FINALS
DERIVATIVE MARKET
What is a “Derivative”?
• The term ‘Derivative’ stands for a contract whose
price is
derived from or is dependent upon an underlying
asset.
• The underlying asset could be a financial asset
such as
currency, stock and market index, an interest
bearing
security or a physical commodity.
• As Derivatives are merely contracts between two
or more parties, anything like weather data or
amount of rain can be used as underlying assets.
Need for Derivatives
The derivatives market performs a number of
economic
functions. They help in :
• Transferring risks• Derivatives allow risk related
to the price of underlying assets, such as
commodities, to be transferred from one party
to another. For example, a wheat farmer and a
miller could sign a futures contract to exchange a
specified amount of
cash for a specified amount of wheat in the future.
Both parties have reduced a future risk: for the
wheat farmer, the
uncertainty of the price, and for the miller, the
availability of wheat
• Discovery of future as well as current prices•
Derivative market serves as an important source of
information about prices. Prices of derivative
instruments such as
futures and forwards can be used to determine what
the market expects future spot prices to be. In most
cases, the
information is accurate and reliable. Thus, the
futures and forwards markets are especially helpful
in price discovery
mechanism.
• Catalyzing entrepreneurial activity• Something
that causes an important event to happen
• Increasing saving and investments in long run.
Participants in Derivative markets
• Hedgers use futures or options markets to reduce
or eliminate the risk associated with price of an
asset.•The term hedging means to minimize the risk
or loss. An investor who protects his investment
from unfavourable price movements is known as a
hedger.
• Speculators use futures and options contracts to
get extra leverage in betting on future movements
in the price of an asset.
•Driven by the opportunity of making profits.
They expect high risks in short time. They buy the
stock and expect the price to rise and when it does,
they sell it. They need to effectively make
predictions so that they position themselves
accordingly
• Arbitrageurs are in business to take advantage of
a discrepancy between prices in two different
markets.
• This kind of an investor buys an asset at a lesser
price from one market and sells it for a
higher price in a different market
• Example, if the price of a share of ABC Bank is
100 Rupees in Cash Market and 103 Rupees
in Futures Market. An Arbitrageur will buy the
stock at 100 Rupees in Cash Market and sell
it for 103 in Futures Market.
• Over the Counter (OTC) derivatives are those
which are privately traded between two parties and
involves no exchange or intermediary.
• Non-standard products are traded in the so-called
over-the- counter (OTC) derivatives markets
.•Varying size and amount
• The Over the counter derivative market consists of
the investment banks and include clients like hedge
funds,
Exchange Traded Derivatives Market
• A derivatives exchange is a market where
individuals trade standardized contracts that have
been defined by the exchange.
• A derivatives exchange acts as an intermediary to
all related transactions, and takes initial margin
from both sides of the trade to act as a guarantee.

Basic Terminologies
• Spot Contract: An agreement to buy or sell an
asset today.
• Spot Price: The price at which the asset changes
hands on the spot date.
• Spot date: The normal settlement day for a
transaction
done today.
• Long position: The party agreeing to buy the
underlying
asset in the future assumes a long position.
• Short position: The party agreeing to sell the
asset in the future assumes a short position
• Delivery Price: The price agreed upon at the time
the contract is entered into.
FORWARD CONTRACT
• Forward is a non-standardized contract between
two parties to buy or sell an asset at a specified
future time at a price agreed today.
• For Example: If A has to buy a share 6 months
from now. and B has to sell a share worth P.100.
So they both agree to enter in a forward contract of
P. 104. A is at “Long Position” and B is at “Short
Position” Suppose after 6 months the price of share
is P.110. so, B overall gained P. 4 but lost P 6
while A made an overall profit of Rs. 6.
SWAP CONTRACT
The derivative in which counterparties exchange
certain benefits of one party's
financial instrument for those of the other party's
financial instrument. The benefits in
question depend on the type of financial
instruments involved. The types of Swaps
are:
• Interest rate swaps
• Parties exchange a fixed-rate loan for one with a
floating rate
• Currency swaps
• One party exchanges loan payments and principal
in one currency for payments and
principal in another currency
• Commodity swaps• A contract where party and
counterparty agree to exchange cash flows, which
are dependent on the
price of an underlying commodity.
• A commodity swap is usually used to hedge
against price swings in the market for a commodity,
such
as oil and livestock.
• Equity Swap• An equity swap contract is a
derivative contract between two parties that
involves the exchange of one stream (leg) of
equity-based cash flows linked to the performance
of a stock or an equity index with another stream
(leg) of fixed-
income cash flows
• Credit default swaps• The term credit default swap
(CDS) refers to a financial derivative that allows an
investor to swap or offset their credit risk with
that of another investor
Futures contract
 is a standardized contract between two parties to
exchange a specified asset of standardized quantity
and quality for a price agreed today (the futures
price or the strike price) with delivery occurring at a
specified future date, the delivery date.
• Since such contract is traded through exchange,
the purpose of the futures exchange institution is to
act as intermediary and minimize the risk of default
by either party.
Thus the exchange requires both parties to put up an
initial amount of cash, the margin.
Concept of Margin
 Since the futures price will generally change
daily, the difference in the prior agreed-upon
price and the daily futures price is settled daily
also.
 The exchange will draw money out of one
party's margin account and put it into the
other's so that each party has the appropriate
daily loss or profit.
 Thus on the delivery date, the amount
exchanged is not the specified price on the
contract but the spot value.
Suppose an investor opens a margin account with
$5,000 of their own money and
$5,000 borrowed from their brokerage firm as a
margin loan. They purchase 200
shares of a stock on margin at a price of $50.
Assume that this investor’s broker’s
maintenance margin requirement is 30%
Value of Stocks = 10,000, 200x50
(5,000 equity and 5,000 Margin loan)
let’s say the price of this investor’s stock falls from
$50 to $35
Value of the stocks is 7,000.00. It says that the
equity should have an MMR of 30%
Equity = 7000 – 5000 (Margin loan)
= 2,000.00
MMR = 7000 x 30%
= 2,100.00
Equity < MMR (2,000<2,100)
The account equity of $2,000 is now below the
MMR of $2,100 (i.e., $7,000 x 30%). This will
trigger a margin call of $100 (or $2,100 - $2,000).
OPTIONS
An option is a derivative financial instrument that
specifies a contract between two parties for a future
transaction on an asset at a reference price.
• The buyer of the option gains the right, but not the
obligation, to engage in that transaction, while the
seller incurs the corresponding obligation to fulfill
the transaction.
TYPES OF OPTION
 Options are of two types – call and put.
 Call option give the buyer the right but not
the obligation to buy a given quantity of the
underlying asset, at a given price on or before
a particular date by paying a premium.
  Puts give the owner the right, but not
obligation to sell a given quantity of the
underlying asset at a given price on or before a
particular date by paying a premium.
FEATURE OF OPTIONS
 A fixed maturity date on which they expire.
(Expiry date)
  The price at which the option is exercised is
called the exercise price or strike price.
  The person who writes the option and is the
seller is referred as the “option writer”, and
who holds the option and is the buyer is called
“option holder”.
  The premium is the price paid for the option
by the buyer to the seller.
  A clearing house is interposed between the
writer and thebuyer which guarantees
performance of the contract.

Call Option: Investors buy calls when they believe
the price of the underlying asset will increase
Put Option: Investors buy puts when they believe
the price of the underlying asset will decrease
OPTION STYLES
• European option – an option that may only be
exercised on expiration.
• American option – an option that may be
exercised on any trading day on or before expiry.
The Process of Portfolio
Management
Investments
u Traditional investments covers:
• Security analysis
– Involves estimating the merits of individual
investments
• Portfolio management
– Deals with the construction and maintenance of a
collection of investments
Security Analysis
A three-step process
1) The analyst considers prospects for the
economy, given the state of the business cycle
2) The analyst determines which industries are
likely to fare well in the forecasted economic
conditions
3) The analyst chooses particular companies
within the favored industries
(a top-down approach)
Portfolio Management
Literature supports the efficient markets
paradigm
• On a well-developed securities exchange,
asset prices accurately reflect the tradeoff
between relative risk and potential returns of a
security
– Efforts to identify undervalued undervalued
securities are fruitless
– Free lunches are difficult to find
Market efficiency and portfolio
management
• A properly constructed portfolio achieves a
given level of expected return with the least
possible risk
– Portfolio managers have a duty to create the best
possible collection of investments for each
customer’s unique needs and circumstances
Purpose of Portfolio
Management
Portfolio management primarily involves
reducing risk rather than increasing return
• Consider two $10,000 investments:
1) Earns 10% per year for each of ten years (low
risk)
2) Earns 9%, -11%, 10%, 8%, 12%, 46%, 8%, 20%, -
12%, and 10% in the ten years, respectively (high
risk)
Low Risk vs. High Risk
Investments (cont’d)
1) Earns 10% per year for each of ten years (low
risk)
• Terminal value is $25,937
2) Earns 9%, -11%, 10%, 8%, 12%, 46%, 8%,
20%, -12%, and 10% in the ten years,
respectively (high risk)
• Terminal value is $23,642
u The lower the dispersion of returns, the greater
the terminal value of equal investments
The Portfolio Manager’s Job
Begins with a statement of investment
policy, which outlines:
• Return requirements
• Investor’s risk tolerance
• Constraints under which the portfolio must
Operate
The Six Steps of Portfolio
Management
1) Learn the basic principles of finance
2) Set portfolio objectives
3) Formulate an investment strategy
4) Have a game plan for portfolio revision
5) Evaluate performance
6) Protect the portfolio when appropriate
Background, Basic Principles, and
Investment Policy
A person cannot be an effective portfolio
manager without a solid grounding in the
basic principles of finance
u Egos sometimes get involved
• Take time to review “simple” material
• Fluff and bluster have no place in the formation
of investment policy or strategy

There is a distinction between “good
companies” and “good investments”
• The stock of a well-managed company may be
too expensive
• The stock of a poorly-run company can be a
great investment if it is cheap enough
The two key concepts in finance are:
1) A dollar today is worth more than a dollar
tomorrow
2) A safe dollar is worth more than a risky dollar
These two ideas form the basis for all
aspects of financial management
Other important concepts
• The economic concept of utility
• Return maximization
Setting objectives
• It is difficult to accomplish your objectives
until you know what they are
• Terms like growth or income may mean
different things to different people
Investment policy
• The separation of investment policy from
investment management is a fundamental
tenet of institutional money management
– Board of directors or investment policy committee
establish policy
– Investment manager implements policy
Portfolio Construction
Formulate an investment strategy based
on the investment policy statement
• Portfolio managers must understand the basic
elements of capital market theory
– Informed diversification
– Naïve diversification
Pension funds
• Significant holdings in gold and timberland
(real assets)
• In many respects, timberland is an ideal
investment for long-term investors with no
liquidity problems
Portfolio Management
Subsequent to portfolio construction:
• Conditions change
• Portfolios need maintenance
Passive management has the following
characteristics:
• Follow a predetermined investment strategy
that is invariant to market conditions or
• Do nothing
• Let the chips fall where they may
Active management:
• Requires the periodic changing of the
portfolio components as the manager’s
outlook for the market changes
Performance evaluation
• Did the portfolio manager do what he or she
was hired to do?
– Someone needs to verify that the firm followed
directions
• Interpreting the numbers
– How much did the portfolio earn?
– How much risk did the portfolio bear?
– Must consider return in conjunction with risk
• More complicated when there are cash deposits
and/or withdrawals
• More complicated when the manager uses options to
enhance the portfolio yield
Fiduciary duties
• Responsibilities for looking after someone else’s
money and having some discretion in its investment

International investment Portfolio Protection and Contemporary Issues

• Emerging markets carry special risk  Portfolio protection
• Emerging markets may not be informationally • Called portfolio insurance prior to 1987
Efficient • A managerial tool to reduce the likelihood
that a portfolio will fall in value below a
Stock categories and security analysis predetermined level
• Preferred stock
• Blue chips, defensive stocks, cyclical stocks Futures
Security screening • Related to options
• A screen is a logical protocol to reduce the • Use of derivative assets to:
total to a workable number for closer – Generate additional income
Investigation – Manage risk
Interest rate risk
Debt securities • Duration
• Pricing
• Duration Contemporary issues
– Enables the portfolio manager to alter the risk of • Derivative securities
the fixed-income portfolio component • Tactical asset allocation
• Bond diversification • Program trading
• Stock lending
• CFA program