FM-REV-DERIVE-F

7/29/2019 FM-REV-DERIVE-F

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DERIVATIVES

GOAL-to make profits?

- To mitigate risks.

- To transact efficiently?

- for price discovery ?

ORIGIN- AUG-1971

BREAK DOWN OF

BRETTON-WOODS

SYSTEM-

INFLATION/VOLATALITY

OF INT/EXCH.RATES

6th OCTOBER,1979

SATURDAY NIGHTMASSACRE OF FEDERAL

RESERVE-INT. RATE

DEREGULATIONS/PLR-20%

1971 TO 1979 WATERSHEDS

IN DEVELOPMENT OFWORLD DERIVATIVE

MARKET.


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DERIVATIVES-WHAT ARE THEY?

Financial Instruments/contracts whose value is

derived from the value of the underlying.

The underlying can be:- Agricultural produce-wheat,barley, tea etc.

Stocks-of HUL/Wipro/Zee-telefilms etc.

Stock Index-S & P-500, BSE-500, NSE-Nifty

Treasury bills/notes/bonds etc.

Currencies- Dollars/Pounds/Euro etc.

Interest rates

OR any intangible too!!!-weather, a match, etc.


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Financial derivativesEvolution

of products

Phased introduction to ensure smooth transition to an

active derivatives market

EquityIndex

futures

EquityIndex

options

Stock

options

Stockfutures

Sectoralindices

June 2000 June 2001 July 2001 Nov 2001 June 2003

Interest

Ratefutures

Dec 2002


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DERIVATIVES-GROWTH

130% growth from 1995 to 1998

Notional amount outstanding-

OTC Market- $ 72 trillion ** Exchangetraded- $ 14 trillion

**Of this, Interest rate derivatives-67% and

Exchange rate derivatives31%


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Accelerators to Derivatives

1971-Break down of Fixed Exchange rate system.

Oil price shock- 1971-1973

Excessive government spendings

Expansion in trade/capital flows Dismantling of tariff barriers

Lifting of exchange controls.

Leading to increased volatility in world economy. Information technology/financial theories


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DERIVATIVES-TYPES

PRICE-

FIXING

FORWARDS

FUTURES

FRAS

SWAPS

PRICE-

INSURANCE

OPTIONS


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DERIVATIVES-TYPES

OVER THECOUNTER(OTC)

Over phone/fax/

e-mail] Flexible but limited

liquidity

Physically delivered

E.g:Forwards/FRAs

Swaps/options

EXCHANGE-TRADED

Traded on exchanges

Standardised/high liquidity

Large market players

No physical delivery higherliquidity

Less expensive

E.g:Futures

Swaps/options


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DERIVATIVES-CLASSES

FORWARDS/

FUTURES/SWAPS

Equal

rights/obligations of

buyer and seller

So no upfront paid bybuyer.

OPTIONS

Non-

linear/asymmetric

pay-off. Hence Option

premium upfront.


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DERIVATIVES

A Derivative is an instrument whose value is

derived from the value of one or more underlying

assets, which can be currency, bonds, shares,

indices, metals, commodities etc.


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COMMON DERIVATIVES

FORWARDS FUTURES OPTIONS SWAPS

A customized

contract

between two

parties where

settlement takesplace on a

specific date, in

future, at a price

agreed today.

Are exchange

traded

contracts to

sell or buy

financialinstruments or

physical

commodities

for futuredelivery at an

agreed price.

Are contracts

which give the

buyer (holder) the

right, but not the

obligation, to buyor sell specified

quantity of the

underlying asset,

at a specific(strike) price on or

before a specified

time (expiration

date)

Are contracts

between two

parties,

referred to as

counterparties, to

exchange two

streams of

payments foran agreed

period of

time.


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PLAYERS IN DERIVATIVES MARKET

HEDGERS: Are investors who wish to eliminate or reduceprice risk to which they are already exposed. They providethe economic substance to any financial market.

SPECULATORS: Are investors who willingly take pricerisks to profit from price changes in the underlying asset.They provide liquidity and depth to the market.

ARBITRAGEURS: Profit from a price differential existingin two markets by simultaneously operating in two differentmarkets. They bring price uniformity and help pricediscovery.


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WHY DERIVATIVES

To manage risks more efficiently by unbundling the risksallowing either hedging or taking only one risk at a time. Risks

inherent in a transaction are many.

If we buy a share of TISCO from our broker, we take the

following risks:-1. Price risk-due to co. specific (unsystematic risk)

2. Price risk-due to market sentiments (systematic risk)

3. Liquidity risk-due to large position, being unable to

cover at the prevailing price (called impact cost)

4. Counter party (credit) risk on the broker becomingbankrupt.


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5. Counter party (credit) risk on the Exchangein case of

brokers default, only partial or full compensation from the

Exchange.

6. Cash out-flow risk-unable arrange funds at the time of

delivery resulting in default, auction and subsequent losses.

7. Operating risk like errors, omissions, loss of documents,

frauds, forgeries, delay in settlement, loss of dividend, and

other corporate actions.

Sum up: If we are long on TISCO (buy futures contract) we can

Hedge the systematic risk (market sentiments) by going short(selling futures contract) on index futures. On the other hand, if

we do not want to take unsystematic risk (co. failure), we can go

long on index futures without buying any individual share


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DERIVATIVES-SWAPS

Exchange of two streams of Cash Flows over adefinite period of time through anintermediary.

Multi-periodprice fixing contracts Transforms characteristics of financial claims.

Access to financial markets and varied needs

give rise to Swaps


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Derivatives-Swaps

ECONOMIC RATIONALE:

Principle of Comparative advantage.

Principle of offsetting risk.

TYPES:

INTEREST RATE SWAPS CURRENCY SWAPS


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SWAP CONTRACTS

1. A Currency Swap helps in lowering funding cost, entering

restricted capital markets, reducing currency risks, etc.

2. Interest Rate swaps help in reducing cost of capital.

3. Asset Swap is used to change the characteristics of theasset held.

4. Commodity Swaps are used by dealers to manipulate

payments of their products.

5. Equity Swaps are used to hedge the downside risk of themarket.


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DOCUMENTATION

A) Swap agreements are generally initiated over phone and

confirmed within 24 hours.

B) Swap documentation Agreement is standardised.

C) Swap Agreement can be exited by termination and

assignment. The marked to market value of the swap isdetermined to settle a gain or loss.


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SWAPAN EXERCISE

Exchange Rates: Spot GBP - $ 1.6400

Interest Rates: GBP = 7.5%

USD = 5.5%

Forward rate for 1 year (assume) = same as spot rate.

A SWAP can be arranged by borrowing $ 1 ml. at 5.5% and

placing it in GBP at 7.5% for one year.

SWAP ACTIVITY = Sell Spot USD and Buy Forward USD


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Spot GBP/USD rate = GBP 655488 = $ 1055000

1 GBP = $ 1.60949

Forward GBP/USD rate = 1 GBP = $ 1.6400

Therefore Forward difference = 0.03051

Activity GBP (inflow) GBP (outflow) $ (inflow) $ (outflow)

Spot borrow ---- ---- 1000000 ----

Sell $ spot 609756 ---- ---- 1000000

One year

interest

45732

(earned)

---- ---- 55000

(pay)

Total 655488 1055000

1-year hence

Sell GBP @

1.6400

---- 655488 1075000 ----

Net Gain ---- ---- 20000 ----


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Options contracts

Nature and type of Options:

Party CALL OPTIONS PUT OPTIONS

Option buyer or

Option holder

Buys the right to buy

the underlying assetat the specified price

Buys the right to sell

the underlying assetat the specified price

Option Seller or

Option writer

Has the obligation to

sell the underlying

asset (to the option

holder) at the

specified price

Has the obligation to

buy the underlying

asset (from the

option holder) at the

specified price


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TERMINOLOGY IN OPTIONS

CONTRACT

Term used CALL OPTIONS PUT OPTIONS

Inthemoney Strike Price < Spot

Price of underlying

asset

Strike Price > Spot

Price of underlying

asset

Atthemoney Strike Price = Spot

Price

Strike

Out- ofthe

money

Strike Price >Spot

Price

Strike Price


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OPTIONS CONTRACT

FEATURES:

High leverage- by investing small sum (premium) one

can take large exposure of greater value. Pre-known maximum risk for an option buyer.

Large profit potential for option buyer.

Limited risk.

Good protection for equity portfolio.

Index options enable exposure to a large market.

An ESOP holder can buy Put option to cover the risk.


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PROCEDURE FOR TRADING IN

OPTIONS

The investor to register with a broker who is a member ofthe Derivatives Segment of the stock exchange.

Can buy a Sensex Call or Put Option through the broker.The premium paid in cash up-front.

Can hold on till maturity or reverse the same in between.If closed out, he will receive the premium in cash the nextday.

If held till maturity and exercised, the investor will get the

difference between Option Settlement Price and the StrikePrice in cash. If option is not exercised, the premium is aloss and contract expires.


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WHY FUTURES TRADING

Efficient and transparent price discovery

Price Risk Mgmt. for hedgers

Price dissemination No counter- party risk

Integration of markets at National Level.


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DERIVATIVES-FUTURES

Exchange Traded & Price fixing contracts.

Single Period contract

Standardisation of :- Quality and Quantity

Expiration months

Delivery terms & Delivery dates

Tick size, daily price limit, trading hours/days.


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DERIVATIVES-FUTURES

THEY ARE AKIN TO DAILY SETTLED

FORWARD CONTRACTS

INITIAL MARGINS/DAILY MARGINS

HIGHLY GEARED /LEVERAGEDINSTRUMENTS

MARKING TO MARKET ON DAILY BASIS

HIGHLY LIQUID/SETTLED BY CLOSING OUT


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DERIVATIVES-FUTURES

BENEFITS:-

PRICE DISCOVERY

HEDGING

SPECULATIONS ABSENCE OF CREDIT RISK

HIGH LEVERAGE

PRICING- COST OF CARRY MODELEXPECTATIONS MODEL


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FUTURES CONTRACT

FEATURES:1. Being Exchange traded, the contract has terms standardized

by the exchange.

2. Once the trade is confirmed, the Exchange itself becomesthe counter party (or guarantees) to every trade. Credit risk

gets transferred to the exchange, reducing the risk to almostnil.

3. Due to market reporting of volumes and price, the contractis more liquid and transparent.

4. A Futures contract can be reversed with any member of theexchange.

5. Due to price volatility of an individual stocks, the futuresare generally Index-Based.


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PRICING

A Futures Contract is priced at:-

Spot Price plus Cost of Carry.

Cost of Carry is the sum of all costs incurred if a similar

position is taken in cash market and carried to maturity less any

revenue which may result in this period.

Cost includes interest in case of financial futures (also insurance

and storage cost in case of commodity futures). The revenue

may be dividend in case of Index futures.Actual value may vary depending on demand/supply of the

underlying asset at present and the future expectations.


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BARINGS BANK

233 years old, the British Bank goes bankrupt on 26th

Feb.. 1995. The downfall was attributed to a single

trader, 28 year old, Nick Leeson. The loss was on

account of large exposure to the Japanese futuresmarket. Leeson, chief trader for Bankings futures in

Singapore took huge position in index futures of Nikkie-

225. Market falls by more than 1.5% in the first two

months of 1995 and Barings suffered huge losses. TheBank lost $ 1.3 bl. on account of derivative trading. The

loss wiped out the entire capital of Bearings.


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FORWARD CONTRACTS

BILATERAL CONTRACTS WHERE

BUYER AND SELLER AGREE UPON THE

DELIVERY OF A SPECIFIED

QUANTITY/QUALITY OF ASSET AT ASPECIFIED TIME AT A PRE-

DETERMINED PRICE.

HENCE AN OTC DERIVATIVE


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FORWARD CONTRACTS

FEATURES:

Being Bilateral contract, exposed to counter party risk.

Each contract is custom designed and unique.

Contract price is not available in public.

Contract is settled by delivery of the asset on expiration date.

If contract has to be reversed. The counterpart party can command over

price.

EXAMPLE

A corn merchant selling his entire future crop of next season

corn at a predetermined price today.

ADVANTAGE

Protection against fall in price for the seller.

A determined future liability for the buyer.


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FORWARD CONTRACTS-

FEATURES

OTC DERIVATIVE-PRICE FIXING

PRODUCT

FORWARD PRICE = SPOT OR CASH

PRICE + COST OF CARRY

LIMITATIONS-CREDIT RISK.


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DERIVATIVES-FORWARD

RATE AGREEMENT

FORWARD FIXING OF INTEREST RATES

ON MONEY MARKET TRANSACTIONS

ON NOTIONAL FUTURE LOAN /DEPOSIT

FOR A SPECIFIED PERIOD

QUOTED AS 3 vs. 6, 3 x 6 etc.

TWO WAY BIDS- SAY 4.35-4.40 %


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DERIVATIVES-FRAs

Price fixing & OTC product.

Inter-Bank tool for hedging short term interest raterisk.

No upfront premium payable Min size $ 5 million

3 to 6 months are most liquid & traded

Maximum upto 2 years

FRAs available in currencies where there are noFutures.

FM-REV-DERIVE-F

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