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Prepared by:
Nishank Gonsalves (16)
Nayantara Gore (17)
Mansingh Gorkha (18)
Krishna Gosavi (19)
Mukesh Gupta (20)
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A derivative is a contract between two parties which derives its value from an underlyingasset.
The different underlying assets are:
Currency
Exchange rate Interest rate
Equity
C
ommodities
What is a Financial Derivative?
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FEATURES OF ADERIVATIVE
A derivative instrument relates to the futurecontract between two parties
The derivative instruments have the value which derived from the values of otherunderlying assets.
In general the counter parties have specifiedobligation under the derivative contract.
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Why derivative is so important today?-Growth
Driving Factors
Increased volatility in asset prices in Financial
Markets
Increased integration between International
Markets
One of the most important services provided by thederivatives is to control, avoid, shift and manage
efficiently different types of risks through various
strategies like hedging, arbitraging, spreading, etc.
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Why derivatives are used?
To insure against changes or risk (hedgers).
To get a high profit from a certain market
behavior (speculators).
To get a quick low-risk profit (arbitrageurs).
To change the nature of an investmentwithout the costs of selling one portfolio andbuying another.
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What are the different types of traders/participants inderivatives market ?
Hedgers:They are in the position where they face risk associatedwith the price of an asset. They use derivatives to reduce oreliminate risk.
For example: A farmer may use futures or options to establishthe price for his crop long before he harvests it. Various factorsaffect the supply and demand for that crop, causing prices to
rise and fall over the growing season. The farmer can watch theprices discovered in trading at the CBOT and, when they reflectthe price he wants, will sell futures contracts to assure him of afixed price for his crop.
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Speculators:
Speculators wish to bet on the future movement in theprice of an asset. They use derivatives to get extra leverage.Aspeculator will buy and sell in anticipation of future pricemovements, but has no desire to actually own the physical
commodity.
Arbitrators:
They are in the business to take advantage of a discrepancy
between prices in two different markets. If, for example,they see the future prices of an asset getting out of line withthe cash price, they will take offsetting positions in the twomarkets to lock in a profit.
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Types of Derivatives
Forwards :
A Forward is an agreement between twoparties to purchase or sell an instrument ata fixed time in the future and at a certainprice.
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Example of a forward
contract On January 20, 2009 a trader (long
position) enters into an agreement to buy
1 million in three months at an exchangerate of 1.6196
This obligates the trader to pay $1,619,600(=K) for 1 million on April 20, 2009
If the exchange rate rose to 1.65, the spotprice S
Tis $1,650,000 and the payoff is
ST
K= $1,650,000 - $1,619,600 = $30,400
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What is Offsetting the Forward Contract
One cannot unilaterally back out from the obligation
arisen in the forward contract, but he can certainly
enter into another forward position exactly opposite
the original position. This strategy is popularly
known as offsetting the forward contract.
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EXAMPLE:
January 01, 2005, a party X enters into a forwardcontract with another party Y, in which he
agrees to buy one kg of gold onA
pril 01, 2005for Rs.5,000 per 10 grams of gold. On February01, 2005, X decides to get out of his position,and hence, enters into another forward
contract with Z which he agrees to sell one kgof gold on April 01, 2005 for Rs.5,200/- per 10gram of gold.
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The Advantage/Disadvantage ofAforward Contract
Advantage
Both partieshave limited
their risk.
Disadvantage
You must make or take deliveryof the commodity and settle onthe deliver date and honor thecontract as agreed upon.
The buyer and seller aredependent upon each other.
In a forward contract, anyprofits or losses are not realizeduntil the contract "comes due"
on the predetermined date.
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A future is a standardized derivative contractbetween two parties: a buyer and a seller.
Futures are similar to forwards but they aretraded on exchanges and their terms are
standardized.
FUTURES CONTRACTS
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When the market is bullish
y Take a long positiony When Reliance Futures is at Rs. 480
y Market rises and Reliance Futures goes to Rs. 500y Sell Reliance Futuresy Profit is = Rs 20/-
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y Take a short positiony When Reliance Future is at 480
y Sell Reliance Futuresy Market falls and Reliance Futures goes to 460/-
y Buy Reliance Futures
y Profit = Rs.20/-
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WHAT IS OPTIONS?
An option is a particular type of a contract
between two parties where one person gives
the other person the right to buy or sell a
specific asset at a specified price within a
specific time period.
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TYPES OF OPTIONS
Call and Put Options
American and European Options
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Call Options : The option to buy
Put Options : The option to sell
American Options : The option can be exercisedanytime prior tomaturity.
European Options : The option can be exercised atmaturity.
TYPES OF OPTIONS
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Example ofCall Option
An investor buys a European call option onsatyam will exercise price at RS 280 for apremium of RS.10.If the price of the sharerises and current market price is RS 350 ,the owner of the option may exercise his
option to buy the shares at Rs 280.
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Example of Put Option
The investor buys a European put option onONGC share with a strike price of Rs 850 andexpiration in June, by paying a premium ofRS 25.The investor has the right to sell ONGCshare at RS 850 before the expiry date of theoption. If the current market price of share isRS 950.The investor should not exercised hisoption.
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SWAPS
Swaps have been termed as private agreementsbetween the two parties to exchange stream of cashflows against one another.
Why? To hedge risks like floating
interest rate, Currency
fluctuations, equity returns.
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Characteristics
Two parties involved
Private agreement
Cannot be traded
Termination by mutual consent
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Types of Swaps
Interest Swaps
Currency Swaps
Equity Swaps Commodity Swaps
Credit Swaps
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Interest Swap
Parties hedge interest rate
like fixed to floating
Also called vanilla swaps
Principal is not exchanged
Most commonly used.
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Example of Interest Rate Swap
Aborrows $10 million with a floating interestrate of 11% and B borrows $10 million with a
fixed interest rate of 10%. A and B can enterinto an interest rate swap arrangement underwhich Awill pay a fixed rate of interest of 10percent and B will pay a f loating interest rateof 11%.
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Currency Swap
Parties hedge on currency
fluctuations
Across two different currencies Actual exchange of currency
Interest rates/variations
swapped Transactions are reversed later
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Example ofCurrency Swap
Company A raises 1 million by issuing 10%German mark bonds and the company Braises 2 million by issuing 13% dollar bonds.Both the company Swap the transaction.
In the beginning company A receives 2million and company B receives 1 million.Both the companies re-exchange theprincipal amounts at the time of maturity.
CompanyApays, 2,60,000 to company B andcompany B in turn pays 1,10,000 to companyAas interest during the currency of loan.
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Equity Swap
Parties hedge returns on equity withFixed interest
Generally entered to avoid tax Portfolio is not exchanged
Can be hedged against currency
fluctuations.
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Credit Swap
Debt is transferred from one
Party to other
Seller guarantees creditworthiness
Buyer will make money
if credit is recovered properly
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