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7/29/2019 FM-REV-DERIVE-F
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DERIVATIVES
GOAL-to make profits?
- To mitigate risks.
- To transact efficiently?
- for price discovery ?
ORIGIN- AUG-1971
BREAK DOWN OF
BRETTON-WOODS
SYSTEM-
INFLATION/VOLATALITY
OF INT/EXCH.RATES
6th OCTOBER,1979
SATURDAY NIGHTMASSACRE OF FEDERAL
RESERVE-INT. RATE
DEREGULATIONS/PLR-20%
1971 TO 1979 WATERSHEDS
IN DEVELOPMENT OFWORLD DERIVATIVE
MARKET.
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DERIVATIVES-WHAT ARE THEY?
Financial Instruments/contracts whose value is
derived from the value of the underlying.
The underlying can be:- Agricultural produce-wheat,barley, tea etc.
Stocks-of HUL/Wipro/Zee-telefilms etc.
Stock Index-S & P-500, BSE-500, NSE-Nifty
Treasury bills/notes/bonds etc.
Currencies- Dollars/Pounds/Euro etc.
Interest rates
OR any intangible too!!!-weather, a match, etc.
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Financial derivativesEvolution
of products
Phased introduction to ensure smooth transition to an
active derivatives market
EquityIndex
futures
EquityIndex
options
Stock
options
Stockfutures
Sectoralindices
June 2000 June 2001 July 2001 Nov 2001 June 2003
Interest
Ratefutures
Dec 2002
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DERIVATIVES-GROWTH
130% growth from 1995 to 1998
Notional amount outstanding-
OTC Market- $ 72 trillion ** Exchangetraded- $ 14 trillion
**Of this, Interest rate derivatives-67% and
Exchange rate derivatives31%
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Accelerators to Derivatives
1971-Break down of Fixed Exchange rate system.
Oil price shock- 1971-1973
Excessive government spendings
Expansion in trade/capital flows Dismantling of tariff barriers
Lifting of exchange controls.
Leading to increased volatility in world economy. Information technology/financial theories
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DERIVATIVES-TYPES
PRICE-
FIXING
FORWARDS
FUTURES
FRAS
SWAPS
PRICE-
INSURANCE
OPTIONS
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DERIVATIVES-TYPES
OVER THECOUNTER(OTC)
Over phone/fax/
e-mail] Flexible but limited
liquidity
Physically delivered
E.g:Forwards/FRAs
Swaps/options
EXCHANGE-TRADED
Traded on exchanges
Standardised/high liquidity
Large market players
No physical delivery higherliquidity
Less expensive
E.g:Futures
Swaps/options
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DERIVATIVES-CLASSES
FORWARDS/
FUTURES/SWAPS
Equal
rights/obligations of
buyer and seller
So no upfront paid bybuyer.
OPTIONS
Non-
linear/asymmetric
pay-off. Hence Option
premium upfront.
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DERIVATIVES
A Derivative is an instrument whose value is
derived from the value of one or more underlying
assets, which can be currency, bonds, shares,
indices, metals, commodities etc.
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COMMON DERIVATIVES
FORWARDS FUTURES OPTIONS SWAPS
A customized
contract
between two
parties where
settlement takesplace on a
specific date, in
future, at a price
agreed today.
Are exchange
traded
contracts to
sell or buy
financialinstruments or
physical
commodities
for futuredelivery at an
agreed price.
Are contracts
which give the
buyer (holder) the
right, but not the
obligation, to buyor sell specified
quantity of the
underlying asset,
at a specific(strike) price on or
before a specified
time (expiration
date)
Are contracts
between two
parties,
referred to as
counterparties, to
exchange two
streams of
payments foran agreed
period of
time.
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PLAYERS IN DERIVATIVES MARKET
HEDGERS: Are investors who wish to eliminate or reduceprice risk to which they are already exposed. They providethe economic substance to any financial market.
SPECULATORS: Are investors who willingly take pricerisks to profit from price changes in the underlying asset.They provide liquidity and depth to the market.
ARBITRAGEURS: Profit from a price differential existingin two markets by simultaneously operating in two differentmarkets. They bring price uniformity and help pricediscovery.
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WHY DERIVATIVES
To manage risks more efficiently by unbundling the risksallowing either hedging or taking only one risk at a time. Risks
inherent in a transaction are many.
If we buy a share of TISCO from our broker, we take the
following risks:-1. Price risk-due to co. specific (unsystematic risk)
2. Price risk-due to market sentiments (systematic risk)
3. Liquidity risk-due to large position, being unable to
cover at the prevailing price (called impact cost)
4. Counter party (credit) risk on the broker becomingbankrupt.
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5. Counter party (credit) risk on the Exchangein case of
brokers default, only partial or full compensation from the
Exchange.
6. Cash out-flow risk-unable arrange funds at the time of
delivery resulting in default, auction and subsequent losses.
7. Operating risk like errors, omissions, loss of documents,
frauds, forgeries, delay in settlement, loss of dividend, and
other corporate actions.
Sum up: If we are long on TISCO (buy futures contract) we can
Hedge the systematic risk (market sentiments) by going short(selling futures contract) on index futures. On the other hand, if
we do not want to take unsystematic risk (co. failure), we can go
long on index futures without buying any individual share
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DERIVATIVES-SWAPS
Exchange of two streams of Cash Flows over adefinite period of time through anintermediary.
Multi-periodprice fixing contracts Transforms characteristics of financial claims.
Access to financial markets and varied needs
give rise to Swaps
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Derivatives-Swaps
ECONOMIC RATIONALE:
Principle of Comparative advantage.
Principle of offsetting risk.
TYPES:
INTEREST RATE SWAPS CURRENCY SWAPS
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SWAP CONTRACTS
1. A Currency Swap helps in lowering funding cost, entering
restricted capital markets, reducing currency risks, etc.
2. Interest Rate swaps help in reducing cost of capital.
3. Asset Swap is used to change the characteristics of theasset held.
4. Commodity Swaps are used by dealers to manipulate
payments of their products.
5. Equity Swaps are used to hedge the downside risk of themarket.
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DOCUMENTATION
A) Swap agreements are generally initiated over phone and
confirmed within 24 hours.
B) Swap documentation Agreement is standardised.
C) Swap Agreement can be exited by termination and
assignment. The marked to market value of the swap isdetermined to settle a gain or loss.
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SWAPAN EXERCISE
Exchange Rates: Spot GBP - $ 1.6400
Interest Rates: GBP = 7.5%
USD = 5.5%
Forward rate for 1 year (assume) = same as spot rate.
A SWAP can be arranged by borrowing $ 1 ml. at 5.5% and
placing it in GBP at 7.5% for one year.
SWAP ACTIVITY = Sell Spot USD and Buy Forward USD
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Spot GBP/USD rate = GBP 655488 = $ 1055000
1 GBP = $ 1.60949
Forward GBP/USD rate = 1 GBP = $ 1.6400
Therefore Forward difference = 0.03051
Activity GBP (inflow) GBP (outflow) $ (inflow) $ (outflow)
Spot borrow ---- ---- 1000000 ----
Sell $ spot 609756 ---- ---- 1000000
One year
interest
45732
(earned)
---- ---- 55000
(pay)
Total 655488 1055000
1-year hence
Sell GBP @
1.6400
---- 655488 1075000 ----
Net Gain ---- ---- 20000 ----
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Options contracts
Nature and type of Options:
Party CALL OPTIONS PUT OPTIONS
Option buyer or
Option holder
Buys the right to buy
the underlying assetat the specified price
Buys the right to sell
the underlying assetat the specified price
Option Seller or
Option writer
Has the obligation to
sell the underlying
asset (to the option
holder) at the
specified price
Has the obligation to
buy the underlying
asset (from the
option holder) at the
specified price
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TERMINOLOGY IN OPTIONS
CONTRACT
Term used CALL OPTIONS PUT OPTIONS
Inthemoney Strike Price < Spot
Price of underlying
asset
Strike Price > Spot
Price of underlying
asset
Atthemoney Strike Price = Spot
Price
Strike
Out- ofthe
money
Strike Price >Spot
Price
Strike Price
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OPTIONS CONTRACT
FEATURES:
High leverage- by investing small sum (premium) one
can take large exposure of greater value. Pre-known maximum risk for an option buyer.
Large profit potential for option buyer.
Limited risk.
Good protection for equity portfolio.
Index options enable exposure to a large market.
An ESOP holder can buy Put option to cover the risk.
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PROCEDURE FOR TRADING IN
OPTIONS
The investor to register with a broker who is a member ofthe Derivatives Segment of the stock exchange.
Can buy a Sensex Call or Put Option through the broker.The premium paid in cash up-front.
Can hold on till maturity or reverse the same in between.If closed out, he will receive the premium in cash the nextday.
If held till maturity and exercised, the investor will get the
difference between Option Settlement Price and the StrikePrice in cash. If option is not exercised, the premium is aloss and contract expires.
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WHY FUTURES TRADING
Efficient and transparent price discovery
Price Risk Mgmt. for hedgers
Price dissemination No counter- party risk
Integration of markets at National Level.
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DERIVATIVES-FUTURES
Exchange Traded & Price fixing contracts.
Single Period contract
Standardisation of :- Quality and Quantity
Expiration months
Delivery terms & Delivery dates
Tick size, daily price limit, trading hours/days.
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DERIVATIVES-FUTURES
THEY ARE AKIN TO DAILY SETTLED
FORWARD CONTRACTS
INITIAL MARGINS/DAILY MARGINS
HIGHLY GEARED /LEVERAGEDINSTRUMENTS
MARKING TO MARKET ON DAILY BASIS
HIGHLY LIQUID/SETTLED BY CLOSING OUT
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DERIVATIVES-FUTURES
BENEFITS:-
PRICE DISCOVERY
HEDGING
SPECULATIONS ABSENCE OF CREDIT RISK
HIGH LEVERAGE
PRICING- COST OF CARRY MODELEXPECTATIONS MODEL
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FUTURES CONTRACT
FEATURES:1. Being Exchange traded, the contract has terms standardized
by the exchange.
2. Once the trade is confirmed, the Exchange itself becomesthe counter party (or guarantees) to every trade. Credit risk
gets transferred to the exchange, reducing the risk to almostnil.
3. Due to market reporting of volumes and price, the contractis more liquid and transparent.
4. A Futures contract can be reversed with any member of theexchange.
5. Due to price volatility of an individual stocks, the futuresare generally Index-Based.
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PRICING
A Futures Contract is priced at:-
Spot Price plus Cost of Carry.
Cost of Carry is the sum of all costs incurred if a similar
position is taken in cash market and carried to maturity less any
revenue which may result in this period.
Cost includes interest in case of financial futures (also insurance
and storage cost in case of commodity futures). The revenue
may be dividend in case of Index futures.Actual value may vary depending on demand/supply of the
underlying asset at present and the future expectations.
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BARINGS BANK
233 years old, the British Bank goes bankrupt on 26th
Feb.. 1995. The downfall was attributed to a single
trader, 28 year old, Nick Leeson. The loss was on
account of large exposure to the Japanese futuresmarket. Leeson, chief trader for Bankings futures in
Singapore took huge position in index futures of Nikkie-
225. Market falls by more than 1.5% in the first two
months of 1995 and Barings suffered huge losses. TheBank lost $ 1.3 bl. on account of derivative trading. The
loss wiped out the entire capital of Bearings.
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FORWARD CONTRACTS
BILATERAL CONTRACTS WHERE
BUYER AND SELLER AGREE UPON THE
DELIVERY OF A SPECIFIED
QUANTITY/QUALITY OF ASSET AT ASPECIFIED TIME AT A PRE-
DETERMINED PRICE.
HENCE AN OTC DERIVATIVE
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FORWARD CONTRACTS
FEATURES:
Being Bilateral contract, exposed to counter party risk.
Each contract is custom designed and unique.
Contract price is not available in public.
Contract is settled by delivery of the asset on expiration date.
If contract has to be reversed. The counterpart party can command over
price.
EXAMPLE
A corn merchant selling his entire future crop of next season
corn at a predetermined price today.
ADVANTAGE
Protection against fall in price for the seller.
A determined future liability for the buyer.
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FORWARD CONTRACTS-
FEATURES
OTC DERIVATIVE-PRICE FIXING
PRODUCT
FORWARD PRICE = SPOT OR CASH
PRICE + COST OF CARRY
LIMITATIONS-CREDIT RISK.
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DERIVATIVES-FORWARD
RATE AGREEMENT
FORWARD FIXING OF INTEREST RATES
ON MONEY MARKET TRANSACTIONS
ON NOTIONAL FUTURE LOAN /DEPOSIT
FOR A SPECIFIED PERIOD
QUOTED AS 3 vs. 6, 3 x 6 etc.
TWO WAY BIDS- SAY 4.35-4.40 %
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DERIVATIVES-FRAs
Price fixing & OTC product.
Inter-Bank tool for hedging short term interest raterisk.
No upfront premium payable Min size $ 5 million
3 to 6 months are most liquid & traded
Maximum upto 2 years
FRAs available in currencies where there are noFutures.