Page 71 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Derivatives & Risk Management

Notes 8. European options and American options on stock and bonds are usually considered to be
"plain vanilla".
9. Asian options, lookback options, barrier options are often considered to be exotic,
especially if the underlying instrument is more complex than simple equity or debt.
10. The price of options is decided between the buyers and sellers on the trading screens of the
exchanges in a transparent manner.

6.3 Index Derivatives

Index derivatives are derivative contracts which derive their value from an underlying index.
The two most popular index derivatives are index futures and index options. Index derivatives
have become very popular worldwide. Index derivatives offer various advantages and hence
have become very popular.
Institutional and large equity-holders need portfolio-hedging facility. Index-derivatives are
more suited to them and more cost-effective than derivatives based on individual stocks. Pension
funds in the US are known to use stock index futures for risk hedging purposes.
Index derivatives offer ease of use for hedging any portfolio irrespective of its composition.
Stock index is difficult to manipulate as compared to individual stock prices, more so in
India, and the possibility of cornering is reduced. This is partly because an individual
stock has a limited supply, which can be concerned. Stock index, being an average, is much less
volatile than individual stock prices. This implies much lower capital adequacy and margin
requirements.

!
Caution Index derivatives are cash settled, and hence do not suffer from settlement delays
and problems related to bad delivery, forged/fake certificates.
Self Assessment

Fill in the blanks:
11. ……………are derivative contracts which derive their value from an underlying index.
12. Index derivatives are ……………settled.

6.4 European and American Calls and Puts

There are two kinds of options based on the date. The first is the European Option, which can be
exercised only on the maturity date. The second is the American Option, which can be exercised
before or on the maturity date.
In most exchanges the options trading starts with European Options, as they are easy to execute
and keep track of. This is the case in the BSE and the NSE. Cash settled options are those where,
the buyer is paid the difference between stock price and exercise price (call) or between exercise
price and stock price (put). Delivery settled options are those where the buyer takes delivery of
undertaking (calls) or offers delivery of the undertaking (puts).
The distinction between American and European options has nothing to do with geographic
location. European options can be exercised only at expiration time. American options can be

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