Financial Derivatives - Vishnu

8/6/2019 Financial Derivatives - Vishnu

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INANCIAL DERIVATIVESby Vishnu Vardhan (Reg # 093J1E0022)



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DEFINITION

Derivative is a product whose value is derivedfrom the value of an underlying asset in acontractual manner. The underlying assetcan be equity, forex, commodity or any

other asset.

Securities Contracts (Regulation) Act, 1956defines Derivative as “A contract which

derives its value from the prices, or index of prices, of underlying securities”.



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Participants in the DerivativesMarket

HEDGERS: Hedgers face risk associated with the price of an

asset. They use futures or options markets to reduce oreliminate this risk.

SPECULATORS: Speculators wish to bet on future movements in the

price of an asset. Futures and options contracts cangive them an extra leverage; that is, they can increaseboth the potential gains and potential losses in aspeculative venture.

ARBITRAGEURS: Arbitrageurs are in business to take advantage of a

discrepancy between prices in two different markets. If,for example, they see the futures price of an assetgetting out of line with the cash price, they will takeoffsetting positions in the two markets to lock in a

profit.



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FUNCTIONS OF DERIVATIVESMARKET

Prices in an organized derivatives marketreflect the perception of market participantsabout the future and lead the prices of underlying to the perceived future level.

Derivatives market helps to transfer risks fromthose who have them but may not like themto those who have an appetite for them.

Derivative trading acts as a catalyst for new

entrepreneurial activity. Derivatives markets help to increase savings

and investment in the long run.



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USES OF DERIVATIVESDerivatives are used by investors to: provide leverage (or gearing), such that a small

movement in the underlying value can cause a largedifference in the value of the derivative;

speculate and make a profit if the value of the

underlying asset moves the way they expect (e.g.,moves in a given direction, stays in or out of aspecified range, reaches a certain level);

hedge or mitigate risk in the underlying, by enteringinto a derivative contract whose value moves in theopposite direction to their underlying position andcancels part or all of it out;

obtain exposure to the underlying where it is notpossible to trade in the underlying (e.g., weatherderivatives);

create option ability where the value of the derivative islinked to a specific condition or event (e.g., theunderlying reaching a specific price level).



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MAJOR TYPES OF DERIVATIVES

FORWARDS: A forward contract is a customized contract

between two entities, where settlement takesplace on a specific date in the future at

today’s pre-agreed price.

FUTURES: A futures contract is an agreement between

two parties to buy or sell an asset at a certaintime in the future at a certain price.



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OPTIONS: Options are of two types - Calls andPuts.

Call Option: Calls give the buyer the right but notthe obligation to buy a given quantity of theunderlying asset, at a given price on or before agiven future date.

Put Option: Puts give the buyer the right, but notthe obligation to sell a given quantity of the

underlying asset at a given price on or before agiven date



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SWAPS:

Swaps are private agreements between twoparties to exchange cash flows in the futureaccording to a prearranged formula. They can beregarded as portfolios of forward contracts.

The two commonly used swaps are:

1. Interest rate swaps

2. Currency swaps



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Interest rate swaps: These entail swapping only the interest related

cash flows between the Parties in the samecurrency.

Currency swaps:

These entail swapping both principal and interestbetween the parties, with the cash flows in onedirection being in a different currency than those inthe opposite Direction.



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Trading of Derivatives

In broad terms, there are two groups of derivative contracts, which are distinguishedby the way they are traded in the market:

1.Over-the-counter (OTC) Traded

2.

3.Exchange-traded



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Over-the-counter (OTC)Derivatives

These are contracts that are traded (andprivately negotiated) directly between twoparties, without going through an exchangeor other intermediary.

Because OTC derivatives are not traded on anexchange, there is no central counter-party.

Therefore, they are subject to counter-partyrisk, like an ordinary contract, since each

counter-party relies on the other to perform.



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Over-the-counter (OTC)Derivatives

Products such as swaps, forward agreements,and exotic options are almost always tradedin this way.

The OTC derivative market is the largestmarket for derivatives, and is largelyunregulated with respect to disclosure of information between the parties, since the

OTC market is made up of banks and otherhighly sophisticated parties.



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Exchange-Traded DerivativeContracts

These are those derivatives instruments thatare traded via specialized derivativesexchanges or other exchanges.

A derivatives exchange is a market where

individuals trade standardized contracts thathave been defined by the exchange.

A derivatives exchange acts as anintermediary to all related transactions, and

takes Initial margin from both sides of thetrade to act as a guarantee.



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Exchange-Traded DerivativeContracts

The world's largest derivatives exchanges (bynumber of transactions) are the KoreaExchange (which lists Index Futures &Options), Eurex (which lists a wide range of European products such as interest rate &index products), and CME Group (made up of the 2007 merger of the Chicago MercantileExchange and the Chicago Board of Tradeand the 2008 acquisition of the New YorkMercantile Exchange).

These derivatives provide investors access torisk/reward and volatility characteristicsthat, while related to an underlying

commodity, nonetheless are distinctive.



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Valuation Of Derivative Contracts

Two common measures of value are:

Market price : the price at which traders arewilling to buy or sell the contract.

Arbitrage-free price: meaning that no risk-free profits can be made by trading in thesecontracts.



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Determining the Market Price

For exchange-traded derivatives, market priceis usually transparent (often published inreal time by the exchange, based on all thecurrent bids and offers placed on that

particular contract at any one time). Complications can arise with OTC, as trading is

handled manually, making it difficult toautomatically broadcast prices.

In particular with OTC contracts, there is nocentral exchange to collate and disseminateprices.



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Determining the Arbitrage-FreePrice

Arbitrage-free pricing is a central topic of financial mathematics. The stochasticprocess of the price of the underlying assetis often crucial.

A key equation for the theoretical valuation isthe Black–Scholes formula, which is basedon the assumption that the cash flows canbe replicated by a continuous buying and

selling strategy using only the stock. OTC derivatives are priced by Independent

Agents that both counterparties involved inthe deal designate upfront (when signing thecontract).



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Criticism on Derivatives Contracts

qPossible large losses:

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The loss of US$7.2 Billion by Societe Generalein January 2008 through mis-use of futures

contracts. The loss of US$6.4 billion in the failed fund

Amaranth Advisors, which was long naturalgas in September 2006 when the price

plummeted.



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q

qCounter-party risk :

If any of the parties goes bankrupt.q

qLarge notional value: Could result in losses that the investor would

be unable to compensate for.q

qLeverage of an economy's debt : Can cause a recession or even depression.



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Regulation of Derivative Trading

SEBI set up a 24 member committee underChairmanship of Dr.L.C.Gupta to develop theappropriate regulatory framework forderivative trading in India.

On May 11, 1998 SEBI accepted therecommendations of the committee andapproved the phased introduction of Derivatives trading in India beginning with

Stock Index Futures. SEBI also approved the “Suggestive bye-laws”

recommended by the committee forregulation and control of trading andsettlement of Derivatives contracts.



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Financial Derivatives - Vishnu