instruments.
2. The main aim is to cover or eliminate or 2. The main aim is to make profit from short

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 minimise risk term fluctuations.
3. Hedging may be long or short. 3. Speculation may be constructive or
destructive.
4. Risk is less. 4. Risk is high
5. Complicated process. 5. Easy process.

Difference between Speculation and Arbitrage

Speculation Arbitrage
1. Buying and selling of financial 1. Simultaneous buying and selling of
instruments and derivatives in the hope securities or commodities to make profit
of a profit from anticipated changes in on the differences in the prices prevailing
the price of instruments. in the two markets.
2. Profit is the differences between prices 2. Profit is the difference between
at different times prices prevailing in two different
3. Risk is high. markets.
4. It is a necessary evil. 3. Risk is relatively less(if executed properly
5. May or may not hold 4. It is a legal way to make money.
securities/commodities 5. Always hold securities/commodities

DIFFERENCE BETWEEN CASH MAKET AND DERIVATIVE MARKET

Cash market Derivative market

1. Trading takes place for spot delivery 1. It is meant for future delivery.
2. Only tangible commodities such as 2. In addition to these tangibles, some
agricultural products, metals, minerals, intangibles such as interest rates, credit
shares, debentures are traded. standing, weather etc. are traded.
3. The objective of the dealing party is 3. The objective may be hedging or
consumption or investment. speculation or investment.
4. The assets are traded at the prevailing 4. The contracts are traded at the prices
prices. which are derived from the cash market
plus a cost of carry.
5. Contracts are generally settled 5. The contracts can be settled by offsetting
through physical delivery. contracts or by physical delivery (if
allowed) or even cash settlement (of
difference between spot price and agreed
price).
6. In derivatives market, the initial flows 6. In derivatives market, the initial flows
involved in terms of margin are much involved in terms of margin are much
lesser than the full cash price payable in lesser than the full cash price payable in
the cash market. the cash market.

Factors contributing to the Growth of Derivatives (or Derivative markets)

1. Price volatility
2. Globalisation of markets
3. Technological development
4. Advancements in financial theories
5. Development of sophisticated risk management tools

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Growth and development of derivative market in India
Derivative markets in India are comparatively of recent origin. They cater to the investment
risk management needs of the financial and product market. Several committees have been set up to
review the functioning of financial and derivative markets to ensure that investors risk management
needs are fulfilled by products offered by these changes.
At present Indian market trades in both exchange traded and over the counter derivative on
various asset classes including securities, commodities, currencies, stock indices etc. today, the
derivative markets in India are growing. The growth and development of financial derivative in India
may be studied for each asset class as follows:
1. Growth of equity derivative market
India joined the league of exchange traded equity derivative in June 2000, when futures contracts
were introduced at two major exchanges, namely, BSE and NSE. The BSE sensitive index, popularly
known as the SENSEX, and S&P CNX Nifty index commenced trade n futures on June 9, 2000 and
June 12, 2000 respectively. The growth of equity derivatives business on Indian exchanges has been
phenomenal. A modest start of an average daily volume of Rs. 10 crores has developed into a
business opportunity of Rs. 30,000 crores per day.
2. Growth of commodity derivative markets
The forward contract Regulation Act governs commodity derivative in India. The FCRA
specifically prohibits OTC commodity derivatives. Further, FCRA does not even allow options on
commodities. It should be noted that the trading in commodity derivatives has been concentrated
regionally. This is due to the regional exchanges offered only a single product. For example, pepper
exchange in Kochi trades only. Soya exchange in Indore trades only soya.
Recently trading in commodity derivatives began through two nation-wide, on-line commodity
exchanges,-
- The National Commodities and Derivatives Exchange (NCDEX) and
- The Multi Commodity Exchange (MCX)
They started functioning in the last quarter of 2003 with the introduction of futures contracts
on various assets such as gold, silver, rubber, steel, etc. these exchanges were promoted by the
major banks and financial institutions in the country.
3. Growth of currency derivative market
India has been trading forward contracts in currency for the last years. Recently, the RBI has
allowed options in the OTC market. The OTC currency market in the country is well developed.
However, the business is concentrated with a limited number of market participants, mainly, banks-
both international and local. The business in currency derivatives is expected to grow in the near
future.
4. Growth of interest rate derivative markets
There has been significant progress in interest rate derivatives in the India OTC market. The NSE
introduced trading in cash settled interest rate futures in the year 2003. However, due to some
structural issues, the product did not attract market participants. The trading in interest rate derivative
in India is now growing.

16
 5. Growth of other derivative markets
Credit derivatives, weather derivatives etc. have been recently introduced in India. They are
expected to grow in the coming years.
FACTORS RESPONSIBLE FOR THE GROWTH OF FINANCIAL DERIVATIVE
MARKETS IN INDIA
There are a large number of factors that contribute to the growth of financial derivative
markets in India. All such factors may be classified into environmental factors and internal
factors.
A. Environmental factors
Environmental factors contribute to the growth of financial derivative markets in India. Following
are the environmental factors
1. Price volatility: - It refers to rapid changes in the prices of assets in the financial markets over a
short period of time.
2. Globalisation of markets: - Globalization has increased the size of markets. This has exposed the
modern businesses to greater risk. Increased size has also led to greater use of debt in capital
structures. This has contributed to an increase in financial risks of firms.
3. Technological advances: - Technological advances have also motivated the financial derivative
markets. Technological advances involve computer and internet technologies. These developments
encouraged not only the modelling and design of complex financial deals and instruments, but also
facilitated trading in them on 24*7 time frame.
4. Regulatory changes:- Much of the financial derivative markets activity in recent years in India
has been fostered by an atmosphere of deregulation of financial sector. Deregulation has increased
the competition and forced industries to become competitive.
B. Internal factors
The following are internal factors that have contributed to the growth of financial derivative
markets in India.
1. Liquidity needs: Business firms have liquidity needs. Many of the financial innovations pioneered
in the recent past have targeted these needs.
2. Risk aversion: Most of the investors would like to avoid risks. Derivative instruments are useful
for avoiding risk.
3. Risk executives: Increased risk perceptions of corporate organization promoted to
recruit personnel with risk management training. Most big and medium enterprises
maintain risk management team.

Exchange Traded Financial Derivatives for Risk Management in India

Exchange traded financial derivatives are a recent phenomenon in India. Prior to their arrival,
there was an indigenous mechanism of meeting the settlement requirements. In some sections it is
also termed as forward trading (forward contracts are not exchange-traded derivatives). It prevailed
mostly on the stock exchanges at Mumbai, Ahmedabad, and Kolkata and now on NSE in the name of
ALBM (Automated Lending and Borrowing Mechanism).
17
 Badla trading thrived during the days when the equity markets functioned in the account
period settlement mode, where in all the trades done are grouped into predetermined periods and are
settled on a particular day.
In India, the exchange-traded derivatives have been emerged with the enactment of Securities
Laws (Amendment) Act 1999. According to this Act, the derivatives are defined as to include:
a. 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, and
b. A contract which derives its values from the prices or index of prices of underlying securities.
The Act also clarified that derivatives shall be legal and valid only if such contracts are traded on
a recognised stock exchange in accordance with the rules and bye-laws of such stock exchange,
thereby excluding OTC derivatives.
The first exchange to commence derivatives trading is BSE from June 9, 2000. NSE started
operations in the derivatives segment on June 12, 2000. Initially, only futures contracts on market
index were traded. Subsequently, other derivative products were also introduced. Now the contracts
being traded on the exchanges are:-
a. Futures on indices
b. Options on indices
c. Futures on individual securities
d. Options on individual stocks, and
e. Interest rate futures.
On NSE and BSE, only financial derivatives are traded. But recently three exchanges NCDEX,
MCX and NDEX commenced trading in commodity futures.
Trading of derivatives contracts on both NSE and BSE is through an order-driven automated
online system. For the trading of derivatives, NSE and BSE adopted various forms of computerised
trading platforms such as NEAT (National Exchange for Automated Trading), F&O (Futures &
Options) of NSE, and DTSS (Derivatives Trading and Settlement System) of BSE. These systems are
actually electronic limit order book for recording and executing orders.
In India, derivatives trading are dominated at NSE. It stands amongst the top ten exchanges in the
world in terms of number of contracts traded.
Regulatory framework of Derivatives Trading in India
The first step towards introduction of derivatives trading in India was the promulgation of
the Securities Laws (Amendment) Ordinance 1995. This withdrew the prohibition on options in
securities. The market for derivatives, however, did not take off, because there was no regulatory
framework to govern trading of derivatives. SEBI set up a 24-member committee under the
chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop appropriate regulatory framework
for derivatives trading in India. The committee submitted its report on March 17, 1998.
SEBI also set up a group in June 1998 under the chairmanship of Prof.J.R.Varma, to
recommend measures for risk containment in derivatives market in India. The group submitted its
report in October 1998.
The Securities Contracts Regulation Act was amended in December 1999 to include
derivatives as securities. In this way the regulatory framework was developed for governing
derivatives trading. The Act also made it clear that derivatives shall be legal and valid only if such

18
contracts are traded on a recognised stock exchange, thus precluding OTC derivatives. The
Govt.also rescinded in March 2000, the three-decade old notification, which prohibited forward
trading in securities.
Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to
this effect in May 2000. SEBI permitted the derivative segments of two stock exchanges, NSE and
BSE, and their clearing house/corporation to commence trading and settlement in approved
derivatives contracts. To begin with, SEBI approved trading in index futures contracts based on S&P
CNX Nifty and BSE-30 (Sensex) index. The trading in index options commenced in June 2001. The
trading in options on individual securities began in July 2001. Futures contracts on individual stocks
were introduced in November 2001.
Measures Taken by SEBI for the Protection of Investors in the Derivative Market.
1. Investor’s money has to be kept separate at all levels and is permitted to be used only against
the liability of the investor and is not available to the trading member or clearing member or
even any other investor.
2. The trading member is required to provide every investor with a Risk Disclosure
Document. This document will disclose the risks associated with the derivative trading so
that investors can take a conscious decision to trade in derivatives.
3. Investor would get the contract note duly stamped for receipt of the order and execution of
the order. The order will be executed with the identity of the client and without client identity,
order will not be accepted by the system. The investors could also demand the trade
confirmation slip with his identity in support of the contract note. This will protect him from
the risk of price favour, if any, extended by the member.
4. In the derivative markets, all money paid by the investor towards margins on all open
positions is kept in trust with the Clearing House/Clearing Corporation. In the event of
default of the trading or clearing member, the amounts paid by the client towards margins are
segregated and not utilised towards the default of the member. However, in the event of a
default of a member, losses suffered by the investor, if any, on settled or closed out position
are compensated from the Investor Protection Fund.

19
MODULE 3
FORWARD CONTRACTS
A forward contract is a simple customized contract between two parties to buy or sell an asset
at a certain time in the future for a certain price. Unlike future contracts, they are not traded on an
exchange, rather traded in the over-the-counter market, usually between two financial institutions or
between a financial institution and one of its clients. In brief, a forward contract is an agreement
between the counter parties to buy or sell a specified quantity of an asset at a specified price, with
delivery at a specified time (future) and place. These contracts are not standardized; each one is
usually customized to its owner’s specifications.
Features of forward contract
The basic features of a forward contract are given in brief here as under:
Bilateral: Forward contracts are bilateral contracts, and hence, they are exposed to counter-party
risk.
More risky than futures: There is risk of non-performance of obligation by either of the parties, so
these are riskier than futures contracts.
Customised contracts: Each contract is custom designed, and hence, is unique in terms of contract
size, expiration date, the asset type, quality, etc.
Long and short positions: In forward contract, one of the parties takes a long position by agreeing to
buy the asset at a certain specified future date. The other party assumes a short position by agreeing
to sell the same asset at the same date for the same specified price. A party with no obligation
offsetting the forward contract is said to have an open position. A party with a closed position is,
sometimes, called a hedger.
Delivery price: The specified price in a forward contract is referred to as the delivery price. The
forward price for a particular forward contract at a particular time is the delivery price that would
apply if the contract were entered into at that time. It is important to differentiate between the
forward price and the delivery price. Both are equal at the time the contract is entered into. However,
as time passes, the forward price is likely to change whereas the delivery price remains the same.
Synthetic assets: In the forward contract, derivative assets can often be contracted from the
combination of underlying assets, such assets are often known as synthetic assets in the forward
market. The forward contract has to be settled by delivery of the asset on expiration date. In case the
party wishes to reverse the contract, it has to compulsorily go to the same counter party, which may
dominate and command the price it wants as being in a monopoly situation.
Pricing of arbitrage based forward prices: In the forward contract, covered parity or cost-of-carry
relations are relation between the prices of forward and underlying assets. Such relations further
assist in determining the arbitrage-based forward asset prices.
Popular in forex market: Forward contracts are very popular in foreign exchange market as well as
interest rate bearing instruments. Most of the large and international banks quote the forward rate
through their ‘forward desk’ lying within their foreign exchange trading room. Forward foreign
exchange quotes by these banks are displayed with the spot rates.

20
Different types of forward:
As per the Indian Forward Contract Act-1952, different kinds of forward contracts can be
done like hedge contracts, transferable specific delivery (TSD) contracts and non-transferable
specific delivery (NTSD) contracts. Hedge contracts are freely transferable and do not specify, any
particular lot, consignment or variety for delivery. Transferable specific delivery contracts are
though freely transferable from one party to another, but are concerned with a specific and
predetermined consignment. Delivery is mandatory. Non-transferable specific delivery contracts, as
the name indicates, are not transferable at all, and as such, they are highly specific.
Difference between spot contract and forward contract
The difference between the spot contract and a forward contract is that:
1. The spot contract has a fixed price on the currency, and the forward contract has a
flexible price.
2. The spot contract is a contract to be settled immediately, and the forward contract is
a contract to be settled at a future agreed-upon date.
3. The spot contract is a derivative, and the forward contract is not a derivative.
4. The spot contract has a fixed price but the contract can be settled at a later date, and
the forward contract is a contract to be settled immediately.
Difference between Forwards and Futures

Basis Forward Futures

Definition A forward contract is an A futures contract is a
agreement between two parties standardized contract, traded on
to buy or sell an asset (which a futures exchange, to buy or
can be of any kind) at a pre- sell a certain underlying
agreed future point in time at a instrument at a certain date in
specified price. the future, at a specified price.
Structure & Purpose Customized to customer needs. Standardized. Initial margin
Usually no initial payment payment required. Usually used
required. Usually used for for speculation.
hedging.
Transaction method Negotiated directly by the buyer Quoted and traded on the
and seller Exchange
Market regulation Not regulated Government regulated market
(the Commodity Futures
Trading Commission or CFTC
is the governing body)
Institutional guarantee The contracting parties Clearing House
Risk High counterparty risk Low counterparty risk
Guarantees No guarantee of settlement until Both parties must deposit an
the date of maturity only the initial guarantee (margin). The
forward price, based on the spot value of the operation is marked
price of the underlying asset is to market rates with daily
paid settlement of profits and losses.
Contract Maturity Forward contracts generally Future contracts may not
mature by delivering the necessarily mature by delivery
commodity of commodity.

21
Expiry date Depending on the transaction Standardized
Method of pre- termination Opposite contract with same or Opposite contract on the
different counterparty. exchange.
Counterparty risk remains while
terminating with different
counterparty.
Contract size Depending on the transaction Standardized
and the requirements of the
contracting parties.
Market Primary & Secondary Primary

Limitations of forward contract

The disadvantages of forward contracts are:
1) It requires tying up capital. There are no intermediate cash flows before settlement.
2) It is subject to default risk.
3) Contracts may be difficult to cancel.
4) There may be difficult to find counter-party.
Payoff on Forward Contracts
Forward contracts are privately executed between two parties. The buyer of the underlying
commodity or asset is referred to as the long side whereas the seller is the short side. The obligation
to buy the asset at the agreed price on the specified future date is referred to as the long position. A
long position profits when prices rise. The obligation to sell the asset at the agreed price on the
specified future date is referred to as the short position. A short position profits when prices go down.
What is the payoff of a forward contract on the delivery date? Let T denote the expiration date, K
denote the forward price, and PT denote the spot price (or market price) at the delivery date. Then
 For the long position: the payoff of a forward contract on the delivery date is PT_ K
 For the short position: the payoff of a forward contract on the delivery date is K _PT
Figure shows a payoff diagram on a contract forward. Note that both the long and short forward
payoff positions break even when the spot price is equal to the forward price. Also note that a long
forward’s maximum loss is the forward price whereas the maximum gain is unlimited.
For a short forward, the maximum gain is the forward price and the maximum loss is unlimited.

FUTURES
A futures contract is a legal agreement to buy or sell a particular commodity asset, or security
at a predetermined price at a specified time in the future. Futures contracts are standardized for
quality and quantity to facilitate trading on a futures exchange. The buyer of a futures contract is
taking on the obligation to buy and receive the underlying asset when the futures contract expires.
The seller of the futures contract is taking on the obligation to provide and deliver the underlying
asset at the expiration date.

22
Features of Futures
1. Organised Exchanges: Unlike forward contracts which are traded in an over-the-counter market,
futures are traded on organised exchanges with a designated physical location where trading takes
place. This provides a ready, liquid market in which futures can be bought and sold at any time like
in a stock market.
2. Standardisation: In the case of forward currency contracts, the amount of commodity to be
delivered and the maturity date are negotiated between the buyer and seller and can be tailor- made to
buyer’s requirements. In a futures contract, both these are standardised by the exchange on which the
contract is traded.
3. Clearing House: The exchange acts as a clearing house to all contracts struck on the trading floor.
For instance, a contract is struck between A and B. Upon entering into the records of the exchange,
this is immediately replaced by two contracts, one between A and the clearing house and another
between B and the clearing house.
4. Margins: Like all exchanges, only members are allowed to trade in futures contracts on the
exchange. Others can use the services of the members as brokers to use this instrument. Thus, an
exchange member can trade on his own account as well as on behalf of a client. A subset of the
members is the “clearing members” or members of the clearing house and non- clearing members
must clear all their transactions through a clearing member.
5. Marking to Market: The exchange uses a system called marking to market where, at the end of
each trading session, all outstanding contracts are reprised at the settlement price of that trading
session. This would mean that some participants would make a loss while others would stand to gain.
The exchange adjusts this by debiting the margin accounts of those members who made a loss and
crediting the accounts of those members who have gained.
6. Actual Delivery is Rare: In most forward contracts, the commodity is actually delivered by the
seller and is accepted by the buyer. Forward contracts are entered into for acquiring or disposing off
a commodity in the future for a gain at a price known today.
Advantages of futures
1. Opens the Markets to Investors Futures contracts are useful for risk-tolerant investors. Investors
get to participate in markets they would otherwise not have access to.
2. Stable Margin Requirements Margin requirements for most of the commodities and currencies
are well- established in the futures market. Thus, a trader knows how much margin he should put up
in a contract.
3. No Time Decay Involved In options, the value of assets declines over time and severely reduces
the profitability for the trader. This is known as time decay. A futures trader does not have to worry
about time decay.
4. High Liquidity Most of the futures markets offer high liquidity, especially in case of
currencies, indexes, and commonly traded commodities. This allows traders to enter and exit the
market when they wish to.
5. Simple Pricing Unlike the extremely difficult Black-Scholes Model-based options pricing, futures
pricing is quite easy to understand. It's usually based on the cost-of-carry model, under which the
futures price is determined by adding the cost of carrying to the spot price of the asset.

23
6. Protection against Price Fluctuations: Forward contracts are used as a hedging tool in
industries with high level of price fluctuations. For example, farmers use these contracts to protect
themselves against the risk of drop in crop prices.
7. Hedging against Future Risks Many people enter into forward contracts for better risk
management. Companies often use these contracts to limit risk that may arise from foreign currency
exchange.
The Disadvantages of Futures Contracts
1. No Control over Future Events One common drawback of investing in futures trading is that you
don't have any control over future events. Natural disasters, unexpected weather conditions, political
issues, etc. can completely disrupt the estimated demand-supply equilibrium.
2. Leverage Issues High leverage can result in rapid fluctuations of futures prices. The prices can go
up and down daily or even within minutes.
3. Expiration Dates Future contracts involve a certain expiration date. The contracted prices for the
given assets can become less attractive as the expiration date comes nearer. Due to this, sometimes, a
futures contract may even expire as a worthless investment.
Futures Terminology
1. Commodity Futures Market – a physical or electronic marketplace where traders buy and sell
commodity futures contracts.
2. Commodity Futures Contracts – purchase and sales agreements having standardized terms,
including quantities, grades, delivery periods, price basis, and delivery methods of a
particular commodity.
3. Long Position - a buyer of futures contracts. A long position is the number of purchase
contracts held by the buyer.
4. Short Position - a seller of futures contracts. A short position is the number of sales contracts
held by the seller.
5. Trade Volume – the number of transactions executed for a particular time period. The purchase by
the buyer and sale by the seller of one futures contract equals a volume of ONE (Purchases and sales
are not double counted.)
6. Open interest – the number of futures contracts that exist on the book of the Clearinghouse.
One purchase and sale, involving two transacting parties – constitutes an open interest of ONE.
The number of purchase and sale contracts is always equal.
7. Closing Price – the fair value price trading near the end of the trading session, as determined by the
exchange.
8. Futures Delivery – the transfer of commodity ownership from the short (the seller) to the long (the
buyer) during the delivery period. Ownership is transferred by the surrender of warehouse receipts
or some other negotiable instrument specified by the contract.
9. Futures Expiration– the last trading day of futures contract.
10.Volatility – the variability of prices over time (historical) or projected (Implied) as determined
by a formula.

24
11.Historical and Implied Volatility - Historical Volatility is a measure of price variability showing
the variation or “dispersion” of prices from the mean over a chosen time period. Is calculated using a
standard deviation Quantity:50 MT EU origin wheatGrade: Sound, Fair, Merchantable Quality
Deliverable months: Jan, March, May, August, November Price basis Euros per tonn minimum price
movement25 euro cents (€12.50 per contract)Delivery method: Warehouse receipts in store silo
Rouen 2 formula. Implied Volatility is based on a option pricing model (such as Black Scholes) using
premiums paid for at-the-money options on futures, that is – the option with a strike price closest to
the futures price. For example, if maize is trading at $6.03/bushel, than IV is derived from the
premiums paid for $6.00 strike. Historical Volatility is backward looking whereas Implied Volatility
– often called the fear index – is forward looking.
12.Clearinghouse – the entity of a futures exchange that acts as counterparty to every transaction. The
clearinghouse “clears” every transaction by becoming the buyer to the seller and the seller to the
buyer. The clearinghouse always holds an equal number of buy and sell contracts. The purpose of the
clearinghouse is to guard against default.
13.Default – the failure of a long or short to deposit sufficient margin with the clearinghouse. Also –
the failure of a seller to make delivery or the failure of a buyer to take delivery of the commodity
during the delivery period.
14.Position Limit – the maximum number of buy or sell contracts that a speculator can hold at one
time in a futures contract. Normally, exchanges require position limits to be reduced as the delivery
period approaches.
15. Hedging – buying or selling futures contracts against opposite cash positions. Producers that sell
futures against anticipated harvest are called short hedgers. End-users, such as wheat millers that buy
futures against anticipated inventory needs, are called long hedgers.
Types of futures
There are many types of futures contracts available for trading including:
 Commodity futures such as in crude oil, natural gas, corn, and wheat
 Stock index futures such as the S&P 500 Index
 Currency futures including those for the euro and the British pound
 Precious metal futures for gold and silver
 U.S. Treasury futures for bonds and other products
Trading process
The trading process of futures involves the following steps
1. Select brokerage
2. Opening a trading account
3. Choose a commodity or financial instrument to trade
4. Study different contract, the costs and goods
5. Develop a trading strategy
6. Purchase the futures contract

25
Future trading mechanism
1. Placing an order
2. Role of the clearing house
3. Daily settlement
4. Settlement
Role of clearing house
A clearing house acts as an intermediary between a buyer and seller and seeks to ensure that
the process from trade inception to settlement is smooth. Its main role is to make certain that the
buyer and seller honor their contract obligations. Responsibilities include settling trading accounts,
clearing trades, collecting and maintaining margin monies, regulating delivery of the bought/sold
instrument, and reporting trading data. Clearing houses act as third parties to all futures and options
contracts, as buyers to every clearing member seller, and as sellers to every clearing member buyer.
The clearing house enters the picture after a buyer and seller have executed a trade. Its role is
to consolidate the steps that lead to settlement of the transaction. In acting as the middleman, a
clearing house provides the security and efficiency that is integral for financial market stability.
Clearing houses take the opposite position of each side of a trade which greatly reduces the
cost and risk of settling multiple transactions among multiple parties. While their mandate is to
reduce risk, the fact that they have to be both buyer and seller at trade inception means that they are
subject to default risk from both parties. To mitigate this, clearing houses impose margin (initial and
maintenance) requirements.
Functions of clearing house
A clearing house is basically the mediator between two transacting parties. However, there is
also more to what clearing houses do. Let’s take a look at some of their functions in more detail.
1. The clearing house guarantees that the transactions will occur smoothly and that both parties
will receive what is due to them. This is done by checking the financial capabilities of both parties
to enter into a legal transaction, regardless of whether they are an individual or an organization.
2. The clearing firm makes sure that the parties involved respect the system and follow the proper
procedures for a successful transaction. The facilitation of smooth transactions leads to a more liquid
market.
3. It is the clearing house firm that provides a level playing field for both parties, where they can
agree on the terms of their negotiation. This includes having the responsibility for setting the
price, quality, quantity, and maturity of the contract.
4. The clearing house makes sure that the right goods are delivered to the buyer, in terms of
both quantity and quality, so that at the end of the transaction there are no complaints nor
arbitration necessary.
Margin system
In futures contract, the clearing house undertakes the default risk. To protect itself from this
risk, the clearing house requires the participants to keep margin money. Thus margins are amounts
required to be paid by dealers in respect of their futures position to ensure that both parties will
perform their contract obligations.

26
Types of margin
1. Initial Margin
Initial Margin is the capital sum which an investor needs to park with his broker as a
down payment in its account to initiate trades. This acts as collateral. An investor can offer
cash and securities or other collateral like open ended Mutual fund as collateral to enter into a
trade.
In most cases, especially for equity securities, the initial margin requirement is 30 % or
exchange defined margin whichever is higher, but this may vary. And yes, both buyers and
sellers must put up a payment to enter into a trade.
2. Maintenance Margin
After purchasing the stocks, a minimum balance called as maintenance margin needs
to be parked with the broker. In case the margin drops below the limit, your broker will make
a margin call and can also liquidate the position if you do not make up for the requirement
amount. Maintenance Margin varies between 20-30% subject to minimum exchange charged
margin and may change depending on a position an investor wants to hold in a stock market.
3. Variation Margin
Variation margin is the additional amount of cash you are required to deposit in your
trading account to bring it up to the initial margin after you have incurred sufficient losses to
bring it below the "Maintenance Margin". Variation Margin = Initial Margin - Margin
Balance.
Marking to Market (daily settlement)
Marking to market refers to the daily settling of gains and losses due to changes in the market
value of the security. For financial derivative instruments, such as futures contracts, use marking to
market.
If the value of the security goes up on a given trading day, the trader who bought the security
(the long position) collects money – equal to the security’s change in value – from the trader who
sold the security (the short position). Conversely, if the value of the security goes down on a given
trading day, the trader who sold the security collects money from the trader who bought the security.
The money is equal to the security’s change in value.
The value of the security at maturity does not change as a result of these daily price
fluctuations. However, the parties involved in the contract pay losses and collect gains at the end
of each trading day.
Arrange futures contracts using borrowed money via a clearinghouse. At the end of
each trading day, the clearinghouse settles the difference in the value of the contract. They do
this by adjusting the margin posted by the trading counterparties. The margin is also the
collateral.
Stock Futures
Stock Futures are financial contracts where the underlying asset is an individual stock. Stock Future
contract is an agreement to buy or sell a specified quantity of underlying equity share for a future
date at a price agreed upon between the buyer and seller. The contracts have standardized
specifications like market lot, expiry day, unit of price quotation, tick size and method of settlement.
Currency futures
Currency futures are a exchange-traded futures contract that specify the price in one currency at
which another currency can be bought or sold at a future date. Currency futures contracts are legally
27
binding and counterparties that are still holding the contracts on the expiration date must deliver the
currency amount at the specified price on the specified delivery date. Currency futures can be used to
hedge other trades

Features of Currency futures

The Features of currency futures are:
 → High Liquidity or currency risks, or to speculate on price movements in currencies.
 → Simple and easy to understand
 → Standardized trading platform with Online/Offline modes
 → Less volatile market as compared to other trading products
 → Low Margin with High Leverage
 → Currency follows close correlations with Equities, Commodities
 → Currency Options are also available in USD/INR
 → Spread Trading - Inter Currency and Intra Currency Spread
 → Huge trading limits for Retail, corporate and Institutional clients
 → Exchange Traded Currency Derivatives are effective risk management tools

Interest rate futures

Interest rate futures are a type of futures contract that are based on a financial instrument
which pays interest. It is a contract between a buyer and a seller which agrees to buy and sell a debt
instrument at a future date when the contract expires at a price that is determined today.
Some of these futures may require the delivery of specific types of bonds, mostly government
bonds on the delivery date.
These futures may also be cash-settled in which case, the one who holds the long position
receives and one who holds the short position pays. These futures are thus used to hedge against or
offset interest rate risks. Which means investors and financial institutions cover their risks against
future interest rate fluctuations with these.
These futures can be short or long term in nature. Short term futures invest in underlying
securities that mature within a year. Long term futures have a maturity period of more than one
year.
Pricing for these futures is derived by a simple formula: 100 – the implied interest rate. So a
futures price of 96 means that the implied interest rate for the security is 4 percent.
Since these futures trade in government securities, the default risk is nil. The prices depend
only on the interest rates.

28
Applications of interest rate futures
1. Long hedge
T bills futures are used to hedge the short term interest rate risk. A long hedge
involves buying futures contract, in other words, long hedge means assuming a long position
in the futures market.
2. Short hedge
A short hedge involves selling futures contract. If interest rates in the economy go up,
issuer will pay the investors m0re but will be compensated by taking short position in the
futures contract.
3. Converting floating rate loan to a fixed rate loan
A fixed rate loan carries a constant interest rate over the life of the loan. A floating
interest a rate involves the rate being changed at regular pre-defined intervals during the loan
period.
4. Converting a fixed rate loan to floating rate loan
we can convert a fixed rate loan to a floating rate loan by using an interest rate
future to protect from risk of unfavourable changes in the interest rate.
5. Extending the maturity of the security
Interest rate futures can e used to extend the maturity of a debt market security.
6. Shortening the maturity of the security
We can use futures for reducing the maturity of a debt market security.
7. Hedging a commercial paper issue
When short term interest rates are expected to increase, the issuer can hedge the
futures commercial paper issue by taking short position in T bill futures contracts.
8. Hedging a bond portfolio with T bond futures
Fixed income portfolio managers often use T bond futures to shield the futures values of
their portfolios against interest rate changes.
Stock index futures
Stock index futures, also referred to as equity index futures or just index futures, are futures
contracts based on a stock index. Futures contracts are an agreement to buy or sell the value of the
underlying asset at a specific price on a specific date. In this case, the underlying asset is tied to a
stock index. Index futures, however, are not delivered at the expiration date. They are settled in cash
on a daily basis, which means that investors and traders pay or collect the difference in value daily.
Index futures can be used for a few reasons, often by traders speculating on how the index or market
will move, or by investors looking to hedge their position against potential future losses.
Uses of Stock index futures
1. Speculation
To make money, speculators use index futures by taking long or short position. Such
positions are taken on the assumption that the index would go up or down, if a person belives
that the market would go up in the futures, he may buy futures.
2. Funds lending by Arbitrageur
For an arbitrageur willing to employ funds, the methodology involves first buying
shares in the cash market and selling index futures. The quantity of shares to be ought is
decided on the basis of their weightage in the index and the order is put through the
system
29
 simultaneously using the programe trading methods. At the same time a sell position is taken
in the futures market.
3. Securities lending
An arbitrageur can earn returns by lending securities in the market. The methodology
involoved is first selling shares in cash market and buying index futures using the cash
received in some risk free investment, and finally buying the same shares and setting the
futures position at the expiration.
4. Strategic arbitrage
An arbitrageur need not hold his position till the date of maturity. The basis does not
remain uniform. It keeps on changing. This is due to the volatility in the market. The
arbitrageur may keep track of the basis and unwind his position as soon as appropriate
opportunity is seen and take advantage of changes in the basis is short intervals.
5. Hedging
Stock index futures can be effectively used for hedging purposes. They can be used
while taking a long or short position on a stock and for portfolio hedging against unfavorable
price movements.
Commodity futures
A commodity futures contract is an agreement to buy or sell a predetermined amount of a
commodity at a specific price on a specific date in the future. Commodity futures can be used to
hedge or protect an investment position or to bet on the directional move of the underlying asset.
Many investors confuse futures contracts with options contracts. With futures contracts, the holder
has an obligation to act. Unless the holder unwinds the futures contract before expiration, they must
either buy or sell the underlying asset at the stated price.
Features of commodity futures
1. Organized: Commodity futures contracts always trade on an organized exchange. NCDEX
and MCX are examples of exchanges in India. NYMEX, LME, and COMEX are some
international exchanges.
2. Standardized: Commodity futures contracts are highly standardized. This means the
quality, quantity, and delivery date of commodities is predetermined by the exchange on which
they are traded.
3. Eliminate counter-party risk: Commodity futures exchanges use clearinghouses to guarantee
fulfillment of the terms of the futures contract. This eliminates the risk of default by the other
party.
4. Facilitate margin trading: Commodity futures traders do not have to pay the entire value of a
contract. They need to deposit a margin that is 5–10% of the contract value. This allows the investor
to take larger positions while investing less capital.
5. Fair practices: Government agencies regulate futures markets closely. For example, there is the
Forward Markets Commission (FMC) in India and the Commodity Futures Trading Commission
(CFTC) in the Unites States. The regulation ensures fair practices in these markets.
6. Physical delivery: The actual delivery of the commodity can take place on expiry of the contract.
For physical delivery, the member needs to provide the exchange with prior delivery information.
He also needs to complete all delivery-related formalities as specified by the exchange.

30
Benefits of Commodity Futures
1. Price Discovery: Based on inputs regarding specific market information, buyers and
sellers conduct trading at futures exchanges. This results into continuous price discovery
mechanism.
2. Hedging: It is strategy of managing price risk that is inherent in spot market by taking an equal
but opposite position in the futures market to protect their business from adverse price change.
3. Import- Export competitiveness: The exporters can hedge their price risk and improve their
competitiveness by making use of futures market. A majority of traders which are involved in
physical trade internationally intend to buy forwards. The existence of futures market allows the
exporters to hedge their proposed purchase by temporarily substituting for actual purchase till
the time is ripe to buy in physical market.
4.Portfolio Diversification Commodity offers at another investment options which is largely
negatively correlated with equity and currency and thus could offer great portfolio
diversification.
Futures pay-offs or profit or loss
Futures contracts have linear payoffs. In simple words, it means that the losses as well as
profits for the buyer and the seller of futures contracts are unlimited. These liner payoffs are
fascinating as they can be combined with options and the underlying to generate various
complex payoffs.
Payoff for Buyer of Futures:
Long Futures the payoff for a person who buys a futures contract is similar to the payoff for a
person who holds an asset .He has a potentially unlimited upside as well as a potentially unlimited
downside. Take the case of a speculator who buys a two month nifty index futures contract when the
nifty stands at 2220. The underlying asset in this case is the nifty portfolio. When the index moves
down it starts making losses. Fig 5.3shows the payoff diagram for the buyer of a futures contract.
The payoff diagram for the buyer of a futures contract The Fig. shows the profits/losses for a long
futures position. The investor bought futures when the index was at 2220. If the index goes up,
his futures position starts making profit. If the index falls, his futures position starts showing
losses.
Payoff for Seller of Futures:
Short Futures The payoff for a person who sells a futures contract is similar to the payoff for a
person who shorts an asset. He/she has a potentially unlimited upside as well as a potentially
unlimited downside. Take the case of a speculator who sells two-month Nifty index futures when the
Nifty stands at 2220. The underlying asset in this case is the Nifty portfolio. When the index moves
up, it starts making losses. Figure 5.4shows the payoff diagram for the seller of a futures contract.
Fig. The payoff diagram for the seller of a futures contract The Fig. shows the profit/losses for a short
futures position. The investor sold futures when the index was at 2220. If the index goes down, his
futures position starts making profit. If the index rises, his futures position starts showing losses.
Trading strategies in stock futures
Below are four popular futures trading strategies, from the basic to the more complex.
1. Going long Going long — buying a futures contract — is the most basic futures
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trading strategy. An investor buys a futures contract expecting the contract to rise in
price by expiration.

32
 Best to use when: Buying a futures contract is the most straightforward futures trading
strategy for speculating on an asset rising before the contract expires. The futures contract offers a
leveraged return on the underlying asset’s rise, so the trader expects a clear move higher in the near
future.
Risks and rewards: Going long offers the inherent promise of the futures contract: a
leveraged return on the underlying asset’s rise. It has uncapped upside as long as the asset rises,
making this futures trading stategy a potential home run. In this example, if the contract increases 10
cents to $3.60 (a gain of 2.8%), then your equity stake balloons from $4,000 to $6,500 for a return of
nearly 63%. That is, the five contracts are now worth $90,000, and the additional $2,500 is your gain.
2. Going short Going short — selling a futures contract — is the flip side of going
long. An investor sells a futures contract expecting the contract to fall by expiration.
Best to use when: Selling a futures contract is another straightforward futures trading
strategy, but it can be riskier than going long because of the potential for uncapped losses if the
underlying asset continues to rise. Investors going short a contract want the full leveraged returns of
an asset that is expected to fall.
Risks and rewards: Going short offers many of the same benefits that going long does, most
notably the leveraged return on the underlying asset’s decline. However, unlike the long position,
going short has uncapped downside.
3. Bull calendar spread
A calendar spread is a strategy that has the trader buying and selling contracts on the same
underlying asset but with different expirations. In a bull calendar spread, the trader goes long the
short-term contract and goes short the long-term contract. A calendar spread reduces the risk in a
position by eliminating the key driver of the contract’s value — the underlying asset. The goal of this
futures trading strategy is to see the spread widen in favor of the long contract.
With a bull calendar spread, traders have multiple ways to win since the spread can widen in
a few ways: The long contract can go up, the short contract can go down, the long can go up while
the short goes down, the long can go up more than the short goes up, and the long can go down less
than the short goes down. The important point is that the spread widens.
Best to use when: The trader must expect the long contract to move up relatively more than
the short contract, widening the value of the spread and creating a profit for the trader. A bull
calendar spread is a more conservative position that is less volatile than going long. It also requires
less margin to set up than a one-leg futures position, and this is a significant advantage of the trade.
Plus, this lower margin allows the trader to achieve a higher return on capital.
4. Bear calendar spread
Like the bull calendar spread, the bear calendar spread has the trader buying and selling
contracts on the same underlying asset but with different expirations. A calendar spread reduces the
risk by neutralizing the key driver of the contract’s value — the underlying asset. In a bear calendar
spread, the trader sells the short-term contract and buys the long-term contract. The goal of this
futures trading strategy is to see the spread widen in favor of the short contract.
With a bear calendar spread, traders have multiple ways to win since the spread can widen in
a few ways: The long contract goes down, the short contract goes up, the long goes down while the
short goes up, the long goes down more than the short goes down, and the long goes up less than the

33
short goes up. The important point is that the short September contract becomes more expensive
relative to the long December contract.
Best to use when: The trader must expect the short contract to increase relatively more than
the long contract, widening the value of the spread and creating a profit. A bear calendar spread is a
more conservative position that is less volatile, requiring less margin to set up than a one-leg futures
position, and this is a significant advantage of the spread trade. This lower margin requirement allows
the trader to achieve a higher return on capital.
Risks and rewards: The appeal of the bear calendar spread is that you can generate nice
returns on a conservative strategy while the broker requires lower margin. This reduced margin
helps boost your percentage return on a successful trade.
Settlement of futures
When a futures trader takes a position (long or short) in a futures contract, he can settle
the contract in three different ways.
1. Closeout: In this method, the futures trader closes out the futures contract even before the expiry.
If he is long a futures contract, he can take a short position in the same contract. The long and the
short position will be off-set and his margin account will be marked to marked and adjusted for
P&L. Similarly, if he is short a futures contract, he will take a long position in the same contract to
close out the position.
2. Physical Delivery: If the futures trader does not closeout the position before expiry, and keeps
the position open and allows it to expire, then the futures contract will be settled by physical delivery
or cash settlement (discussed below). This will depend on the contract specifications. In case of the
physical delivery, the clearinghouse will select a counterparty for physical settlement (accept
delivery) of the futures contract. Typically the counterpart selected will be the one with the oldest
long position. So, at the expiry of the futures contract, the short position holder will deliver the
underlying asset to the long position holder.
3. Cash Settlement: In case of cash settlement (in case the contract has expired), there is no need for
physical delivery of the contract. Instead the contract can be cash- settled. This can be done only if
the contract specifies so. If a contract can be cash settled, the trader need not closeout the position
before expiry, He can just leave the position open. When the contract expires, his margin account will
be marked-to market for P&L on the final day of the contract. Cash settlement is a preferred option
for most traders because of the savings in transaction costs.

34
MODULE 4
OPTIONS
An option is a contract whereby one party (the holder or buyer) has the right, but not the
obligation, to exercise the contract (the option) on or before a future date (the exercise date or
expiry). The other party (the writer or seller) has the obligation to honor the specified feature of the
contract. Since the option gives the buyer a right and the seller an obligation, the buyer has received
something of value. The amount the buyer pays the seller for the option is called the option
premium.
The idea behind an option is present in everyday situations. For example, you discover a
house that you'd love to purchase. Unfortunately, you won't have the cash to buy it for another three
months. You talk to the owner and negotiate a deal that gives you an option to buy the house in three
months for a price of Rs.200, 000. The owner agrees, but for this option, you pay a price of Rs.3,
000. Now, consider two theoretical situations that might arise: 1.It's discovered that the house is
actually the true birthplace of a great man. As a result, the market value of the house skyrockets to
Rs.1 crore. Because the owner sold you the option, he is obligated to sell you the house for
Rs.200,
000. In the end, you stand to make a profit ofRs.97, 97,000(Rs.1 Crore–Rs.200, 000 –Rs.3, 000). 2.
While touring the house, you discover not only that the walls are chock-full of asbestos, but also that
a ghost haunts the master bedroom; furthermore, a family of super-intelligent rats have built a
fortress in the basement. Though you originally thought you had found the house of your dreams, you
now consider it worthless. On the upside, because you bought an option, you are under no obligation
to go through with the sale. Of course, you still lose the Rs.3, 000 price of the option. This example
demonstrates two very important points. First, when you buy an option, you have a right but notan
obligation to do something. You can always the expiration date go by, at which point the option
becomes worthless. If this happens, you lose 100% of your investment, which is the money you used
to pay for the option. Second, an option is merely a contract that deals with an underlying asset. For
this reason, options are called derivatives, which mean an option derives its value from something
else. In our example, the house is the underlying asset. Most of the time, the underlying asset is a
stock or an index.
Features of options
1. Contractual agreement that gives the buyer the right , but not the obligation, to buy or sell
a specified asset at a specified price on or within a specified period.
2. There are two parties to an option contract. One is buyer (investor or owner) who buys the
right. Second is writer (seller) who sells the right (to buy or sell) to the buyer.
3. The seller of option sells the right to choose to the buyer in return for a payment called
premium. Hence option is somewhat similar to insurance.
4. The buyer of option may exercise his right or may not exercise his right. He will exercise his right
only when it is beneficial for him by doing so. He shall not exercise the option He shall let the option
expired. Then he will lose the premium paid. It becomes a gain to the seller.
5. The seller has no choice. He has no right. He has only obligation. This means that he must meet his
obligation when the buyer exercises his right.
6. There are two types of option-call option and put option.
7. The buyer of option should exercise his right at any time during the period of contract, i.e., at any
35
time between the signing of the contract and the expiry date (American style). This intervening

36
period is called expiration period. If the buyer does not exercise the option within the
specified period, the option gets expired.
8. The specified or agreed price at which the owner is allowed to buy/sell the specified asset is called
exercise or strike price. It is the price at which the option (right) is exercised It is based on the
current quoted prices.
Parties to option contracts
1. Purchaser/investor/holder - who buys the option
2. Writer/seller - who sells the option
Important terms (option terminology)
1. Exercise price/strike price – option price
2. Spot price – current market price of the underlying asset
3. Underlying – the asset on which option is traded.
4. Premium – the amount paid by the option buyer to option seller
5. Exercise date – date on which option is actually exercised.
6. Expiration date – the date on which option expires
Need for options
 Capital gain
 Tax advantage
 Control their right on underlying asset
 Enjoy a much wider risk return conditions
 Possibility of gi8ving a windfall profit
 Reduce total portfolio transaction cost
 Better return with limited amount of investment
 Additional income on stock holdings
 Gives the ability to participate when the market is moving upwards, downwards or sideways.
Advantages
 Once premium paid, no further cash is payable by the buyer
 Limit the downside of risk, without limiting upside(limit the loss, but maximise profit)
 No obligation to exercise
 Used for heding,combined with futures and forwards to achieve more complex hedges
 Used for hedging as well as speculation
Limitations
 Premium payable, if volatility is high – premium amount is also high
 Factors affecting option premiums are very complex
 Future have more liquidity than options
Positions in the Options Contract
There are four types of option positions. They are briefly explained as below.
1. Long position in a call option
A person who buys a call option is said to have a long position in a call option. He
purchases the right, but not the obligation to buy underlying asset at the stated exer cise price at
any time before the option expires. In short, long means buy.
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2. Long position in a put option
A person who buys put option is said to have a long position in a put option. He buys the
right, but not the obligation, to sell the underlying asset at the stated exercise price at any time
before the option expires.
3. Short position in a call option
A person who sells a call option is said to have a short position in a call option. He sells the
right to buy the asset.
4. Short position in a put option
A person who sells a put option is said to have a short position in a put option. He sells the
right to sell the asset at a fixed price. He has the obligation to buy the underlying asset at the
stated exercise price.

Option Buyer Seller

Call Right to buy Obligation to sell
Put Right to sell Obligation to buy

Difference between futures and options

Futures options
1. Both the parties are obliged to perform 1. Only the seller (writer) is obliged to perform
the contract (buy or sell the underlying the contract.
asset).
2. Margin is the basis of the contract. 2. Option premium is the basis of the contract.
3. Both buyers and sellers face the possibility 3.Buyers have the possibility of unlimited profit
of unlimited gain or loss. but their losses are limited. Sellers have the
possibility of limited profit. But their losses are
unlimited.
4. Preferential contracts for the hedgers to
4. Preferential contracts for the speculators minimise risk.
to maximise profit.
5. It can be exercised by the buyer at any time
5. It has to be honoured by both the parties during the life of the contract or option period.
only on the specified date. 6. Binomial model and Black Sholes model
6. Cost of carry model, backwardation
model, expectation model and CAPM

Difference between forwards and options

Forwards options

38
1. Both buyer and seller have obligations. 1. Only the seller has an obligation (buyer
had option but not an obligation).

2. Customised contract. 2. Standardised contract.

3. Not traded in stock exchanges. 3. Trade in stock exchanges.

39
 4. There is no premium and margin. 4. The buyer pays premium to the seller, while
the seller deposits margin initially with
subsequent deposits made depending on the
market.

5. Expiry date depends upon the transactions. 5. American options can be exercised at any time
during the life of the contract.

Classification of options (Types of Option contracts)

A. Classification on the basis of right
1. Call option
Call options are contracts that give the owner the right to buy the underlying asset in
the future at an agreed price.it is useful when prices are rising. You would buy a call if you
believed that the underlying asset was likely to increase in price over a given period of time.
Calls have an expiration date and, depending on the terms of the contract, the underlying
asset can be bought any time prior to the expiration date or on the expiration date.
Under favourable circumstances, the buyer may choose to exercise the option. Under
unfavourable circumstances (when the spot rate falls below the exercise price), the buyer
shall not exercise the option.
2. Put option
Put options are essentially the opposite of calls. The owner of a put has the right to sell
the underlying asset in the future at a pre-determined price. Therefore, you would buy a put if
you were expecting the underlying asset to fall in value. As with calls, there is an expiration
date in the contact.

B. Classification on the basis of style of exercise

1. American Style
Options contracts come with an expiration date, at which point the owner has the right
to buy the underlying security (if a call) or sell it (if a put). With American style options, the
owner of the contract also has the right to exercise at any time prior to the expiration date.
2. European Style
European options are options that can be exercised, only on the expiry date (maturity).
In India, European options are not used.
3. Bermudan Option
A Bermudan option can be exercised on a few specific dates prior to expiration. The
name ‘Bermuda’ was chosen perhaps because Bermuda is half way between America and
Europe.

C. Classification on the basis of nature of underlying assets

1. Commodity Options: The underlying asset for a contract of this type can be either a physical
commodity or a commodity futures contract.
2. Forex/Currency Options: Contracts of this type grant the owner the right to buy or sell
a specific currency at an agreed exchange rate.
3. Stock Options: The underlying asset for these contracts is shares in a specific publically
listed company.
4. Stock Index Options: These are very similar to stock options, but rather than the underlying
security being stocks in a specific company it is an index – such as the S&P 500.stock index
option enables investors to trade in general stock market movements. The stock price
40
41
 movement will reflect in stock index option prices.in stock index option, the transactions are
settled by payment of cash.
D. Classification on the basis of trading place
1. Exchange Traded Options Also known as listed options, this is the most common form of
options. The term “Exchanged Traded” is used to describe any options contract that is listed
on a public trading exchange. They can be bought and sold by anyone by using the services
of a suitable broker.
2. Over The Counter Options “Over The Counter” (OTC) options are only traded in the
OTC markets, making them less accessible to the general public. They tend to be
customized contracts with more complicated terms than most Exchange Traded contracts.
Other types of options
1. Real option:-it is a choice that an investor has when investing in the real economy (i.e., in
the production of goods or services, rather than in financial contracts).
2. Vanilla and exotic option: A vanilla option is a ‘simple’ or well understood option. But
exotic options are more complex or less understood. European options and American
options on stock and bonds are generally considered to be ‘plain vanilla’. Asian options,
look back options, barrier options (hybrid options) are exotic.
3. Warrants: these are long dated options. These are generally traded over the counter.
4. LEAPS: LEAPS means Long term Equity Anticipation Securities. These are options having
a maturity of upto three years.
5. Basket Options: A basket contract is based on the underlying asset of a group of
securities which could be made up stocks, currencies, commodities or other financial
instruments
Moneyness of the Options
Moneyness refers to the potential profit or loss from the exercise of an option. At any time
before the expiration, an option may be in-the-money, at-the-money, out-of the money.
1. In-the-money options: An in-the-money (ITM) option is an option that would lead to a positive
cash flow to the holder if it were exercised immediately. A call option on the index is said to be in
the-money when the current index stands at a level higher than the strike price (i.e. spot price>
strike price). If the index is much higher than the strike price, the call is said to be deep ITM. In the
case of a put, the put is ITM if the index is below the strike price.
2. At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cash
flow if it were exercised immediately. An option on the index is at-the-money when the current index
equals the strike price (i.e. spot price = strike price).
3. Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to a
negative cash flow if it were exercised immediately. A call option on the index is out-of-the-money
when the current index stands at a level which is less than the strike price (i.e. spot price < strike
price). If the index is much lower than the strike price, the call is said to be deep OTM. In the case
of a put, the put is OTM if the index is above the strike price.
Intrinsic value and time value
To buy an option, an investor must pay an option premium. The option premium can be
thought as the sum of two different numbers that represent the value of the option. The first is the
current value of the option, known as the intrinsic value. The second is the potential increase in value
that the option could gain over time, known as the time value.
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Intrinsic Value of an Option
The intrinsic value of an option represents the current value of the option, or in other words
how much in the money it is. When an option is in the money, this means that it has a positive payoff
for the buyer. A $30 call option on a $40 stock would be $10 in the money. If the buyer exercised the
option at that point in time, he would be able to buy the stock at $30 from the option and then
subsequently sell the stock for $40 on the market, capturing a $10 payoff. So the intrinsic value
represents what the buyer would receive if he decided to exercise the option right now. For in the
money options, intrinsic value is calculated as the difference of the current price of the underlying
asset and the strike price of the option.
For options that are out of the money or at the money, the intrinsic value is always zero. This
is because a buyer would never exercise an option that would result in a loss. Instead, he would let
the option expire and get no payoff. Since he receives no payoff, the intrinsic value of the option is
nothing to him.
Time Value of an Option
The time value of an option is an additional amount an investor is willing to pay over the
current intrinsic value. Investors are willing to pay this because an option could increase in value
before its expiration date. This means that if an option is months away from its expiration date, we
can expect a higher time value on it because there is more opportunity for the option to increase or
decrease in value over the next few months. If an option is expiring today, we can expect its time
value to be very little or nothing because there is little or no opportunity for the option to increase or
decrease in value.
Time value is calculated by taking the difference between the option’s premium and the
intrinsic value, and this means that an option’s premium is the sum of the intrinsic value and time
value:
 Time Value = Option Premium - Intrinsic Value
 Option Premium = Intrinsic Value + Time Value
Trading strategies involving stock options (uses of options)

Options open up a lot of possibilities. This means that different strategies can be formulated
by using options. Each of these strategies has a different risk/reward profiles. Some are
comparatively high risk, like purchasing call and put options. Others are meant to earn profit if
specific expectations are met. All trading strategies involving options may be broadly classified into
the following four.
1. Hedging
Hedging involves an attempt to control or manage risk by combining the purchase or sale of
an option with some position in the asset.
2. Speculation
Speculation involves the purchase or sale of an option without any position in the underlying
asset.
3. Spreading
Spreading is a case when hedging is done within the option market ie, by simultaneous
purchase and sale of option of same type.
4. Combinations
Combinations of call options and put options in various ways can also be used to design
option strategies. Different types of options strategies can be framed with different perceptions on ris

43
reward combinations. Alternatively, the option strategies can be classified into bullish strategies,
bearish strategies and neutral strategies.

Option trading strategies

FUNDAMENTAL OPTION STRATEGIES
1. Long call
 Purchase of a call option
 Buys the right to purchase the stock (call option) rather than just buying the stock
 Trader buys the option instead of shares
 Expectation=price rise
 BEP=strike price of long call + premium paid
 This strategy is adopted when an investor is bullish on market direction(expect
a price rise) and bullish on market volatility(unlimited profit, limited loss)
2. Short call
 Selling(writing) of a call option
 Sells the right to purchase the stock (call option) rather than just selling the stock
 Very risky-profit limited, loss unlimited
 Expectation=price falls
 BEP=strike price of short call + premium
 This strategy is adopted when an investor is bearish on market direction(expect a
price fall) and bearish on market volatility(limited profit, unlimited loss)
3. Long put
 Purchase of a put option
 Buys the right to sell the stock (call option) rather than just buying the stock
 Expectation=price falls below the strike price
 BEP=strike price of long put - premium paid
 This strategy is adopted when an investor is bearish on market direction(expect a
price fall) and bullish on market volatility(unlimited profit, limited loss)
4. Short put
 Selling(writing) of a put option

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  Sells the right to sell the stock (put option) rather than just selling the stock
 Very risky-profit limited, loss unlimited
 Expectation=price rise
 BEP=strike price of short put - premium
 This strategy is adopted when an investor is bullish on market direction(expect
a price rise) and bearish on market volatility(limited profit, unlimited loss)
HEDGING WITH OPTIONS
Unique feature of hedging with options is that when combined with position in the asset is
protects the losses from the adverse movement while retaining the potential gain from the favourable
movement of price. The returns from the favourable side are reduced only marginally by the amount
of the premium paid.
We consider hedging with options for long and short position in an asset which need
protection against fall and rise in the prices respectively.
1. Hedging long position in stock (the protective put)[synthetic long call]
The protective put, or put hedge, is a hedging strategy where the holder of a security buys a
put to guard against a drop in the stock price of that security. A protective put strategy is usually
employed when the options trader is still bullish on a stock he already owns but wary of uncertainties
in the near term. It is used as a means to protect unrealized gains on shares from a previous purchase.
Protective Put Construction
Long 100 Shares
Buy 1 ATM Put
Maximum Profit = Unlimited
Maximum Loss = limited

2. Hedging short position in stock with call option

Now consider an opposite position with no asset in possession. Many of us would wonder
what protection one needs on an asset that is not owned yet. Of course, one has nothing to lose
because he does not own. Yet protection is needed if he is intending to own the asset in near
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future.

46
Possibly one does not have funds to acquire the asset now. Such a position is considered as
short position on asset. For short position, the price falls is favourable. But price rise is
unfavourable.
3. Income generation through the strategy of writing covered call
Both the strategies discussed above aim at limiting the risk of an underlying position in an
equity stock option. Both of them may be used for generating returns from the positions in stock. To
earn the premium an investor may choose to write a call option expecting that the price will not
exceed the exercise price.
4. Income generation through the strategy of writing put
The strategy of writing a covered call is used when no upside movement in price is forecast.
Similarly, when one is short on stock and no downside movement is foreseen, an investor can decide
to write a put option to increase returns in the short turn.
5. Speculations with single option
This is another trading strategy involving option. Speculative strategy with options is rather
simple. When one is bullish he will buy a call option. This call option provides a gain if the market
price exceeds the strike price. Similarly under bearish conditions, the investor will buy put option.
OTHER OPTION TRADING STRATEGIES (COMBINATION OF OPTIONS)
1. Straddle
2. Strangle
3. Strap
4. Strip
5. Options spread strategy
STRADDLE
A straddle consists of buying a put option and a call option with the same exercise price and
date of expiration. Straddle is an appropriate strategy for an investor who expects a large move in the
price but does not now in which direction the move will be. Straddles may be long or short.
Long straddle
A long straddle is an options strategy where the trader purchases both a long call and a long
put on the same underlying asset with the same expiration date and strike price. The strike price is at-
the-money or as close to it as possible. Since calls benefit from an upward move, and puts benefit
from a downward move in the underlying security, both of these components cancel out small moves
in either direction, Therefore the goal of a straddle is to profit from a very strong move, usually
triggered by a newsworthy event, in either direction by the underlying asset.

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Short Straddle
A short straddle is simultaneous sale of a call and a put on the same stock, at same expiration
date and strike price.

STRANGLE
A strangle is a combination of one call option and one put option with different exercise
prices but with same expiration date. Strangle may be long or short.
Long strangle
The long strangle, also known as buy strangle or simply "strangle", is a neutral strategy in
options trading that involve the simultaneous buying of a slightly out-of-the-money put and a slightly
out-of-the-money call of the same underlying stock and expiration date.
Long Strangle Construction
Buy 1 OTM Call
Buy 1 OTM Put
Maximum Profit = Unlimited
Maximum Profit = Limited to total premium paid for call and put option

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Short strangle
The short strangle, also known as sell strangle, is a neutral strategy in options trading that
involve the simultaneous selling of a slightly out-of-the-money put and a slightly out-of-the-money
call of the same underlying stock and expiration date.
Short Strangle Construction
Sell 1 OTM Call
Sell 1 OTM Put
Limited profit
Unlimited loss
The short strangle option strategy is a limited profit, unlimited risk options trading strategy
that is taken when the options trader thinks that the underlying stock will experience little volatility in
the near term.
STRAP
Strap is the reverse of strip. In this strategy, the trader buys two call options and one put
option at the same strike price and maturity. This strategy is used when the chances of price going up
are more than the chances of going it down. Thus, strap is similar to long straddle. The only
difference is the quantity traded. When the prices increase, strap strategy will make more profit
compared to long straddle because he has bought two calls.
Strap construction
Buy 2 ATM calls
Buy 1 ATM put
Profit or loss
Maximum loss: maximum loss is limited to net premium paid. It occurs when the price of underlying
is equal to strike price of calls/puts
Maximum profit; profit is unlimited. The gains from upside movement would double when two
calls become in the money. The gains from upside movement will be larger than straddle and
remain same for downside movement.
Breakeven points
There are 2 breakeven points for the strap position. These are calculated as follows.
■ Upper breakeven point =strike price of calls/puts + (net premium paid/2)
■ Lower breakeven point= strike price of call/puts-Net premium paid)

STRIP
A strip is an option strategy that involves the purchase of two put options and one call option
all with the same expiration date and strike price. It can also be described as adding a put option to a
straddle.

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Strip construction
Buy 1 ATM call
Buy 2 ATM puts
Profit or loss
Maximum loss: maximum loss is limited. Maximum loss =net premium paid +commission paid
Maximum profit: profit is unlimited.
Breakeven points
There are 2 break even points for the strip position.
Upper breakeven point= strike price of calls/puts+ net premium paid
Lower breakeven point = strike price of calls/puts – (net premium paid /2)

Example
Suppose cash price of stock X Rs. 100. A trader buys one call and two put options at a strike
price of Rs. 100 on payment of a premium of Rs. 5 each. His total outflow at the time of buying the
strip is Rs. 15(premium). Trader will lose money between the levels of 92.5 and 115 (breakeven
points). He will suffer a maximum loss of Rs. 15, if stock price closes at Rs. 100 on expiry. In the
case of downward move in price of the underlying stock the two put options generate values for the
trader. But in the case of an upward move, only one call option generates profit.
The pay-off position of strip buyer is sown in the following diagram.

When price goes down, two puts become in the money. When prices go up only one call
become in the money, making gains unequal for same rise than fall in the price.
The strip seller will earn the maximum profit if price of the stock happens to e the strike price
of the options, ie, Rs. 100 at expiry of the options. The maximum profit will be equivalent to the total
premium received ie, Rs. 15.

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 OPTION SPREADS STRATEGY
Combinations, as discussed above are created by using to different types of options on the
same asset and same expiration dates. spreads are created with positions on the same type of options
on the same asset but with different strike prices. Thus, an option spread trading strategy involves
taking a position in two or more options of the same type simultaneously on same asset but with
different strike prices.
Option spread may be classified under three categories
1. Vertical spreads - combination of options having different strike prices but the same
maturity.
2. Horizontal spread – option position in similar options having different expiration dates but
with the same strike prices.
3. Diagonal spread – taking positions in options of the same type with different strike
prices and different maturities.
Spread strategies can be evolved for bearish conditions and bullish conditions. Accordingly,
spread can be classified into bull spreads and bear spreads.
1. Bull spread
2. Bear spread
3. Butterfly spread
4. Condor spread
5. Calendar spread
6. Box spread
7. Ratio spread
BULL SPREAD
Bull Spread is a strategy that option traders use when they try to make profit from an expected
rise in the price of the underlying asset. It can be created by using both puts and calls at different
strike prices. Usually, an option at a lower strike price is bought and one at a higher price but with the
same expiry date is sold in this strategy.
Description: In the graphic example shown below, the user has bought a long call at strike price 60
and shorted (sold) a long call at strike price of 65.

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Bull put spread
A bull put spread is an options strategy that is used when the investor expects a moderate rise
in the price of the underlying asset. The strategy uses two put options to form a range consisting of a
high strike price and a low strike price. The investor receives a net credit from the difference between
the two premiums from the options.
Bull put spreads can be implemented by selling a higher striking in-the-money put option and
buying a lower striking out-of-the-money put option on the same underlying stock with the same
expiration date.
If the stock price closes above the higher strike price on expiration date, both options expire
worthless and the bull put spread option strategy earns the maximum profit which is equal to the
credit taken in when entering the position
BEAR SPREAD
A trader purchases a contract with a higher strike price and sells a contract with a lower strike
price. This strategy is used to maximize profit of a decline in price while still limiting any loss that
could occur from a steep decrease in price.
Bear call spread
A bear call spread is a type of vertical spread. It contains two calls with the same expiration
but different strikes. The strike price of the short call is below the strike of the long call, which means
this strategy will always generate a net cash inflow (net credit) at the outset.
Breakeven stock price at expiration
Strike price of short call (lower strike) plus net premium received.
Bear Call Spread Construction
Buy 1 ATM Call
Sell 1 OTM Call
Put bear spread
A bear put spread is a type of options strategy where an investor or trader expects a moderate
decline in the price of a security or asset. A bear put spread is achieved by purchasing put options
while also selling the same number of puts on the same asset with the same expiration date at a lower
strike price. The maximum profit using this strategy is equal to the difference between the two strike
prices, minus the net cost of the options.
Bear Put Spread Construction
Buy 1 ATM Put
Sell 1 OTM Put
By shorting the out-of-the-money put, the options trader reduces the cost of establishing the
bearish position but forgoes the chance of making a large profit in the event that the underlying asset
price plummets.

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 BUTTERFLY SPREADS
A butterfly spread is an options strategy combining bull and bear spreads, with a fixed risk
and capped profit. These spreads, involving either four calls or four puts are intended as a market-
neutral strategy and pay off the most if the underlying does not move prior to option expiration.
Long call butterfly
A long butterfly spread with calls is a three-part strategy that is created by buying one call at
a lower strike price, selling two calls with a higher strike price and buying one call with an even
higher strike price. All calls have the same expiration date, and the strike prices are equidistant.
Short call butterfly
A short butterfly spread with calls is a three-part strategy that is created by selling one call at
a lower strike price, buying two calls with a higher strike price and selling one call with an even
higher strike price. All calls have the same expiration date, and the strike prices are equidistant.
Long put butterfly
The long put butterfly spread is a limited profit, limited risk options trading strategy that
is taken when the options trader thinks that the underlying security will not rise or fall much by
expiration.
Short put butterfly
The short put butterfly is a neutral strategy like the long put butterfly but bullish on volatility.
It is a limited profit, limited risk options strategy. There are 3 striking prices involved in a short put
butterfly and it can be constructed by writing one lower striking out-of-the-money put, buying two at-
the-money puts and writing another higher striking in-the-money put, giving the options trader a net
credit to put on the trade.
CONDOR SPREADS
A condor spread is a non-directional options strategy that limits both gains and losses while
seeking to profit from either low or high volatility. There are two types of condor spreads.
A long condor seeks to profit from low volatility and little to no movement in the underlying asset.
A short condor seeks to profit from high volatility and a sizable move in the underlying asset in either
direction.
Long condor
A long condor spread with calls is a four-part strategy that is created by buying one call at a
lower strike price, selling one call with a higher strike price, selling another call with an even higher
strike price and buying one more call with an even higher strike price. All calls have the same
expiration date, and the strike prices are equidistant.
Short condor
The short condor is a neutral strategy similar to the short butterfly. It is a limited risk, limited
profit trading strategy that is structured to earn a profit when the underlying stock is perceived to be
making a sharp move in either direction.

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 CALENDAR SPREAD
A calendar spread is an options or futures spread established by simultaneously entering a
long and short position on the same underlying asset at the same strike price but with different
delivery months. It is sometimes referred to as an inter-delivery, intra-market, time, or horizontal
spread.
BOX SPREADS
A box spread, also known as a long box, is an option strategy that combines buying a bull
call spread with a bear put spread, with both vertical spreads having the same strike prices and
expiration dates. The long box is used when the spreads are under-priced in relation to their
expiration values.

RATIO SPREADS
The ratio spread is a neutral strategy in options trading that involves buying a number of
options and selling more options of the same underlying stock and expiration date at a different strike
price. It is a limited profit, unlimited risk options trading strategy that is taken when the options
trader thinks that the underlying stock will experience little volatility in the near term.

Settlement of option contracts

1. By exercising
2. By letting option expire
3. By offsetting
Exotic options (non generic options)
Exotic options are the classes of option contracts with structures and features that are
different from plain-vanilla options (e.g., American or European options). Exotic options are
different from regular options in their expiration dates, exercise prices, payoffs, and underlying
assets. All the features make the valuation of exotic options more sophisticated relative to the
valuation of plain- vanilla options. Below is a list of various Exotic Options.
Types of Exotic Options
The most common types of exotic options include the following:
1. Asian options:-The Asian option is one of the most commonly encountered types ofexotic
options. They are option contracts whose payoffs are determined by the average price of the
underlying security over several predetermined periods of time.
2. Barrier options:-The main feature of barrier exotic options is that the contracts become
activated only if the price of the underlying asset reaches a predetermined level.
3. Basket options: - Basket options are based on several underlying assets. The payoff of a
basket option is essentially the weighted average of all underlying assets. Note that the weights of the
underlying assets are not always equal.
4. Bermuda options: - These are a combination of American and European options.
Similar to European options, Bermuda options can be exercised at the date of their expiration. At
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the same

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time, these exotic options are also exercisable at predetermined dates between the purchase
and expiration dates.
5. Binary options: - Binary options are also known as digital options. The options guarantee
the payoff based on the occurrence of a certain event. If the event has occurred, the payoff is a fixed
amount or a predetermined asset. Conversely, if the event has not occurred, the payoff is nothing. In
other words, binary options provide only all-or-nothing payoffs.
6. Chooser options: - Chooser exotic options provide the holder with the right to decide
whether the purchased options are calls or puts. Note that the decision can be made only at a fixed
date prior to the expiration of the contracts.
7. Compound options: - Compound options (also known as split-fee options) are essentially
an option on an option. The final payoff of this option depends on the payoff of another option. Due
to this reason, compound options have two expiration dates and two strike prices.
8. Extendible options: - Extendible option contracts provide the right to postpone their
expiration dates. For example, the holder-extendible options allow a purchaser extending their
options by a predetermined amount of time if the options are out-of-money. Conversely, the writer-
extendible options provide similar rights to a writer (issuer) of options.
9. Lookback options: - Unlike other types of options, lookback options initially do not have
a specified exercise price. However, on the maturity date, the holder of lookback options has the right
to select the most favourable strike price among the prices that have occurred during the lifetime of
the options.
10. Spread options: - The payoff of a spread option depends on the difference between
the prices of two underlying assets.
11. Range options: - Range options are also distinguished by their final payoff. The final
payoff of range exotic options is determined as the spread between maximum and minimum prices of
the underlying asset during the lifetime of the options.

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MODULE 5
SWAPS
Swap refers to an exchange of one financial instrument for another between the parties
concerned. This exchange takes place at a predetermined time, as specified in the contract. A swap in
simple terms can be explained as a transaction to exchange one thing for another or ‘barter’. In
financial markets the two parties to a swap transaction contract to exchange cash flows. A swap is a
custom tailored bilateral agreement in which cash flows are determined by applying a prearranged
formula on a notional principal. Swap is an instrument used for the exchange of stream of cash flows
to reduce risk.

The advantages of swaps are as follows:

1) Swap is generally cheaper. There is no upfront premium and it reduces transactions costs.
2) Swap can be used to hedge risk, and long time period hedge is possible.
3) It provides flexible and maintains informational advantages.
4) It has longer term than futures or options. Swaps will run for years, whereas forwards and
futures are for the relatively short term.
5) Using swaps can give companies a better match between their liabilities and revenues.
6) Vehicles for meeting the financial needs of MNCs.

The disadvantages of swaps are:

1) Early termination of swap before maturity may incur a breakage cost. Termination requires mutual
consent of both the parties.
2) Lack of liquidity (not easily tradable)
3) It is subject to default risk
4) Difficult to find a counter party with opposite cash flow obligation who could enter for a
swap deal.

Uses of Swaps
Swaps are very useful derivatives. It has variety of uses to different people.
1. Uses to treasurers: Treasurers can use swaps to hedge against rising interest rates and to reduce
borrowing costs.
2. Uses to financial managers: Swaps give financial managers the ability to: (a) convert floating rate
debt to fixed rate or fixed rate to floating rate (b) to lock in an attractive interest rate in advance of a
future debt issue (c) position fixed rate liabilities in anticipation of a decline in interest rates (d)
arbitrage debt price differentials in the capital markets
3. Uses to financial institutions,etc.: Financial institutions, pension managers and insurers use
swaps to balance asset and liability positions without leveraging up the balance sheet and to lock
in higher investment returns for a given risk level.
FEATURES OF SWAPS
1. It is a combination of forwards. So it has all the properties of forward contracts
2. Two parties with equal and opposite needs must come into contact with each other.
3. Customised, tailor-made and OTC derivatives
4. It is in the nature of long-term agreement. It is just like long dated forward contract.
5. Arranged mostly through an intermediary. This intermediary is known as swap facilitator.
Usually intermediaries will be large international financial institutions or banks.
6. Most of swap deals are bilateral agreements. Therefore, there is a problem of potential default
by either of the counter-party. This makes swaps more risky.
7. Swaps do not involve an upfront payment. Thus, they have a zero value at the start.

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TERMS USED IN SWAP CONTRACT
1. Parties: Generally, there are two parties in a swap deal. Intermediaries are excluded. For example,
in an interest rate swap, the first party can be a fixed rate payer / receiver and the second party can
be a floating rate receiver / payer. The parties to the swap contract are known as counter-parties.
2. Swap facilitators: A swap facilitator is a mediator who assists in formation and completion of
a swap arrangement between the interested parties. A swap facilitator is generally a bank. There
are two kinds of swap facilitators - Swap broker and swap dealer.
(a) Swap broker: A swap broker is an intermediary. He is an economic agent. He helps in identifying
the potential counter parties in a swap deal. He acts only as a facilitator. He does not take any
individual position in the swap contract. He will charge commission for his services.
(b) Swap dealer: A swap dealer associates himself with the swap deal. He often becomes an actual
party to the transaction. He may be actively involved as a financial intermediary for earning a profit.
He is also known as market maker.
3. Notional Principal: Notional principal is the underlying amount in a swap contract. This
underlying amount becomes the basis for the deal between counterparties. It is called "notional"
because this amount does not vary, but the cash flows in the swap are attached to this amount.
For example, in an interest rate swap, the interest is calculated on the notional principal.
4. Trade date: Trade date is the dates on which both the parties in a swap deal enter into the contract.
5. Effective date: This is the date when the initial cash flows in a swap contract begin. The maturity
of swap contract is calculated from this date. Effective date is also known as value date.
6. Reset Date: This is the date on which the LIBOR rate is determined. The first next date will be
generally two days before the second payment date and so on.
7. Maturity date: This is the date on which the outstanding cash flows stop in the swap contract.

Economic Functions of Swap Transactions

1. Transforming the nature of liabilities
2. Transforming the nature of assets
3. Hedging
4. Reducing the cost of funds.

DIFFERENT TYPES OF SWAPS

1. Currency Swaps
Cross currency swaps are agreements between counter-parties to exchange interest and principal
payments in different currencies. Like a forward, a cross currency swap consists of the exchange of
principal amounts (based on today’s spot rate) and interest payments between counter-parties. It is
considered to be a foreign exchange transaction and is not required by law to be shown on the
balance sheet. In a currency swap, these streams of cash flows consist of a stream of interest and
principal payments in one currency exchanged for a stream, of interest and principal payments of the
same maturity in another currency. Because of the exchange and re-exchange of notional principal
amounts, the currency swap generates a larger credit exposure than the interest rate swap. Cross-
currency swaps can be used to transform the currency denomination of assets and liabilities. They are
effective tools for managing foreign currency risk. They can create currency match within its
portfolio and minimize exposures. Firms can use them to hedge foreign currency debts and foreign
net investments. Currency swaps give companies extra flexibility to exploit their comparative
advantage in their respective borrowing markets. Currency swaps allow companies to exploit
advantages across a matrix of currencies and maturities. Currency swaps were originally done to get
around exchange controls and hedge the risk on currency rate movements. It also helps in Reducing
costs and risks associated with currency exchange. They are often combined with interest rate swaps.
For example, one company would seek to swap a cash flow for their fixed rate debt denominated in
US dollars for a floating-rate debt denominated in Euro. This is especially common in Europe where
companies shop for the cheapest debt regardless of its denomination and then seek to exchange it for
the debt in desired currency.

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Forms or Types of Currency Swaps

1. Fixed-for-floating currency swap: This is the normal form of swap. In this case one
counter party pays fixed rate of interest and the other floating rate of interest.
2. Fixed for fixed currency swap: In this case both counterparties are paying fixed rate of
interest. It is adopted when one counter party possesses an advantageous position while
borrowing a particular currency.
3. Floating for floating currency swap: In this case both the counter parties pay floating rates
of interest.
4. Amortising swap: In this case principal amounts amortise over the life of the swap.
5. Basis swaps: These involve an exchange of floating rate payments calculated on different
basis.
The other form of swaps are participation swaps, zero-coupon swaps, commodity swaps etc.

Advantages of Currency Swaps

1. Currency swaps can be used to hedge against foreign exchange risk.
2. It increases the total amount that a firm can borrow. This facilitates economies of scale.
This reduces operating costs.
3. A firm can use its surplus funds more effectively in blocked currencies.
4. It can be used as a means of exploiting the opportunity for arbitrage.
5. It plays an important role in integrating the world's capital markets by overcoming barriers to
international capital movements.

2. Interest Rate Swap

An interest rate swap, or simply a rate swap, is an agreement between two parties to exchange a
sequence of interest payments without exchanging the underlying debt. In a typical fixed/floating rate
swap, the first party promises to pay to the second at designated intervals a stipulated amount of
interest calculated at a fixed rate on the “notional principal”; the second party promises to pay to the
first at the same intervals a floating amount of interest on the notional principle calculated according
to a floating-rate index.
The interest rate swap is essentially a strip of forward contracts exchanging interest payments.
Thus, interest rate swaps, like interest rate futures or interest rate forward contracts, offer a
mechanism for restructuring cash flows and, if properly used, provide a financial instrument for
hedging against interest rate risk.
The reason for the exchange of the interest obligation is to take benefit from comparative
advantage. Some companies may have comparative advantage in fixed rate markets while other
companies have a comparative advantage in floating rate markets. When companies want to borrow
they look for cheap borrowing i.e. from the market where they have comparative advantage.
However this may lead to a company borrowing fixed when it wants floating or borrowing floating
when it wants fixed. This is where a swap comes in. A swap has the effect of transforming a fixed
rate loan into a floating rate loan or vice versa. In an interest rate swap they consist of streams of
interest payments of one type (fixed or floating) exchanged for streams of interest payments of the
other-type in the same currency.
Interest rate swaps are voluntary market transactions by two parties. In an interest swap, as in all
economic transactions, it is presumed that both parties obtain economic benefits. The economic
benefits in an interest rate swap are a result of the principle of comparative advantage. Further, in the
absence of national and international money and capital market imperfections and in the absence of
comparative advantages among different borrowers in these markets, there would be no economic
incentive for any firm to engage in an interest rate swap.

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Advantages of Interest Rate Swaps
Swaps are essentially a derivative used for hedging and risk management. The advantages of
interest rate swaps are summarized as below:
1. It does not involve any exchange of principal amounts. It consists only of an to
exchange interest flows: Therefore risk is less.
2. The documentation charge is minimum agreement
3. It is not contingent liability because the risk is unquantifiable. Hence it need not be shown as
a foot-note. It means it is an off balance sheet item.
4 Interest rate swap can be used both in asset and liability management to allow for flexibility. It
can also be used for hedging and for increasing profitability.
5. Swapping fixed to fixed rate may save the issuer's money if interest rates decline.
6. By swapping, a borrower can raise funds at a fixed rate when interest rates are rising and then
switch to floating rates in case they are falling.

DIFFERENCE BETWEEN CURRENCY SWAPS AND INTEREST SWAP

Interest rate swap Currency swap
1. Cash flows exchanged are in the same 1. Cash flows exchanged are in two
currency. different currencies.
2. There is only one notional principal amount. 2. There are two notional principal amounts
3. Notional principal amount is not exchanged. 3. Notional principal amounts are exchanged
4. No counter party risk is involved 4. Counter party risk is involved
5. Benchmark rate is MIBOR for all domestic 5. Benchmark rate is LIBOR
swaps

3. Credit Default Swap

Credit Default Swap is a financial instrument for swapping the risk of debt default. Credit default swaps may b
The buyer of a credit default swap pays a premium for effectively insuring against a debt default. He receives a
The seller of a credit default swap receives monthly payments from the buyer. If the debt instrument defaults th
The first credit default swap was introduced in 1995 by JP Morgan. By 2007, their total value has increased to
As Warren Buffett calls them “financial weapons of mass destruction”. The credit default swaps are being blam
Example of Credit Default Swap;
An investment trust owns £1 million corporation bond issued by a private housing firm.
If there is a risk the private housing firm may default on repayments, the investment trust may buy a CDS from
The investment trust will pay an interest on this credit default swap of say 3%. This could involve payments of

 If the private housing firm doesn’t default. The hedge fund gains the interest from the
investment bank and pays nothing out. It is simple profit.
 If the private housing firm does default, then the hedge fund has to pay compensation to
the investment bank of £1 million – the value of the credit default swap.
 Therefore the hedge fund takes on a larger risk and could end up paying £1million

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 4. Commodity Swap
A commodity swap is an agreement whereby a floating (or market or spot) price is exchanged for
a fixed price over a specified period. The vast majority of commodity swaps involve oil. A swap
where exchanged cash flows are dependent on the price of an underlying commodity. This swap
usually used to hedge against the price of a commodity. Commodities are physical assets such as
precious metals, base metals, energy stores (such as natural gas or crude oil) and food (including
wheat, pork bellies, cattle, etc.).
In this swap, the user of a commodity would secure a maximum price and agree to pay a
financial institution this fixed price. Then in return, the user would get payments based on the market
price for the commodity involved.
They are used for hedging against Fluctuations in commodity prices or Fluctuations in spreads
between final product and raw material prices.
A company that uses commodities as input may find its profits becoming very volatile if the
commodity prices become volatile. This is particularly so when the output prices may not change as
frequently as the commodity prices change. In such cases, the company would enter into a swap
whereby it receives payment linked to commodity prices and pays a fixed rate in exchange. There are
two kinds of agents participating in the commodity markets: end-users (hedgers) and investors
(speculators).
5. Equity Swap
The outstanding performance of equity markets in the 1980s and the 1990s, have brought in some
technological innovations that have made widespread participation in the equity market more feasible
and more marketable and the demographic imperative of baby-boomer saving has generated
significant interest in equity derivatives. In addition to the listed equity options on individual stocks
and individual indices, a burgeoning over-the-counter (OTC) market has evolved in the distribution
and utilization of equity swaps.
An equity swap is a special type of total return swap, where the underlying asset is a stock, a
basket of stocks, or a stock index. An exchange of the potential appreciation of equity’s value and
dividends for a guaranteed return plus any decrease in the value of the equity. An equity swap
permits an equity holder a guaranteed return but demands the holder give up all rights to appreciation
and dividend income. Compared to actually owning the stock, in this case you do not have to pay
anything up front, but you do not have any voting or other rights that stock holders do have.
Equity swaps make the index trading strategy even easier. Besides diversification and tax
benefits, equity swaps also allow large institutions to hedge specific assets or positions in their
portfolios

DIFFERENCE BETWEEN SWAP AND FUTURE

• Swaps and futures are both derivatives, which are special types of financial instruments that
derive their value from a number of underlying assets.
• A swap is a contract made between two parties that agree to swap cash flows on a date set in
the future.
• A futures contract obligates a buyer to buy and a seller to sell a specific asset, at a specific price
to be delivered on a predetermined date.
• Futures contract are exchange traded and are, therefore, standardized contracts, whereas swaps
generally are over the counter (OTC); they can be tailor made according to specific
requirements.
• Futures require a margin to be maintained, with the possibility of the trader being exposed to
margin calls in the event that the margin falls below requirement, whereas there are no margin
calls in swaps.

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Swap derivative
When swaps are combined with options and forwards, we shall derive some other derivatives,
for example, when swap is combined with forward, we get a new derivative called forward swap. It
combines the features of swaps and forwards.
Similarly, when swap is combined with option, we get an innovative derivative called swaption. This
combines the features of swap and option. Thus forward swaps and swaptions are swap derivative.
They are derived from swaps.

Non generic or exotic swaps

A number of new generation swaps have been emerged in recent years, they have unusual
features, and their structure is very complex. They are non-standard swaps. Their coupon, notional,
accrual and calendar used for coupon determination and payments are tailor made to serve client
perspectives and needs in terms of risk management, accounting hedging, asset repackaging, credit
diversification etc., such swaps are called nongeneric or exotic swaps.
Some of the very popular first generation non generic swaps may be briefly discussed
as follows.
1. Forward staring swap
2. Roller coaster swap
3. Amortising swap
4. Accreting swap
5. Constant maturity swap.
6. In arrear swap
7. Quanto swap
8. Leveraged swap
9. Power swap
10. Overnight index swap
The first generations of non generic swaps have been widely used for asset and liability
management as well as simple trading strategies. Some of the second generation non generic swaps
may be outlined as below.
1. Index amortising swap 5. Bermudan swaps.
2. Range accrual swaps 6. Asian swaps
3. Digital swap 7. Barrier swap
4. Chooser swap 8. Corridor swap

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