Derivatives Presentation on 5th December 2007 1218215674168576 9

8/9/2019 Derivatives Presentation on 5th December 2007 1218215674168576 9

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Derivatives

Prof.L. Augustin Amaladas

M.com.,AICWA.,PGDFM.,B.Ed.

5th December 2007

What do you mean by rest?


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Why does BSE index movesupwards and volatile?

Mortgage market?


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Reasons

In USA most of the banks engaged in mortgagemarket by lending without seeing the client's creditworthiness. But most of the customers fail to repaythe long term loan. The banks are allowed to recover

such loans by sale of such properties. The total funds have to be reinvested in profitable

way. Most of the banks see(BRIC countries)India isone of the countries where they can get better returnand also indias inflation is arround 4% and growth

rate is around 9%. BRIC-Bracil, Russia, India and China


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Leading Investment and

Commercial banks Banc of America Securities LLC Citigroup

Credit Suisse

Goldman Sachs

JPMorganChase

Lehman Brothers

Merrill Lyn

ch Morgan Stanley

UBS


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banks in the international markets

Categories of banks in the international markets:

1. commercial banks-JP Morgan Chase

2.investment banks-Goldman Sachsas, Londoninvestment bank Morgan Grenfell Bankers Trustin New York, Crdit Lyonnais Belgium ,BrusselsMoscow-based investment bank United

Financial Group inR

ussia ,the Germannorisbank and Berliner Bank.

3.mixed banks-HSBC


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Investment And Commercial Banks

Differ? Commercial Banks (CB) acceptdeposits and make commercial loansas a financial intermediary.

CB traditionally could underwrite onlylow-risk securities of governments perthe Glass-Steagall Act.

Many large firms now use the directfinancial markets to finance rather thanbank loans.


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RISK /Uncertain???

Case-1 An Indian Garments company has received an

order to supply I,00,000 units of shirts from USA.The price of $ 500,000 is receivable after sixmonths. The current exchange rate isRs.39.76/$. At the current exchange rate, thecompany would get: 39.76 500,000 = Rs1,98,80,000. But the company anticipates

appreciation of Indian rupee over time. Does thecompany loose/gain due to appreciation in theIndian Rupee? How does company minimise therisk?

Alternative work is rest


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Minimising risk case-1

The company can lock in the exchangerate by entering into an advance contractand forget about any fluctuation in the

exchange rate. Suppose, the six-monthforward exchange rate is Rs39.00/$ Thecompany can make an agreement at spotrate at 39.76 in the spot market or at alesser price. At the time of receiving dollar,it will exchange $500,000 at Rs39.76= Rs1,98,80,000. or agreed price.

Happiness by giving/receiving?


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Case 2

You have imported machinery for $ 100,000 on 180 dayscredit at zero interest. The dollar quotes at Rs 39. Isthis deal risk free?

This deal is not free of risk because after six monthswhen you pay the loan, if the dollar quotes anythingmore than Rs39., say Rs 40, you will end up payingmore [Rs 1 extra for every $ 1, which is equivalent to Rs100,000 additional cost]. On the other hand, if the dollarquotes anything less than Rs 39, you will stand to gain

The question here is not whether you stand to gain orloose it is the riskyou are taking

You have imported machinery for $ 100,000 on 180 dayscredit at zero interest. The dollar quotes at Rs 39. Isthis deal risk free?

This deal is not free of risk because after six monthswhen you pay the loan, if the dollar quotes anythingmore than Rs39., say Rs 40, you will end up payingmore [Rs 1 extra for every $ 1, which is equivalent to Rs100,000 additional cost]. On the other hand, if the dollarquotes anything less than Rs 39, you will stand to gain

The question here is not whether you stand to gain orloose it is the riskyou are taking

Happiness by giving not receiving


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Case 03

You have surplus cash for investment. Youthink of investing in Wipro, currently quoting atRs 3,500, which you believe will rise to Rs 3,950

in six months. Is this deal risk free? This deal is not free of risk because there is no

guarantee that Wipros shares would touch Rs3,950 in six months time.

The share prices could rise beyond Rs 3,950 orcould also fall below Rs 3,500 giving you noreturn on investment and you could stand toloose some portion of your investment

Old lady in a seashore!....


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How do you protect yourself ?

Use Derivative instruments.

What is derivatives?

See the next example.

Picking up something?...


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Example

You [along with two friends] want to go for theAero India January 2008 air show, for whichtickets are sold out. Through one of your closefriends, you obtain a recommendation letter,

which will enable you to buy three tickets. Theprice of a ticket is Rs 1,000.

Which is the commodity that you are suppose tobuy?

In order to buy the________ what are requirednow? Money/recommendation letter (instrument) or

both?

People walking in the seashore scared?...


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Financial instruments

The recommendation letter is a derivativeinstrument. It gives you a right to buy the ticket

The underlying asset is the ticket

The letter does not constitute ownership of theticket

It is indeed a promise to convey ownership

The value of the letter changes with changes inthe price of the ticket. It derives its value fromthe value of the ticket

Children are scared to go near by?...


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Different risk coverage

Firms are exposed to several risks in the ordinary courseof operations and borrowing funds.

For some risks, management can obtain protectionfrom an insurance company(fire,loss of profit,loss of

stock,marine insurance)

Similarly, there are capital market products available toprotect against certain risks. Such risks include risksassociated with a rise in the price of commoditypurchased as an input, a decline in a commodityprice of a product the firm sells, a rise in the cost ofborrowing funds and an adverse exchange ratemovement. The instruments that can be used toprovide such protection are called derivative instruments

What was see doing? Why?...


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Meaning

Derivative instruments are called so becausethey derive their value from whatever thecontract is based on

Aderivative contract is a financial instrumentwhose payoff structure is derived from the value

of the underlying asset

These instruments include futures contracts,forward contracts, options contracts, swapagreements, and cap and floor agreements

See the next slide


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Advantages

The derivative market helps people meetdiverse objectives such as:

Hedging Profit making through price changes

Profit making through arbitrage

Guess what does she pick up?


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uses

Price discovery Most price changes are first reflected in the derivative market.

That way derivative market feeds the spot market

For instance, if the dollars are going down, it means that the

professional investors are expecting dolor price to go down inthe future this is a good sign for you to buy in the spot market

Risk transfer A derivative market is like an insurance company

Derivative instruments redistribute the risk amongst market

players However, if you want protection against adverse pricemovements, you must pay a price, ie the premium

Children are not allowed to go near by!


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Derivative instruments on

Stocks (Equity)

Agri Commodities including grains, coffee beans, pepper,.

Precious metals like gold and silver.

Crude oil

Foreign exchange rate

Bonds

Short-term debt securities such as T-bills

Index

Interest rate

The old lady looked shabby


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TYPES OF DERIVATIVES

Futures

Forwards

Option

Floor

cap

Policemen also ask the public to go away from her


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Players in the market

Banks-Citi Bank

Deutsche Bank

Goldman Saches JP Morgan Chase

HSBC

ICICI

See next slide


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Old lady in a seashore?Old lady in a seashore?

She picked up broken glasses fromseashore?

Picked up stones? Does she harm anybody?


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What is your answer?


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Broken glasses should not

harm the children


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Lesson:1 What we perceive may notbe what is real

Judge not based on outlook /

colour

Lesson-2


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Ways of making contract?

1. Private contracts- Known as Forwards

2. Through Stock - Known as

exchanges Futures, OptionsSwap, Floor andCap

Threat is an opportunity


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How do they settle the contract?

Daily basis -Known as Marking to market

Present strengths are your threats


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How does stock exchange operate?

It collects amounts from both the partiesof contract known as Initial Margin Money.

Stock Exchange also collect additionalmargin money is known as VariationMargin.


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Important terms

LIBOR SWAP OPTION HODER EXERCISE THE CONTRACT CURRENCY SWAPS

INTEREST SWAPS PREMIUM AMERICAN OPTION EUROPEAN OPTION BERMUDA OPTION OPTION HOLDER

OPTION WRITER CALL OPTION PUT OPTION LONG SHORT

STRIKE PRICE

SPOT PRICE

EXPIRY OFCONTRACT

BASIS RISK

COUNTER PARTY RISK


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QUESTIONS?

Thank you for all professors & students ofII B.Com classes of SJCC .

By Prof.Augustin Amaladas

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Derivatives Presentation on 5th December 2007 1218215674168576 9