STRATEGIC FINANCIAL MANAGEMENT Types of Derivatives PUT AND CALL OPTIONS
Types of Derivatives : CA Final students will find some knowledge about derivatives and its types and learning about put and call options. I will try to cover and explain calls and put options together with an example for clear understanding. Here we start.
Books Definition: Derivatives are financial contracts which derive its value from some underlying assets reference rate.
Another way it can be defined as an instrument designed for betting.
TYPES OF DERIVATIVES
Derivates are categories on the basis of –
Forward Commitment– Both sided betting for example Forward Financial Swap.
Contingent Claims– One Sided Betting Example Option, CAP, Floor.
Derivates are of various types, most commonly are Forward contract, Futures, Financial Swaps(counter) and Options.
- Forward contract both sided betting involves:
- Long position will gain if the price
- A short position will gain if prices fall.
- Futures are similar to forward contract but they are exchange-traded.
- Financial swaps are a portfolio of forward contracts it is called over the counter.
- Options – Put option and Call option
- Call options are upside betting in which buy of call defines the right to buy and right to enjoy upside without paying downside. While the selling of call options defines obligation to sale and obligation to pay upside without enjoying downside.
- Put Options are defined as downside betting where the purchase of put options right to the sale and right to enjoy downside without paying upside. While the sale of put option gives obligation to sale and obligation to pay downside without receiving upside.
In both above call and put option, the buyer of the option will pay a premium for buying an option to sales of the option.
You bought a put option at a strike price of Rs. 500.00 at a premium of Rs. 60.00 per option. At the date of maturity what will be profit and pay off, if:
- Spot rate happens to be 590.00.
- Spot rate happens to be Rs. 430.00.
- Case 1: Spot Rate 590.00, in this case, put will lapse no pay off in such a case and a loss of premium to the buyer of Rs. 60.00 per option.
- Case 2: Spot Rate 430.00, in this case, put will be exercised in our favor i.e. payoff will be 500-430-60=10.00.
You sold a call option of a stock at a strike price of Rs. 800.00 for a premium of Rs. 90.00 what would be payoff and profit.
Case-1 Spot Price Rs. 1000.00
Case-2 Spot Price Rs. 500.00
Case 1 if Spot price happens to be Rs. 1000.00 call will be exercised against us and pay off will be 1000-200+90 = Rs110.00
Case 2 if spot price happens to be Rs. 500.00 than call will lapse no pay off in such a case and profit will be equal to the premium received on sale of the call option.
Food for thought:
Option buyer runs a high probability of losing small amount with a low possibility of winning a high amount.
This is how to put and call options in the market of derivatives works and this is how stakeholders according to their calculations get to enter into the contracts of buying call and put options. This topic is very vast in scope and learning. For the deep understanding of the topic please visit the e-learning portal provided by takshila e-learning. Where you all will get a great learning from experienced faculties.
CA FINAL – STRATEGIC FINANCIAL MANAGEMENT– DERIVATIVES ANALYSIS AND VALUATION-DERIVATIVES – DIFFERENCE BETWEEN OVER THE COUNTER AND EXCHANGE TRADED DERIVATIVES AND PLAYERS OF DERIVATIVE MARKET
In this article I have tried to cover about the differences in between exchange derivatives and over the counter derivatives.
Derivatives are two types in nature in the view of trading which are called exchange traded and over the counter derivatives.
Exchange Traded Derivatives : Derivatives which have standardized lot size and traded on an organized future exchange furthermore they required payment of initial deposit settled through a clearing house.
Over the Counter : A stock that is not listed on an exchange. Trading is carried out directly between dealers over various means of communication like telephone and computer etc.
Going through the above definitions we can differentiate both of derivatives on the following basis.
- Lot Size and Maturity Date: Exchange Traded Derivatives has standardized lot size and fixed the date of maturity, while over the counter derivatives happen to be customized.
- Margin Requirement: Exchange Traded Derivatives have strict margin requirement, while Over the Counter does not have any margin requirement.
- Settlement: Exchange Traded are marked to margin every day with the difference being adjusted in the margin. So there is a daily settlement of gain and losses. In case of over the counter, there is no reprising hence gains and losses are accumulated.
- Law and Regulations: Exchange Traded are highly regulated in comparison to over the counter.
- Liquidity: Exchange Traded are highly liquid but over the counter are not.
- Risk: virtually in case of Exchange Traded there no counterparty default risk, but in case of over the counter, there is high counterparty default risk.
- Suitability: Exchange traded is more suitable for speculation while over the counter is more suitable for hedging.
- Settlement: Exchange traded squared off on the date of maturity, while over the counter settled on the date of maturity.
- Futures are generally happened to be exchange-traded while forward and swaps are happening to be over the counter.
PLAYERS AND PARTICIPANTS OF DERIVATIVE MARKET
- Hedgers: They have an existing exposure. They take up a long or short position in derivative to reduce exposure.
- Speculator: They have no exposure but a strong price belief. They take up a long and short position in the derivative market to earn profit from their price belief knowing well that they can lose.
- Arbitragers: They are sophisticated institutions, who invest in human and physical infrastructure to discover mispricing. Accordingly, they take up simultaneous long and short position with a view to making a riskless
Note: All the derivatives are priced according to the prevention of arbitrage principal.
WHY DERIVATIVES PREFERED OVER CASH MARKET
- Derivatives provide leverage, taking a big exposure by putting in a small amount.
- Derivatives have high liquidity.
- Derivatives have a lower transaction cost.
- Shorting is easier done through derivatives.
That is all I can cover to differentiate in between exchange-traded and over the counter derivatives and its participants. To get further knowledge about the topic please visit takshila e-learning portal. Where you all may get the online facility to learn all subjects of CA Final or Subjects as per your needs or your choices.
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