UNDERSTANDING DERIVATIVES

UNDERSTANDING DERIVATIVES (Part 1)

Definition: A derivative is a contract or product whose value is derived from the value of some other asset known as the underlying.
Details: Derivatives are based on a wide range of underlying assets such as metals, energy resources, agri commodities, and financial assets.

Zero Sum Game: A concept where the counterparties who enter into a contract have opposing views and needs, resulting in a net position of zero when considering both parties' profits and losses.
Settlement Mechanism: A method where derivative contracts are settled, either through cash settlement or physical settlement.
Margining Process: A process where Clearing Members deposit collateral as a guarantee for their financial commitments, including initial margin and premium margin.
Open Interest: The total number of outstanding derivative contracts that have not been settled, representing market activity and the flow of money into a futures or options market.

Forwards: A bilateral over-the-counter (OTC) transaction where the terms of the contract are negotiated between two parties, used to fix the price and avoid price risk.
Futures: Standardized forward contracts traded on an exchange, creating an obligation on both buyer and seller's part, with the exchange acting as a counterparty to both parties.
Options: A contract giving the buyer the right, but not the obligation, to buy or sell the underlying asset on or before a stated date, at a stated price, for a premium.
Swaps: An instrument to be settled at a future date, whose value is derived from changes in interest rates, foreign exchange rates, credit ratings, or credit indices.

In-the-Money (ITM): When the underlying asset's price is greater than the strike price for a call option, or less than the strike price for a put option.
At-the-Money (ATM): When the underlying asset's price is equal to the strike price.
Out-of-the-Money (OTM): When the underlying asset's price is less than the strike price for a call option, or greater than the strike price for a put option.

Intrinsic Value: The excess of the current price over the strike price for ITM options.
Time Value: The excess price a buyer is willing to pay over the intrinsic value, in anticipation of future increases in the option's value.
Swaps: Contracts where two parties agree to exchange cash flows on a future date(s), commonly used for interest rate and currency swaps.

A borrower pays a fixed rate to a swap dealer and receives a floating rate in return, allowing them to convert a floating rate borrowing into a fixed rate obligation.
The principal amount (notional amount) is agreed upon but not exchanged, only the interest rates are exchanged on settlement dates.

FIMMDA: The Fixed Income Money Market and Derivatives Association of India, a voluntary market body for bond, money, and derivatives markets.
Objectives: Interface with regulators, undertake developmental activities, provide training, adopt international standard practices, and devise standardized best market practices.

Derivative Market: Formed when market players come together to manage price risks.
Available Products: Indices, stocks, interest rates, commodities, and forward markets for agricultural commodities and swap markets for interest rates.
OTC Markets: Non-standard contracts settled between counterparties, prevalent among institutions.
Exchange-Traded Markets: Standard contracts defined by an exchange, settled through a clearing house, allowing anonymous trading.

Hedging: Managing risk by protecting an investment from future price movements.
Speculation: Trading based on a view about future prices, without an underlying investment.
Arbitrage: Identifying price differentials in two markets and trading to reduce the gap, earning riskless profits.

Benefits: Enables hedging, enhances liquidity, and increases participation.
Risks: Counterparty risk, price risk, liquidity risk, legal or regulatory risk, and operational risk.
Considerations: Market participants should carefully consider their resources, experience, and risk tolerance before trading in derivatives.

Commodity Derivatives: Contracts based on commodities like oil or wheat, used for risk protection and investment strategies.
Currency Derivatives: Contracts based on exchange rates, used for hedging and speculation.
Commodity Futures Contracts: Standardized contracts to buy or sell commodities for a particular price and delivery date.

Currency Derivatives: Currency risks can be managed through forwards, futures, swaps, and options. Each instrument has its role in managing currency risk.
Currency Pairs: Every trade in the FX market is a currency pair, where one currency is bought or sold for another. Currency derivatives are available on four currency pairs: US Dollars (USD), Euro (EUR), Great Britain Pound (GBP), and Japanese Yen (JPY).
Pricing a Futures Contract: The pricing of a futures contract is based on the carry cost, which is the interest rate on the money for the period between the spot and futures delivery.
Spot-Future Convergence: On the settlement date, the spot and futures prices of the same underlying asset are identical, as the carry cost of buying spot and selling futures is zero.
Spot-Future Arbitrage: Arbitrage opportunities arise when the spot price and futures price for the same stock vary more than what is justified by a normal rate of interest.
Option Pay-offs: An option contract features an asymmetric pay-off, where the upside and downside are not uniform. The payoff profile of various option positions depends on the level of the underlying asset price at the time of exercise or expiry of the contract.

Key concepts:

Basis: The difference between the spot price and the futures price.
Carry Cost: The interest rate on the money for the period between the spot and futures delivery.
Arbitrage: The practice of taking advantage of a price difference between two or more markets.
Option Contract: A contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specified price.
Long on Option: The buyer of an option contract, who has the right to exercise the option.
Short on Option: The seller of an option contract, who has the obligation to sell or buy the underlying asset if the option is exercised.