DERIVATIVES

INTRODUCTION:

 The financial derivatives came into spotlight in post-1970 period due to

growing instability in the financial markets

 Important derivatives are listed below:

Derivatives

Forwards Futures Swaps

Interest Rate
Options Currency Swaps
Swaps

Call Options Put Options

 Derivative products initially emerged, as hedging devices against fluctuations

in commodity prices.

 They derive value from an underlying asset class.

A DERIVATIVE IS A FINANCIAL INSTRUMENT WHOSE VALUE IS DERIVED FROM THE

PRICE OF A MORE BASIC ASSET CALLED THE UNDERLYING ASSET. THEY ARE WIDELY
USED AS HEDGING INSTRUMENTS DUE TO THEIR FLEXIBILITY

 The term Derivative has been defined in Securities Contracts (Regulations)

Act, as:

 A security derived from a debt instrument, share, loan, whether

secured or unsecured, risk instrument or contract for differences or
any other form of security.

 A contract which derives its value from the prices, or index of prices, of
underlying securities.
  These underlying can be :

 Stocks (Equity)

 Agricultural Commodities including grains, coffee beans, etc.

 Precious metals like gold and silver.

 Foreign exchange rate

 Bonds

 Short-term debt securities such as T-bills

DERIVATIVES IN INDIA

14 December 1995 : NSE asked SEBI for permission to trade index futures.

18 November 1996 : SEBI setup L.C.Gupta (chairmen of SEBI) Committee to draft a

policy framework for index futures.

11 May 1998 : L.C.Gupta Committee submitted report.

December 1999 : The Securities Contract Regulation Act (SCRA)

 25 May 2000 : SEBI gave permission to NSE and BSE to do index futures
trading.

 9 June 2000 : Trading of BSE SenSex futures commenced at BSE.

 12 June 2000 : Trading of Nifty futures commenced at NSE.

 July 2001 : Trading in options on individual securities

 2008 NSE has Started Currency Derivatives

Derivatives can be broadly classified as under:

 Forward Contract

 Future Contract

 Options

 Swaps

 FORWARD CONTRACT
A FORWARD CONTRACT IS AN AGREEMENT BETWEEN TWO COUNTERPARTIES TO
EXCHANGE AN ASSET AT AN AGREED-UPON PRICE AT A SPECIFIED POINT IN THE
FUTURE.

A forward contract is an agreement between two parties to buy or sell an asset at a

certain future time for a certain future price.

 Forward contracts are normally not exchange traded.

 The party that agrees to buy the asset in the future is said to have the
long position.

 The party that agrees to sell the asset in the future is said to have the
short position.

 The specified future date for the exchange is known as the delivery
(maturity) date.

MAIN FEATURES OF FORWARD CONTRACTS:

 Over the Counter (OTC) product.

 Customized contract terms.

 No cash flows until delivery

 Less Liquid.

 No margin payment.

 Exposed to counter party risk.

 Settlement happens at end of contract .

 FUTURE CONTRACT

A FUTURE CONTRACT IS SIMILAR TO A FORWARD CONTRACT , It involves an

obligation on both the parties i.e the buyer and the seller to fulfill the terms of the
contract (i.e. these are pre-determined contracts entered today for a date in the
future)

Futures Contract

 TRADED ON ORGANIZED EXCHANGES

 Margin requirements and periodic margin calls

 NOT SUBJECT TO COUNTERPARTY RISK

  Standardized Contracts.

 At a specific price.

 Stated date (Expiration Date).

 Marked to Market on a daily basis.

 Futures can be cash settled or settled by physical delivery. .

Options:

 Options are financial instruments whose value depends on an underlying

asset.

 Options are the most versatile trading instrument ever invented.

 Options give the holder the right but not the obligation to buy or sell the
underlying asset at a pre-specified price for a fixed duration.

 For every buyer of an option there is a seller, called the ‘writer’. The seller
receives an amount called the ‘premium’ from the buyer.

 The premium is dependent on many factors like the underlying asset price.

There are two kinds of options. An ‘European option’, which can only be exercised
on the maturity date, and an ‘American option’ which can be exercised any day
till the maturity date of the option.

THEY ARE TRADED ON :

 EXCHANGES

 OVER-THE –COUNTER MARKET

 OPTIONS ARE CLASSIFIED INTO :

 CALL OPTION: PROVIDES THE RIGHT TO BUY AN ASSET.

 PUT OPTION: PROVIDES THE RIGHT TO SELL AN ASSET.

 CALL OPTION

 A call option gives the buyer/holder the right to buy the underlying asset at a
predetermined price (called the strike or exercise price) on or before the
expiration of the option.
 The buyer pays a price or premium for this right. This is called the price of an
option.

 If at expiration the option is not exercised it expires and becomes worthless.

 Call options gives the buyer the right to buy the underlying asset.

 A call option is said to be ‘in the money’ if the strike price is less than the
market price of the underlying asset.

 A call option is said to be ‘out of the money’ if the strike price is greater
than the market price of the underlying asset.

 Call Option Example

 Suppose the market price of equity share of Reliance on the expiration date
is Rs 140 and the exercise price is Rs 125 .The value of call option is Rs 15
[Rs 140 –Rs 125] In case the value of share on expiration date turn out to be
Rs 120 the value of c would not be negative Rs 5 [Rs 120 –rs125 ], it would
be zero as the investor would not purchase share Rs 125 which is available
in the market and thereby incur a loss Rs 5per share.

 In the money, at the money and out of the money

 1. If price of stock > strike price – it is profitable for the holder to

exercise the call options. The option is in the money.

 2. If stock price = strike price – the option is at the money.

 3. If the stock price < strike price - the option is out of the money. The
investor should not exercise the option.

 Put Option

 Put options gives the buyer the right to sell the underlying asset.

 A put option is ‘in the money’ when the strike price is greater than the
market price.

 A put option is ‘out of the money’ if the strike price is less than the market
price.

 A put option gives the buyer of the option the right to sell the underlying
asset at a fixed price on or before the expiration of the option. The buyer of
the put option also pays a price to acquire this right.
 If the price of the underlying asset is greater than the strike price the option
will not be exercised and expires worthless.

 If the price of the underlying asset is smaller than the strike price the holder
of the put option will exercise the option and sell the stock at the strike price,
claiming the difference between the strike price and the market value of the
asset as gross profit.

 Netting out the initial cost paid for the put option yields the net profit from
the transaction.

 There is however no guarantee that the investor will make a profit. The value
of the underlying asset may be greater than the strike price and the investor
must not exercise the put option. In that case he makes a loss equal to the
initial cost of the investment.

 Put Option Example

 Consider an investor who wants the right to sell reliance equity shares at Rs
135 after 2 months. He is to buy a 2 month put option with a Rs 135
exercise price. In case the market price of the reliance share increases to Rs
150 (S1< E) the put option will expire worthless as it will be more profitable
for an investor to sell in the open market at Rs 150 than to the put option
writer at Rs 135.

 If the market price falls below the sp say to Rs 125 it will be profitable for the
put option holder to excise his put option right as he get Rs 135 compared to
Rs 125.

 SWAPS

 Meaning

 Traded In OTC Markets

 Swaps are not debt instrument to raise capital

 Types of Swaps

 A swap is an agreement between two parties to exchange the cash flows in

the future. The agreement defines the dates when the cash flow are to be
paid and the way it has to be calculated.

 There are two basic types of swaps : (1) Interest Rate Swap

 (2) Currency Swap

  Interest rate swaps Example

 It can be used to overcome the asset-liability mismatch, with the help of the
following example. Bank A has floating rate assets earning (MIBOR+3%)
(Mumbai Inter Bank Offer Rate) funded with fixed rate liability of 12%. Bank B
has fixed rate assets earning 17%, funded with floating rate liability
(MIBOR+1%). Now, if the interest rate falls, Bank A will suffer as it will
receive less on its assets whereas it will have to pay fixed interest. And if the
interest rate rises, Bank B will suffer as it will have to pay more, liabilities
being floating in nature. Hence both the banks suffer from asset-liability
mismatch.

 To overcome this, they may enter into a swap transaction wherein:

 Bank A will pay Bank B, floating rate of interest, say MIBOR annually, on the
notional principal.

 Bank B will pay Bank A, a fixed rate of interest, say 14% annually, on the
same notional principal.

 This would ensure that both the banks will stand to gain a definite spread
irrespective of the level of MIBOR.

 Currency Swaps Example

 Suppose company C wants to borrow US$ funds and the Company D wants to
borrow £ funds. Their financing details are given in the following example:

$
£ Borrowing Preference
Company Borrowing
C 10% 7% $ Loan
D 11% 11% £ Loan
Spread 1% 4%


 From the given information, C enjoys absolute advantage over D in both the
$ and £ loan market. But the comparative advantage for C exists in the £
loan market. So it is advisable for C to borrow £ funds and for D to borrow $
funds from the market and then enter into a foreign currency swap deal to
achieve their preferred form of funding with a lower cost. Let us check how to
 construct a deal between them. It is assumed that C needs $100 crores. The
current spot $/£ rate at the time of entering into the swap is 1.80 $/£.

 The calculation of the benefit earned from the swap is :

 Total cost of borrowing without the swap = 10 + 11 = 21%

 Total cost of borrowing with the swap = 7+11 = 18%

 Therefore, net savings = 3%

 This savings may be shared between C and D in a mutually agreed upon

ratio. In our discussion, we assume it to be shared equally for easy
calculation. Hence, the net cost of borrowing for both the parties will be:

 C = 10-1.50 = 8.50%

 D = 11-1.50 = 9.50%

 Their swap structure is :

 Therefore, to enter into the swap deal the following transactions are
required:

 Exchange of Principal: C will borrow £55.55 (100/1.80) crore and give it to

D and D will borrow $100 crore and give it to C.

 Interest Payments: C will pay 11% to D on the $100 crore borrowed by D

and D will pay 9.5% to C on the £55.55 crore borrowed by C.

 Re-exchange of Principal: After the swap matures, the principal amount

exchanged between C and D will be re-exchanged between them. That is, C
will return $100 crore to D and D will return £55.55 crore to C.

 Benefits of currency swaps:

 Help portfolio managers regulate their exposure to interest rates.

 Speculators can benefit from a favorable change in interest rates.

 Reduce uncertainty associated with future cash flows as it enables companies

to modify their debt conditions.

 Reduce costs and risks associated with currency exchange.

 Companies having fixed rate liabilities can capitalize on floating-rate swaps

and vise versa, based on the prevailing economic scenario.
 Limitations of currency swaps:

 Exposed to credit risk as either one or both the parties could default on
interest and principal payments.

 Vulnerable to the central government’s intervention in the exchange

markets.

 This happens when the government of a country acquires huge foreign debts
to temporarily support a declining currency. This leads to a huge downturn in
the value of the domestic currency.

 Derivatives are traded in two kinds of markets: in exchanges and in over-the-

counter (OTC) markets.

 (OTC) derivatives are contracts that are traded directly between two
parties, without going through an exchange or other intermediary.

 Eg:- Swaps, Forward contract.

 Exchange Traded Derivatives (ETD) are those derivatives instruments that

are traded via specialized derivatives exchanges or other exchanges.

 Examples of Derivatives:

 Equity derivative.

 Commodity derivatives.

 Interest rate derivatives.

 Foreign exchange derivatives.

 Credit derivatives.

Three main traders of derivatives

 HEDGERS:

 Meaning of Hedging.

 Derivatives are viewed as a hedging instrument.

 However derivatives are increasingly being used for taking up Hedged

positions in an underlying asset.

 This enables higher returns for taking on higher risk

 Hedgers are those who protect themselves from the risk associated with the
price of an asset by using derivatives.

 Hedgers use derivatives to reduce risk that they face from potential future
movements in market variables.

 SPECULATORS:

 Speculators use derivatives to bet on the future direction of a market variable

They can, for example, buy a put option on a stock if they think it will go
down. If they think that the price of the stock will go up they will buy a call
option.

 ARBITRAGEURS

 Aim to make a risk less profit by taking advantage of price differentials and
thus bring about an alignment in prices by participating in two markets
simultaneously.

 take offsetting positions in two or more instruments to lock in a profit if

securities are inconsistently prices.

 Equity Arbitrageurs

 Commodity Arbitrageurs

 Currency Arbitrageurs