Management of Financial Derivatives

Objectives
 To

understand the meaning of financial derivatives;  To know the various types of financial derivatives are available;  To know about background and uses of financial derivatives;  To know classification of derivatives markets;  Difference between Forward & Futures ontract;  To know important players in the derivatives market ;

!ntroduction
" derivative is a financial product which has been derived from another financial product or commodity# Concept of Derivatives: $ " derivative is instrument whose value is derived from the value of one or more underlying assets%# These underlying assets can be securities& commodities& bullion& currency& livestocks and so forth#

-.& ' ()* "& defines the word /derivatives0 to include.3egal definition of Derivatives 4 !ndian onte2t !n !ndia& the 'ecurities ontracts ()egulations* "ct of +. " security derived from a debt instrument& share& loan whether secured or unsecured& risk instrument or contract for differences or any other form of security# " contract which derives its value from the prices& or inde2 of prices& of underlying securities# +# 1# .

!n the case of 8ifty Futures& 8ifty !nde2 is underlying asset# !t may be single stock futures like !nfosys stocks are underlying assets# .3egal definition of Derivatives5##  Derivatives derived from another financial instrument6contract called the underlying# 72ample.

counter. 1# Over.9inds of derivative contracts: Two kinds of contract: +# 72change.the.derivatives : contracts traded outside the e2changes# .traded derivatives : products 6 contracts that are traded on the e2changes .

Types of Derivatives One form of classification of derivative: (a* ommodity derivatives : Derivatives contracts traded on gold& sugar& jute& pepper& metal& agricultural products etc# (a* Financial derivatives: Derivatives contracts traded on currencies& securities& stock market indices& interest etc# .

72change traded products 4 more standardi=ed . Options . OT mechanism 4 not standardi=ed . ommodities .Features of derivatives: (1) (2) (3) Nature of Contract: Three imp# ontracts . 7<uities Market Mec anis!: . Forward & Futures . !nterest bearing financial assets . 'waps Underlying Asset: Four imp# Types . Foreign e2change .

they are said to trade over the counter (OT *# The <uantities of the underlying asset and the contract terms are fully negotiable# 3ong position 4 one of the party agrees to buy the underlying asset 'hort >osition 4 the party agrees to sell the asset# .Definitions : Derivative !nstruments "or#ard Contract: !s an agreement to buy or sell an asset on a specified future date for a specified price# These are not traded on an e2change.

Definitions : Derivative !nstruments5## "utures contract: !s traded on a futures e2changes as standardi=ed contract& subject to the rules and regulations of the e2change# !t facilitates the secondary market trading& it relates to a given <uantity of the underlying assets& for no trading of fractional contracts is allowed# .

before the contract settlement day $ Margins ?y the both parties $'rofit(loss Marked to market daily profit6loss "or#ard Tailor made& mutual agreement& 8o secondary market Delivery of asset on on maturity date 8o margin On date of maturity profit6loss booked .Differences: Futures & Forward "utures 'tandardi=ation 'td# <uality& <uantity place of delivery $%i&uidity Organi=ed e2change more li<uidity $Conclusion of Offset.

'uts give the buyer the right& but not the obligation& to sell a given <uantity of the underlying asset at a given price on or before a given date# .Definitions : Derivative !nstruments55##  )ptions : ?roadly classified as alls and >uts# Calls give the buyer the right but not the obligation to a *uy a given <uantity of the underlying asset& at a given price (e2ercise price* on or before a given future date.

The buyer pays . both the )ptions . 8o premium is paid . ontract must perform at . Obligation . @older of the contract . The buyer can e2ercise settlement date# 8ot option at any time prior obliged to perform before to the e2piry date# the date# . The buyer0s loss is is e2posed to the entire restricted to downside spectrum of downside risk risk to the premium paid# . Only the seller (writer* parties of the contract is obliged .Differences: Futures & Options "utures .

nterest rate s#aps: which entail swapping only the interest.related cash flows between the parties& in the same currency# Currency s#aps: which entail swapping both principal and interest between the parties& with the cash flows in one direction being in a different currency to those in the opposite direction# . +#aps: 'waps re agreements between two parties to swap the cash flows arising from particular financial instruments# .

Arowth of derivatives market: (in !ndia* Derivatives are financial risk management tools& which have gained a lot of importance today# Factors& responsible for the growth of financial derivatives are.  !ncreased volatility in financial markets#  !nter.linkage of national financial markets with international financial markets#  )emarkable improvement in the area of communication and !T# .

higher returns& .Arowth 55##contd##  !nnovations in financial markets& which present a combination of risk and return over a number of financial assets leading to . reduced transaction costs but increased risk# .

Arowth 55##contd## "part from acting as a risk management tool derivative& markets perform a number of economic functions like. @elping in determining current and future prices of assets# Facilitating transfer6redistribution of risk from risk averse to risk takers# .

Arowth 55##contd##  >romote entrepreneurial activities#  !ncrease market activity and efficiency#  Direct savings towards investment#  !mprove upon allocation of credit by sharing of risk#  To allow investors to leverage relatively small amounts of funds over a wide class of assets and thus diversity their portfolios# .

Derivatives:  Trading in ?'7. Dune .Derivatives market in !ndia: -&uity Derivatives: .BC(sense2* inde2 Futures .+. 1CCC# !t was introduced with three month trading cycle 4 the near month (one*& the ne2t month (two* and the far month (three*#  ?'7 'ense2 Options 4 Dune E& 1CC+  !ndividual options 4 Duly 1CC+# .

Derivatives market in !ndia55##  N+- Derivatives:  8'7 launched the '&> 8F 8ifty !nde2 futures 4 on Dune +1& 1CCC#  Futures contract on !ndividual 'tocks 4 8ov& 1CC+  !nde2 Options 4 Dune E& 1CC+  Options on individual securities 4 Duly 1& 1CC+ .

8M 7 ("hmedabad* 4 First commodity e2change.GC  -/c ange: ommodity e2change through OT otton was the first trade commodity on organi=ed e2change in !ndia# ontract )egulation "ct (F )"* governs commodity e2change in !ndia# ommodity 72change.Derivatives market in !ndia55##  Co!!odity  +.1CC1  The Forward  8ational Multi .

Derivatives market in !ndia55## ommodity 72change5555  8ational ommodities and Derivatives 72change (8 D7F* & Multi ommodity 72change (M 7* started functioning by last <uarter of 1CCB#  ?ullion and 7nergy products contribute G-.products which contribute around HC percent of 8 D7F business#  ?anks& F!s& MFs& >Fs& !nsurance & F!!s are allowed in the commodity market# .HC percent of M F business#  "gri.

.the. urrency Derivatives:  !ndia trading forward contracts in currency for the last G years#  )?! recently allowed options in the over.Derivatives market in India…….counter currency# !nterest )ate Derivatives: 8'7 introduced trading in cash settled interest rate Futures in 1CCB .

Ises of Derivatives:  Derivatives are used to control& avoid& shift and manage efficiently different risk by using various strategies like hedging& arbitraging& spreading etc#  8o immediate full amount& enhance li<uidity and reduce transaction cost#  "ttract the investors due to competitive trading in the market#  !t develops /complete markets0& where no particular investors be better of than others& or there is no further scope of additional security# .

ritics of Derivatives: 'peculative and gambling motives: more speculative trading due to more trading volume increased in multiples & only one or two percent of derivatives settled by the actual delivery#  !ncrease in risk: OT markets& as customi=ed& privately managed more credit risk#  >rice instability: due to fluctuations in asset prices#  !ncreased regulatory burden  Displacement effect: increased volume in secondary market by the investors& reduce the volume of the business in the primary market#  .

>layers in derivatives market (a) 0edgers 4 who wish to eliminate the risk (price change* to which they are already e2posed# Ex. Forex risk (Forward contract* .

#EC# !ndian firm has commitment to pay J+CC&CCC& three months now# Firm buy a forward contract at I' J+K)s#E.Hedgers Example….rupee e2change rate is I' J+K)s#E-#-C& while the three month forward rate is I'J+K)s#E. 'uppose today0s dollar.#EC "t the end of B months if the rate is J+K)s#EG#1C firm would gain 1s2345444 ()s#C#HC 2 J+CC&CCC* Lithout contract& firm needed to pay )s#EG&1C&CCC ()s#EG#1C 2 J+CC&CCC* .

#+C 2 J+CC&CCC* Firm stand to loss )s#C#BC 2 J+CC&CCC K )s#BC&CCC ..&EC&CCC ()s#E.#EC 2 J+CC&CCC* Instead of )s#E.Hedgers Example….&+C&CCC ()s#E.  'imilarly& !f the e2change rate is J+ K )s#E.#+C& firm would regret to having entered into forward contract& it would have to pay )s#E.

(*) +peculators: 'peculators are those who are willing to take risk# They consume information& make forecast about prices and put their money in these forecasts# .

72: !f share current <uoted price )s#B1 'peculators call option e2ercise price after one month )s#B>remium . Call shall not e2ercised (loss would be )s#-C or +CCM of investment* !f price of the share at )s#EC 4 all shall e2ercised +CC 2 ()s#EC 4 )s#B-* K )s#-CC (profit . ?uying option would be )s#-C (a call for +CC shares at )s#C#-C paise* !f price of the share less than or e<ual to )s#B.CM of the investment* .

Speculators may : Day traders 4 one day trading >ositions traders 4 positions for longer position (few days& weeks or even months* .

(c* "rbitrageurs: "rbitrage involves making risk.pricing# .less profit by simultaneously entering into transactions in two or more markets# "rbitrage keeps the futures and cash prices in line with one another# "rbitrage trading helps to make market li<uid& ensure accurate pricing and enhance price stability# !t involves making profits from relative mis.

72: 'uppose that at the e2piration of the gold futures contract& the futures price is )s#+-&-CC per +C grams& but the spot price is )s#+-&EHC per +C grams# "n arbitrageur could purchase the gold for )s#+-&EHC and go short a futures contract that e2pires immediately& and make a profit of )s#1C per +C grams by delivering the gold for )s#+-&-CC in the absence of transaction costs# .

)isk Transfer . with the better information and judgment# . >rice Discovery .Functions of derivatives: .

End .

Sign up to vote on this title
UsefulNot useful