MBA (Finance specialisation)

&

MBA – Banking and Finance

(Trimester)

Term VI

Module : – International Financial Management

Unit V: Managing Foreign Operations

Lesson 5.1

(Financial Derivative, Foreign Currency futures and Options)

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FINANCIAL DERIVATIVES

• Fluctuations in the prices of financial assets expose the dealers in such assets to risk. The dealers would like to hedge the risk involved in their financial transactions. Financial derivatives have evolved as instruments for hedging the risk involved in buying, holding and selling various kinds of financial assets.

• Basically, they are financial instruments for the management of risk arising from the uncertainty prevailing in financial markets regarding asset prices.

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FINANCIAL DERIVATIVES

• Financial Derivatives are those assets whose value is derived from the value of underlying assets

• Underlying assets may be equity, commodity, or currency

• Derivatives have no independent value• Derivatives are promise to convey ownership• Derivatives may be exchange traded or privately

negotiated over the counter

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Types of Derivatives

• Forwards• Futures• Options

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FORWARD CONTRACTS

• A forward contract is customised contract between two entities where settlement takes place on a specific date in the future at today’s pre agreed price

• Two parties irrevocably agree to settle a trade at a future date, for a stated price and quantity

• No money changes hands

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LIMITATATIONS OF FORWARD CONTRACTS

• Private Bilateral agreement, Involves Counter Party Risk

• Cannot take Reverse Position, Lack of Liquidity

• Lack of Standardization These limitations can be overcome by use of

Future Contracts

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Futures Contracts

FUTURES • A future contract is an agreement between two parties

to buy or sell an asset at a certain time in the future at a certain price. These are special types of forward contracts in the sense that the former are standardised exchange- traded contracts.

• Traded over an Exchange• Standardized Forward Contract• Contract to buy or sell a specified asset at a specified

price on a specific date

Currency Futures - Example Mr. X purchases $1000 at Rs 62/$ (on 1st April, 2014) in 3- months futures market and the due date of contract is 30 June, 2014. Now, as per the terms of the contract, irrespective of actual relationship between Rupee and dollar on 30th June,2014, Mr. X would get $ 1000 at Rs 62/$. If the actual price of a dollar on 30th June,2014 is Rs 65, Mr. X would make gain of Rs 3000. However, if the actual price of a dollar happens to be Rs 60/$ , Mr. X would be having loss of Rs 2000.

Illustration

A software company in India expects to get $10000 three months from now. The prevailing price of dollar in terms of rupees in the currency market is Rs 61/$. It is being anticipated that rupee will get strengthen against dollar and the relationship between is expected to be Rs 59/$. Explain the impact on the earning of the company and advise suitable strategy to protect fall in earning of the company.

IllustrationIn case the actual price of dollar happens to be Rs 59 at

the time of receipt of dollar, the company would suffer forex loss of Rs (61 – 59) x 10000 = Rs 20,000.

In order to protect itself from this loss, the company shall sell $ 10,000 in the 3 months futures market at a current price of Rs 61. The company would be required to make delivery of dollars after three months which will be made through the receipt of payment due to the company.

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COMPARISON OF FORWARDS AND FUTURES

BASIS FORWARDS FUTURES

Standardization Non standardized products

Standardized

Liquidity No liquidity Highly liquid

Risk Risk of non performance

No such risk

Margin Money Nil Paid to clearing corporation

P & L Settlement At the time of maturity

Daily cash settlement

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OPTIONS CONTRACTS

• Options may be defined as a contract, between two parties whereby one party obtains the right, but not the obligation, to buy or sell a particular asset, at a specified price, on or before a specified date

• Give the buyer the right but not the obligation to buy/sell a specified underlying asset

• At a set price• On or before a specified period• One who receives the right is the Option buyer/holder• One who is obliged to perform the contract is the

Option seller/writer

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COMPARISON OF FUTURES AND OPTIONSBASIS FUTURES OPTIONS

Obligatory Obligatory on boththe parties

Not obligatory forthe buyer/holder

Premium No premium paid Buyer payspremium to seller

Risk – ReturnExposure

Buyer exposed toentire downsiderisk and potentialfor upside returns

Downside risklimited for buyerbut infinitepotentials forupside returns

Performance ofthe contract

Obligatory toperform on theexpiry date

Can be on or beforethe maturity datedepending uponwhether option isamerican oreuropean

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• Call Option• Put Option

Types of Options

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Call Option

• A Call Option gives the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date.

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PUT OPTION

• Put Option gives the buyer the right but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.

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Comparison of Call & Put Option

Buyer / Holder(privileged person)

Seller/ Writer(Bearing risk)

Call Option Right to buy an asset

Obligation to Sell

Put Option Right to Sell Obligation to Buy

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Styles of Options

• European Style : They can be exercised on specified future date only. ( Last Thursday of expiry month in India )

• American Style : They can be exercised on or before a specified future date.( They are difficult to administer but more beneficial to the buyer.

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Terminology to be used for Options Pricing

• Spot Price : The current price of the stock• Exercise Price/Striking Price: The fixed price at

which the option holder can by and / or sell the underlying asset.

• Exercise Date : When option is exercised• Expiry Date : Last Date when option can be

exercised• Option Premium :It is the price the buyer pays

the writer for an option contract.

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Advantages Of Options

• Leverage• Unlimited Profit Potential• Fixed Risk

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Example- Call Option• A dollar is traded at prevailing market price of Rs.60

(S0). A call option contract having exercise price (E) of 61 and 3 months maturity is available at an option premium of Re 1(c).

• InterpretationOut of pocket cost right now is Re.1 If market price 3 months hence S1= 64Exercise the call optionNet pay off = (64 - 61 – 1 ) = 2 (gain)

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• If price of dollar after three months price is Rs 62Do not exercise the call optionNo benefit / No lossNet payoff = Re1 (loss)Net loss will remain max Re1 irrespective of S1

• If S1= 66Net pay off = (66 - 61 – 1 ) = Rs 4 (gain)There is potential for unlimited gain

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Diagrammatic Representation

Break evenpoint

Loss

Gain Area

Price of one dollar in terms ofrupee

6261

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• If S1> EExercise Call Option• If S1< EDo not exercise call optionA call option will be exercised if S1> E or S1= ENet payoff = S1- E -c

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Option Pricing FACTORS AFFECTING OPTION PRICE

• Stock price (on expiration date): The value of call option, other things being constant, increases with the stock price.

• Strike/ Exercise price: Other things being constant, the higher the exercise price, lower would be the value of a call option.

• Time to Expiration: Other things being constant, longer the time to expiration date the more valuable the call option. The holder gets more time for exercising the option

• Variability of the stock price: Other things being constant, the higher the variability of the stock price, the greater the likelihood that the stock price will exceed the exercise price.

• Risk Free Rate of Interest: The higher the interest rate , the greater the benefit will be from delayed payment and vice-versa. So, the value of a call option is positively related to the interest rate.

• Dividends: The call option price is lower at the ex-dividend date compared to the pre-dividend date.

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BLACK AND SCHOLES OPTION PRICING MODEL

Assumptions• No dividends are paid out• The option can be exercised at the expiry• Efficient markets• Commissions are non existent• Interest rate are known and constant• Stock returns follow a log normal distribution

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Black and Scholes Model C0 = S0 N (d1) - E N (d2)

ert

Where C0 = value of a call option now

S0 = current price of the stock

E = exercise price

e = base of natural logarithm

r = continuously compounded risk-free annual

interest rate

t = length of time in years to the expiration date N(d) = value of the cumulative normal density function

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d1 = ln (S0/ E) + (r + ½ σ2) t σ√ t

d2 = d1 - σ√ t

where ln = natural logarithm σ = standard deviation of the continuously compounded annual rate of return on the stock

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ASSIGNMENT 1

1. Calculate the value of a call option given the following information, using the Black-Scholes formula:Stock price = Rs. 60Exercise price = Rs. 50Risk free rate = 8%Time to expiration = 3 monthsStandard deviation = 0.4

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ASSIGNMENT 1

2. Following is the information available for Abhishek Industries:Stock price (S0)= Rs. 70Exercise price (E) = Rs. 72Risk free rate (r)= 12%Time to expiration (t)= 6 monthsStandard deviation σ = 0.3

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ASSIGNMENT 1

3.The following data is available for Thermal Plastics Limited, a company that is not expected to pay dividend for a year:: S0 = Rs. 120 E = Rs. 110 r = 0.14 t = 1.0σ = 0.4