ORIGIN OF ALL DERIVATIVES

Risk is the only constant, Uncertainty is the only certainty

DERIVATIVES
GOAL-to make profits? - To mitigate risks. - To transact efficiently? - for price discovery ? ORIGIN- AUG-1971 BREAK DOWN OF BRETTON-WOODS SYSTEMINFLATION/VOLATALITY OF INT/EXCH.RATES 1971 TO 1979 WATERSHEDS IN DEVELOPMENT OF WORLD DERIVATIVE MARKET.

6th OCTOBER,1979 SATURDAY NIGHT MASSACRE OF FEDERAL RESERVE-INT. RATE DEREGULATIONS/PLR-20%

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.

Financial derivatives Evolution of products

Sectoral indices Stock futures Equity Index options Stock options

Interest Rate futures

Equity Index futures

June 2000

June 2001

July 2001

Nov 2001

Dec 2002

June 2003

Phased introduction to ensure smooth transition to an active derivatives market

DERIVATIVES-GROWTH

130% growth from 1995 to 1998 Notional amount outstandingOTC Market$ 72 trillion ** Exchange traded- $ 14 trillion

**Of this, Interest rate derivatives-67% and Exchange rate derivatives31%

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

DERIVATIVES-TYPES

PRICEFIXING
FORWARDS FUTURES FRAS SWAPS

PRICEINSURANCE
OPTIONS

DERIVATIVES-TYPES

OVER THE COUNTER(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 higher liquidity Less expensive E.g:Futures Swaps/options

DERIVATIVES-CLASSES

FORWARDS/ FUTURES/SWAPS Equal rights/obligations of buyer and seller So no upfront paid by buyer.

OPTIONS
Nonlinear/asymmetric pay-off. Hence Option premium upfront.

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.

COMMON DERIVATIVES
FORWARDS FUTURES
A customized contract between two parties where settlement takes place on a specific date, in future, at a price agreed today. Are exchange traded contracts to sell or buy financial instruments or physical commodities for future delivery at an agreed price.

OPTIONS
Are contracts which give the buyer (holder) the right, but not the obligation, to buy or sell specified quantity of the underlying asset, at a specific (strike) price on or before a specified time (expiration date)

SWAPS
Are contracts between two parties, referred to as counter parties, to exchange two streams of payments for an agreed period of time.

PLAYERS IN DERIVATIVES MARKET

HEDGERS: Are investors who wish to eliminate or reduce price risk to which they are already exposed. They provide the economic substance to any financial market. SPECULATORS: Are investors who willingly take price risks to profit from price changes in the underlying asset. They provide liquidity and depth to the market. ARBITRAGEURS: Profit from a price differential existing in two markets by simultaneously operating in two different markets. They bring price uniformity and help price discovery.

WHY DERIVATIVES
To manage risks more efficiently by unbundling the risks allowing 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 becoming bankrupt.

5.

6.

7.

Counter party (credit) risk on the Exchange in case of brokers default, only partial or full compensation from the Exchange. Cash out-flow risk-unable arrange funds at the time of delivery resulting in default, auction and subsequent losses. 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

DERIVATIVES-SWAPS

Exchange of two streams of Cash Flows over a definite period of time through an intermediary. Multi-period price fixing contracts Transforms characteristics of financial claims. Access to financial markets and varied needs give rise to Swaps

Derivatives-Swaps

ECONOMIC RATIONALE: Principle of Comparative advantage. Principle of offsetting risk. TYPES: INTEREST RATE SWAPS CURRENCY SWAPS

SWAP CONTRACTS
1.

2. 3.

4.

5.

A Currency Swap helps in lowering funding cost, entering restricted capital markets, reducing currency risks, etc. Interest Rate swaps help in reducing cost of capital. Asset Swap is used to change the characteristics of the asset held. Commodity Swaps are used by dealers to manipulate payments of their products. Equity Swaps are used to hedge the downside risk of the market.

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 is determined to settle a gain or loss.

SWAP AN EXERCISE
Exchange Rates: Interest Rates: Spot GBP - $ 1.6400 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

Activity
Spot borrow Sell $ spot

GBP (inflow)
---609756

GBP (outflow)
-------

$ (inflow)
1000000 ----

$ (outflow)
---1000000

One year interest

Total 1-year hence Sell GBP @ 1.6400 Net Gain

45732 (earned)
655488 ----

----

----

55000 (pay)
1055000 ----

655488

1075000

----

----

20000

----

Spot GBP/USD rate = GBP 655488 = $ 1055000 1 GBP = $ 1.60949

Forward GBP/USD rate = 1 GBP = $ 1.6400 Therefore Forward difference = 0.03051

Options contracts
Nature and type of Options:
Party CALL OPTIONS PUT OPTIONS

Option buyer or Option holder Option Seller or Option writer

Buys the right to buy the underlying asset at the specified price Has the obligation to sell the underlying asset (to the option holder) at the specified price

Buys the right to sell the underlying asset at the specified price Has the obligation to buy the underlying asset (from the option holder) at the specified price

TERMINOLOGY IN OPTIONS CONTRACT

Term used CALL OPTIONS In the money Strike Price < Spot Price of underlying asset At the money Strike Price = Spot Price Out- of the Strike Price >Spot money Price PUT OPTIONS Strike Price > Spot Price of underlying asset Strike Strike Price <Spot Price

Strike Price = the price at which the option is exercised. Spot Price = Price ruling on the date of exercising option

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.

PROCEDURE FOR TRADING IN OPTIONS

The investor to register with a broker who is a member of the 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 next day. If held till maturity and exercised, the investor will get the difference between Option Settlement Price and the Strike Price in cash. If option is not exercised, the premium is a loss and contract expires.

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.

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.

DERIVATIVES-FUTURES

THEY ARE AKIN TO DAILY SETTLED FORWARD CONTRACTS INITIAL MARGINS/DAILY MARGINS HIGHLY GEARED /LEVERAGED INSTRUMENTS MARKING TO MARKET ON DAILY BASIS HIGHLY LIQUID/SETTLED BY CLOSING OUT

DERIVATIVES-FUTURES

BENEFITS:PRICE DISCOVERY HEDGING SPECULATIONS ABSENCE OF CREDIT RISK HIGH LEVERAGE PRICING- COST OF CARRY MODEL EXPECTATIONS MODEL

FUTURES CONTRACT FEATURES:

1. 2.

3.

4.

5.

Being Exchange traded, the contract has terms standardized by the exchange. Once the trade is confirmed, the Exchange itself becomes the counter party (or guarantees) to every trade. Credit risk gets transferred to the exchange, reducing the risk to almost nil. Due to market reporting of volumes and price, the contract is more liquid and transparent. A Futures contract can be reversed with any member of the exchange. Due to price volatility of an individual stocks, the futures are generally Index-Based.

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.

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 futures market. Leeson, chief trader for Bankings futures in Singapore took huge position in index futures of Nikkie225. Market falls by more than 1.5% in the first two months of 1995 and Barings suffered huge losses. The Bank lost $ 1.3 bl. on account of derivative trading. The loss wiped out the entire capital of Bearings.

FORWARD CONTRACTS

BILATERAL CONTRACTS WHERE BUYER AND SELLER AGREE UPON THE DELIVERY OF A SPECIFIED QUANTITY/QUALITY OF ASSET AT A SPECIFIED TIME AT A PREDETERMINED PRICE. HENCE AN OTC DERIVATIVE

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.

FORWARD CONTRACTSFEATURES

OTC DERIVATIVE-PRICE FIXING PRODUCT FORWARD PRICE = SPOT OR CASH PRICE + COST OF CARRY LIMITATIONS-CREDIT RISK.

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 %

DERIVATIVES-FRAs

Price fixing & OTC product. Inter-Bank tool for hedging short term interest rate risk. 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 no Futures.