1. Introduction to Derivatives
A derivative is a financial contract whose value is derived from an underlying asset such as:
- Stocks
- Bonds
- Interest Rates
- Currencies
- Commodities
Key Features
- It is a future contract between two parties
- Value depends on spot market movements
- Used for:
- Risk Management (Hedging)
- Speculation
Classification of Derivatives
1. OTC (Over-the-Counter) Products
- Customized contracts
- Direct negotiation with banks/financial institutions
- Examples:
- Forwards
- Options
- Swaps
2. Exchange Traded Derivatives
- Standardized contracts
- Traded on exchanges like NSE, MCX
- Examples:
- Futures
- Options
Role of Treasury in Derivatives
- Manage ALM risks
- Serve customer hedging needs
- Conduct trading operations
2. Forward Contracts
A forward contract is an agreement to buy/sell foreign currency at a fixed rate on a future date.
Types of Forward Contracts
- Forward Purchase Contract (FPC)
- Bank buys foreign currency from exporter
- Forward Sale Contract (FSC)
- Bank sells foreign currency to importer
Important Formula
- Forward Rate = Spot Rate ± Premium/Discount
Interest Rate Relationship
- Higher interest currency → Discount
- Lower interest currency → Premium
Settlement
- Mandatory delivery on due date
- If not, difference settled between spot and contracted rate
3. Options
An option gives the holder the right but not obligation to buy/sell an asset.
Types of Options
- Call Option → Right to BUY
- Put Option → Right to SELL
Types based on Exercise
- American Option → Anytime before expiry (Not allowed in India)
- European Option → Only on expiry (Used in India)
4. Option Terminology
- Option Holder → Buyer (pays premium)
- Option Writer → Seller (receives premium)
- Strike Price → Agreed price
- Expiry Date → Maturity
- Premium → Cost of option
5. Option Pricing Components
Intrinsic Value
- Call = Spot – Strike
- Put = Strike – Spot
- Cannot be negative
Time Value
- Option Price – Intrinsic Value
- Decreases as expiry approaches
📌 Example (from Page 6):
- Spot = 78, Strike = 75, Premium = 5
- Intrinsic = 3
- Time Value = 2
6. Moneyness of Options
| Type | Condition |
|---|---|
| ATM | Spot = Strike |
| ITM | Profit situation |
| OTM | Loss situation |
Call Option
- ITM → Spot > Strike
- OTM → Spot < Strike
Put Option
- ITM → Spot < Strike
- OTM → Spot > Strike
7. Option Example (Exam Important)
📌 From PDF (Page 10):
- Buy 100 shares @ ₹500
- Premium = ₹25
Scenario 1 (Spot ₹600)
- Profit = ₹7,500
Scenario 2 (Spot ₹400)
- Loss = ₹2,500 (premium only)
8. Forwards vs Options
| Feature | Forward | Option |
|---|---|---|
| Obligation | Mandatory | Optional |
| Upfront Cost | No | Premium |
| Risk | Both parties | Writer unlimited risk |
| Flexibility | Low | High |
9. Futures Contracts
A futures contract is a standardized forward contract traded on exchanges.
Key Features
- Standardized quantity & quality
- Margin required
- Daily Mark-to-Market (MTM)
- Mostly settled before expiry
Types
- Currency Futures
- Interest Rate Futures
- Commodity Futures
10. Futures Example (Important)
📌 From Page 15:
- Contract: USD 50,000 @ 1.31
Case 1: Rate = 1.32
→ Profit = AUD 500
Case 2: Rate = 1.28
→ Loss = AUD 1500
11. Forwards vs Futures
| Feature | Forwards | Futures |
|---|---|---|
| Market | OTC | Exchange |
| Margin | No | Yes |
| Settlement | On maturity | Daily MTM |
| Liquidity | Low | High |
12. Swaps
A swap is an exchange of cash flows.
Types
- Interest Rate Swap (IRS)
- Fixed ↔ Floating
- Used to hedge interest risk
- Currency Swap
- Exchange of principal + interest in different currencies
13. Currency Swap Types
- Principal Only Swap (POS)
- Coupon Only Swap (COS)
- Principal + Interest Swap (P+I)
Purpose
- Hedge exchange risk
- Manage currency mismatch
14. Forward Rate Agreement (FRA)
A FRA is a contract to fix interest rate for a future loan.
Positions
- Long FRA → Borrower
- Short FRA → Lender
Example (Page 19)
- FRA 1/7 → Borrow after 1 month for 6 months
Notation
- FRA 3/5 → Loan starts after 3 months for 2 months
15. Money Market & Treasury Instruments
Treasury Bills (T-Bills)
- Short-term borrowing by GOI
- Issued at discount
- Types:
- 91 days
- 182 days
- 364 days
Interest
- Discount-based
Cash Management Bills (CMBs)
- Tenure < 91 days
- Tradable
- T+1 settlement
Call Money & Notice Money
- Call Money → Overnight
- Notice Money → Up to 14 days
16. Corporate Debt & Other Instruments
- Commercial Paper (CP)
- Certificates of Deposit (CoD)
- Corporate Bonds
Key Points:
- CoD is a promissory note
- No loan against CoD
- Tier-2 bonds are subordinated
17. RBI Monetary Tools
Repo
- Liquidity injection
Reverse Repo
- Liquidity absorption
Important Correction
- Repo = Ceiling
- SDF = Floor
18. Important Exam Concepts
- Spread = Bid – Ask difference
- OMO = Buy/Sell govt securities
- TREPS → Launched by CCIL
19. Important Numerical (T-Bill Yield)
📌 From Page 37:
Yield = 6.11% for 91-day T-Bill
20. High-Probability Exam MCQ Insights
- Derivative value depends on underlying
- Futures are marked to market daily
- Options holder has limited risk
- IRS used to switch interest basis
- Currency swap removes exchange risk
- Call exercised when Strike < Market Price
