Intro Fdrm

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    Introduction

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    What is a Derivative?

    A derivative is an instrument whose value

    depends on, or is derived from, the value

    of another asset.

    Examples: futures, forwards, swaps,

    options, exotics

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    Underlying Assets

    Commodities including grain, coffee beans,orange juice;

    Precious metals like gold and silver;

    Foreign exchange rates or currencies;

    Bonds of different types, including medium tolong term negotiable debt securities issued bygovernments, companies, etc.

    Shares and share warrants of companiestraded on recognized stock exchanges and

    Stock Index Short term securities such as T-bills; and

    Over- the Counter (OTC)2 money marketproducts such as loans or deposits.

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    Participants

    Hedgers:They use derivatives markets to reduce oreliminate the risk associated with price of an asset.Majority of the participants in derivatives marketbelongs to this category.

    Speculators:They transact futuresand options

    contracts to get extra leverage in betting on futuremovements in the price of an asset. They canincrease both the potential gains and potential lossesby usage of derivatives in a speculative venture.

    Arbitrageurs:Their behavior is guided by the desire to

    take advantage of a discrepancy between prices ofmore or less the same assets or competing assets indifferent markets. If, for example, they see the futuresprice of an asset getting out of line with the cashprice, they will take offsetting positions in the twomarkets to lock in a profit.

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    Financial Weapons of Mass Destruction??Year

    Amount (USD in bn) Country Organization Key Player Instruments

    2008 USD 9 bn USA Morgan Stanley Howie Hubler credit default Swaps

    2008 7.1 France Societe Generale Jerome Kerviel Equity Index Futures

    2006 6.5 Canada Amaranth Advisors Brian Hunter Natural Gas Futures

    1998 4.6 USA

    Long Term Capital

    Management John Meriwether

    Interest

    rate/equity/currency

    futures

    1996 2.6 Japan Sumitomo Corporation Yasuno Hamanaka Copper Futures

    2008 BRL 4.62 bn brazil Aracruz

    Isac Zagury, Rafael

    Sotero FX options

    2011 USD 2 bn UK UBS Kweku Adoboli

    Equities, ETF and Delta

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    1994 1.7 USA Orange County Robert Citron

    Interest rate

    derivatives

    2006 1.9 Austria Bawag Bank

    Helmut Elsner,

    Wolfgang Flottl,Johann Zwettler

    Foreign ExchangeTrading

    1993 DEM 2.63 bn Germany Metallgesellschaft Heinz Schimmelbusch Oil Futures

    2008 HKD 14.7 bn China CITIC Pacific Frances Yung

    Foreign Exchange

    Trading

    2008 USD 1.8 bn USA Deutsche Bank Boaz Weinstein Derivatives

    1995 1.32 UK Barings Bank Nick Leeson Nikkei Futures5

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    Applications

    Management of risk

    Efficiency in trading

    Speculation

    Price discovery Price stabilization function

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    CLASSIFICATION OF DERIVATIVES

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    Forward Contract

    agreement between two parties to buy or

    sell an asset at a specified point of time in

    the future

    the price which is paid/ received by the

    parties is decided at the time of entering

    into contract

    It is the simplest form of derivative contract

    mostly entered by individuals in day to

    days life.

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    One of the parties to a forward contract

    assumes a long position (buyer) and

    agrees to buy the underlying asset at a

    certain future date for a certain price.

    The other party to the contract known as

    seller assumes a short position and agrees

    to sell the asset on the same date for the

    same price.

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    The specified price is referred to as the

    delivery price.

    The contract terms like delivery price and

    quantity are mutually agreed upon by the

    parties to the contract.

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    Futures Contracts

    Agreement to buy or sell an asset for a certain

    price at a certain time

    Similar to forward contract

    Whereas a forward contract is traded OTC, a

    futures contract is traded on an exchange

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    Exchanges Trading Futures

    CME Group (formerly Chicago Mercantile

    Exchange and Chicago Board of Trade)

    NYSE Euronext

    BM&F (Sao Paulo, Brazil) TIFFE (Tokyo)

    and many more (see list at end of book)

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    Futures Contract Standardized

    Terms

    1. Quantity

    2. Quality

    3. Expiration months

    4. Delivery terms

    5. Delivery differentials

    6. Delivery dates

    7. Minimum price fluctuation

    8. Daily price limits

    9. Trading days and hours

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    Forward Versus Futures

    COMPARISON FORWARD FUTURES

    Trade on organized exchanges No Yes

    Use standardized contract terms No Yes

    Use associate clearinghouses to guarantee contract fulfillment No Yes

    Require margin payments and daily settlements No Yes

    Close easily No Yes

    Regulated by identifiable agencies No Yes

    Any quantity Yes No

    Any product Yes No

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    Options An option is the right, but not the

    obligation, to buy or sell something at a

    stated date at a stated price

    A call option is an option to buy a certain

    asset by a certain date for a certain price

    (the strike price)

    A put option is an option to sell a certain

    asset by a certain date for a certain price

    (the strike price)

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    American vs European Options

    An American option can be exercised at

    any time during its life

    A European option can be exercised only

    at maturity

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    Options vs Futures/Forwards

    A futures/forward contract gives the holder

    the obligation to buy or sell at a certain

    price

    An option gives the holder the right to buy

    or sell at a certain price

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    SWAPS

    A swapcan be defined as a barter orexchange.

    a swap is an agreement between two or

    more parties to exchange stream of cash

    flows over a period of time in the future.

    The parties that agree to the swap are

    known as counter parties

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    Interest rate swapswhich entail swappingonly the interest related cash flows

    between the parties in the same currency

    Currency swaps: These entail swappingboth principal and interest between the

    parties, with the cash flows in one direction

    being in a different currency than the cash

    flows in the opposite direction.

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    How to Avoid Derivative Disasters?

    Set up controls to ensure derivatives are being used for

    their intended purpose.

    Risk limits should be set and the activities of traders

    should be monitored daily to ensure that these risk limitsare adhered to.

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    Indian Derivatives Market

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    Regulations

    Based on the L.C. Gupta Committee

    Report, and the J.R. Varma Committee

    Report.

    It is mostly consistent with the IOSCO5

    principles and addresses the common

    concerns of investor protection, market

    efficiency and integrity and financial

    integrity

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    Products traded in Derivatives Segment in BSE

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    Products traded in F&O segment of NSE

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    Index Futures

    Turnover (RsCr), 2000-01,

    2365

    Turnover (RsCr), 2001-02,

    21483

    Turnover (RsCr), 2002-03,

    43952

    Turnover (RsCr), 2003-04,

    554446

    Turnover (RsCr), 2004-05,

    772147

    Turnover (RsCr), 2005-06,

    1513755

    Turnover (RsCr), 2006-07,

    2539574

    Turnover (RsCr), 2007-08,

    3820667

    Turnover (Rs

    Cr), 2008-09,3570111

    Turnover (RsCr), 2009-10,

    3934388

    Turnover (RsCr), 2010-11,

    4356754

    Turnover (RsCr), 2011-12,

    3577998

    Turnover (RsCr), , 0

    Turnover (Rs Cr)

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    Stock Futures

    Turnover (RsCr), 2000-01, 0

    Turnover (RsCr), 2001-02,

    51515

    Turnover (RsCr), 2002-03,

    286533

    Turnover (RsCr), 2003-04,

    1305939

    Turnover (RsCr), 2004-05,

    1484056

    Turnover (Rs

    Cr), 2005-06,2791697

    Turnover (RsCr), 2006-07,

    3830967

    Turnover (RsCr), 2007-08,

    7548563

    Turnover (RsCr), 2008-09,

    3479642

    Turnover (RsCr), 2009-10,

    5195246

    Turnover (Rs

    Cr), 2010-11,5495756

    Turnover (RsCr), 2011-12,

    4074670

    Turnover (RsCr), , 0

    Turnover (Rs Cr)

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    Index Options

    Column1,

    2000-01, 3765

    Column1,2001-02, 9246

    Column1,2002-03,

    52816

    Column1,2003-04,121943

    Column1,

    2004-05,338469

    Column1,2005-06,791906

    Column1,2006-07,1362110

    Column1,2007-08,3731501

    Column1,

    2008-09,8027964

    Column1,2009-10,18365365

    Column1,2010-11,

    22720031

    Turnover (Rs Cr)

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    Stock Options

    Series 1,2000-01,

    25163

    Series 1,2001-02,100131

    Series 1,2002-03,217207 Series 1,

    2003-04,168836

    Series 1,2004-05,180253

    Series 1,2005-06,193795

    Series 1,2006-07,

    359136Series 1,2007-08,229226

    Series 1,2008-09,506065

    Series 1,2009-10,1030344

    Series 1,2010-11,977031

    Turnover (Rs Cr)

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    Source: Bank of International Settlement

    Global Perspective

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    Foreign Exchange Contracts

    Column1,Dec-13,49181

    Column1,Jun-14,53153

    Column1,Dec-14,57796

    Column1,Jun-15,64698

    Column1,Dec-15,63349

    y = 21.849x - 827495R = 0.9131

    USD Bn

    Source: BIS

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    Interest Rate Contracts

    Series 1, Dec-13, 449875

    Series 1, Jun-14, 451831

    Series 1, Dec-14, 465260

    Series 1, Jun-15, 553240

    Series 1, Dec-15, 504098

    USD Bn

    Source: BIS

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    Equity-linked Contracts

    Series 1, Dec-13, 5937

    Series 1, Jun-14, 6260

    Series 1, Dec-

    14, 5635

    Series 1, Jun-15, 6841

    Series 1, Dec-

    15, 5982

    USD Bn

    Source: BIS

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    Commodity Contracts

    Column1,Dec-13, 2944

    Column1,Jun-14, 2852

    Column1,Dec-14, 2922

    Column1,Jun-15, 3197

    Column1,Dec-15, 3091

    USD Bn

    Source: BIS

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    Credit Default Swaps

    Series 1, Dec-13, 32693

    Series 1, Jun-

    14, 30261

    Series 1, Dec-

    14, 29898

    Series 1, Jun-15, 32409

    Series 1, Dec-15, 28633

    USD Bn

    Source: BIS