Derivatives Final Ppt

7/31/2019 Derivatives Final Ppt

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IntroductionIntroduction

The origin of derivatives can beThe origin of derivatives can be

traced back to the need of farmers totraced back to the need of farmers to

protect themselves againstprotect themselves against

fluctuations in the price of their crop.fluctuations in the price of their crop.

In 1848, the Chicago Board OfIn 1848, the Chicago Board Of

Trade, or CBOT, was established toTrade, or CBOT, was established tobring farmers and merchantsbring farmers and merchants

together.together.

In 1925 the first futures clearingIn 1925 the first futures clearing


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DefinitionDefinition

A derivative is a product whose valueA derivative is a product whose value

is derived from the value of one oris derived from the value of one or

more underlying variables or assetsmore underlying variables or assets

in a contractual manner. Thein a contractual manner. The

underlying asset can be equity,underlying asset can be equity,

forex, commodity or any other asset.forex, commodity or any other asset.

The Forwards Contracts (Regulation)The Forwards Contracts (Regulation)Act, 1952, regulates theAct, 1952, regulates the

forward/futures contracts inforward/futures contracts in

commodities all over India.commodities all over India.


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What do derivatives do?What do derivatives do?

Derivatives attempt either toDerivatives attempt either to minimizeminimize

the lossthe loss arising from adverse pricearising from adverse price

movements of the underlying assetmovements of the underlying asset

OrOr maximize the profitsmaximize the profits arising out ofarising out of

favorable price fluctuation. Sincefavorable price fluctuation. Since

derivatives derive their value from thederivatives derive their value from the

underlying asset they are called asunderlying asset they are called asderivatives.derivatives.


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Types of DerivativesTypes of Derivatives

((UA: Underlying Asset)UA: Underlying Asset)

Based on theBased on the underlying assetsunderlying assetsderivatives are classified into.derivatives are classified into.Financial Derivatives (UA: Fin asset)Financial Derivatives (UA: Fin asset)

Commodity Derivatives (UA: gold etc)Commodity Derivatives (UA: gold etc)

Index DerivativeIndex Derivative (BSE sensex)(BSE sensex)


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How are derivatives used?How are derivatives used?Derivatives are basicallyDerivatives are basically risk shiftingrisk shifting

instruments. Hedging is the mostinstruments. Hedging is the mostimportant aspect of derivatives and alsoimportant aspect of derivatives and alsotheir basic economic purposetheir basic economic purpose

Derivatives can be compared to anDerivatives can be compared to aninsurance policy. As one pays premium ininsurance policy. As one pays premium inadvance to an insurance company inadvance to an insurance company inprotection against a specific event, theprotection against a specific event, the

derivative products have a payoffderivative products have a payoffcontingent upon the occurrence of somecontingent upon the occurrence of someevent for which he pays premium inevent for which he pays premium inadvance.advance.


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What is Risk?What is Risk?

The concept of risk is simple. It isThe concept of risk is simple. It is

the potential for change in the pricethe potential for change in the price

or value of some asset oror value of some asset or

commodity. The meaning of risk iscommodity. The meaning of risk isnot restricted just to the potential fornot restricted just to the potential for

loss. There is upside risk and there isloss. There is upside risk and there is

downside risk as well.downside risk as well.


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Derivative Instruments.Derivative Instruments.Forward contractsForward contracts

FuturesFutures CommodityCommodity

Financial (Stock index, interest rate &Financial (Stock index, interest rate &

currency )currency )OptionsOptions

PutPut

CallCallSwaps.Swaps.

Interest RateInterest Rate

CurrencyCurrency


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Forward Contracts.Forward Contracts.A one to one bipartite contract, which is to beA one to one bipartite contract, which is to be

performed in future at the terms decided today.performed in future at the terms decided today.

Eg: Jay and Viru enter into a contract to tradeEg: Jay and Viru enter into a contract to trade

in one stock on Infosys 3 months from todayin one stock on Infosys 3 months from today

the date of the contract @ a price of Rs4675/-the date of the contract @ a price of Rs4675/-

Note: Product ,Price ,Quantity & Time haveNote: Product ,Price ,Quantity & Time havebeen determined in advance by both thebeen determined in advance by both the

parties.parties.

Delivery and payments will take place as perDelivery and payments will take place as perthe terms of this contract on the designatedthe terms of this contract on the designated

date and place. This is a simple example ofdate and place. This is a simple example of

forward contract.forward contract.


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Risks in a forward contractRisks in a forward contract

Liquidity risk: these contracts aLiquidity risk: these contracts a

biparty and not traded on thebiparty and not traded on theexchange.exchange.

Default risk/credit risk/counter partyDefault risk/credit risk/counter party

risk.risk.Say Jay owned one share of InfosysSay Jay owned one share of Infosys

and the price went up to 4750/-and the price went up to 4750/-

three months hence, he profits bythree months hence, he profits bydefaulting the contract and sellingdefaulting the contract and selling

the stock at the market.the stock at the market.


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Futures.Futures.

Future contracts are organized/standardizedFuture contracts are organized/standardized

contracts in terms of quantity, quality, deliverycontracts in terms of quantity, quality, deliverytime and place for settlement on any date intime and place for settlement on any date infuture. These contracts are traded onfuture. These contracts are traded onexchangesexchanges..

These markets are very liquidThese markets are very liquidIn these markets, clearing corporation/houseIn these markets, clearing corporation/housebecomes the counter-party to all the trades orbecomes the counter-party to all the trades orprovides the unconditional guarantee for theprovides the unconditional guarantee for the

settlement of trades i.e. assumes the financialsettlement of trades i.e. assumes the financialintegrity of the whole system. In other words,integrity of the whole system. In other words,we may say that the credit risk of thewe may say that the credit risk of thetransactions is eliminated by the exchangetransactions is eliminated by the exchange

through the clearing corporation/house.through the clearing corporation/house.


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The key elements of a futures contractThe key elements of a futures contract

are:are:

Futures priceFutures price

Settlement or Delivery DateSettlement or Delivery Date

Underlying (infosys stock)Underlying (infosys stock)


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Illustration.Illustration.

Let us once again take the earlierLet us once again take the earlierexample where Jay and Viru enteredexample where Jay and Viru entered

into a contract to buy and sell Infosysinto a contract to buy and sell Infosys

shares. Now, assume that this contractshares. Now, assume that this contract

is taking place through the exchange,is taking place through the exchange,

traded on the exchange and clearingtraded on the exchange and clearing

corporation/house is the counter-partycorporation/house is the counter-party

to this, it would be called a futuresto this, it would be called a futurescontract.contract.


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Positions in a futures contractPositions in a futures contract

LongLong - this is when a person buys a- this is when a person buys a

futures contract, and agrees tofutures contract, and agrees to

receive delivery at a future date. Eg:receive delivery at a future date. Eg:

Virus positionVirus position

ShortShort - this is when a person sells a- this is when a person sells a

futures contract, and agrees to makefutures contract, and agrees to make

delivery. Eg: Jays Positiondelivery. Eg: Jays Position


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OptionsOptionsAn option isAn option is a contract giving thea contract giving the

buyer the right, but not thebuyer the right, but not theobligation, to buy or sell anobligation, to buy or sell an

underlying asset at a specific price onunderlying asset at a specific price on

or before a certain dateor before a certain date. An option is a. An option is asecurity, just like a stock or bond, and issecurity, just like a stock or bond, and is

a binding contract with strictly defineda binding contract with strictly defined

terms and properties.terms and properties.


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Options LingoOptions Lingo

Underlying:Underlying: This is the specificThis is the specific

security / asset on which an optionssecurity / asset on which an optionscontract is based.contract is based.

Option Premium:Option Premium: Premium is thePremium is the

price paid by the buyer to the sellerprice paid by the buyer to the sellerto acquire the right to buy or sell. Itto acquire the right to buy or sell. Itis the total cost of an option. It is theis the total cost of an option. It is thedifference between the higher pricedifference between the higher price

paid for a security and the security'spaid for a security and the security'sface amount at issue. The premiumface amount at issue. The premiumof an option is basically the sum ofof an option is basically the sum ofthe option's intrinsic and time value.the option's intrinsic and time value.


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Strike Price or Exercise PriceStrike Price or Exercise Price ::price ofprice of

an option is the specified/ pre-an option is the specified/ pre-

determined price of the underlying assetdetermined price of the underlying assetat which the same can be bought or soldat which the same can be bought or sold

if the option buyer exercises his right toif the option buyer exercises his right to

buy/ sell on or before the expiration day.buy/ sell on or before the expiration day.Expiration dateExpiration date:: The date on which theThe date on which the

option expires is known as Expirationoption expires is known as Expiration

DateDate

Exercise:Exercise: An action by an option holderAn action by an option holder

taking advantage of a favourable markettaking advantage of a favourable market

situationsituation .Trade in the option for stock..Trade in the option for stock.


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Exercise Date:Exercise Date: is the date on which theis the date on which theoption is actually exercisedoption is actually exercised..

European style of options:European style of options: TheTheEuropean kind of option is the one whichEuropean kind of option is the one whichcan be exercised by the buyer on thecan be exercised by the buyer on theexpiration day only & not anytime beforeexpiration day only & not anytime before

that.that.American style of options:American style of options: An AmericanAn Americanstyle option is the one which can bestyle option is the one which can be

exercised by the buyer on or before theexercised by the buyer on or before theexpiration date, i.e. anytime between theexpiration date, i.e. anytime between theday of purchase of the option and the dayday of purchase of the option and the dayof its expiry.of its expiry.


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Bermuda OptionBermuda Option

They are similar in style to AmericanThey are similar in style to American

style options in that there is astyle options in that there is a

possibility of early exercise, butpossibility of early exercise, but

instead of a single exercise dateinstead of a single exercise date

there are predetermined discretethere are predetermined discrete

exercise dates.exercise dates.

i l f iA i t l f ti h bth i b t


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Asian style of optionsAsian style of options: these are in-between: these are in-between

European and American. An Asian option'sEuropean and American. An Asian option's

payoff depends on the average price of thepayoff depends on the average price of the

underlying asset over a certain period of time.underlying asset over a certain period of time.Option HolderOption Holder

Option seller/ writerOption seller/ writer

Call optionCall option: An option contract giving the: An option contract giving theowner theowner the right to buyright to buy a specified amount ofa specified amount of

an underlying security at a specified pricean underlying security at a specified price

within a specified time.within a specified time.

Put OptionPut Option: An option contract giving the: An option contract giving theowner the right to sell a specified amount of anowner the right to sell a specified amount of an

underlying security at a specified price within aunderlying security at a specified price within a

specified timespecified time

hI th llF ll ti i


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In-the-money:In-the-money: For a call option, in-For a call option, in-

the-money is when the option's strikethe-money is when the option's strike

price is below the market price of theprice is below the market price of the

underlying stock. For a put option, inunderlying stock. For a put option, inthe money is when the strike price isthe money is when the strike price is

above the market price of theabove the market price of the

underlying stock. In other words, thisunderlying stock. In other words, thisis when the stock option is worth moneyis when the stock option is worth money

and can be turned around and exercisedand can be turned around and exercised

for a profit.for a profit.

I t i i V lI t i i V l Th i t i i l fTh i t i i l f


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Intrinsic Value:Intrinsic Value: The intrinsic value of anThe intrinsic value of an

option is defined as the amount by which anoption is defined as the amount by which an

option is in-the-money, or the immediateoption is in-the-money, or the immediate

exercise value of the option when theexercise value of the option when theunderlying position is marked-to-market.underlying position is marked-to-market.

For a call option: Intrinsic Value = SpotFor a call option: Intrinsic Value = SpotPrice - Strike PricePrice - Strike Price

For a put option: Intrinsic Value = StrikeFor a put option: Intrinsic Value = StrikePrice - Spot PricePrice - Spot Price


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PositionsPositionsLong Position:Long Position: The term used when aThe term used when a

person owns a security or commodityperson owns a security or commodityand wants to sell.and wants to sell. If a person is long inIf a person is long in

a security then he wants it to go up ina security then he wants it to go up in

price.price.Short positionShort position: The term used to: The term used to

describe the selling of a security,describe the selling of a security,

commodity, or currency. Thecommodity, or currency. Theinvestor's sales exceed holdingsinvestor's sales exceed holdings

because they believe the price will fall.because they believe the price will fall.

SSummary


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SummarySummaryThe profit and loss profile for aThe profit and loss profile for a

short put option is the mirror imageshort put option is the mirror imageof the long put option. Theof the long put option. The

maximum profit from this positionmaximum profit from this position

is the option price. The theoriticalis the option price. The theoriticalmaximum loss can be substantialmaximum loss can be substantial

should the price of the underlyingshould the price of the underlying

asset fall.asset fall.Buying calls or selling puts allowsBuying calls or selling puts allows

investor to gain if the price of theinvestor to gain if the price of the

underlying asset rises; and sellingunderlying asset rises; and selling


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SwapsSwaps

An agreement between twoAn agreement between twoparties to exchange one set ofparties to exchange one set of

cash flows for another. In essencecash flows for another. In essence

it is a portfolio of forwardit is a portfolio of forwardcontracts. While a forwardcontracts. While a forward

contract involves one exchange atcontract involves one exchange at

a specific future date, a swapa specific future date, a swapcontract entitles multiplecontract entitles multiple

exchanges over a period of time.exchanges over a period of time.

The most popular are interest rateThe most popular are interest rate


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Interest Rate SwapInterest Rate Swap

A B

Fixed Rate of12%

LIBOR

A is the fixed rate receiver and variablerate payer.

B is the variable rate receiver and fixed

Rs50,00,00,000.00 Notional Principle

CounterParty

Counter Party

Th l R h d b t thThe onl R pee e changed bet een the


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The only Rupee exchanged between theThe only Rupee exchanged between the

parties are the net interest payment, notparties are the net interest payment, not

the notional principle amount.the notional principle amount.

In the given eg A pays LIBOR/2*50crs toIn the given eg A pays LIBOR/2*50crs to

B once every six months. Say LIBOR=5%B once every six months. Say LIBOR=5%

then A pays be 5%/2*50crs= 1.25crsthen A pays be 5%/2*50crs= 1.25crs

B pays A 12%/2*50crs=3crsB pays A 12%/2*50crs=3crs

The value of the swap will fluctuate withThe value of the swap will fluctuate with

market interest rates.market interest rates.

If interestIf interest rates declinerates declinefixed ratefixed rate

payerpayer is at ais at a lossloss, If interest, If interest rates riserates risevariable rate payervariable rate payer is at ais at a lossloss..

Conversely if rates rise fixed rate payerConversely if rates rise fixed rate payer


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How Swaps work in real lifeHow Swaps work in real life

Maruti BOA

BOT

LIBOR +3/8%

10.5%Fixed

LIBOR +3/8%


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What is aWhat is a HedgeHedge

To Be cautious or to protect against loss.To Be cautious or to protect against loss.

In financial parlance, hedging is the actIn financial parlance, hedging is the act

of reducing uncertainty about future priceof reducing uncertainty about future price

movements in a commodity, financialmovements in a commodity, financial

security or foreign currencysecurity or foreign currency ..

Thus a hedge is a way of insuring anThus a hedge is a way of insuring an

investment against risk.investment against risk.


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What isWhat is SpeculatorsSpeculators

Speculators wish to bet on futureSpeculators wish to bet on future

movements in the price of an asset.movements in the price of an asset.

Derivatives can give them an extraDerivatives can give them an extra

leverage to enhance their returnsleverage to enhance their returns..

For example, if a speculator believesFor example, if a speculator believes

XYZ Company stock is overpriced,XYZ Company stock is overpriced,

they may short the stock, wait forthey may short the stock, wait forthe price to fall, and make athe price to fall, and make a profitprofit..

It's possible to speculate on virtuallyIt's possible to speculate on virtually

every security,every security,

Wh t iWh t i A bitA bit
http://www.investinganswers.com/financial-dictionary/businesses-corporations/profit-2042http://www.investinganswers.com/financial-dictionary/businesses-corporations/profit-2042http://www.investinganswers.com/financial-dictionary/businesses-corporations/profit-2042


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What isWhat is ArbitrageursArbitrageurs

Over-the-counter (OTC)derivatives are contracts that are traded (andl d) d l b h h h


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( ) (privately negotiated) directly between two parties, without going through anexchange or other intermediary. The largest market for derivatives Largely unregulated with respect to disclosure of information between the

parties.

No central counterparty. Subject to counterparty risk, since each counterparty relies on the other

to perform. Examples:

Swaps Forward rate agreements

Exotic options

Exchange-traded derivatives (ETD) are derivatives products that aretraded via specialized derivatives exchanges.

Exchange acts as an intermediary to all related transactions

Margin posted from both sides of the trade to act as a good faith deposit Provide investors access to risk/reward and volatility characteristics related

to an underlying commodity.

Examples: Futures

Options on Futures

OTC M k t P d tOTC M k t P d t


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OTC Markets: ProductOTC Markets: Product

OverviewOverviewTwo parties agree on the terms of obligations.Two parties agree on the terms of obligations.

Derivatives on unique products are suited to the OTCDerivatives on unique products are suited to the OTC

market.market.

Counterparty risk can be a significant factor in the pricing.Counterparty risk can be a significant factor in the pricing.

Function best when non-standardized agreements areFunction best when non-standardized agreements areneeded -- that is, when delivery dates, locations, quantitiesneeded -- that is, when delivery dates, locations, quantities

or quality adjustments are necessary.or quality adjustments are necessary.

The guarantee that supports an OTC position is as good asThe guarantee that supports an OTC position is as good as

the credit-worthiness of the weaker of the two parties.the credit-worthiness of the weaker of the two parties.

International Swaps and Derivatives Association (ISDA)International Swaps and Derivatives Association (ISDA)agreements or similar bilateral documents required toagreements or similar bilateral documents required to

support trading. These are typically heavily negotiated.support trading. These are typically heavily negotiated.

C dit D f lt S (CDS)C dit D f lt S (CDS)


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Credit Default Swaps (CDS)Credit Default Swaps (CDS)

Definition:Definition: CDS are a financial instrument forCDS are a financial instrument for

swapping the risk of debt default. Credit defaultswapping the risk of debt default. Credit default

swaps may be used for emerging market bonds,swaps may be used for emerging market bonds,

mortgage backed securities, corporate bonds andmortgage backed securities, corporate bonds and

local government bondlocal government bondThe buyer of a credit default swap pays a premiumThe buyer of a credit default swap pays a premium

for effectively insuring against a debt default. Hefor effectively insuring against a debt default. He

receives a lump sum payment if the debt instrumentreceives a lump sum payment if the debt instrument

is defaulted.is defaulted.The seller of a credit default swap receives monthlyThe seller of a credit default swap receives monthly

payments from the buyer. If the debt instrumentpayments from the buyer. If the debt instrument

defaults they have to pay the agreed amount to thedefaults they have to pay the agreed amount to the

buyer of the credit default swapbuyer of the credit default swap


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The market for these securities is enormous. Since 2000, it hasballooned from $900 billion to more than $45.5 trillion.

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Derivatives Final Ppt