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Derivatives Instrument 1. Bhargav2. Mukesh3. Rucha4. Heena5. Ketan

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The term derivative refers to a broad class of financial instrument which mainly include option and future.

These instrument derive their value from the price and other related variables of the underlying assets.

A simple example of derivative is butter which is derivative of milk. The price of butter depends upon price of milk. Which in turn depends upon the demand and supply of milk.

What is a “Derivative”?

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In finance a derivative is a contract that derive its value from performance of an underlying entity.

To derive something from something else.

Derivatives are those financial instrument that derive their value from the other assets.

For Example The price of gold to be delivered after two months

will depend among so many things. On the present and expected price of this commodity

Definition of derivatives

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There are 3 types of traders in the Derivatives Market :

HEDGER

A hedger is someone who faces risk associated with price movement of an asset and who uses derivatives as means of reducing risk.

They provide economic balance to the market.

SPECULATOR

A trader who enters the futures market for pursuit of profits, accepting risk in the endeavor.

They provide liquidity and depth to the market.

Players in Derivatives Market

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ARBITRAGEUR

A person who simultaneously enters into transactions in two or more markets to take advantage of the discrepancies between prices in these markets.

Arbitrage involves making profits from relative mispricing.

Arbitrageurs also help to make markets liquid, ensure accurate and uniform pricing, and enhance price stability

They help in bringing about price uniformity and discovery.

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Broadly it can be classified in two categories:1.Commodities 2.Financial

In case of commodity derivatives underlying assets like wheat, gold, silver, etc.

Whereas in Financial underlying assets are stock, currencies, bonds and other int. Rate bearing securities

Classification of derivatives

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DERIVATIVES

Commodity

BasicInstrument

Forward Futures Option

s Swaps

Financial

ComplexInstruments

Exotic, Swaptions and LEAPS etc

Classification of Derivatives

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Forward contract

Future contract

Option contract

Swap contract

Various types of derivative contracts

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A customized contract between two parties to buy or sell an asset at a specified price on a future date.

A forward contract can be used for hedging.

Forward contract can be customized to any commodity, amount and delivery date.

It’s useful when futures do not exist for commodities and financials being considered

Forward contract

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Over-the-counter (OTC) or off-exchange trading is to trade financial instruments such as stocks, bonds, commodities or derivatives directly between two parties without going through an exchange or other intermediary.

Over-the-counter

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Forward Contract ExampleI agree to sell 500kgs wheat

at Rs.40/kg after 3

months.

Farmer Bread Maker

3 months Later

FarmerBread Maker

500kgs wheat

Rs.20,000

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Long position - Buyer

Short position - seller

Spot price – Price of the asset in the spot market.(market price)

Delivery/forward price – Price of the asset at the delivery date.

Terminology

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A futures contract is similar to the forward contract but is more liquid because it is traded in an organized exchange.

Future contract are standardized. Future contract transaction method is Quoted

and traded on the Exchange

Future contract

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I have bought 1 lot (250 shares) of Reliance 26th July Future @ Rs 700.

If the actual price of Reliance is Rs 800 on the settlement day (26th July), I will buys 250 shares at the contracted price of Rs 700. so I get 100 more per share is my profit.

if the price falls to 650 he loses Rs 50 per share as I have to buy at Rs 700.

Example

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Difference Between Forward & Future

FUTURE FORWARDThey trade on exchanges Trade in OTC markets

Are standardized Are Customized

Identity of Counterparties is irrelevant Identity is relevant

Marked to market( M to M) No Marked to market

Less Costly More Costly

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Options are of two types 1. Call Option2. Put Option

3. Call Option The owner of a Call Option has the right to purchase the

underlying good at a specific price, and this right lasts until a specific date.

2. Put Option The owner of a Put Option has the right to sell the

underlying good at a specific price, and this right lasts until a specific date.

Option

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Call Option Example

Right to buy 100 Reliance shares at a price of Rs.300 per

share after 3 months.

CALL OPTION

Strike Price

Premium = Rs.25/share

Amt to buy Call option = Rs.2500

Current Price = Rs.250

Suppose after a month, Market price is Rs.400, then the option is exercised i.e. the shares are bought.Net gain = 40,000-30,000- 2500 = Rs.7500

Suppose after a month, market price is Rs.200, then the option is not exercised.Net Loss = Premium amt = Rs.2500

Expiry date

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Put Option Example

Right to sell 100 Reliance shares at a price of Rs.300 per

share after 3 months.

PUT OPTION

Strike Price

Premium = Rs.25/share

Amt to buy Call option = Rs.2500

Current Price = Rs.250

Suppose after a month, Market price is Rs.200, then the option is exercised i.e. the shares are sold.Net gain = 30,000-20,000-2500 = Rs.7500

Suppose after a month, market price is Rs.300, then the option is not exercised.Net Loss = Premium amt = Rs.2500

Expiry date

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Option Characteristics Options are created only by buying and selling. Therefore, for every owner of an option, there

is a seller.Options on futures Futures option contract as its underlying good. The structure is similar something physical option owner has the right to exercise and the

seller has the duty to perform on exercise.

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• The call owner receives a long position in the underlying futures

• The call owner also receives a payment that equals the settlement price minus the exercise price of the futures option.

Cont…

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Options Terminology

• Moneyless: Concept that refers to the potential profit or loss from the exercise of the option. An option maybe in the money, out of the money, or at the money.

In the money

At the money

Out of the money

Call Option Put OptionSpot price > strike price

Spot price = strike price

Spot price < strike price

Spot price < strike price

Spot price = strike price

Spot price > strike price

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In a swap, two counter parties agree to enter into a contractual agreement wherein they agree to exchange cash flows at periodic intervals.

Most swaps are traded “Over The Counter”.

Some are also traded on futures exchange market.

Swaps

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Two Way of Swaps

1. Interest rate swaps: These involve swapping only the interest related cash

flows between the parties in the same currency.

2. Currency swaps:  These entail swapping both principal and interest

between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction

Cont..

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Interest Rate Swap Example

Mr A Mr .BSWAPS BANK

8%8.5%

A is fixed Rate gaining interest

B is floating rate gaining interest

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Direct Currency Swap Example

Miss A Firm B

Rupees

Dolour

Miss A is Importing some product then she need a dolour so she swap rupees with dolour

Mr B is coming to India he need rupees so he swap rupees with dolour to miss A

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Firm A has a comparative advantage in borrowing Dollars.

Firm B has a comparative advantage in borrowing Euros.

This comparative advantage helps in reducing borrowing cost and hedging against exchange rate fluctuations.

Comparative Advantage

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Abstract In order to stay in business, a passenger airline has to consistently

generate profits. Profits come only from paying passengers, hence all stratagems must be customer oriented.

In a scenario where there are many airlines competing with each other, one way of attracting passengers is to keep the cost of flying low, while providing value for money.

On the other hand, expenses must tightly controlled to reach and stay at the lowest possible.

Certain expenses are unavoidable; however, one variable that can be kept low through decisive planning and foresight is the cost of fuel, which, at best, can be called volatile.

The Case of Southwest Airlines

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To understand that how the airline company using the derivative instruments for reducing there cost.

Objective

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INTRODUCTION Southwest was formed in 1971. Southwest Airlines, is

the third largest airline in the world as well as in America in terms of passenger aircraft among all of the world's commercial airlines.

It operates more than 540 Boeing 737 aircraft today between 67 cities in the U.S.A. Today, Southwest operates approximately 3,300 flights daily.

Southwest’s business model is the best low cost model yielding considerable profit, while providing value for money.

Southwest Airlines

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On June 12, 2001,Southwest Airlines is concerned about the cost of fuel for Southwest.

High jet fuel prices in the past 18 months have caused havoc in the airline industry. They knows that since deregulation in the industry in 1978, airline profitability and survival depends on controlling costs.

After labor cost, jet fuel is the second largest operating expense. If airlines can control the cost of fuel, they can more accurately estimate budgets and forecast earnings.

Jet fuel prices are largely unpredictable.

Case background

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jet fuel spot prices (Gulf Coast) have been on an overall upward trend since reaching a low at $0.28 per gallon on December 21, 1998.

On September 11, 2000, the Gulf Coast jet fuel spot price was $1.01 per gallon increase of 255 % in the spot price since the low in 1998.

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Southwest’s average fuel cost per gallon in 2000 was $0.7869, which was the highest annual average fuel cost per gallon experienced by the company since 1984.

Although they thought the price of jet fuel would

decrease over the next year, they cannot be sure energy prices are hard to predict. Any political instability in the Middle East could cause energy prices to rise dramatically without much warning.

Southwest’s jet fuel usage to be approximately 1,100 million gallons for next year.

Airlines use derivative instruments based on crude oil, heating oil, or jet fuel to hedge their fuel cost risk.

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Following the Fuel Cost per Gallon for the past 7 years.

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Which kind of player the Southwest Airlines should be?

For what kind of product they can make a strategy?

Which kind of contract they should do? Does basis risk exist for Southwest Airlines in

their strategy?

Questions

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Thank you for your attention crew … !