Upload
vikash-nishad
View
220
Download
0
Embed Size (px)
Citation preview
8/3/2019 RMD Derivatives (vikash Nishad from Patna )
1/17
Asian School of Business Management
Hyderabad
Subject- Risk Management and Derivatives
Topic- Over View of Derivatives and Derivatives
Markets
Submitted by:
Vikash Nishad
PGPM/HYD/2010-2012/12
8/3/2019 RMD Derivatives (vikash Nishad from Patna )
2/17
Derivatives
INTRODUCTION
Derivative instruments have been a feature of modern financial markets for several decades.
They play a vital role in managing the risk of underlying securities such as bonds, equity,
equity indexes, currency, and short-term interest rate asset or liability positions. In the
commodity markets they have, in general, been around for a great deal longer.
Through the use of derivative products, it is possible to partially or fully transfer price risks
by locking-in asset prices. As instruments of risk management, these generally do not
influence the fluctuations in the underlying asset prices. However, by locking-in asset prices,
derivative products minimize the impact of fluctuations in asset prices on the profitability and
cash flow situation of risk-averse investors.
What is a Derivative?
The financial instruments we've considered so far - stocks, bonds, commodities and
currencies - are generally referred to as cash instruments (or sometimes, primary
instruments). The value of cash instruments is determined directly by markets. By contrast,
aderivativederives its value from the value of some other financial asset or variable. For
example, a stockoptionis a derivative that derives its value from the value of astock. An
interest rate swapis a derivative because it derives its value from an interest rate index. The
asset from which a derivative derives its value is referred to as the underlying asset. The price
of a derivative rises and falls in accordance with the value of the underlying asset.
Derivatives are designed to offer a return that mirrors the payoff offered by the instruments
on which they are based
Ex:The Bombay stock exchange share index is called SENSEX it is a derivative
whose value depend upon the prices of the underling 30 shares. The weighted average of the
prices of 30 shares is the SENSEX. If the prices of the entire share increase or decrease the
SENSEX will also increase or decrease. So SENSEX is the derivative and 30 shares arethe underling assets.
OBJECTIVES of Derivative
http://www.investopedia.com/terms/d/derivative.asphttp://www.investopedia.com/terms/d/derivative.asphttp://www.investopedia.com/terms/d/derivative.asphttp://www.investopedia.com/terms/o/option.asphttp://www.investopedia.com/terms/o/option.asphttp://www.investopedia.com/terms/o/option.asphttp://www.investopedia.com/terms/s/stock.asphttp://www.investopedia.com/terms/s/stock.asphttp://www.investopedia.com/terms/s/swap.asphttp://www.investopedia.com/terms/s/swap.asphttp://www.investopedia.com/terms/s/swap.asphttp://www.investopedia.com/terms/s/stock.asphttp://www.investopedia.com/terms/o/option.asphttp://www.investopedia.com/terms/d/derivative.asp8/3/2019 RMD Derivatives (vikash Nishad from Patna )
3/17
Demonstrate knowledge of the regulatory framework for financial derivatives;Demonstrate knowledge of the operations of derivatives exchanges, and be able tocompare and contrast Exchange Traded and Over the Counter (OTC) instruments;
Demonstrate a detailed knowledge of the different types of forwards, futures,swaps options and other financial derivatives, the principal differences betweenthem, and where and how they are traded;
Demonstrate a detailed understanding of the variables (inputs) which influence thevalue of such derivatives and the relationship of financial derivatives to theirunderlying assets;
Present the alternative derivatives strategies that would be appropriate for differentmarket circumstances, and describe the advantages and disadvantages of each;
Demonstrate the uses of all financial derivatives, either alone, or in conjunctionwith underlying assets, to realize investment, hedging and trading objectives;
Demonstrate an understanding of the risks of all types of financial derivatives andderivatives portfolios, and efficient ways of reporting and managing those risks.
Types of derivative:
There are four types of derivative are as follows:
I. ForwardII. Futures
III. OptionIV. SwapForward
A forward is an agreement between two counterpartiesa buyer and seller. The buyer agrees
to buy an underlying asset from the other party (the seller). The delivery of the asset occurs at
a later time, but the price is determined at the time of purchase. Key features of forwardcontracts are:
Highly customized - Counterparties can determine and define the terms and features
to fit their specific needs, including when delivery will take place and the exact
identity of the underlying asset.
All parties are exposed to counterparty default riskThis is the risk that the other
party may not make the required delivery or payment.
Transactions take place in large, private and largely unregulated markets consisting of
banks, investment banks, government and corporations.
Underlying assets can be stocks, bonds, foreign currencies, commodities or some
combination thereof. The underlying asset could even be interest rates.
8/3/2019 RMD Derivatives (vikash Nishad from Patna )
4/17
They tend to be held to maturity and have little or no market liquidity.Any commitment between two parties to trade an asset in the future is a forward
contract.
Example: Forward Contracts
Let's assume that you have just taken up sailing and like it so well that you expect you might
buy your own sailboat in 12 months. Your sailing buddy, John, owns a sailboat but expects to
upgrade to a newer, larger model in 12 months. You and John could enter into a forward
contract in which you agree to buy John's boat for $150,000 and he agrees to sell it to you in
12 months for that price. In this scenario, as the buyer, you have entered a long forward
contract. Conversely, John, the seller will have the short forward contract. At the end of one
year, you find that the current market valuation of John's sailboat is $165,000. Because John
is obliged to sell his boat to you for only $150,000, you will have effectively made a profit of$15,000. (You can buy the boat from John for $150,000 and immediately sell it for
$165,000.) John, unfortunately, has lost $35,000 in potential proceeds from the transaction.
Like all forward contracts, in this example, no money exchanged hands when the contract
was negotiated and the initial value of the contract was zero.
Future Contract
Future contracts are also agreements between two parties in which the buyer agrees to buy anunderlying asset from the other party (the seller). The delivery of the asset occurs at a later
time, but the price is determined at the time of purchase.
Terms and conditions are standardized.
Trading takes place on a formal exchange wherein the exchange provides a place to
engage in these transactions and sets a mechanism for the parties to trade these
contracts.
There is no default risk because the exchange acts as counterparty, guaranteeing
delivery and payment by use of a clearing house.
The clearing house protects itself from default by requiring its counterparties to settle
gains and losses or mark to market their positions on a daily basis.
Futures are highly standardized, have deep liquidity in their markets and trade on an
exchange.
An investor can offset his or her future position by engaging in an opposite
transaction before the stated maturity of the contract.
Example: Future Contracts
8/3/2019 RMD Derivatives (vikash Nishad from Patna )
5/17
Let's assume that in September the spot or current price for hydroponic tomatoes is $3.25 per
bushel and the futures price is $3.50. A tomato farmer is trying to secure a selling price for
his next crop, while McDonald's is trying to secure a buying price in order to determine how
much to charge for a Big Mac next year. The farmer and the corporation can enter into a
futures contract requiring the delivery of 5 million bushels of tomatoes to McDonald's inDecember at a price of $3.50 per bushel. The contract locks in a price for both parties. It is
this contract - and not the grain per se - that can then be bought and sold in the futures
market.
In this scenario, the farmer is the holder of the short position (he has agreed to sell the
underlying assettomatoes) and McDonald's is the holder of the long position (it has agreed
to buy the asset). The price of the contract is 5 million bushels at $3.50 per bushel.
OptionsAn option is common form of a derivative. It's a contract, or a provision of a contract, that
gives one party (the option holder) the right, but not the obligation to perform a specified
transaction with another party (the option issuer or option writer) according to specified
terms. Options can be embedded into many kinds of contracts. For example, a corporation
might issue a bond with an option that will allow the company to buy the bonds back in ten
years at a set price. Standalone options trade on exchanges or OTC. They are linked to a
variety of underlying assets. Most exchange-traded options have stocks as their underlying
asset but OTC-traded options have a huge variety of underlying assets (bonds, currencies,
commodities, swaps, or baskets of assets).
There are two main types of options: calls and puts:
I. Calls andII. Puts
Call optionsprovide the holder the right (but not the obligation) to purchase an underlying
asset at a specified price (the strike price), for a certain period of time. If the stock fails to
meet the strike price before the expiration date, the option expires and becomes worthless.Investors buy calls when they think the share price of the underlying security will rise or sell
a call if they think it will fall. Selling an option is also referred to as ''writing'' an option.
Put optionsgive the holder the right to sell an underlying asset at a specified price (the
strike price). The seller (or writer) of the put option is obligated to buy the stock at the strike
price. Put options can be exercised at any time before the option expires. Investors buy puts if
they think the share price of the underlying stock will fall, or sell one if they think it will rise.
Put buyersthose who hold a "long" - put are either speculative buyers looking for leverage
http://www.investopedia.com/terms/c/calloption.asphttp://www.investopedia.com/terms/c/calloption.asphttp://www.investopedia.com/terms/p/put.asphttp://www.investopedia.com/terms/p/put.asphttp://www.investopedia.com/terms/p/put.asphttp://www.investopedia.com/terms/c/calloption.asp8/3/2019 RMD Derivatives (vikash Nishad from Patna )
6/17
or "insurance" buyers who want to protect their long positions in a stock for the period of
time covered by the option. Put sellers hold a "short" expecting the market to move upward
(or at least stay stable) A worst-case scenario for a put seller is a downward market turn. The
maximum profit is limited to the put premium received and is achieved when the price of the
underlie is at or above the option's strike price at expiration. The maximum loss is unlimitedfor an uncovered put writer.
To obtain these rights, the buyer must pay an option premium (price). This is the amount of
cash the buyer pays the seller to obtain the right that the option is granting them. The
premium is paid when the contract is initiated.
Basic Characteristics of Option Contracts
Both put and call options have three basic characteristics: exercise price, expiration date and
time to expiration.
The buyer has the right to buy or sell the asset.
To acquire the right of an option, the buyer of the option must pay a price to the seller.
This is called the option price or the premium.
The exercise price is also called the fixed price, strike price or just the strike and is
determined at the beginning of the transaction. It is the fixed price at which the holder
of the call or put can buy or sell the underlying asset.
Exercising is using this right the option grants you to buy or sell the underlying asset.The seller may have a potential commitment to buy or sell the asset if the buyer
exercises his right on the option.
The expiration date is the final date that the option holder has to exercise her right to
buy or sell the underlying asset.
Time to expiration is the amount of time from the purchase of the option until the
expiration date. At expiration, the call holder will pay the exercise price and receive
the underlying securities (or an equivalent cash settlement) if the option expires in the
money. (We will discuss the degrees of moneyless later in this session.) The call seller
will deliver the securities at the exercise price and receive the cash value of those
securities or receive equivalent cash settlement in lieu of delivering the securities.
Defaults on options work the same way as they do with forward contracts. Defaults on
over-the counter option transactions are based on counterparties, while exchange-
traded options use a clearing house.
Example: Call Option
8/3/2019 RMD Derivatives (vikash Nishad from Patna )
7/17
IBM is trading at 100 today. (June 1, 2005)
The call option is as follows: Strike price = 120, Date = August 1, 2005, Premium on the call= $3
In this case, the buyer of the IBM call today has to pay the seller of the IBM call $3 for theright to purchase IBM at $125 on or before August 1, 2005. If the buyer decides to exercisethe option on or before August 1, 2005, the seller will have to deliver IBM shares at a price of$125 to the buyer.
Example: Put Option
IBM is trading at 100 today (June 1, 2005)
Put option is as follows: Strike price = 90, Date = August 1, 2005, Premium on the put =$3.00
In this case, the buyer of the IBM put has to pay the seller of the IBM call $3 for the right tosell IBM at $90 on or before August 1, 2005. If the buyer of the put decides to exercise theoption on or before August 1, 2005, the seller will have to purchase IBM shares at a price of$90.
Example: Interpreting Diagrams
European, American Options and Moneyless
European Option
Europeans Options can only be exercised on the expiry date. European options are typicallyvalued using the Black-Sholes or Black model formula. This is a simple equation with aclosed-form solution that has become standard in the financial community.
American Option
http://www.investopedia.com/terms/e/europeanoption.asphttp://www.investopedia.com/terms/e/europeanoption.asp8/3/2019 RMD Derivatives (vikash Nishad from Patna )
8/17
This is an option that can be exercised at any time up to and including the expiry date. Thereare no general formulas for valuing American options, but a choice of models to approximatethe price is available (for example Whaley, binomial options model, Monte Carlo and others),although there is no consensus on which is preferable.
American options are rarely exercised early. This is because all options have a non-negativetime value and are usually worth more unexercised. Owners who wish to realize the full valueof their options will mostly prefer to sell them rather than exercise them early and sacrificesome of the time value.
Note that the names of these types of options are in no way related to Europe or the UnitedStates.
Moneyless
The concept of moneyless describes whether an option is in-, out-, at-, or in-the-money byexamining the position of strike vs. existing market price of the option's underlying security.
In the Money - Any option that has intrinsic value is in the money. A call option issaid to be in the money when the futures price exceeds the option's strike price. A putis in the money when the futures price is below the option's strike price. For example,a March CME euro 90 call options will be in the money if March CME euro futuresare above 90, meaning that the holder has the right to buy these futures at 90,regardless of how much the price has risen. The further in the money an option, theless time value it will have.
Deep In the Money -These options represent a larger spread between the strikeand market price of an underlying security. Options that are deep in themoney generally trade at or near their actual intrinsic values, calculated by subtractingthe strike price from the underlying asset's market price for a call option (and viceversa for a put option). This is because options with a significant amount of intrinsicvalue built in have a very low chance of expiring worthless. Therefore, the primaryvalue they provide is already priced into the option in the form of their intrinsic value.As an option moves deeper into the money, the delta approaches 100% (for calloptions), which means for every point change in the underlying asset's price, therewill be an equal and simultaneous change in the price of the option, in the same
direction. Thus, investing in the option is similar to investing in the underlying asset,except the option holder will have the benefits of lower capital outlay, limited risk,leverage and greater profit potential.
Out of the Money -These options exist when the strike price of a call (put) isabove (below) the underlying asset's market price. (Essentially, it is the inverse of anin the money option). Options that are out of the money have a high risk of expiringworthless, but they tend to be relatively inexpensive. As the time value approacheszero at expiration, out of the money options have a greater potential for total loss ifthe underlying stock moves in an adverse direction.
http://www.investopedia.com/terms/a/americanoption.asphttp://www.investopedia.com/terms/i/inthemoney.asphttp://www.investopedia.com/terms/d/deepinthemoney.asphttp://www.investopedia.com/terms/d/deepinthemoney.asphttp://www.investopedia.com/terms/o/outofthemoney.asphttp://www.investopedia.com/terms/o/outofthemoney.asphttp://www.investopedia.com/terms/d/deepinthemoney.asphttp://www.investopedia.com/terms/d/deepinthemoney.asphttp://www.investopedia.com/terms/d/deepinthemoney.asphttp://www.investopedia.com/terms/i/inthemoney.asphttp://www.investopedia.com/terms/a/americanoption.asp8/3/2019 RMD Derivatives (vikash Nishad from Patna )
9/17
At the Money - These options exist when the strike price of a call or put is equal tothe underlying asset's market price. You can essentially think ofat the money as thebreakeven point (excluding transaction costs)
PayoffCalculated by deducting the option premium paid from the intrinsic valueof the option. In this case, an in-the-money option could produce a negative payoff ifthe premium is greater than the intrinsic value of the option.
Intrinsic Value -Intrinsic value in options is the in-the-money portion of theoption's premium. It is the value that any given option would have if it were exercisedtoday. It is defined as the difference between the option's strike price (X) and thestock's actual current price (CP). In the case of a call option, you can calculate thisintrinsic value by taking CP - X. If the result is greater than zero (in other words, ifthe stock's current price is greater than the option's strike price), then the amount leftover after subtracting CP - X is the option's intrinsic value. If the strike price is greater
than the current stock price, then the intrinsic value of the option is zero - it would notbe worth anything if it were to be exercised today (please note that an option'sintrinsic value can never be below zero). To determine the intrinsic value of a putoption, simply reverse the calculation to XCP.
Time Value - The time value is any value of an option other than its intrinsic value.Time value is basically the risk premium that the seller requires to provide the optionbuyer with the right to buy or sell the stock up to the expiration date. While the actualcalculation is complex, fundamentally, time value is related to a stock's beta orvolatility. If the market does not expect the stock to move much (if it has a low beta),then the option's time value will be relatively low. Conversely, the option's time value
will be high if the stock is expected to fluctuate significantly.
Time value decreases as an option gets closer and closer to expiration. This is whyoptions are considered "wasting" assets. As an option approaches expiration, theunderlying stock has less and less time to move in a favorable direction for the optionbuyer; therefore, if you have two identical options - one that expires in six months andone expires in 12 months - the option that expires in 12 months will have greater timevalue because it has a better chance of moving higher.
Swaps
A swap is one of the most simple and successful forms of OTC-traded derivatives. It is a
cash-settled contract between two parties to exchange (or "swap") cash flow streams. As long
as the present value of the streams is equal, swaps can entail almost any type of future cash
flow. They are most often used to change the character of an asset or liability without actually
having to liquidate that asset or liability. For example, an investor holding common stock can
exchange the returns from that investment for lower risk fixed income cash flows - without
having to liquidate his equity position.
http://www.investopedia.com/terms/a/atthemoney.asphttp://www.investopedia.com/terms/i/intrinsicvalue.asphttp://www.investopedia.com/terms/i/intrinsicvalue.asphttp://www.investopedia.com/terms/t/timevalue.asphttp://www.investopedia.com/terms/s/swap.asphttp://www.investopedia.com/terms/s/swap.asphttp://www.investopedia.com/terms/t/timevalue.asphttp://www.investopedia.com/terms/i/intrinsicvalue.asphttp://www.investopedia.com/terms/a/atthemoney.asp8/3/2019 RMD Derivatives (vikash Nishad from Patna )
10/17
The difference between a forward contract and a swap is that a swap involves a series of
payments in the future, whereas a forward has a single future payment.
Two of the most basic swaps are:
Interest Rate Swap- This is a contract to exchange cash flow streams that might be
associated with some fixed income obligations. The most popular interest rate swaps
are fixed-for-floating swaps, under which cash flows of a fixed rate loan are exchanged for
those of a floating rate loan.
Currency SwapThis is similar to an interest rate swap except that the cash flows are in
different currencies. Currency swaps can be used to exploit inefficiencies in international
debt markets. For example, assume that a corporation needs to borrow $1O million Euros and
the best rate it can negotiate is a fixed 6.7%. In the U.S., lenders are offering 6.45% on a
comparable loan. The corporation could take the U.S.loan and then find a third party willingto swap it into an equivalent euro loan. By doing so, the firm would obtain its Euros at more
favorable terms.
Cash flow streams are often structured so that payments are synchronized, or occur on the
same dates. This allows cash flows to be netted against each other (so long as the cash flows
are in the same currency). Typically, the principal (or notional) amounts of the loans are
netted to zero and the periodic interest payments are scheduled to occur on that same dates so
they can also be netted against one another.
As is obvious from the above example, swaps are private, negotiated and mostly unregulated
transactions (although FASB 133 has begun to impose some regulations).
Purposes and Benefits of Derivatives
Purposes and Benefits
Today's sophisticated international markets have helped foster the rapid growth in derivativeinstruments. In the hands of knowledgeable investors, derivatives can derive profit from:
Changes in interest rates and equity markets around the world
Currency exchange rate shifts
Changes in global supply and demand for commodities such as agricultural products,
precious and industrial metals, and energy products such as oil and natural gas
Adding some of the wide variety of derivative instruments available to a traditional portfolio
of investments can provide global diversification in financial instruments and currencies, help
hedge against inflation and deflation, and generate returns that are not correlated with more
http://www.investopedia.com/terms/i/interestrateswap.asphttp://www.investopedia.com/terms/i/interestrateswap.asphttp://www.investopedia.com/terms/f/fixed_floatswap.asphttp://www.investopedia.com/terms/f/fixed_floatswap.asphttp://www.investopedia.com/terms/c/currencyswap.asphttp://www.investopedia.com/terms/c/currencyswap.asphttp://www.investopedia.com/terms/c/currencyswap.asphttp://www.investopedia.com/terms/f/fixed_floatswap.asphttp://www.investopedia.com/terms/i/interestrateswap.asp8/3/2019 RMD Derivatives (vikash Nishad from Patna )
11/17
traditional investments. The two most widely recognized benefits attributed to derivative
instruments are price discovery and risk management.
1. Price DiscoveryFutures market prices depend on a continuous flow of information from around the world and
require a high degree of transparency. A broad range of factors (climatic conditions, political
situations, debt default, refugee displacement, land reclamation and environmental health, for
example) impact supply and demand of assets (commodities in particular) and thus the
current and future prices of the underlying asset on which the derivative contract is
based. This kind of information and the way people absorb it constantly changes the price of
a commodity. This process is known as price discovery.
With some futures markets, the underlying assets can be geographically dispersed, having
many spot (or current) prices in existence. The price of the contract with the shortest time toexpiration often serves as a proxy for the underlying asset.
Second, the price of all future contracts serve as prices that can be accepted by those who
trade the contracts in lieu of facing the risk of uncertain future prices.
Options also aid in price discovery, not in absolute price terms, but in the way the market
participants view the volatility of the markets. This is because options are a different form of
hedging in that they protect investors against losses while allowing them to participate in the
asset's gains.
As we will see later, if investors think that the markets will be volatile, the prices of
options contracts will increase. This concept will be explained later.
2. Risk ManagementThis could be the most important purpose of the derivatives market. Risk management is the
process of identifying the desired level of risk, identifying the actual level of risk and altering
the latter to equal the former. This process can fall into the categories of hedging and
speculation.
Hedging has traditionally been defined as a strategy for reducing the risk in holding a market
position while speculation referred to taking a position in the way the markets will move.
Today, hedging and speculation strategies, along with derivatives, are useful tools or
techniques that enable companies to more effectively manage risk.
3. They Improve Market Efficiency for the Underlying Asset
For example, investors who want exposure to the S&P 500 can buy an S&P 500 stock indexfund or replicate the fund by buying S&P 500 futures and investing in risk-free bonds. Either
8/3/2019 RMD Derivatives (vikash Nishad from Patna )
12/17
of these methods will give them exposure to the index without the expense of purchasing all
the underlying assets in the S&P 500.
If the cost of implementing these two strategies is the same, investors will be neutral as to
which they choose. If there is a discrepancy between the prices, investors will sell the richer
asset and buy the cheaper one until prices reach equilibrium. In this context, derivatives
create market efficiency.
4. Derivatives Also Help Reduce Market Transaction Costs
Because derivatives are a form of insurance or risk management, the cost of trading in them
has to be low or investors will not find it economically sound to purchase such "insurance"
for their positions.
Other Types of Derivatives
Eurodollar Futures
Eurodollar futures work the same as T-bill contracts except the rate is based on LIBOR.
Price quotes and actual price is determined the in the same way as for T-bills.
Settles in cash
One of most active contracts in the markets
Instead of add-on interest, (for example a 100 @ 10% for a year and the bank would
owe $110 dollars), the rate is subtracted from 100, just as it is with T-bills
With T-bills the investor would receive $1 million per contract, while in theEurodollar futures market the firm would pay 1 million Euros
Treasury bond Contracts
A contract based on the delivery of a U.S. Treasury bond with any coupon and at least 15
years to maturity.
There are many different bonds that fit the above description.
To give some type of standardization, the markets use a conversion factor to achieve ahypothetical bond with a 6% coupon.
8/3/2019 RMD Derivatives (vikash Nishad from Patna )
13/17
Because bond prices do not move in a linear fashion, there is a chance to use arbitrage
to capitalize on the deviance of a bond when compared to the 6% standardized bond.
To do this, traders look for the cheapest to deliver bond (CTD). This is the least
expensive underlying product that can be delivered upon expiry to satisfy therequirements of a derivative contract. This helps minimize the slippage between the
conversation factor and the actual price.
The CTD bond is always changing because prices and yields are always changing.
A contract covers $100,000 par value of U.S. Treasuries.
Contract expires March, June, September and December
Stock Index Contracts
Investors trading index options are essentially betting on the overall movement of the stock
market as represented by a basket of stocks. Options on the S&P 500 are some of the most
actively traded options in the world.
Quoted in terms equal to the index itself. For example if the S&P 500 is trading at
1050 the one-month contract may be at 1060.
Each contract has a multiplier. For the S&P 500, it is 250. The actual price in the
above point would equal 1060*250 = $265,000.
S&P 500 contracts expire in March, June, September and December and can have
maturity dates as far away as two years.
Settlement is in cash.
The FTSE 100 and Japan's Nikkei 225 are other types of indexes upon which stock
index contracts are based.
Currency Contracts
Currency contracts function in the same way as forward contracts for currency.
They are typically much smaller than forward contracts.
Each contract has a stated size and quotation unit.
8/3/2019 RMD Derivatives (vikash Nishad from Patna )
14/17
Future price for Euros = 0.92, which leads to a contract price of 125,000(this is thecontract size)(.92) = 115,000
Calls for actual delivery through book entry of the underlying currency.
Derivatives Markets
The derivatives market is the financial market for derivatives, financial instruments like
futures contracts or options, which are derived from other forms of assets.
The market can be divided into two, that for exchange-traded derivatives and that for over-
the-counter derivatives. The legal nature of these products is very different as well as the way
they are traded, though many market participants are active in both.
Derivatives markets broadly can be classified into two categories, those that are traded on theexchange and the traded one to one or over the counter. They are hence known as
Exchange Traded Derivatives
OTC Derivatives (Over The Counter)
Exchange-traded derivative (ETD)
Exchange-traded derivative are those derivatives instruments that are traded via
specialized derivatives exchanges or other exchanges. A derivatives exchange is a market
where individuals trade standardized contracts that have been defined by the exchange. A
derivatives exchange acts as an intermediary to all related transactions, and takes initial
margin from both sides of the trade to act as a guarantee. The world's largest derivatives
exchanges (by number of transactions) are the Korea Exchange (which listsKOSPI 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.
OTC and exchange-traded
In broad terms, there are two groups of derivative contracts, which are distinguished by the
way they are traded in the market:
Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated)
directly between two parties, without going through an exchange or other intermediary.
Products such as swaps, forward rate agreements, and exotic options are almost always traded
in this way. The OTC derivative market is the largest market for derivatives, and is largely
unregulated with respect to disclosure of information between the parties, since the OTC
market is made up of banks and other highly sophisticated parties, such as hedge funds.
Reporting of OTC amounts are difficult because trades can occur in private, without activitybeing visible on any exchange. According to the Bank for International Settlements, the total
http://en.wikipedia.org/wiki/Financial_markethttp://en.wikipedia.org/wiki/Derivative_(finance)http://en.wikipedia.org/wiki/Financial_instrumenthttp://en.wikipedia.org/wiki/Derivative_(finance)#Exchange-traded_derivativeshttp://en.wikipedia.org/wiki/Derivative_(finance)#Over-the-counter_derivativeshttp://en.wikipedia.org/wiki/Derivative_(finance)#Over-the-counter_derivativeshttp://en.wikipedia.org/wiki/Exchange-traded_derivative_contracthttp://en.wikipedia.org/wiki/Derivatives_exchangehttp://en.wikipedia.org/wiki/Initial_marginhttp://en.wikipedia.org/wiki/Initial_marginhttp://en.wikipedia.org/wiki/Korea_Exchangehttp://en.wikipedia.org/wiki/KOSPIhttp://en.wikipedia.org/wiki/Eurexhttp://en.wikipedia.org/wiki/CME_Grouphttp://en.wikipedia.org/wiki/Over-the-counter_(finance)http://en.wikipedia.org/wiki/Swap_(finance)http://en.wikipedia.org/wiki/Forward_rate_agreementhttp://en.wikipedia.org/wiki/Exotic_optionhttp://en.wikipedia.org/wiki/Hedge_fundhttp://en.wikipedia.org/wiki/Bank_for_International_Settlementshttp://en.wikipedia.org/wiki/Bank_for_International_Settlementshttp://en.wikipedia.org/wiki/Hedge_fundhttp://en.wikipedia.org/wiki/Exotic_optionhttp://en.wikipedia.org/wiki/Forward_rate_agreementhttp://en.wikipedia.org/wiki/Swap_(finance)http://en.wikipedia.org/wiki/Over-the-counter_(finance)http://en.wikipedia.org/wiki/CME_Grouphttp://en.wikipedia.org/wiki/Eurexhttp://en.wikipedia.org/wiki/KOSPIhttp://en.wikipedia.org/wiki/Korea_Exchangehttp://en.wikipedia.org/wiki/Initial_marginhttp://en.wikipedia.org/wiki/Initial_marginhttp://en.wikipedia.org/wiki/Initial_marginhttp://en.wikipedia.org/wiki/Derivatives_exchangehttp://en.wikipedia.org/wiki/Exchange-traded_derivative_contracthttp://en.wikipedia.org/wiki/Derivative_(finance)#Over-the-counter_derivativeshttp://en.wikipedia.org/wiki/Derivative_(finance)#Over-the-counter_derivativeshttp://en.wikipedia.org/wiki/Derivative_(finance)#Exchange-traded_derivativeshttp://en.wikipedia.org/wiki/Financial_instrumenthttp://en.wikipedia.org/wiki/Derivative_(finance)http://en.wikipedia.org/wiki/Financial_market8/3/2019 RMD Derivatives (vikash Nishad from Patna )
15/17
outstanding notional amount is US$684 trillion (as of June 2008). Of this total notional
amount, 67% are interest rate contracts, 8% are credit default swaps (CDS), 9% are foreign
exchange contracts, 2% are commodity contracts, 1% are equity contracts, and 12% are other.
Because OTC derivatives are not traded on an exchange, there is no central counter-party.
Therefore, they are subject to counter-party risk, like an ordinary contract, since eachcounter-party relies on the other to perform.
Common derivative contract types
There are three major classes of derivatives:
Futures/Forwards are contracts to buy or sell an asset on or before a
future date at a price specified today? A futures contract differs from a forward contract in
that the futures contract is a standardized contract written by a clearing house that operates an
exchange where the contract can be bought and sold, whereas a forward contract is a non-
standardized contract written by the parties themselves.
Options are contracts that give the owner the right, but not the
obligation, to buy (in the case of a call option) or sell (in the case of a put option) an asset.
The price at which the sale takes place is known as the strike price, and is specified at the
time the parties enter into the option. The option contract also specifies a maturity date. In the
case of a European, the owner has the right to require the sale to take place on (but not
before) the maturity date; in the case of an American option, the owner can require the sale to
take place at any time up to the maturity date. If the owner of the contract exercises this right,
the counter-party has the obligation to carry out the transaction.
Swaps are contracts to exchange cash (flows) on or before a specified
future date based on the underlying value of currencies/exchange rates, bonds/interest rates,
commodities, stocks or other assets.
More complex derivatives can be created by combining the elements of these
basic types. For example, the holder of a swaption has the right, but not the obligation, to
enter into a swap on or before a specified future date.
Examples
The overall derivatives market has five major classes of underlying asset:
Interest rate derivatives (the largest)
Foreign exchange derivatives
Credit derivatives
Equity derivatives
Commodity derivatives.
http://en.wikipedia.org/wiki/Interest_rate_derivativehttp://en.wikipedia.org/wiki/Credit_default_swaphttp://en.wikipedia.org/wiki/Credit_risk#Counterparty_riskhttp://en.wikipedia.org/wiki/Contracthttp://en.wikipedia.org/wiki/Futures_contracthttp://en.wikipedia.org/wiki/Forward_contracthttp://en.wikipedia.org/wiki/Contractshttp://en.wikipedia.org/wiki/Assethttp://en.wikipedia.org/wiki/Clearing_house_(finance)http://en.wikipedia.org/wiki/Option_(finance)http://en.wikipedia.org/wiki/Call_optionhttp://en.wikipedia.org/wiki/Put_optionhttp://en.wikipedia.org/wiki/Strike_pricehttp://en.wikipedia.org/wiki/American_optionhttp://en.wikipedia.org/wiki/Swap_(finance)http://en.wikipedia.org/wiki/Swaptionhttp://en.wikipedia.org/wiki/Interest_rate_derivativeshttp://en.wikipedia.org/wiki/Foreign_exchange_derivativehttp://en.wikipedia.org/wiki/Credit_derivativeshttp://en.wikipedia.org/wiki/Equity_derivativeshttp://en.wikipedia.org/w/index.php?title=Commodity_derivatives&action=edit&redlink=1http://en.wikipedia.org/w/index.php?title=Commodity_derivatives&action=edit&redlink=1http://en.wikipedia.org/wiki/Equity_derivativeshttp://en.wikipedia.org/wiki/Credit_derivativeshttp://en.wikipedia.org/wiki/Foreign_exchange_derivativehttp://en.wikipedia.org/wiki/Interest_rate_derivativeshttp://en.wikipedia.org/wiki/Swaptionhttp://en.wikipedia.org/wiki/Swap_(finance)http://en.wikipedia.org/wiki/American_optionhttp://en.wikipedia.org/wiki/Strike_pricehttp://en.wikipedia.org/wiki/Put_optionhttp://en.wikipedia.org/wiki/Call_optionhttp://en.wikipedia.org/wiki/Option_(finance)http://en.wikipedia.org/wiki/Clearing_house_(finance)http://en.wikipedia.org/wiki/Assethttp://en.wikipedia.org/wiki/Contractshttp://en.wikipedia.org/wiki/Forward_contracthttp://en.wikipedia.org/wiki/Futures_contracthttp://en.wikipedia.org/wiki/Contracthttp://en.wikipedia.org/wiki/Credit_risk#Counterparty_riskhttp://en.wikipedia.org/wiki/Credit_default_swaphttp://en.wikipedia.org/wiki/Interest_rate_derivative8/3/2019 RMD Derivatives (vikash Nishad from Patna )
16/17
Some common examples of these derivatives are:
UNDERLYING
CONTRACT TYPES
Exchange-traded futures
Exchange-tradedoptions
OTC swap OTC forward OTC option
Equity
DJIA Index
future
Single-stock
future
Option
on DJIA Index
future
Single-share
option
Equity swap
Back-to-back
Repurchase
agreement
Stock option
Warrant
Turbo warrant
Interest rate
Eurodollar
future
Euribor future
Option onEurodollar future
Option on
Euribor future
Interest rate
swap
Forward rate
agreement
Interest rate cap
and floor
Swaption
Basis swap
Bond option
Credit Bond futureOption on Bond
future
Credit
default
swap
Total return
swap
Repurchase
agreement
Credit default
option
Foreign exchangeCurrency
future
Option on
currency future
Currency
swap
Currency
forward Currency option
CommodityWTI crude oil
futures
Weather
derivatives
Commodity
swap
Iron ore
forward
contract
Gold option
http://en.wikipedia.org/wiki/Dow_Jones_Industrial_Averagehttp://en.wikipedia.org/wiki/Single-stock_futureshttp://en.wikipedia.org/wiki/Single-stock_futureshttp://en.wikipedia.org/wiki/Dow_Jones_Industrial_Averagehttp://en.wikipedia.org/wiki/Equity_swaphttp://en.wikipedia.org/wiki/Equity_swaphttp://en.wikipedia.org/wiki/Repurchase_agreementhttp://en.wikipedia.org/wiki/Repurchase_agreementhttp://en.wikipedia.org/wiki/Stock_optionhttp://en.wikipedia.org/wiki/Warrant_(finance)http://en.wikipedia.org/wiki/Turbo_warranthttp://en.wikipedia.org/wiki/Interest_rate_swaphttp://en.wikipedia.org/wiki/Interest_rate_swaphttp://en.wikipedia.org/wiki/Interest_rate_swaphttp://en.wikipedia.org/wiki/Forward_rate_agreementhttp://en.wikipedia.org/wiki/Forward_rate_agreementhttp://en.wikipedia.org/wiki/Forward_rate_agreementhttp://en.wikipedia.org/wiki/Interest_rate_cap_and_floorhttp://en.wikipedia.org/wiki/Interest_rate_cap_and_floorhttp://en.wikipedia.org/wiki/Swaptionhttp://en.wikipedia.org/wiki/Basis_swaphttp://en.wikipedia.org/wiki/Bond_optionhttp://en.wikipedia.org/wiki/Credit_default_swaphttp://en.wikipedia.org/wiki/Credit_default_swaphttp://en.wikipedia.org/wiki/Credit_default_swaphttp://en.wikipedia.org/wiki/Total_return_swaphttp://en.wikipedia.org/wiki/Total_return_swaphttp://en.wikipedia.org/wiki/Repurchase_agreementhttp://en.wikipedia.org/wiki/Repurchase_agreementhttp://en.wikipedia.org/wiki/Repurchase_agreementhttp://en.wikipedia.org/wiki/Credit_default_optionhttp://en.wikipedia.org/wiki/Credit_default_optionhttp://en.wikipedia.org/wiki/Credit_default_optionhttp://en.wikipedia.org/wiki/Currency_futurehttp://en.wikipedia.org/wiki/Currency_futurehttp://en.wikipedia.org/wiki/Currency_swaphttp://en.wikipedia.org/wiki/Currency_swaphttp://en.wikipedia.org/wiki/Currency_swaphttp://en.wikipedia.org/wiki/Currency_forwardhttp://en.wikipedia.org/wiki/Currency_forwardhttp://en.wikipedia.org/wiki/Currency_forwardhttp://en.wikipedia.org/wiki/Currency_optionhttp://en.wikipedia.org/wiki/Currency_optionhttp://en.wikipedia.org/w/index.php?title=WTI_crude_oil_futures&action=edit&redlink=1http://en.wikipedia.org/w/index.php?title=WTI_crude_oil_futures&action=edit&redlink=1http://en.wikipedia.org/wiki/Weather_derivativeshttp://en.wikipedia.org/wiki/Weather_derivativeshttp://en.wikipedia.org/wiki/Weather_derivativeshttp://en.wikipedia.org/wiki/Commodity_swaphttp://en.wikipedia.org/wiki/Commodity_swaphttp://en.wikipedia.org/wiki/Commodity_swaphttp://en.wikipedia.org/wiki/Gold_as_an_investment#Derivatives.2C_CFDs_and_spread_bettinghttp://en.wikipedia.org/wiki/Gold_as_an_investment#Derivatives.2C_CFDs_and_spread_bettinghttp://en.wikipedia.org/wiki/Gold_as_an_investment#Derivatives.2C_CFDs_and_spread_bettinghttp://en.wikipedia.org/wiki/Commodity_swaphttp://en.wikipedia.org/wiki/Commodity_swaphttp://en.wikipedia.org/wiki/Weather_derivativeshttp://en.wikipedia.org/wiki/Weather_derivativeshttp://en.wikipedia.org/w/index.php?title=WTI_crude_oil_futures&action=edit&redlink=1http://en.wikipedia.org/w/index.php?title=WTI_crude_oil_futures&action=edit&redlink=1http://en.wikipedia.org/wiki/Currency_optionhttp://en.wikipedia.org/wiki/Currency_forwardhttp://en.wikipedia.org/wiki/Currency_forwardhttp://en.wikipedia.org/wiki/Currency_swaphttp://en.wikipedia.org/wiki/Currency_swaphttp://en.wikipedia.org/wiki/Currency_futurehttp://en.wikipedia.org/wiki/Currency_futurehttp://en.wikipedia.org/wiki/Credit_default_optionhttp://en.wikipedia.org/wiki/Credit_default_optionhttp://en.wikipedia.org/wiki/Repurchase_agreementhttp://en.wikipedia.org/wiki/Repurchase_agreementhttp://en.wikipedia.org/wiki/Total_return_swaphttp://en.wikipedia.org/wiki/Total_return_swaphttp://en.wikipedia.org/wiki/Credit_default_swaphttp://en.wikipedia.org/wiki/Credit_default_swaphttp://en.wikipedia.org/wiki/Credit_default_swaphttp://en.wikipedia.org/wiki/Bond_optionhttp://en.wikipedia.org/wiki/Basis_swaphttp://en.wikipedia.org/wiki/Swaptionhttp://en.wikipedia.org/wiki/Interest_rate_cap_and_floorhttp://en.wikipedia.org/wiki/Interest_rate_cap_and_floorhttp://en.wikipedia.org/wiki/Forward_rate_agreementhttp://en.wikipedia.org/wiki/Forward_rate_agreementhttp://en.wikipedia.org/wiki/Interest_rate_swaphttp://en.wikipedia.org/wiki/Interest_rate_swaphttp://en.wikipedia.org/wiki/Turbo_warranthttp://en.wikipedia.org/wiki/Warrant_(finance)http://en.wikipedia.org/wiki/Stock_optionhttp://en.wikipedia.org/wiki/Repurchase_agreementhttp://en.wikipedia.org/wiki/Repurchase_agreementhttp://en.wikipedia.org/wiki/Equity_swaphttp://en.wikipedia.org/wiki/Dow_Jones_Industrial_Averagehttp://en.wikipedia.org/wiki/Single-stock_futureshttp://en.wikipedia.org/wiki/Single-stock_futureshttp://en.wikipedia.org/wiki/Dow_Jones_Industrial_Average8/3/2019 RMD Derivatives (vikash Nishad from Patna )
17/17
Conclusion
Derivative securities markets play an important role by allowing investors who do not want
the risks associated with holding an asset to transfer it to those who do. However, because
they are markets for risk as opposed to physical assets, derivatives markets can be very
dangerous places for unsophisticated investors. People who reduce their risk by entering a
derivative market are called hedgers, and those who increase their risk are called speculators.
The derivative securities markets play a vital role in the modern financial systems and
without them many common business transactions would be rendered much riskier or
practically impossible.
1. Derivatives can enhance financial intermediation and economic growth but requireefficient underlying cash markets and sound infrastructure
2. Modern exchanges with leading risk systems (CCP, dynamic margins, buffer) canenhance transparency, safety, and competitiveness of a financial system
3. Prudential supervision is critical for FX and credit derivatives which could underminefixed prices, pegged FX regimes, and credit policies
4. Securitization products should be grounded on sound OTC derivative marketstructures