financialderivativesppt-120429233144-phpapp02

7/27/2019 financialderivativesppt-120429233144-phpapp02

1/37

FINANCIAL DERIVATIVES

Prepared by

K.Logasakthi MBA (Ph.D)

Assist.. Professor

VSA School of Management,

Salem.


2/37

OBJECTIVES OF THE LEARING


3/37

Derivatives - (Meaning)

Derivatives: derivatives are instruments which

include

a) Security derived from a debt instrument

share, loan, risk instrument or contract for

differences of any other form of security and ,

b) a contract that derives its value from the

price/index of prices of underlying securities.


4/37

Derivatives (Definition)

A financial instrument whose characteristics and valuedepend upon the characteristics and value of anunderlier,typically a commodity, bond, equity or currency.

Examples of derivatives includefuturesandoptions.Advanced investors sometimes purchase or sell derivativesto manage the risk associated with the underlying security,to protect against fluctuationsin value, or to profit from

periods of inactivity or decline. These techniques can bequite complicated and quite risky.
http://www.investorwords.com/1951/financial_instrument.htmlhttp://www.businessdictionary.com/definition/characteristic.htmlhttp://www.investorwords.com/5124/underlier.htmlhttp://www.investorwords.com/5124/underlier.htmlhttp://www.investorwords.com/5209/value.htmlhttp://www.investorwords.com/975/commodity.htmlhttp://www.investorwords.com/521/bond.htmlhttp://www.investorwords.com/1726/equity.htmlhttp://www.investorwords.com/1240/currency.htmlhttp://www.investorwords.com/5124/underlier.htmlhttp://www.investorwords.com/975/commodity.htmlhttp://www.investorwords.com/521/bond.htmlhttp://www.investorwords.com/1726/equity.htmlhttp://www.investorwords.com/1240/currency.htmlhttp://www.investorwords.com/2630/investor.htmlhttp://www.investorwords.com/3952/purchase.htmlhttp://www.investorwords.com/3952/purchase.htmlhttp://www.investorwords.com/3952/purchase.htmlhttp://www.investorwords.com/4467/sell.htmlhttp://www.investorwords.com/4467/sell.htmlhttp://www.investorwords.com/3477/option.htmlhttp://www.investorwords.com/2630/investor.htmlhttp://www.investorwords.com/4292/risk.htmlhttp://www.investorwords.com/2630/investor.htmlhttp://www.investorwords.com/3952/purchase.htmlhttp://www.investorwords.com/5836/underlying_security.htmlhttp://www.investorwords.com/5836/underlying_security.htmlhttp://www.investorwords.com/5836/underlying_security.htmlhttp://www.investorwords.com/5836/underlying_security.htmlhttp://www.investorwords.com/4292/risk.htmlhttp://www.businessdictionary.com/definition/fluctuation.htmlhttp://www.investorwords.com/5836/underlying_security.htmlhttp://www.investorwords.com/3880/profit.htmlhttp://www.investorwords.com/5836/underlying_security.htmlhttp://www.investorwords.com/3669/period.htmlhttp://www.businessdictionary.com/definition/fluctuation.htmlhttp://www.investorwords.com/1335/decline.htmlhttp://www.investorwords.com/1335/decline.htmlhttp://www.businessdictionary.com/definition/technique.htmlhttp://www.businessdictionary.com/definition/technique.htmlhttp://www.investorwords.com/3880/profit.htmlhttp://www.investorwords.com/3669/period.htmlhttp://www.investorwords.com/1335/decline.htmlhttp://www.businessdictionary.com/definition/technique.htmlhttp://www.businessdictionary.com/definition/technique.htmlhttp://www.investorwords.com/1335/decline.htmlhttp://www.investorwords.com/3669/period.htmlhttp://www.investorwords.com/3880/profit.htmlhttp://www.businessdictionary.com/definition/fluctuation.htmlhttp://www.investorwords.com/5836/underlying_security.htmlhttp://www.investorwords.com/4292/risk.htmlhttp://www.investorwords.com/4467/sell.htmlhttp://www.investorwords.com/3952/purchase.htmlhttp://www.investorwords.com/2630/investor.htmlhttp://www.investorwords.com/3477/option.htmlhttp://www.investorwords.com/2134/futures.htmlhttp://www.investorwords.com/1240/currency.htmlhttp://www.investorwords.com/1726/equity.htmlhttp://www.investorwords.com/521/bond.htmlhttp://www.investorwords.com/975/commodity.htmlhttp://www.investorwords.com/5124/underlier.htmlhttp://www.investorwords.com/5209/value.htmlhttp://www.businessdictionary.com/definition/characteristic.htmlhttp://www.investorwords.com/1951/financial_instrument.html


5/37

Advantages of Derivative Market


6/37


7/37

Continue,Basics Four Parts:

1. Forward

2. Future

3.Option

4. Warrents& Convertibles.

Complex

1. Swap2. Exotics


8/37

Forward contract


9/37

The salient features of forward contracts

are as follows:

They are bilateral contracts and hence, exposed tocounterparty risk.

Each contract is customer designed, and hence is

unique in terms of contract sixe, expiration date andthe asset type and quality.

The contract price is generally not available in publicdomain.

On the expiration date, the contract has to besettled by delivery of the asset and

If party wishes to reverse the contract.


10/37

Limitations of Forward contract

1. Forward markets are afflicted by severalproblems:

2. Lack of centralization of trading,

3. Liquidity and Counterparty risk. The basic problem in the first two is that they

have too much flexibility and generality.

Counterparty risk arises from the possibility ofdefault by any one party to the transaction.When one of the two sides to the transactiondeclares bankruptcy, the other suffers


11/37

FUTURE CONTRACT

Future contract

Future contract is an agreement

between two parties to buy or sell an asset at a

certain time in the future, at a certain price. Butunlike forward contract, futures contract are

standardized and stock ex-changed traded.


12/37

Continue.,,.,,

The standardized items in a futures contract are:

1. Quantity of the underlying,

2. Quality of the underlying,

3. The date/month of delivery,4. The units of price quotation and minimum

price change and

5. Location of settlement.


13/37

Distinction between futures and

forwardS.no Future Contract S.no Forward Contract

1 Traded on an organized stock

exchange

1 Over the Counter (OTC) in nature

2 Standardized contract terms, hence,more liquid.

2 Customized contract terms, hence,less liquid

3Requires margin payments

3 No margin payment

4Follows daily settlement

4 Settlement happens at the end of the

period


14/37

Over The Counter(OTC) Trading In general, the reason for which a stock is traded

over-the-counter is usually because the companyis small, making it unable to meet exchange listingrequirements.

Also known as "unlisted stock", these

securities are traded by broker-dealers whonegotiate directly with one another overcomputer networks and by phone.

OTC stocks are generally unlisted stockswhich trade on the Over the Counter BulletinBoard (OTCBB)


15/37

Important terms in future contract

Spot price: The price at which an

instrument/asset trades in the spot market.

Future Price: The price at which the futures

contract trade in the future market.

Contract cycle: The period over which acontract trades. The index futures contract

typically have one month, two months and

three months expiry cycles that expire on thelast Thursday of the month.


16/37

Continue,,,,

Expiry date: It is the date specified in the

futures contract. This is the last day on whichthe contract will be traded, at the end of whichit will cease to exist.

Contract size: The amount of asset that has tobe delivered under one contract.

Basis: Basis is defined as the future price minusthe spot price. There will be different basis for

each delivery month for each contract. In the anormal market, basis will be positive. Thisreflects that futures prices normally exceed

spot prices.


17/37

Continue,

Cost of Carry: The relationship between

futures prices and spot prices can besummarised in terms of the cost of carry.

Initial Margin: The amount that must be

deposited in the margin account at the time afutures contract is first entered into is the

initial margin.


18/37

Pay off for FuturesA pay off is the likely profit/loss that

would accrue to a market participant withchange in the price of the underlying asset.

Futures contracts have linear pay off.

Linear pay off:

losses as well as profits for both the

buyer and the seller of futures are unlimited


19/37

Pay off for Buyer of Futures: (Long

Future)

The pay offs for a person who buys a futurescontract is similar to the pay off for a personwho holds an asset. He has a potentiallyunlimited upside as well as downside.

e.g. Take the case of a speculator who sells a twomonth Nifty index futures contact when theNifty stands at 1220. the underlying asset in this

case is the nifty portfolio. When the index movesdown the short futures position starts makingprofits and when the index moves up it startsmaking losses.


20/37

Pay off for Seller Futures (short future)

The pay off for a person who sells a futures

contract is similar to the pay off for a person

who shorts an asset. he has potentially

unlimited upside as well as downside.


21/37

OPTIONS

Meaning of options:

An option is the right, but not the

obligation to buy or sell something on a

specified date at a specified price. In the

securities market, an option is a contractbetween two parties to buy or sell specified

number of shares at a later date for an agreed

price.


22/37

Continue,,There are three parties involved in the option

trading, the option seller, buyer and the broker.

1. The option seller or writer is a person who grantssomeone else the option to buy or sell. Hereceives premium on its price.

2. The option buyer pays a price to the optionwriter to induce him to write the option.

3. The securities broker acts as an agent to find theoption buyer and the seller, and receives acommission or fee for it.


23/37

Options

An option to buy anything is known as a CALLwhile an option to sell a thing is called a PUT.Options trade in an organized market but,large percentage of it is traded over the

counter (i.e. privately).Note that this is just an option. That

means it is a right and not an obligation.

Strike price: Price specified in the optionscontract is known as the strike price orexercise price.
http://hubpages.com/hub/options-futures-and-hedging-meaning-features-similarities-and-differenceshttp://hubpages.com/hub/options-futures-and-hedging-meaning-features-similarities-and-differences


24/37

Types of Options1. Call option: A call option is a contract giving the

right to buy the shares.2. Put option is a contract giving the right to sell theshares.

Call option that gives the right to buy in its contract

gives the particulars of The name of the company whose shares are to be

bought.

The number of shares to be purchased.

The purchase price or the exercise price or thestrike price of the shares to be bought.

The expiration date, the date on which thecontract or the option expires.


25/37

Put option

Put option gives its owner the right to sell (orput) an asset or security to someone else.

Put option contract contains:

1. The name of the company shares to be sold.

2. The number of shares to be sold.

3. The selling price or the striking price.

4. The expiration date of the option.

Distinction between Futures and


26/37

Distinction between Futures and

Options

Futures

Exchange traded, with novation

Exchange defines the product

Price is zero, strike price moves

Price is zero

Linear payoff

Both long and short at risk

Options

Same as futures

Same as futures

Strike price is fixed, price moves

Price is always positive

Non linear payoff

Only short at risk

N ti


27/37

Novation

1. The substitution of a new contract for an old

one; or the substitution of one party in a

contract with another party.

2. The replacement of existing debt or

obligation with a new one.
http://www.businessdictionary.com/definition/substitution.htmlhttp://www.investorwords.com/1079/contract.htmlhttp://www.investorwords.com/3610/party.htmlhttp://www.businessdictionary.com/definition/replacement.htmlhttp://www.investorwords.com/1313/debt.htmlhttp://www.investorwords.com/3373/obligation.htmlhttp://www.investorwords.com/3373/obligation.htmlhttp://www.investorwords.com/1313/debt.htmlhttp://www.businessdictionary.com/definition/replacement.htmlhttp://www.investorwords.com/3610/party.htmlhttp://www.investorwords.com/1079/contract.htmlhttp://www.businessdictionary.com/definition/substitution.html


28/37


29/37

SWAPS (Meaning)

Swaps: Swaps are private agreements

between two parties to exchange cash flows in

the future according to a prearranged

formula. They can be regarded as portfolios offorward contracts.


30/37

Commonly two kind of swaps

Interest rate swaps: These entail swappingonly the interest related cash flows between

the parties in the same currency.

Currency swaps: These entail swapping bothprincipal and interest between the parties,

with the cash flows in one direction being in a

different currency than those in the opposite

direction.


31/37

Types Of Swaps

There are four types of swaps.

(1).Interest Rate Swaps.

(2).Currency Swaps.(3).Commodity Swaps.

(4).Equity Swaps.


32/37

UNIT-II


33/37

FUTURES

Future contract is an agreement betweentwo parties to buy or sell an asset at a certain

time in the future, at a certain price. But unlike

forward contract, futures contract arestandardized and stock ex-changed traded.


34/37

Continue,

Future is a financial contract which derives its

value from the underlying asset.For example:

Sugar cane or wheat or cotton farmers

may wish to have contracts to sell theirharvest at a future date to eliminate the risk

of change in price by that date.

There are commodity futures and financialfutures.


35/37

Continue.,,

In the financial futures, there are foreign

currencies, interest rate and market index

futures.

Market index futures directly related with the

stock market.


36/37


37/37

Futures markets are designed to solve the

problems of trading, liquidity andcounterparty risk. Basically, futures markets

resemble the forward market

Three distinct features of the futures marketsare:

- standardized contracts

- centralized trading

- Settlement through clearing houses to avoid

counterparty risk.

Continue..,

financialderivativesppt-120429233144-phpapp02

Documents

Transcript of financialderivativesppt-120429233144-phpapp02