INTRODUCTION TO DERIVATIVES:

A derivative is a contract between two parties which derives its value or underlying asset.
It is a financial instrument which derives its value or price from an underlying asset.

Derivatives can be used to hedge a position, speculate on the directional movement of an

underlying asset, or give leverage to holdings. Their value comes from the fluctuations of the
values of the underlying asset.

Originally, derivatives were used to ensure balanced exchange rates for goods traded
internationally. With the differing values of national currencies, international traders needed a
system to account for differences.

COMMON FORMS OF DERIVATIVES:

There are many different types of derivatives that can be used for risk management, for
speculation, and to leverage a position. Derivative is a growing marketplace and offer products to
fit nearly any need or risk tolerance. Common derivatives include futures contracts,
forwards, options, and swaps.

FUTURES:
A Futures Contract is an agreement between two parties for the purchase and delivery of
an asset at an agreed upon price at a future date. Futures trade on an exchange, and the contracts
are standardized. Traders will use a futures contract to hedge their risk or speculate on the price
of an underlying asset. The parties involved in the futures transaction are obligated to fulfill a
commitment to buy or sell the underlying asset.

Not all futures contracts are settled at expiration by delivering the underlying asset. Many
derivatives are cash-settled, which means that the gain or loss in the trade is simply an
accounting cash flow to the trader's brokerage account. Futures contracts that are cash settled
include many interest rate futures, stock index futures, and more unusual instruments like
volatility futures or weather futures.
FORWARDS:
Forward contracts are similar to futures, but do not trade on an exchange, only over-the-counter.
When a forward contract is created, the buyer and seller may have customized the terms, size and
settlement process for the derivative. As OTC products, forward contracts carry a greater degree
of counterparty risk for both buyers and sellers.

Counterparty risks are a kind of credit risk in that the buyer or seller may not be able to live up to
the obligations outlined in the contract. If one party of the contract becomes insolvent, the other
party may have no recourse and could lose the value of its position. Once created, the parties in a
forward contract can offset their position with other counterparties, which can increase the
potential for counterparty risks as more traders become involved in the same contract.

SWAPS:
Swaps are another common type of derivative, often used to exchange one kind of cash flow
with another. For example, a trader might use an interest rate swap to switch from a variable
interest rate loan to a fixed interest rate loan, or vice versa. Swaps can also be constructed to
exchange currency exchange rate risk or the risk of default on a loan or cash flows from other
business activities. Swaps related to the cash flows and potential defaults of mortgage bonds are
an extremely popular kind of derivative. It was the counterparty risk of swaps like this that
eventually spiraled into the credit crisis of 2008.

OPTIONS:
An options contract is similar to a futures contract in that it is an agreement between two parties
to buy or sell an asset at a predetermined future date for a specific price. The key difference
between options and futures is that, with an option, the buyer is not obliged to exercise their
agreement to buy or sell. It is an opportunity only, not an obligation—futures are obligations. As
with futures, options may be used to hedge or speculate on the price of the underlying asset.

The put and call option sellers are obligated to fulfill their side of the contract if the call or put
option buyer chooses to exercise the contract. However, if a stock's price is above the strike price
at expiration, the put will be worthless and the seller—the option writer—gets to keep the
premium as the option expires. If the stock's price is below the strike price at expiration, the call
will be worthless and the call seller will keep the premium. Some options can be exercised
before expiration. These are known as American-style options, but their use and early exercise
are rare.

ADVANTAGES OF DERIVATIVES:

Derivatives can be a useful tool for businesses and investors alike. They provide a way to lock in
prices, hedge against unfavorable movements in rates, and mitigate risks—often for a limited
cost. In addition, derivatives can often be purchased on margin—that is, with borrowed funds—
which makes them even less expensive.

 Lock in prices

 Hedge against risk

 Can be leveraged

 Diversify portfolio

DISADVANATGES OF DERIVATIVES:

Derivatives are difficult to value because they are based on the price of another asset. The risks
for OTC derivatives include counter-party risks that are difficult to predict or value as well. Most
derivatives are also sensitive to changes in the amount of time to expiration, the cost of holding
the underlying asset, and interest rates. These variables make it difficult to perfectly match the
value of a derivative with the underlying asset.

 Hard to value

 Subject to counterparty default (if OTC)

 Complex to understand

 Sensitive to supply and demand factors

ORIGIN OF DERIVATIVES MARKET IN INDIA:

Derivatives market in India has a history dating back in 1875. The Bombay Cotton Trading
Association started future trading in this year. History suggests that by 1900 India became one of
the world’s largest futures trading industry.

However after independence, in 1952, the government of India officially put a ban on cash
settlement and options trading. This ban on commodities future trading was uplift in the year
2000. The creation of National Electronics Commodity Exchange made it possible.

In 1993, the National stocks Exchange, an electronics based trading exchange came into
existence. The Bombay stock exchange was already fully functional for over 100 years then.

Over the BSE, forward trading was there in the form of Badla trading, but formally derivatives
trading kicked started in its present form after 2001 only. The NSE started trading in CNX Nifty
index futures on June 12, 2000, based on CNX Nifty 50 index

In India, derivatives instruments are available for stocks, currency, bonds, and commodities. The
NSE, the Bombay Stock Exchange, the Multi Commodity Exchange are the main exchanges
which facilitate derivatives trading. While MCX purely deals with commodities, NSE and BSE
deal exclusively in stocks.

However, we can trade in various currency derivatives on any of the three exchanges. Also,
derivatives product for bonds is part of National Stocks Exchange.

The product family of the derivatives market in stocks segment includes stocks future and
options. Similarly, there are derivatives product for indices and includes index future and
options. Further, commodities derivatives products comprise commodities future.

While currency derivatives instruments in India includes currency future and options in 4 major
currency pairs. These pairs are USD-INR, GBP-INR, JPY-INR, and EUR-INR.

The NSE has a dedicated platform for bonds derivatives products in India. We can trade Interest
Rate Futures on this platform. The NSE offers two instruments on Interest Rate Future segment.
Futures on 6 years, 10 years and 13 year Government of India Security (NBF II) and 91-day
Government of India Treasury Bill (91DTB).
MECHANISM OF FUTURES MARKET

Futures—also called futures contracts—allow traders to lock in a price of the underlying asset or
commodity. These contracts have expirations dates and set prices that are known up front.
Futures are identified by their expiration month. For example, a December gold futures contract
expires in December. The term futures tend to represent the overall market. However, 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

1. Regulation of Futures
The futures markets are regulated by the Commodity Futures Trading Commission (CFTC). The
CFTC is a federal agency created by Congress in 1974 to ensure the integrity of futures market
pricing, including preventing abusive trading practices, fraud, and regulating brokerage firms
engaged in futures trading. 

The futures markets typically use high leverage. Leverage means that the trader does not
need to put up 100% of the contract's value amount when entering into a trade. Instead, the
broker would require an initial margin amount, which consists of a fraction of the total contract
value. The amount held by the broker can vary depending on the size of the contract, the
creditworthiness of the investor, and the broker's terms and conditions.
The exchange where the future trades will determine if the contract is for physical delivery or if
it can be cash settled. A corporation may enter into a physical delivery contract to lock in—
hedge—the price of a commodity they need for production. However, most futures contracts are
from traders who speculate on the trade. These contracts are closed out or netted—the difference
in the original trade and closing trade price—and are cash settled.

2. Futures Speculation
A futures contract allows a trader to speculate on the direction of movement of a commodity's
price.

If a trader bought a futures contract and the price of the commodity rose and was trading above
the original contract price at expiration, then they would have a profit. Before expiration, the buy
trade—long position—would be offset or unwound with a sell trade for the same amount at the
current price effectively closing the long position. The difference between the prices of the two
contracts would be cash settled in the investor's brokerage account, and no physical product will
change hands. However, the trader could also lose if the commodity's price was lower than the
purchase price specified in the futures contract.

Speculators can also take a short or sell speculative position if they predict the price of the
underlying asset will fall. If the price does decline, the trader will take an offsetting position to
close the contract. Again, the net difference would be settled at the expiration of the contract. An
investor would realize a gain, if the underlying asset's price was below the contract price and a
loss, if the current price was above the contract price.

3. Futures Hedging
Futures can be used to hedge the price movement of the underlying asset. Here, the goal is to
prevent losses from potentially unfavorable price changes rather than to speculate. Many
companies that enter hedges are using—or in many cases producing—the underlying asset.

ORIGIN OF FUTURES MARKET:

The first modern organized futures exchange began in 1710 at the Dojima Rice
Exchange in Osaka, Japan. The 1970s saw the development of the financial futures contracts,
which allowed trading in the future value of interest rates. These (in particular the
90-day Eurodollar contract introduced in 1981) had an enormous impact on the development of
the interest rate swap market. Today, the futures markets have far outgrown their agricultural
origins. With the addition of the New York Mercantile Exchange (NYMEX) the trading
and hedging of financial products using futures dwarfs the traditional commodity markets, and
plays a major role in the global financial system, trading over $1.5 trillion per day in 2005. In
terms of trading volume, the National Stock Exchange of India in Mumbai is the largest stock
futures trading exchange in the world, followed by JSE Limited in Sandton, Gauteng, South
Africa.

PROCEDURES FOR OPENING AN FUTURES ACCOUNT:

HOW TO OPEN A TRADING ACCOUNT FOR COMMENCING TRADING IN THE

FUTURES & OPTIONS?

For trading in futures and options an investor first needs to open a trading account with
his broker (trading member). If an investor already has a trading account for capital markets then
only a futures & options trading account is to be opened by submitting necessary documents.
No demat account is required since futures and options trading in India does not involve any
delivery of securities. Only a trading account and a savings bank account are sufficient to
commence trading. An investor can choose to trade on-line (internet based) or the conventional
off-line method. An investor would need to fill in a client registration form and submit
documents that will prove his identity, his residential address, income details etc. A passport,
driving license, voter‟s ID, ration card etc. are some of the documents for residence proof.

Permanent Account Number (PAN) would be required for opening a trading account and
is also used as a proof of identity. Trading members provide investors a client registration kit
which contains all the details for opening an account. Investors should read all documents
carefully, fill in the forms and submit them along with necessary proofs.

WHAT ARE THE DIFFERENT FORMS / DOCUMENTS WHICH ARE REQUIRED TO

SUBMITTED WHILE OPENING A TRADING ACCOUNT?

Generally the following are required for opening a trading account :-

1. Know Your Client (KYC) form – document captures basic information about the investor.

Please fill this form correctly and strike off blank fields in the form.
2. Risk Disclosure Document - This document contains important information on risks

associated with trading in Futures & Option (F&O) Segment of stock exchanges. Investors

should read and understand this document before trading on the F&O segment of the

Exchange.

3. Power of attorney PoA (non-mandatory) – an important document authorizing your trading

member to operate your bank account. The PoA should be specific and not a general one.

4. For identity proof, residential address proof, income proof :

o Two recent passport size photographs

o Proof of bank account : any one of the following may be submitted :-

 Copy of bank statement

 Copy of first page of the bank pass book.

 A cancelled cheque

o Proof of identity: Pan Card, Aadhar, passport etc.

o Proof of address: any one of the following:-

 Passport copy

 Voter id card copy

Copy of ration card

 Driving license copy

Bank pass book copy

 Verified copies of

 Electricity bill or telephone bill in the investor‟s name

 Leave and license agreement/agreement for sale.

o Identity card/document with address, issued by

 Central/state government and its departments

 Statutory /regulatory authorities

 Public sector undertakings

 Scheduled commercial banks

 Public financial institutions

 Colleges affiliated to Universities

 Professional Bodies such as ICAI, ICWAI, ICSI, Bar council etc. to their

Members

o Copy of tax return

o Copy of salary slip

o Bank statement for last six months

Originals of documents should be produced for verification along with self-attested copies of

documents. Trading member would allot a Unique Client Code to the investor. The investor

should place orders and ensure his trades are executed only in the Unique Client Code assigned

to him.

ROLE AND OPERATION OF CLEARING HOUSE:

A clearing house acts as a mediator between any two entities or parties that are engaged in a
financial transaction. Its main role is to ensure that the transaction goes smoothly, with the buyer
receiving the tradable goods he intends to acquire and the seller receiving the right amount paid
for the tradable goods he is selling.

FUNCTIONS OF A CLEARING HOUSE

A clearing house is basically the mediator between two transacting parties. However, there is
also more to what clearing houses do.

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.

IMPORTANCE OF CLEARING HOUSES:

A common fear of traders about the market is getting involved in transactions that don’t end
well, with one of the parties not fulfilling their end of the agreement. Clearing houses function to
provide extra security so that investors can trade freely, knowing that their investment decisions
will be honored and enforced by the clearing firm.
DELIVERY:

Delivery is the action of transferring a commodity, currency, security, cash or another instrument
that is the subject of a sales contract, and is tendered to and received by the buyer.

Delivery can occur in spot, option or forward contracts. However, in many instances, a contract
is closed out before settlement and no delivery occurs.

Delivery is the final stage of a contract for the purchase or sale of an instrument. The price and
maturity are set on the transaction date. Once the maturity date is reached, the seller is required
to either deliver the instrument if the transaction has not yet been closed out or reversed or close
it out at that point and settle the gain or loss for cash.

Transactions In Which Delivery Is Common

Currency transactions to pay for imports or receive export proceeds are often delivered. An
importer in the United States who needs to pay for goods from Europe would enter into a
contract to buy euros. At maturity, the importer delivers dollars to its bank counter-party, and the
bank delivers euros to the supplier. This applies to both spot and forward transactions.

A contract for the purchase of a stock or commodity for immediate settlement is usually
delivered.

Transactions in Which Delivery Is Less Common

An option gives its owner the right but not the obligation to buy or sell something at a stipulated
price on or before an agreed date. If the option expires in the money, the holder of the option can
either exercise it and take delivery of the underlying instrument or sell the option to make a
profit. An option that is in the money can also be sold before the exercise date. The choice of
delivering or closing out the option depends on the business needs of its owner.

Transactions That Are Not Delivered

Speculative traders don't take delivery. They buy and sell multiple times for delivery on the same
date. The gains and losses are netted against each other, and only the difference is settled. Trades
that are done outside of exchanges and are not intended for delivery are often covered by
the International Swaps and Derivatives Association (ISDA) agreements, formerly known as the
International Swaps Dealers Association. These agreements set out the terms and conditions for
the settlement of offsetting contracts, known as netting, and reduce the associated credit risk.

Futures contracts are similar to forwards but are for standardized amounts and dates; they are
bought and sold on exchanges. If held to maturity, they are cash-settled for the gain or loss on the
contract. They can also be sold back to the exchange prior to maturity. In that case, the gain or
loss is settled at the time of the sale, not at maturity.

A subsection of forwards that must be closed out and netted is the "non-deliverable forward"
(NDF). They are designed to hedge exposure in currencies that are not convertible or are
very thinly traded. NDFs are usually covered by an ISDA agreement.

MARGIN:

Margin is the money borrowed from a brokerage firm to purchase an investment. It is the
difference between the total value of securities held in an investor's account and the loan amount
from the broker. Buying on margin is the act of borrowing money to buy securities. The practice
includes buying an asset where the buyer pays only a percentage of the asset's value and borrows
the rest from the bank or broker. The broker acts as a lender and the securities in the investor's
account act as collateral.

In a general business context, the margin is the difference between a product or service's selling
price and the cost of production, or the ratio of profit to revenue. A margin can also refer to the
portion of the interest rate on an adjustable-rate mortgage (ARM) added to the adjustment-index
rate.

Buying on margin is borrowing money from a broker in order to purchase stock. You can think
of it as a loan from your brokerage. Margin trading allows you to buy more stock than you'd be
able to normally. To trade on margin, you need a margin account. This is different from a
regular cash account, in which you trade using the money in the account.
OTHER USES OF MARGIN
Accounting Margin
In business accounting, a margin refers to the difference between revenue and expenses, where
businesses typically track their gross profit margins, operating margins, and net profit margins.

The gross profit margin measures the relationship between a company's revenues and the cost of
goods sold (COGS). Operating profit margin takes into account COGS and operating expenses
and compares them with revenue, and net profit margin takes all these expenses, taxes and
interest into account.

Margin in Mortgage Lending

Adjustable-rate mortgages offer a fixed interest rate for an introductory period of time, and then
the rate adjusts. To determine the new rate, the bank adds a margin to an established index. In
most cases, the margin stays the same throughout the life of the loan, but the index rate changes.

To understand this more clearly, imagine a mortgage with an adjustable rate has a margin of 4%
and is indexed to the Treasury Index. If the Treasury Index is 6%, the interest rate on the
mortgage is the 6% index rate plus the 4% margin, or 10%.

LEVERAGE:

Leverage results from using borrowed capital as a funding source when investing to expand the
firm's asset base and generate returns on risk capital. Leverage is an investment strategy of using
borrowed money—specifically, the use of various financial instruments or borrowed capital—to
increase the potential return of an investment. Leverage can also refer to the amount of debt a
firm uses to finance assets. When one refers to a company, property or investment as "highly
leveraged," it means that item has more debt than equity.

Leverage is the use of debt (borrowed capital) in order to undertake an investment or project.
The result is to multiply the potential returns from a project. At the same time, leverage will also
multiply the potential downside risk in case the investment does not pan out.
The concept of leverage is used by both investors and companies. Investors use leverage to
significantly increase the returns that can be provided on an investment. They lever their
investments by using various instruments that include options, futures and margin accounts.
Companies can use leverage to finance their assets. In other words, instead of issuing stock to
raise capital, companies can use debt financing to invest in business operations in an attempt to
increase shareholder value. 

Investors who are not comfortable using leverage directly have a variety of ways to access
leverage indirectly. They can invest in companies that use leverage in the normal course of their
business to finance or expand operations—without increasing their outlay.

SPECIAL CONSIDERATIONS

The Disadvantages of Leverage

Leverage is a multi-faceted, complex tool. The theory sounds great, and in reality, the use of
leverage can be profitable, but the reverse is also true. Leverage magnifies both gains and losses.
If an investor uses leverage to make an investment and the investment moves against the
investor, his or her loss is much greater than it would've been if he or she had not leveraged the
investment.

In the business world, a company can use leverage to generate shareholder wealth, but if it fails
to do so, the interest expense and credit risk of default destroy shareholder value.

LIQUIDITY:

Liquidity describes the degree to which an asset or security can be quickly bought or sold in the

market at a price reflecting its intrinsic value. In other words: the ease of converting it to cash.

Cash is universally considered the most liquid asset, while tangible assets, such as real estate,
fine art, and collectibles, are all relatively illiquid. Other financial assets, ranging from equities to
partnership units, fall at various places on the liquidity spectrum.
Market Liquidity
Market liquidity refers to the extent to which a market, such as a country's stock market or a
city's real estate market, allows assets to be bought and sold at stable, transparent prices.

Markets for real estate are usually far less liquid than stock markets. The liquidity of markets for
other assets, such as derivatives, contracts, currencies, or commodities, often depends on their
size, and how many open exchanges exist for them to be traded on.

Accounting Liquidity
Accounting liquidity measures the ease with which an individual or company can meet their
financial obligations with the liquid assets available to them—the ability to pay off debts as they
come due. 

In investment terms, assessing accounting liquidity means comparing liquid assets to current
liabilities, or financial obligations that come due within one year. There are a number of ratios
that measure accounting liquidity, which differ in how strictly they define "liquid assets."
Analysts and investors use these to identify companies with strong liquidity. It is also considered
a measure of depth.

Measuring the accounting liquidity:

1. Current Ratio

2. Quick ratio

3. Cash ratio

UNIT - 2

FORWARD CONTRACT:
A forward contract is a customized contract between two parties to buy or sell an asset at a
specified price on a future date. A forward contract can be used for hedging or speculation,
although its non-standardized nature makes it particularly apt for hedging.

The Basics of Forward Contracts

Unlike standard futures contracts, a forward contract can be customized to a commodity, amount
and delivery date. Commodities traded can be grains, precious metals, natural gas, oil, or even
poultry. A forward contract settlement can occur on a cash or delivery basis.

Forward contracts do not trade on a centralized exchange and are therefore regarded as over-the-
counter (OTC) instruments. While their OTC nature makes it easier to customize terms, the lack
of a centralized clearinghouse also gives rise to a higher degree of default risk. As a result,
forward contracts are not as easily available to the retail investor as futures contracts.

ADVANTAGES OF FORWARD CONTRACT:

Forward contract is a non-standardized contract between two parties to buy or sell an asset at a
specified time at an agreed price.

The advantages of forward contracts are as follows:

1) They can be matched against the time period of exposure as well as for the cash size of the
exposure.

2) Forwards are tailor made and can be written for any amount and term.

3) It offers a complete hedge

4) Forwards are over-the-counter products.

5) The use of forwards provide price protection.

6) They are easy to understand.

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 a counter-party.

ADVANTAGES AND DISADVANTAGES OF FORWARD CONTRACT

Forwards specify a trade between two counter-parties. There is a commitment to deliver an asset
(this is the seller), at a specified forward price. There is a commitment to take delivery of an
asset (this is the buyer), at a specified forward price. At delivery, cash is exchanged for the asset.
In other words in a forward contract, the purchaser and its counterparty are obligated to trade a
security or other asset at a specified date in the future. A forward rate is calculated by viewing
the interest rate difference between the two currencies concerned. In the forward market, the
currency of a nation with lower interest rates than our nations will trade at a “premium”. The
currency of a nation with higher rates than ours will trade at a “discount”.

A Forward Contract is a non-standardized contract among the two parties. These contracts are
very similar to futures contracts, the only difference is they are not exchange-traded or defined
on standardized assets. A forward contract is an over the counter instrument which is not traded
on a centralized exchange. The party agreeing to buy the underlying asset in the future is a long
position, whereas the party agreeing to sell the asset in the future assumes a short position.

The advantages of the forward contract are as follows;

 It offers a complete hedge

 They can be matched against the time period of exposure as well as for the cash size of
the exposure
 Forwards are tailor-made and can be written for any amount and term
  Forwards are over the counter products
 The use of forwards provide price protection
 They are easy to understand
 It is a tailor-made contract and is flexible to adjust the needs of both the parties
 Offers a complete hedge (i.e. delta neutral hedge) and helps in mitigating the risk
 It can be matched with the time period and cash flows of exposure
 As it is an over-the-counter (OTC) contract, the price of contracts are not known to
others, hence provide a price protection.
 There are no immediate cash outflows before settlement of the contract but might require
an upfront fee i.e. margin
 It is a tool for speculation
 Payoffs are symmetrical, meaning thereby, there is a distinction as one party will gain
while other making a loss of an equivalent amount
 There is no daily marking to market requirements as mandatory in futures contract
 fixes the future rate, thus eliminating downside risk exposure
 flexibility with regard to the amount to be covered
 relatively straightforward both to comprehend and to organise.

DEMERITS OF FORWARD CONTRACT

 Like every other derivative, forwards also have some demerits as follows:
 As it is a private contract, there is no liquidity
 Counterparty risk of defaulting on the contract is too high
 Market of forward contracts is extremely unorganized as it is traded over-the-counter
 It may be difficult to find a counterparty to enter into a contract
 contractual commitment that must be completed on the due date (option date forward
contract can be used if uncertain)
 no opportunity to benefit from favourable movements in exchange rates.
 availability 
UNIT III

Introduction: OPTION

An option is a unique instrument that confers a right without an obligation to buy or sell another
asset, called the underlying asset. Like forwards and futures it is a derivative instrument because
the value of the right so conferred would depend on the price of the underlying asset. As such
options derive their values inter alia from the price of the underlying asset.

EXAMPLE: For easier comprehension of the concept of an option, an example from the stocks
as underlying asset is most apt. Consider an option on the share of a firm, say ITC Ltd. It would
confer a right to the holder to either buy or sell a share of ITC. Naturally, this right would be
available at a price, which in turn is derived from the price of the share of ITC? Hence, an option
on ITC would be priced according to the price of ITC shares prevailing in the market. Of course
this right can be made available at a specific predetermined price and remains valid for a certain
period of time rather than extending indefinitely in time.

The unique feature of an option is that while it confers the right to buy or sell the underlying
asset, the holder is not obligated to perform. The holder of the option can force the counterparty
to honors the commitment made. Obligations of the holder would arise only when he decides to
exercise the right. Therefore, an option may be defined as a contract that gives the owner the
right but no obligation to buy or sell at a predetermined price within a given time frame. It is the
absence of obligation to perform for one of the parties that makes the option contract a
substantially different derivative product from forwards and futures, where there is equal and
binding obligation on both the parties to the contract. This unique feature of an option makes
several applications possible that may not be feasible with other derivative products.

CALL OPTION:

A call options gives the buyer of the option the right to buy the underlying asset at a fixed price,
called the strike or the exercise price, it any time prior to the expiration date of the option. The
buyer pays a price for this right. If at expiration, the value of the asset is less than the strike price,
the option is not exercised and expires worthless. If, on the other hand, the value of the asset is
greater than the strike price, the option is exercised- the buyer of the option buys the asset (stock)
at the exercise price. And the difference between the asset value and the exercise price comprises
the gross profit on the option investment. The net profit on the investment is the difference
between the gross profit and the price paid for the call initially

PUT OPTION:

A put option gives the buyer of the option the right to sell the underlying asset at a fixed price,
again called the strike or exercise price, at any time prior to the expiration date of the option. The
buyer pays a price for this right. If the price of the underlying asset is greater than the strike
price, the option will not be exercised and will expire worthless. If on the other hand, the price of
the underlying asset is less than the strike price, the owner of the put option will exercise the
option and sell the stock a the strike price, claiming the difference between the strike price and
the market value of the asset as the gross profit. Again, netting out the initial cost paid for the put
yields the net profit from the transaction. A put has a negative net payoff if the value of the
underlying asset exceeds then strike price, and has a gross pay off equal to the difference
between the strike price and the value of the underlying asset if the asset value is less than the
strike price.

FOREIGN CURRENCY OPTIONS:

Foreign currency is another important asset, which is traded on various exchanges. One among
these is the Philadelphia Stock Exchange. It offers both European as well as American option
contracts. Major currencies which are traded in the option markets are US dollar, Australian
dollar, British pound, Canadian dollar, German mark, French franc, Japanese yen, Swiss franc,
etc. The size of the contract differs currency to currency. This has been explained in more detail
in the chapter on currency option.

OTC Options
OTC options are exotic options that trade in the over-the-counter market rather than on a formal
exchange like exchange traded option contracts.

 OTC options are exotic options that trade in the over-the-counter market rather than on a
formal exchange like exchange traded option contracts.
  OTC options are the result of a private transaction between the buyer and the seller.
 OTC option strike prices and expiration dates are not standardized, which allows
participants to define their own terms, and there is no secondary market.
OTC Options
Investors turn to OTC options when the listed options do not quite meet their needs. The
flexibility of these options is attractive to many investors. There is no standardization of strike
prices and expiration dates, so participants essentially define their own terms and there is
no secondary market. As with other OTC markets, these options transact directly between buyer
and seller. However, brokers and market makers participating in OTC option markets are usually
regulated by some government agency, like FINRA in the U.S.

With OTC options, both hedgers and speculators avoid the restrictions placed on listed options
by their respective exchanges. This flexibility allows participants to achieve their desired
position more precisely and cost-effectively.

Aside from the trading venue, OTC options differ from listed options because they are the result
of a private transaction between the buyer and the seller. On an exchange, options must clear
through the clearing house. This clearing house step essentially places the exchange as the
middleman. The market also sets specific terms for strike prices, such as every five points,
and expiration dates, such as on a particular day of each month.

Because buyers and seller deal directly with each other for OTC options, they can set the
combination of strike and expiration to meet their individual needs. While not typical, terms may
include almost any condition, including some from outside the realm of regular trading and
markets. There are no disclosure requirements, which represents a risk that counterparties will
not fulfill their obligations under the options contract. Also, these trades do not enjoy the same
protection given by an exchange or clearing house.

Finally, since there is no secondary market, the only way to close an OTC options position is to
create an offsetting transaction. An offsetting transaction will effectively nullify the effects of the
original trade. This is in stark contrast to an exchange-listed option where the holder of that
option merely has to go back to the exchange to sell their position.
Over the Counter (OTC) derivatives are traded between two parties (bilateral negotiation)
without going through an exchange or any other intermediaries. OTC is the term used to refer
stocks that trade via dealer network and not any centralized exchange. These are also known as
unlisted stocks where the securities are traded by broker-dealers through direct negotiations.

With different characteristics, the two types of markets complement each other in providing a
trading platform to suit different business needs. On one hand, exchange-traded derivative
markets have better price transparency as compared to OTC markets. Also, the counterparty risks
are smaller in exchange-traded markets with all trades on exchanges being settled daily with the
clearinghouse. On the other hand, the flexibility of OTC market means that they suit better for
trades that do not have high order flow or special requirements. In this context, OTC market
performs the role of an incubator for new financial products.

OTC Contracts can be broadly classified on the basis of the underlying asset through which the
value is derived:

Interest rate derivatives: The underlying asset is a standard interest rate. Examples of interest
rate OTC derivatives include LIBOR, Swaps, US Treasury bills, Swaptions and FRAs.
Commodity derivatives: The underlying are physical commodities like wheat or gold. E.g.
forwards.

Forex derivatives: The underlying is foreign exchange fluctuations.

Equity derivatives: The underlying are equity securities. E.g. Options and Futures

Fixed Income: The underlying are fixed income securities.

Credit derivatives: It transfers the credit risk from one party to another without transferring the
underlying. These can be funded or unfunded credit derivatives. e.g: Credit default swap (CDS),
Credit linked notes (CLN).

OTC markets have two dimensions to it, namely customer market and interdealer market. In
customer market, bilateral trading happens between the dealers and customers. This is done
through electronic messages which are called dealer-runs providing the prices for buying and
selling the derivatives. On the other hand, in the interdealer market, dealers quote prices to one
other to offset some of the risk in the trade. This is passed on to other dealers within fractions.
This clearly provides a view point on the customer market.

Advantages of OTC

 These derivatives offer companies more flexibility because, unlike the “standardised”
exchange-traded products, they can be tailored to fit specific needs, such as the effects of
a particular exchange rate or commodity price over a given period.
 Companies say such derivatives play a big part in helping them to provide consumers
with stable prices.
 The Company may be small and hence not qualifying the exchange listing requirements
 It is an instrument that is used for hedging, risk transfer, speculation and leverage
 OTC gives exposure to different markets as an investment avenue
 In many cases it implies less financial burden and administrative cost for the end users
(e.g. corporate)
 Swaps are widely regarded as the first modern example of OTC financial derivatives. All
OTC derivatives are negotiated between a dealer and the end user or between two
dealers. Inter-dealer brokers (IDBs) also play an important role in OTC derivatives by
 helping dealers (and sometimes end users) identify willing counterparties and compare
different bids and offers.

Disadvantages of OTC

 Lack of a clearing house or exchange, results in increased credit or default risk associated
with each OTC contract.
 Precise nature of risk and scope is unknown to regulators which leads to increased
systemic risk.
 Lack of transparency.
 Speculative nature of the transactions causes market integrity issues.

RISKS managed using OTC Derivatives

Interest rate risk: Companies prefer to take loans from banks at a fixed rate of interest in order
to avoid the exposure to rising rates. This can be achieved through interest rate swap which locks
the fixed rate for a term of loan.

Currency Risk: Currency derivatives allow companies to manage risk by locking the exchange
rate, beneficial for importer or exporter companies that face the risk of currency fluctuations.

Commodity Price Risk: Financing in terms of expansion can only be available if the future
selling price is locked. This price risk protection is provided through customized OTC derivative.
e.g. Crude Oil producer would like to increase production in tandem to increase in the demand.
The financing will be done only if the future selling price of the crude is locked.

UNIT-4

SWAPS:

Swap, in the simplest form, may be defined as an exchange of future cash flows between two
parties as agreed upon according to the terms of the contract. The basis of future cash flow can
be exchange rate for currency/ financial swap, and/or the interest rate for interest rate swaps.
Apart from interest rates and currency rates, the formula for determination of the periodic cash
flows can be equity returns, commodity prices, etc. In essence one of the cash flow would be
fixed, called fixed leg, while the other called floating leg would be variable depending upon the
value of the variable identified for the swap.

INTEREST RATE SWAPS:

If the exchange of cash flows is done on the basis of interest rates prevalent at the relevant time,
it is known as interest rate swap. The simplest example of interest rate swap is a forward contract
where only one payment is involved. In a forward transaction of any commodity the buyer
acquires the commodity and incurs an outflow of cash equal to the forward price, F If the buyer
after acquiring the commodity were to sell it for the spot price 5, then there would be a cash
inflow of S. From the cash flow perspective a forward contract for the buyer is a swap
transaction with inflow of S and outflow of F. Likewise, the seller would have equivalent cash
flows in the opposite direction. Therefore, a forward contract can be regarded as a swap with a
single exchange of cash flow; alternatively swap can be viewed as a series of several forward
transactions taking place at different points of time.

TYPES OF INTEREST RATE SWAPS:

With the bank as intermediary and each party deals with the bank rather than each other. Interest
rate swaps (IRS) can be categorized as follows. Fixed-to-Floating In the fixed-to-floating rate
swaps the party pays fixed rate of interest to the bank or swap dealer and in exchange receives a
floating rate interest determined on the basis of a reference/benchmark rate at predetermined
intervals of time. Such a swap is used by a firm wich has floating rate liability and it anticipates a
rise in the interest rates. Through the swap the firm will cancel out the receipts and payments of
floating rate and have cash outflow based on the fixed rate of interest. Floating-to-Fixed In this
kind of swap the party pays floating rate of interest to the bank or swap dealer and in exchange
receives a fixed rate interest at predetermined intervals of time. Such a swap is used by a firm
who has fixed rate liability and it anticipates a fall in the interest rates. Through the swap the
firm will cancel out the receipts and payments of fixed rate liability and have cash outflow based
on the floating rate of interest.
 CURRENCY SWAPS

In a currency swap the exchange of cash flows between counterparties take place in two
different currencies. Since two currencies are involved, currency swaps become different from
interest rate swaps in its uses functionality, and administration. The first recorded currency swap
was initiated in 1981 between IBM and World Bank. Where the exchange of cash flows is in two
different currencies on the basis of a predetermined formula of exchange rates, it is known as
currency swap. More complex swaps involve two currencies with fixed and floating rates of
interest in two currencies. Such swaps are called ‘cocktail swaps’.

BOND SWAPS:

A bond swap consists of selling one debt instrument and using the proceeds to purchase another
debt instrument. Investors engage in bond swapping with the goal of improving their financial
positions. Bond swapping can reduce an investor's tax liability, give an investor a higher rate of
return, or help an investor to diversify his or her portfolio.

Swapping can be a very effective investment tool to:

 increase the quality of your portfolio;

 increase your total return;

 benefit from interest rate changes; and

 lower your taxes.

SUBSTITUITION SWAPS:

A substitution swap is a bond exchange that trades fixed-income securities for higher-yielding

security with a similar coupon rate, maturity date, call feature, credit quality, etc. A substitution
swap allows the investor to increase returns without altering the terms or risk level of the
security. 

Investors participate in substitution swaps when they believe there is a temporary discrepancy in
bond prices or yields-to-maturity due to market disequilibrium.
International Swaps and Derivatives Association
The International Swaps and Derivatives Association (ISDA) is a trade organization created by
the private negotiated derivatives market that represents participating parties. This association
helps to improve the private negotiated derivatives market by identifying and reducing risks in
the market. For nearly three decades the industry has used the ISDA master agreement as a
template for entering into contractual obligation for derivatives, creating a basic structure and
standardization where there were only bespoke transactions before.

ISDA
The International Swaps and Derivatives Association was created to make the world of privately
negotiated derivatives safer and more efficient. The ISDA fulfills this role by providing
templates for counterparties in derivatives contracts to use in negotiation and by providing a
platform for the institutions that deal in the market to network and raise common concerns and
issues. The ISDA identifies its three key work areas as:

1. Reducing counterparty credit risk

2. Increasing transparency
3. Improving the operational infrastructure of the derivatives industry

The ISDA was created due to the challenges the growing derivatives market posed for financial
institutions. The demand for derivatives grew with the increasingly global nature of finance, but
a lack of clarity on what the parties in a derivatives transaction were risking and receiving hurt
the industry. The ISDA was created to help demystify the derivatives market, thereby enabling
further growth.