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MPE (Finance) 2008/10 Batch NMIMS PTMBA III – Div A DERIVATIVES Mahesh Parikh / August, 2010. 1 DEFINITION “Derivative is a product whose value is derived from the value of one or more basic variables, called underlying asset, in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset.” 2 HISTORY Internationally Derivative product dealing with commodities price fluctuation. In India it started with Badla System. Later on Badla was replaced with Automatic Lending Borrowing Mechanism. Finally F&O launched. 3 NEED FOR DERIVATIVES Hedging: Investors use derivatives to hedge against risk. Speculation: The process of selecting investments with higher risk in order to profit from an anticipated price movement . Arbitrage: The simultaneous purchase and sale of an asset in order to profit from a difference in the price. This usually takes place on different exchanges or marketplaces. 4 GROWTH DRIVING FACTORS: 1. 2. 3. 4. 5. 6. Increased volatility in asset prices in financial markets. Increased integration of national financial markets, per-se and with international markets. Marked improvement in communication facilities (E-mail, Fax etc) and sharp decline in their cost (Mobile call charges Rs.16/- to Rs.1/-). Development of more sophisticated risk management tools and wider choice of risk management strategies. Innovations in derivative market, which optimally, combine the risk and returns over large number of financial assets. Reducing Transactions Costs. 5 ADVANTAGES Lower Transaction Costs: Lower brokerage charged than on spot market. Only margin money blocked. Flexibility: Derivatives can be used with respect to commodity price, interest and exchange rates and equity price. Risk Reduction: Derivatives can protect your business from huge losses.. Stable Economy: Derivatives have a stabilizing effect on the economy by reducing the number of businesses that go under due to volatile market forces. 6 DISADVANTAGES Highly volatile instrument which attracts huge Mark to Market losses. Various Risk involved are Systematic Risk, Liquidity Risk. F&O Trading – A Temptation to Leverage on Trading Limits. If over leveraged it is a “Weapon of mass destruction” as rightly quoted by Warren Buffet 7 Derivative Markets There are two distinct groups of derivative contracts: Over-the-counter (OTC) derivatives: Contracts that are traded directly between two eligible parties, with or without the use of an intermediary and without going through an exchange. Exchange-traded derivatives: Derivative products that are traded on an exchange. 8 Participants Derivatives serve a useful risk-management purpose for both financial and non-financial firms. It enables transfer of various financial risks to entities who are more willing or better suited to take or manage them. Participants of this market can broadly be classified into two functional categories namely, market-makers and users. User: A user participates in the derivatives market to manage an underlying risk. Market-maker: A market-maker provides continuous bid and offer prices to users and other market-makers. A market-maker need not have an underlying risk. At least one party to a derivative transaction is required to be a marketmaker. 9 DIFFERENT MARKETS Pioneer in India was NSE Was followed by BSE Now NCDEX and MCX in Commodities Unorganized Markets like OTC 10 TYPES OF DERIVATIVES Derivatives Forwards Futures Options Swaps 11 FORWARDS A contract that obligates one counter party to buy and the other to sell a specific underlying asset at a specific price, amount and date in the future. Counterparty Risk. Customized Contracts. It Includes Agricultural Products Physical commodities Interest rates and currencies 12 Hedging – Example ABC Ltd having order in hand to supply copper wire worth 500 MT of copper to be delivered 2 months from now Case I – Price of copper is fixed at current spot price Case II – The price of copper would be fixed based on flexibility: – on any dates at the hands of the buyer after one month of the order or – On any dates in the delivery month What should your hedging strategy be? 13 Hedging Hedging Options – evaluation • Option I • Buy in the spot market at current price – Buying in the spot market blocks the working capital – Increased inventory carrying cost – Copper available in the spot market priced at last months average price which is higher than landed spot price • Option II • Lock in the price on the futures market at one month forward – This gives flexibility in terms of pricing spot market purchases – Increases negotiation capacity with the supplier • Option III • Leave the position un-hedged and buy copper when actually required for production leaving to vagaries of volatile copper price risk Risk Management 14 FUTURES Futures were designed to solve the problems that existed in the forward markets. A futures contract is an agreement between two parties to exchange an asset at a certain date at a certain price. Futures contracts are standardized forward contracts that are traded on an exchange 15 Types of Derivatives: Forwards: Commodities, Interest Rate & Currencies Counter Party Risks, Customised Contract, Movement of Assets Futures: Standardised Contract Equity / Commodity FORWARDS FUTURE * A tailor made contract (terms are negotiated between parties). * A standardised contract (Qty, Date, Delivery Conditions are standardised). * No Secondary Market. * Traded on recognised exchanges,. * Forward Contracts generally end with deliveries. * Future Contracts are typically settled with the differences. * No collateral is required. * Margin is required. * Settled on Maturity Date. * Future Contracts are “Marked to Market” on daily basis i.e. Profit / Loss settled on daily basis. * Parties are exposed to credit risk because one of the party will have incentive to default. * Future Contracts are virtually free from credit risk as they come with risk – eliminating measures. 16 TERMINOLOGY Spot Price: Price at which an asset trades in the spot market Futures price: Price at which futures contract trades in the futures market. Contract cycle: Period over which a contract trades Derivatives contracts have one, two and three months expiry cycles Contracts expire on last Thursday New contracts are fired on Friday 17 TERMINOLOGY Expiry date: Date specified on the derivatives contract It’s the last Thursday and the last day for the contract to be traded Contract will cease to exist from this day. Initial margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin. 18 TERMINOLOGY Marking-to-market: In the futures market, at the end of each trading day, the margin account is adjusted to reflect the investor's gain or loss depending upon the futures closing price. Maintenance Margin: This is lower than the initial margin. This margin is set to ensure that the balance in the margin account never becomes negative.the balance falls below maintenance margin, margin call is made. Trader is expected to top up the margin account to the initial margin level. 19 FINANCIAL INNOVATION & DERIVATIIVES Types: Code Market Lot Nos. of Scripts Base Value CNXIT 100 20 w.e.f. 28.05.2004 BANK NIFTY 50 12 w.e.f. 01.01.2000 CNX NIFTY JUNIOR 25 50 1996 CNX 100 50 100 2003 NIFTY MID CAP 50 75 50 2004 S & P CNX DEFTY 150 50 1995 CNX NIFTY 50 50 1995 * Equity shares are of two types. STOCK INDEX FUTURES and FUTURE ON INDIVIDUAL SECURITIES. 20 OPTIONS An options contract gives buyer the right, but not the obligation to buy or sell a specified underlying at a set price on or before a specified date. Option buyer: Buys the option by paying premium and gets the right to exercise options on writer/seller Option seller: Sells/writes the option and receives the premium and is hence under obligation to buy/sell asset if the buyer exercises option 21 TERMINOLOGY Option premium: Price paid by the buyer to seller to acquire the right. Comprises of Intrinsic Value and Time Value Strike/Exercise price: Price at which the underlying may be purchased or sold Expiry date: It’s last Thursday of the month for options to be exercised/ traded. Options cease to exist after expiry 22 TERMINOLOGY Exercise : Invoke the rights approved to buyer of option. Assignment: When the buyer of an option exercises his right to buy / sell, a randomly selected option seller ( at the client level ) is assigned the obligation to honor the underlying contract. American options: American options are options that can be exercised at any time upto the expiration date. Most exchange-traded options are American. European options: European options are options that can be exercised only on the expiration date itself 23 CALL OPTION A call option gives the buyer, the right to buy specified quantity of the underlying asset at a set strike price on or before expiration date. The seller (writer) however, has the obligation to sell the underlying asset if the buyer of the call option decides to exercise the option to. 24 PUT OPTION A put option gives the buyer the right to sell specified quantity of the underlying asset at a set strike price on or before expiration date. The seller (writer) however, has the obligation to buy the underlying asset if the buyer of the put option decides to exercise his option to sell. 25 Types of Option • European Option - can be exercised only on the expiration date • American Option - can be exercised any time on or before the expiration date 26 27 OPTION CONTRACT 1. CALL OPTION: gives its holder right to purchase an assets for a specific price called EXERCISE OR STRIKE PRICE. e.g. 26.08.2010 CALL OPTION on RIL with an Exercise Price of Rs. 1060/- at any time upto and including the expiration date 26.08.2010. The holder would exercise right to purchase provided market price of RIL is more than Rs. 1060/- i.e. Exercise price. 2. PREMIUM: The Purchase Price of OPTION is called Premium that represents the compensation the Purchaser of the CALL must PAY for the right to exercise the option; say Premium on above example is Rs.4.35/-. 3. SELLERS OF CALL OPTION: Also called the WRITERS receive the premium income now as payment against the possibility they will be required at later date (i.e. during expiration period) to deliver the asset in return for an EXERCISE PRICE (which is lower than Market Price). If Option is left to expire worthless, then the WRITER of the call clears a PROFIT equal to Premium Income derived from the sale of the OPTION. (i.e. Rs. 4.35 x 250 shares = Rs. 1087.50) 28 4. PROFIT / LOSS ON CALL OPTION (BUYERS): say Market Price Rs.1100/-. Exercise Price + Premium < Market Price then PROFIT Exercise Price + Premium > Market Price then LOSS 5. 1060 + Rs. 4.25 < Market Price Exercise RIGHT & hence Profit is Rs. 35.75 per share NOT Exercise of Right & hence loss is Rs.27 x 75 = Rs.2025/-. PROFIT / LOSS ON CALL OPTION (WRITER): say Market Price Rs.990/-. Exercise Price + Premium > Market Price 1060 + 4.25 = 1064.25 > 990 :. CALL BUYER would not exercise right :. WRITER gets 250 x 4.25 (Premium) = Rs. 1062.50 PROFIT 29 PUT OPTION 1. PUT OPTION: gives its holder right to sell an asset for a specific price called EXERCISE OR STRIKE PRICE. E.g.: 26 August, 2010 PUT OPTION on Reliance with Exercise Price of Rs.1040/- entitles the owner to sell RIL for Rs.1040/- at any time upto & including the expiration date 26 August, 2010 . The holder would exercise right to sell if Market Price of RIL is less than Rs.1040/-. 2. PREMIUM: The Sale Price on OPTION is called Premium that represents the compensation the Seller of the PUT must PAY to the Purchaser for the right (to sellers) to exercise the option; say Premium on above example is Rs.43.45/-. 3. PURCHASERS OF PUT OPTION: Also called the WRITER receive the premium income now as payable against the possibility they will be required to buy the assets at a later date (i.e. during expiration period) in return for an EXERCISE PRICE (which is lower than Market Price). 30 4. PROFIT / LOSS ON PUT OPTION: say Market Price Rs.1100/-. If Exercise Price + Premium > Market Price then PROFIT Exercise Price + Premium < Market Price then LOSS 1040 + 43.45 – Market Price = Rs.16.55 Buyers of PUT OPTION does not exercise the right to sell & loss is Rs. 43.45 x 250 = 10862.50. say Market Price is Rs.990/-. 1040 + 43.45 > Rs. 990/- :. Profit Put Option would be exercised. Profit would be Rs. 23362.50 (93.45 x 250 shares) 31 ILLUSTRATION: OPTION QUOTE at NSE on 11.02.2008 at 12:20 P.M. SCRIPT EXERCISE DATE EXERCISE PRICE (EP) OPTION PREMIUM RELIANCE 26 August, 2010 1060 CA 4.25 RELIANCE 26 August, 2010 1050 CA 5.50 RELIANCE 26 August, 2010 1040 CA 6.80 ASSUME MARKET PRICE (MP) @ Rs.1050/- ON 26 August, 2010 : Therefore, Situation I EP 1060 > MP 1050 No obligation to BUY BUT, Loss is Rs.4.25 x 250 = 1062.50 as against Rs.10 x 250 = 2500 Situation II EP 1050 = MP 1050 Right to buy does not seem exercisable But, look at 1050 + 5.50 (Premium) = 1055.50 > 1050 (MP) Seems, NO OBLIGATION Hence, Loss is Rs.5.50 x 250 = Rs. 1375 Situation III EP 1040 < MP 1050 RIGHT to buy seems exercisable Total Cost 1040 + 5.25 = 1045.50 Also, Exercise Cost < MP Seems, Exercise RIGHT to BUY PROFIT Rs.4.50 x 250 = 1125 (on investment of Rs.1375/i.e. 82% app.). 32 TYPES OF OPTION - MONEYNESS : IN the MONEY: OUT of the MONEY: Moneyness When Exercise produce PROFIT When Exercise produce LOSS Call Options Put Options Out-of the Money Market Price < Exercise Price Market Price > Exercise Price In-the-money Market Price > Exercise Price Market Price < Exercise Price At-the-money Market Price = Exercise Price Market Price = Exercise Price 33 Impact of volatility : Gains from price increase Call Option Holder Has fixed downside risk when price decrease Benefits from price decline Pun Option Holder Has limited risk in upward movement of stock price Value of call and put increase as volatility increases. Impact of Risk free Interest Rate : Expected growth rate of stock price increase Interest Rate Rise Value of future cash flow declines Put Option value decrease Interest Rate Rise Call option value enhance (however much the present value effect tends to decrease it) Impact of Dividends : Value of stock in anticipation of dividend declaration. Value of stock after record date. 34 EXERCISE OF OPTION CALL Stock Price S > > Strike Price X X PUT Net-Inflow Yes Stock Price S < > < Strike Price X X X Net-Inflow Yes * * i.e. If stock price declines to lesser and lesser than strike price, the value of Put Option increases. This means, if stock price goes up higher than strike price, the value of Put Option decreases VALUE OF CALL OPTION Value of Call Option when decline in strike price Value of Call Option when increase in strike price Value of Call Option depends upon spot price & strike price and is actually the difference between them. 35 VALUE OF PUT OPTION Value of Put Option when strike price is higher than SPOT. Value of Put Option when strike price is lower than SPOT. Pay-off from Put with increase in strike price Pay-off from Put with decline in strike price 36 OPTION V/S. STOCK INVESTMENT Purchase of Call Option Bullish Strategy Purchase of Put Option Bearish Strategy Calls Provide Profit Stock Prices (MP) increases PUTS Provide Profit Stock Prices (MP) decreases Writing Call Bearish Strategy Writing Put Bullish strategy 37 TRADING STRATEGIES – OPTIONS * * * * * Covered Call Writing Protective PUT Straddles & Strangles Stripes & Straps Spreads 38 1. 2. 3. CASH PRICE CALL (BUY) March PUT (SELL) March March Rs.310/310 21 270 310 2 42 Trading Strategy What it is Covered Call Writing BUY underlying Asset WRITE a CALL Cash Sale (Write a CALL) Protective PUT BUY underlying Asset BUY A PUT on Asset Cash Sale June Impact 350 8 Illustration / Initial Investment (Rs.) Cash Obligation Cash Right to Sell BUY 100 of ABC WRITE a JUNE 350 CALL -310 + 8 -302 BUY 100 of ABC BUY MARCH 270 PUT -310 - 2 -312 39 COVERED CALL WRITING BUY 100 Shares of ABC -310 Write June 350 Call + 8 Initial Cash Flow -302 ____________________________________________ Expiration Day Cash Flow for a Covered CALL i. ii. iii. iv. Marketing Price 1 Sell Stock 2 Buy Call 3 Cash Flow 4 Net Cash Flow (Difference between Initial Cash Flow and Cash Flow) 5 270 270 0 270 -32 290 290 0 290 -12 310 310 0 310 8 330 330 0 330 28 350 350 0 350 48 370 370 -20 350 48 400 400 -50 350 48 Call expires worth less for a price at or below Rs.350/-. If Market Price is Rs.302/- investor breaks even (i.e. call not exercised and cash purchased 100 ABC is sold at Rs.302/- which was initial investment). If Market Price goes above Rs.350/-, the investor profit goes up in cash purchase shares but in Option it goes down by the same quantum nullifying increase. Thus the maximum Profit is bounded at Rs.48/-. 40 Covered Call Writing Who uses this Strategy: Investor who believes stock offers scope for a small price appreciation. Covered CALL WRITER will not enjoy price appreciation beyond Exercise Price of CALL and will regret, if Market Price rises sharply. Similarly, if Market Price falls sharpely, he too will regret. 41 PROTECTIVE PUT BUY 100 Shares of ABC -310 BUY March 270 PUT - 2 Initial Investment -312 ____________________________________________ Expiration Date Cash Flow for a Protective PUT i. ii. iii. iv. v. vi. Market Value 1 Sell Stock 2 Sell PUT 3 Cash Flow 4 Net Cash Flow (Difference between Initial Cash Flow and Cash Flow) 5 240 240 30 270 -42 260 260 10 270 -42 280 280 0 280 -32 300 300 0 300 -12 320 320 0 320 8 340 340 0 340 28 PUT expires worth less for a price at or above Rs.270/-. Cash Purchased Shares sold at below Rs.310 is loss. B/E is sale of cash purchased share at Rs.312/-. If Market Price goes above Rs.312/-, the Cash Purchased Shares make Profit. For Market Price below Rs.270/- PUT makes gain (but cash purchased share make loss). Loss is thus bounded at Rs.42/- for Market Price Rs.270/-. 42 PROTECTIVE PUT Who uses this Strategy: It appeals to those investors who are concerned with protection against fluctuations in stock prices. Protection, of course, costs in terms of premium paid for buying the PUT. 43 1. 2. 3. Trading Strategy CASH PRICE CALL (BUY) March PUT (SELL) March March Rs.310/310 21 270 310 2 42 What it is June Impact 350 8 Illustration / Initial Investment (Rs.) STRADDLE BUY / SELL CALL & PUT at same Exercise Price & same Expiration Date Right to Buy Right to Sell OR Obligation to Buy Obligation to Sell BUY a March 310 CALL BUY a March 310 PUT -21 -42 -63 STRANGLE Combination of a CALL & PUT with same expiration date and different Exercise Price chosen in such a way that CALL Exercise Price > Put Exercise Price Right to Buy Right to Sell BUY a March 310 CALL BUY a March 270 PUT -21 - 2 -23 44 STRADDLE BUY a March 310 CALL BUY a March 310 PUT Initial Investment -21 -42 -63 Market Price 1 Sell CALL 2 Sell PUT 3 Cash Flow 4 Net Cash Flow (Difference between Initial Cash Flow and Cash Flow) 5 220 0 90 90 27 240 0 70 70 7 260 0 50 50 -13 280 0 30 30 -33 300 0 10 10 -53 310 0 0 0 -63 320 10 0 10 -53 340 30 0 30 -33 360 50 0 50 -13 380 70 0 70 7 400 90 0 90 27 500 190 0 190 127 45 STRADDLE i. Maximum Loss associated with long straddle position is the cost of two premiums. ii. Profit Potential is unlimited when Market Prices rise significantly & limited (to Rs.310/- in the event of Market Price becoming zero). Who uses this Strategy: Investor purchasing Straddle makes profits at prices which are significantly lower or higher than the prevailing Market Price. It is for investor who wants to take position in an asset which is volatile but he has no clue on whether price Will go up or down, in short-run. 46 STRANGLE BUY a March 310 CALL BUY a March 270 PUT Initial Investment -21 - 2 -23 Market Price 1 Sell CALL 2 Sell PUT 3 Cash Flow 4 Net Cash Flow (Difference between Initial Cash Flow and Cash Flow) 5 220 0 50 50 27 240 0 30 30 7 260 0 10 10 -13 270 0 0 0 -23 300 0 0 0 -23 310 0 0 0 -23 320 10 0 10 -13 340 30 0 30 7 360 50 0 50 27 47 STRANGLE i. Profit associated with a sharp potential price appreciation is higher under the long strangle strategy. ii. Initial investment in strangle is less than in straddle. 48 1. 2. CASH PRICE CALL (BUY) March PUT (SELL) March March 3. Rs.310/310 21 270 310 2 42 Impact June 350 8 Trading Strategy What it is Illustration / Initial Cash Flow (Rs.) STRIPS Long Position in ONE CALL and TWO PUTS with same Exercise Price & same Expiration Period Right to Buy Right to Sell BUY ONE March 310 CALL BUY TWO March 310 PUT - 21 - 84 -105 STRAPS Long Position in TWO CALLS and ONE PUT with same Exercise Price & same Expiration Date Right to Buy Right to Sell BUY TWO March 310 CALL BUY ONE March 310 PUT -42 -42 -84 49 STRIP BUY a March 310 CALL - 21 BUY TWO March 310 PUT - 84 Initial Cash Flow -105 Market Price 1 Sell CALL 2 Sell PUT 3 Cash Flow 4 Net Cash Flow (Difference between Initial Cash Flow and Cash Flow) 5 220 0 180 180 75 240 0 140 140 35 260 0 100 100 -5 270 0 80 80 -25 300 0 20 20 -85 310 0 0 0 -105 320 10 0 10 -95 340 30 0 30 -75 360 50 0 50 -55 400 90 0 90 -15 50 STRIP i. Profit from both rise & fall in Market Price. ii. Profit will be more when stock declines sharply. The strategy appeals investors who want to take position in asset which is volatile but likely to decline sharply. 51 STRAPS BUY 2 March 310 CALL BUY 1 March 310 PUT Initial Investment -42 -42 -84 Market Price 1 Sell CALL 2 Sell PUT 3 Cash Flow 4 Net Cash Flow (Difference between Initial Cash Flow and Cash Flow) 5 220 0 90 90 6 240 0 70 70 -14 260 0 50 50 -34 270 0 40 40 -44 300 0 10 10 -74 310 0 0 0 -84 320 20 0 20 -64 340 60 0 60 -24 360 100 0 100 16 400 180 0 180 96 52 STRAPS i. Investor makes Profit at price which are significantly higher or lower than the prevailing market price. ii. Profit is higher in bullish market condition. The strategy attracts the investor who expect market to be volatile but thinks that it will ultimately rise. 53 BOX SPREAD ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Combination of BULL & BEAR spreads with CALLS & PUTS respectively with the same set of EXERCISE PRICES. X1 Prices available with CALLS X2 Prices available with PUTS BOX SREAD involves: (1) Buying CALLS with Exercise Price (STRIKE PRICE) X1 Selling CALLS with Exercise Price (STRIKE PRICE) X2 (2) Selling PUTS with Exercise Price (STRIKE PRICE) X2 Buying PUTS with Exercise Price (STRIKE PRICE) X1 GOOD for RISK AVERSE INVESTOR GIVES PAY-OFF 54 BUTTERFLY SPREAD: 4 identical OPTIONS with same expiration date but different exercise price Say, there are three prices: X1 } X2 } X1 < X2 < X3 X3 } BUTTERFLY spread means BUY ONE OPTION each at X1 & X3 SELL TWO OPTIONS at X2 OR SELL ONE OPTION each at X1 & X3 BUY TWO OPTIONS at X2 55 CALENDAR SPREAD (HORIZONTAL SPREAD) : A Calendar Spread is almost similar to Butterfly Spread. It is created by selling a CALL Option with a certain Exercise Price and Purchasing another call with longer Maturity but same Exercise Price. Long Maturity Option can be sold when short maturity option expires ; thus resulting in PROFIT. 56 SYNTHETICS : Involves: PURCHASE OF CALL OPTION } Exactly SAME WRITING (SALE) OF PUT OPTION } PRICE If prices go below Exercise Price, WINDFALL GAINS AND If prices go above Exercise Price, Purchase at Exercise Price 57 CONVERSIONS : It means holding long position stock i.e. BUY CALL at longer maturity and create a synthetic short position i.e. Purchase Call Option / Sell Put Option in order to get possibility of arbitrate profit. 58 OPTION VALUATION _______________________________________________________________ _ Consider Stock Price < Exercise Price i.e. Immediate Exercise is unprofitable But a chance that Stock Price will increase sufficiently by expiration date. Hence it allows profitable exercise (Exercise Price < Stock Price). However in worst scenario of SP < EP, the option to expire with ZERO VALUE. The value So – X is called Intrinsic Value of in-money call option as it gives PAY-OFF obtainable by immediate exercise. Time Value is the difference between ACTUAL CALL PRICE and the INTRINSIC VALUE (the terminology confuse the OPTION’s TIME value with the TIME VALUE OF MONEY). In Option, it simply refers to the difference between the OPTION’s PRICE and the value of the OPTION would have if it were expiring immediately. OPTION, per-se, confers RIGHT TO EXERCISE to holders. Thus it provides insurance against poor stock price performance. If stock price increases substantially, it is more likely that the OPTION will be exercised by expiration. As stock prices become larger, the OPTION value approaches the “adjusted” intrinsic value, stock price minus the present value of the exercise price, So – PV (X). 59 Why So? When stock prices increase, investor is certain to exercise right and hence, even without payment of stock-price, the concerned stock is in his safe deposit box. The present value of investor’s obligation is the present value of Exercise Price i.e. X. So, the net value of CALL OPTION is So – PV (X). The diagram, below indicates “CALL OPTION VALUATION FUNCTION”: (i) Value curve shows that when stock price is very low ; the option is worthless. (ii) When stock price is very high, option value approaches adjusted intrinsic value. (iii) In midrange case, when OPTION is “at money” (i.e. Call Price = Stock Price) the option curve diverges from the straight line corresponding to adjusted intrinsic value ; (because exercise now would have negligible pay-off, the volatility value of OPTION is quite high). OPTION INCREASES IN VALUE WITH THE STOCK PRICE 60 SWAPS “Swaps are transactions which obligates the two parties to the contract to exchange a series of cash flows at specified intervals known as payment or settlement dates” 61 TYPES Interest Rate Swap: Interest rate swaps is an arrangement by which one party agrees to exchange his series of fixed rate interest payments to a party in exchange for his variable rate interest payments. Currency Swaps: Currency swaps is an arrangement in which both the principle amount and the interest on loan in one currency are swapped for the principle and the interest payments on loan in another currency. Credit Default Swaps: The buyer of a credit swap receives credit protection, whereas the seller of the swap guarantees the credit worthiness of the product. By doing this, the risk of default is transferred from the holder of the fixed income security to the seller of the swap. 62 Types to IRS • Fixed-for-floating rate swap, same currency • Fixed-for-floating rate swap, different currencies • Floating-for-floating rate swap, same currency • Floating-for-floating rate swap, different currencies • Fixed-for-fixed rate swap, different currencies 63 Settlement Physical settlement: The protection seller pays the buyer par value, and in return takes delivery of a debt obligation of the reference entity. Cash settlement: The protection seller pays the buyer the difference between par value and the market price of a debt obligation of the reference entity. 64 REGULATORY AUTHORITY SEBI set up a 24- member committee under the Chairmanship of Dr. L. C.Gupta to develop the appropriate regulatory framework for derivatives trading. Exchange should have minimum 50 members. Existing member cannot automatically become members in derivatives segment. The clearing and settlement of derivatives trades would be through a SEBI approved clearing corporation/house. 65 REGULATORY AUTHORITY The initial margin requirement, exposure limits linked to capital adequacy and margin demands will be prescribed by SEBI. Approved users on the F&O segment have to pass a certification program which has been approved by SEBI. Position limits have been specified by SEBI at trading member, client, market and FII levels 66 TAXATION Securities transaction tax on derivatives entered into in a recognized stock exchange. transactions This tax is payable by the seller of the derivative instrument. The rate of tax applicable on F&O is 0.017% of the value of taxable securities transaction only on sale side. Transaction charges Rs. 2 per lacs In case the option is exercised it is paid by purchaser at 0.125%. 67 FINALLY…. Perhaps this is the starting “Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria. The time of maximum pessimism is the best time to buy, and time of maximum optimism is the best time to sell.” 68 THANK YOU 69