DIFFERENT ASSET CLASSES

Equity Debt Gold & other commodities Real Estate Foreign Exchange & Currency Derivatives

RISK
What

do you mean by Risk ?

Financial risk is defined as the unexpected variability of returns & thus includes both potential worse-than-expected as well as betterthan-expected returns

How

do you reduce risk ?

DERIVATIVES

Derivative is a product whose value is derived from the value of the underlying asset. Underlying asset can be equity, forex, commodity, or any other asset.

HISTORY OF DERIVATIVES
Chicago Board of Trade (1848) is the first recognised Futures Exchange Next 100 years Futures Exchanges were dominated by trading in futures of Agricultural commodities 1970 saw the introduction of futures on Financial instruments (equity, bonds & currency)

CURRENT STATUS
According to various distinguished sources the amount of outstanding derivatives worldwide as of Dec 2007 crossed USD 1,144 Trillion.
Listed

credit derivatives: USD 548 trillion;

Over-The-Counter

(OTC) derivatives: face value at USD 596 trillion and included:

Interest Rate Derivatives at about USD 393+ trillion (66%); Credit Default Swaps at about USD 58+ trillion (10%); Foreign Exchange Derivatives at about USD 56+ trillion (9%); Commodity Derivatives at about USD 9 trillion (1.5%); Equity Linked Derivatives at about USD 8.5 trillion (1.5%); Unallocated Derivatives at about USD 71+ trillion (12%)

WHAT WOULD BE THE RELATIVE POSITIONING OF USD 1,144 TRILLION FOR OUTSTANDING DERIVATIVES, I.E., WHAT IS THEIR SCALE ???
The entire GDP of the US is about USD 14 trillion. The entire US money supply is also about USD 15 trillion. The GDP of the entire world is USD 50 trillion. USD 1,144 trillion is 22 times the GDP of the whole world. The real estate of the entire world is valued at about USD 75 trillion. The world stock and bond markets are valued at about USD 100 trillion. The population of the whole planet is about 6 billion people. So the derivatives market alone represents about USD 190,000 per person on the planet.

Features:
Defined & limited life Bilateral Agreement

Purpose:
Price Discovery Risk Management / Hedging Making Markets more efficient Lowering Transaction costs

Derivatives are often criticised as being Dangerous for unknowledgeable investors & have been inappropriately linked to Gambling

TOP ON THE CHARTS

Company
Socit Gnrale Amaranth Advisors Long Term Capital Management Sumitomo Corporation Orange County Aracruz BAWAG Metallgesellschaft CITIC Pacific Barings Bank

Amount Lost
USD 7.1 bn USD 6.7 bn USD 5.85 bn USD 3.44 bn USD 2.38 bn USD 2.1 bn USD 1.97 bn USD 1.96 bn USD 1.9 bn USD 1.8 bn

Source of Loss
European Index Futures Gas Futures Interest Rate and Equity Derivatives Copper Futures Interest Rate Derivatives FX Options Foreign Exchange Trading Oil Futures Foreign Exchange Trading Nikkei Futures

Year
2008 2006 1998 1996 1994 2008 2000 1993 2008 1995

TYPES OF DERIVATIVES

Forwards

Futures

Derivatives

Swaps

Options

CLASSIFICATION OF DERIVATIVES
Derivatives
Contingent Claims
Exchange Traded OTC

Forward Commitment
Exchange Traded OTC

Standard Options

Standard Options

Forward Contract

Int Rate Options

Warrants Options on Futures Callable Bonds Convertible Bonds

Int Rate Options

Convertible Bonds Exotic Options Warrants Asset Backed Sec

Swaps

OTHER EXAMPLES OF UNDERLYING

EXCHANGEABLE
Property derivatives Energy derivatives that pay off according to a wide variety of indexed energy prices.

Oil Gas power

Commodities Freight derivatives Inflation derivatives Insurance derivatives Weather derivatives Credit derivatives Economic derivatives

FORWARD CONTRACT
Forward Contract A forward contract is a simple derivative that
involves an agreement to buy/sell an asset on a certain date at an agreed price. This is a contract between two parties.

Money

Buyer
Security

Seller

FEATURES

Delivery & Settlement of a Forward Contract Default Risk Termination of a Forward Contract

TYPES OF FORWARD CONTRACT

EQUITY FORWARDS:

Forward Contracts on Individual Stock Forward Contracts on Stock Portfolios Forward Contracts on Stock Indices

BOND & INTEREST RATE FORWARD CONTRACTS:

Forward Contracts on Individual Bonds & Bond Portfolio Forward Contracts on Interest Rates: Forwards Rate Agreements

Currency Forward Contracts Commodity Forwards

PRICING A FORWARD CONTRACT

We use the principle of No-arbitrage for pricing a Forward contract. The principle assumes the following Transaction cost is Zero There are no restrictions on short sales or on use of short sales proceeds Borrowing & Lending for unlimited amount at risk free rate Forward price = price that would not permit risk less arbitrage in frictionless market

PRICE OF A FORWARD CONTRACT

FP = S0 x (1+Rf)T

FP = Forward price of an asset S0 = Spot price Rf = Risk free rate T = Forward Contract term in years

S0 = FP / (1+Rf)T

VALUATION OF A FORWARD CONTRACT

Value of the Long Forward Contract at Zero day

V0 = S0 FP / (1+Rf)T

Value of the Long Forward Contract at any day t

Vt = St FP / (1+Rf)(T-t)

Value of the Long Forward Contract at Expiry

Vt = St FP

VALUATION OF A FORWARD CONTRACT

Value of the short Forward Contract at Zero day

V0 = FP / (1+Rf)T S0

Value of the short Forward Contract at any day t

Vt = FP / (1+Rf)(T-t) St

Value of the short Forward Contract at Expiry

Vt = FP St

EQUITY FORWARD CONTRACT

FP

(on an equity security)

= (S0 PVD) x (1+Rf)T = [S0 x (1+Rf)T] - FVD

FP

(on an equity security)

PVD = Present Value of Expected Dividends FVD = Future Value of Expected Dividends

VALUE OF EQUITY FORWARD CONTRACT

For

a long contract

Vt = [St PVDt] [FP / (1+Rf) (T-t) ]

For

a short contract

Vt = [FP / (1+Rf) (T-t) ] [St PVDt]

FORWARD CONTRACTS ON FIXED INCOME SECURITIES & RATES

Forward price on a coupon paying bond is similar to dividend paying stock

FP(fixed income security) = (S0 PVC) x (1+Rf)T

For

a long contract

Vt = [St PVCt] [FP / (1+Rf) (T-t) ]

PVC = Present Value of Expected Coupon payments

FORWARD RATE AGREEMENTS (FRA)

Forward price in a FRA is actually a forward interest rate

Today

3m

FRA 1x4
Today FRA initiation 1m FRA Expiration & Loan Initiation 4m Loan Maturity

CURRENCY FORWARDS
Consider

a importer who has to make a USD payment 12 months from now he would have to buy USD exactly 12 months from now he is not sure what the USD/INR rate would be???

Thus,

However,

Hence,

he can enter into a Forward contract to buy USD 12 months from now at a predetermined rate

Calculated as follows: Combination of spot exchange rate and interest rates over a period of time in the future
USD / INR: 42.50, US Int rates: 2.00%, Indian Interest rates: 7.50% Bank buys USD at 42.50 Borrows INR 42,500,000

Places Deposit @ 2.00%

Borrows at 7.50%

Gets USD 1,020,000

Pays INR 45,687,500

Forward rate: 45,687,500 / 1,020,000 = 44.79 Forward premium: 2.29

FP

(currency forward contract )

= S0 x[(1+RDC)T/(1+RFC)T]

F and S are quoted in domestic currency per unit of foreign currency RDC = Domestic currency interest rate RFC = Foreign currency interest rate

FUTURES
Similarity to Forwards: Deliverable contracts obligate the long to buy & short to sell a certain quantity of an asset for a certain price on specified future date Cash settlements are settled in cash on expiration date Both futures & forwards are priced to have zero value at the time of initiation

FUTURES VS FORWARDS
CRITERION Buyer-Seller Interaction Contract Terms Unilateral Reversals Default risk borne by FUTURES Via Exchange Standardised Possible Exchange FORWARDS Direct Tailor made Not Possible Individual Parties Collaterals

Default Controlled Margin Accounts by

PAYOFF PROFILE OF FUTURES

CONTRACTS
100

50
Gain / Loss

Profit
0 5000 -50 5050 5100 5150 5200

Buyer
Seller

Loss
Price

-100

PRICING INDEX FUTURES DIVIDEND AMOUNT

GIVEN

EXPECTED

Nifty futures trade on NSE as one, two and three-month contracts. Money can be borrowed at a rate of 10% per annum. What will be the price of a new two-month futures contract on Nifty? 1. Let us assume that ABC Ltd. will be declaring a dividend of Rs.20 per share after 15 days of purchasing the contract. 2. Current value of Nifty is 4000 and Nifty trades with a multiplier of 100. 3. Since Nifty is traded in multiples of 100, value of the contract is 100*4000 = Rs.400,000. 4. If ABC Ltd. Has a weight of 7% in Nifty, its value in Nifty is Rs.28,000 i.e.(400,000 * 0.07). 5. If the market price of ABC Ltd. Is Rs.140, then a traded unit of Nifty involves 200 shares of ABC Ltd. i.e. (28,000/140).

6. To calculate the futures price, we need to reduce the cost-of-carry to the extent of dividend received. The amount of dividend received is Rs.4000 i.e. (200*20). The dividend is received 15 days later and hence compounded only for the remainder of 45 days. To calculate the futures price we need to compute the amount of dividend received per unit of Nifty. Hence we divide the compounded dividend figure by 100. 7. Thus, futures price

FUTURE MARGINS & MTM

Initial Margin Requirement Maintenance Margin

Variation Margin

CALCULATION OF MARGIN FOR A LONG

POSITION
Initial Futures prices: Rs.100; Initial Margin: Rs.5; Maintenance Margin Requirement: Rs.3; No of Contracts:10
Day Beginning Balance (Margin) Funds Deposited Settlement Price Futures Price Change Gain / Loss Ending Balance (Margin)

0 1 2

0 50 42

50 0 0

100.00 99.20 96.00 -0.80 -3.20 -8.00 -32.00

50.00 42.00 10.00

3 4
5 6

10 100
125 120

40 0
0 0

101.00 103.50
103.00 104.00

5.00 2.50
-0.50 1.00

50.00 25.00
-5.00 10.00

100.00 125.00
120.00 130.00

MONETARY & NON MONETARY BENEFITS & COSTS OF HOLDING THE UNDERLYING

Recall: FP = S0 x (1+Rf)T
Any positive costs associated with holding the asset in a cash & carry arbitrage will increase the no arbitrage Futures price A monetary benefit from holding the asset will decrease the no arbitrage Futures price

FP = S0 x (1+Rf)T + FV (NC)
Net Cost (NC) = Storage cost convenience yield

FP = S0 x (1+Rf)T - FV (NB)
Net benefits (NB) = Convenience Yield storage cost

BACKWARDATION: refers to a situation where the futures price is below the spot price. For this to occur, there must be significant benefit to holding the asset, either monetary or non-monetary.

CONTANGO: refers to a situation where the futures price is above the spot price

Consider an asset priced at Rs.50. Risk free interest rate is 8% & the futures contract expires in 45 days.
a. Find the appropriate futures price if the underlying asset

b.

c. d.

e.

has no storage cost, cash flows or convenience yield Find the appropriate futures prices if the future value of storage cost on the underlying at the futures expiration equals Rs.2.25 Find the appropriate futures price if the future value of positive cash flow on the underlying asset equals Rs.0.75 Find the appropriate futures price if the future value of the net overall cost of carry on the underlying asset equals Rs.3.55 Using Part D above, illustrate how an arbitrage transaction could be executed if the futures contract is trading at Rs.60

OPTIONS
Call Options A call option gives the holder (buyer/ one who is long call), the right to buy specified quantity of the underlying asset at the strike price on or before expiration date.
The

seller (one who is short call) however, has the obligation to sell the underlying asset if the buyer of the call option decides to exercise his option to buy.

 An

investor buys One European call option on Infosys at the strike price of Rs. 2500 at a premium of Rs. 100. If the market price of Infosys on the day of expiry is more than Rs. 2500, the option will be exercised.
investor will earn profits once the share price crosses Rs. 2600 (Strike Price + Premium i.e. 2500+100). stock price is Rs. 2800, the option will be exercised and the investor will buy 1 share of Infosys from the seller of the option at Rs 2500 and sell it in the market at Rs 2800 making a profit of Rs. 200 {(Spot price - Strike price) - Premium}

The

Suppose

Put Options A Put option gives the holder (buyer/ one who is long Put), the right to sell specified quantity of the underlying asset at the strike price at expiry date.
The

seller of the put option (one who is short Put) however, has the obligation to buy the underlying asset at the strike price if the buyer decides to exercise his option to sell.

 An

investor buys one European Put option on Reliance at the strike price of Rs. 2300/- , at a premium of Rs. 125/-. If the market price of Reliance, on the day of expiry is less than Rs. 2300, the option can be exercised as it is 'in the money'.

The

investor's Break-even point is Rs. 2175/ (Strike Price - premium paid) i.e., investor will earn profits if the market falls below 2175. stock price is Rs. 2160, the buyer of the Put option immediately buys Reliance share in the market @ Rs. 2160/- & exercises his option selling the Reliance share at Rs 2300 to the option writer thus making a net profit of Rs. 15 {(Strike price Spot Price) - Premium paid}

Suppose

POSITION OF CALL OPTION BUYER

Traders

rights- Buy underlying at strike

price. Traders obligations- Nil. Premium paid or received - Paid. Margin requirements - No. Risk profile - Limited, to the extent of the premium paid. Profit potential - Unlimited, if prices go up. Breakeven point - Strike price + Premium.

POSITION OF CALL OPTION SELLER

Traders

rights- Nil. Traders obligations- Sell underlying at strike price. Premium paid or received - Received. Margin requirements - Yes. Risk profile - Unlimited, if prices go up. Profit potential - Limited , to the extent of the premium received. Breakeven point - Strike price + Premium.

PAYOFF PROFILE OF CALL OPTIONS

Strike : 100 & Premium : 5
20 Profit / Loss 15 10 5

0
-5 -10 -15 -20 Price 90 95 100 105 110 115 120

Buyer

Writer

POSITION OF PUT OPTION BUYER

Traders

rights- Sell underlying at strike price. Traders obligations- Nil. Premium paid or received - Paid. Margin requirements - No. Risk profile - Limited, to the extent of the premium paid. Profit potential - Unlimited*, if prices go down (BEP = Strike price - Premium). Practically, Put option buyers profit is limited as the price of the asset can not go below zero (Max. profit = Strike price Premium paid)

POSITION OF PUT OPTION SELLER

Traders rights- Nil. Traders obligations- Buy underlying at strike price. Premium paid or received - Received. Margin requirements - Yes. Risk profile - Unlimited*, if prices go down. Profit potential - Limited, to the extent of the premium received (BEP = Strike price - Premium) Practically, Put option sellers risk is limited as the price of the asset can not go below zero (Maximum loss = Strike price Premium received)

PAYOFF PROFILE OF PUT OPTIONS

Strike : 100 & Premium :5
15 10 Profit / Loss 5 Buyer 85 90 95 100 105 110 115 Writer

0
-5 -10 -15 Price