Diploma In Management Adani Group Financial Management

Derivative
Submitted to : Prof. Deepak Dhanak Submitted by : Shalin Shah Yogesh Dalal Ishwar Dubey

RISK /Uncertainty???
Case : • An Indian Garments company has received an order to supply I,00,000 units of shirts from USA. • The price of $ 100,000 is receivable after six months. The current exchange rate is Rs.55/$ • At the current exchange rate, the company would get after 6 months : 55 × 100,000 = Rs 55,00,000 • But the company anticipates appreciation of Indian rupee over time i.e rupee will be at Rs. 50/ usd after 6 months • Does the company loose/gain due to appreciation in the Indian Rupee? • Can company minimise such risk?

Minimizing risk case
• The company can lock in the exchange rate by entering into an advance contract and forget about any fluctuation in the exchange rate. • Suppose, company can enter into contract to sell USD after 6 months at exchange rate is Rs55.50/$ • At the time of receiving dollar, it will exchange $100,000 at Rs55.50= Rs 55,50,000 • Thus company can eliminate further volatility of exchange rate in future by entering forward contract rate.

Types of Risk - Coverage
• • • • Firms are exposed to several risks in the ordinary course of operations and borrowing funds. For some risks, management can obtain protection from an insurance company(fire, loss of profit / loss of stock, marine insurance) Similarly, there are capital market products available to protect against certain risks. Such risks include risks associated with a rise in the price of commodity purchased as an input, a decline in a commodity price of a product the firm sells, a rise in the cost of borrowing funds and an adverse exchange rate

movement.

• The instruments that can be used to provide such protection are called derivative instruments

What is a Derivative?  Derivative comes from the word “ to derive”  A derivative is a contract whose value is derived from the value of another asset called underlying asset  If the price of underlying asset/security changes the price of derivative security also changes. foreign exchange or commodities. interest rates.  The price movements of derivative products are related to that of the underlying securities. options contracts .  The underlying asset can be equity.  These instruments include futures contracts. forward contracts. fixed income instruments.

natural gas. pepper. silver. crude oil. bulk of wheat.  Financial derivatives – • Derivative minimises the risk of owning things that are subject to unexpected price fluctuations like foreign currencies. cotton. stocks & bonds. soyabean. indexes. Eurodollar etc. foreign exchange. . corn. bonds.  Underlying is stocks. turmeric etc. gold. oats.Underlying Asset/Security  Commodity derivative –  Underlying is wheat.

coffee beans. – Crude oil – Foreign exchange rate – Short-term debt securities such as T-bills – Index – Interest rate . pepper.Derivative instruments on – Stocks (Equity) – Agri Commodities including grains.. – Precious metals like gold and silver.

Various types of Derivatives .

Why Derivatives exist Two Purposes HEDGING SPECULATION .

currencies.Factors Driving The Growth Of Derivatives • Increased volatility in commodity prices. . stock prices etc • Increased integration with the international markets • Development of more sophisticated risk management tools.

Advantages • The derivative market helps people meet diverse objectives such as: – Hedging – Profit making through arbitrage .

if the dollars are going down.Derivatives . it means that the professional investors are expecting dolor price to go down in the future – this is a good sign for you to buy in the spot market • Risk transfer – A derivative market provides protection against risk – Derivative instruments redistribute the risk amongst market players . That way derivative market feeds the spot market – For instance.Uses • Price discovery – Most price changes are first reflected in the derivative market.

Players in the market • Banks-Citi Bank • Deutsche Bank • Goldman Saches • JP Morgan Chase • HSBC • ICICI .

Participants in Forward Contracts • Hedgers – They participate in the forward market with a view to protect or cover an existing exposure in the spot market. • Speculators – These dealers based on their opinion about the market movements take an exposure in the forward market with a view to make profits from the expected movement in the underlying element. • Arbitrageurs – These players neither hedge nor speculate. . They try to take advantage of the price differences in the spot and forward markets.

Types of Financial Derivatives • • • • Forwards Futures Options Swaps .

• These contracts are not standardized. . the end users can tailor make the contracts to fit their very specific needs.FORWARDS • It is a contract between two parties to buy or sell an underlying asset at today’s preagreed price (known as Forward Price) on a specified date in the future. • This forward price is set at the inception of contract • It is the most basic form of derivative contract. Traded at Over The Counter exchange.

000 is payable after six months. 55.000. . then also the company has to pay Rs. The price of $ 1.000 • If the company anticipates depreciation of Indian rupee over time i. 60 / use • The company can enter into a forward contract at 55& forget about any exchange rate fluctuations.Example • An Indian Company has ordered machinery from USA.00.00.000 for buying $ 1.00. At the current rate the company needs 55*1.000 though the value is 6.000 = 55. The current exchange rate is 55 as on date. Suppose the exchange rate becomes 60.e expect the rupee to reach up to Rs.00.00.00.

and • Commodity Forwards . the most common types of forward contracts are: • Currency Forwards • Interest Rate Forwards.Different Types of Forward Contracts Depending on the underlying asset.

FUTURES  Futures are financial contracts to eliminate the risk of change in price in the future date.  Futures Price : The price agreed by the two traders on the floor of exchange.  In simple terms. a futures contract is a contract that allows the counterparties to exchange the underlying assets in future at a price agreed upon today. Futures are highly standardized exchange traded contracts to buy or sell specified quantity of financial instruments/commodity in a designated future month at a future price.  Following are the features of a futures contract-      Settlement guaranteed by the clearing corporation of the exchange Contract through an exchange To exchange obligations on a future date At a price decided today For a quantity / quality standardized by the exchange .

Types of Futures Types of Futures • Commodity futures (Wheat. .) and • Financial futures Financial futures include: – Foreign currencies – Interest rate – Market index futures (Market index futures are directly related with the stock market) – Individual stock. corn. etc.

Difference between forwards and futures Forwards Futures Nature of the contract Counterparty Customized Any entity Forwards Futures Standardized Clearing house of exchange Credit Risk Liquidity Margins Exists Poor Not Required Assumed by the exchange Very High Received / Paid on daily basis Done on daily basis Valuation Not Done .

the change in the amount of an account on a given day in response to a market –to-market process. is settled on daily basis.e. • The initial margin is fixed by the broker.Margin • It is the initial deposit required to open a trading account in a futures trading exchange. . • The variation margin i. but has to satisfy an exchange minimum.

. This process is known as marking to market.Margin . the difference in the prior agreed-upon price and the daily futures price is settled daily • 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. • If the margin account goes below a certain value. the margin. then a margin call is made and the account owner must replenish the margin account. since the futures price will generally change daily.Process • The exchange requires both parties to put up an initial amount of cash. Additionally.

the investor is expected to top up the initial level before trading commences on the next day. • Marking to Market – In the futures market at the end of each trading day.• Initial Margin – The amount that must be deposited in the margin account when establishing a position. The margin requirement is about 12% futures & 8% for options. . If the balance in the margin account falls below the maintenance margin. the margin account is adjusted to reflect the investor’s gain or loss depending upon the futures closing account. • Maintenance Margin – This is set to ensure that the balance in the margin account never becomes negative.

This means the MTM loss is 25% which is more than the threshold MTM loss % of 20% and hence additional margin to be called in for.1625 .2625 Rs.1000 Rs.100 and Threshold MTM Loss is 20% and the applicable margin % is 35%. You would be having a margin of Rs.75. Additional margin to be calculated as follows: (a) Margin available (b) Less : MTM Loss (c) Effective available margin (d) Required Margin (e) Additional Margin required 100*100*35% (100-75)*100 (a-b) 75*100*35% (d-c) Rs.2500 Rs.For example say you have bought 100 shares of XYZ at Rs.3500 Rs. The current market price is now say Rs.3500 blocked on this position.

• If the buyer decides to exercise his right the seller of the option has an obligation to deliver or take delivery of the underlying asset at the price agreed upon. • The option buyer has the right not an obligation to buy or sell.OPTIONS • An option is a contract between two parties in which one party has the right but not the obligation to buy or sell some underlying asset on a specified date at a specified price. option is like general insurance . • Hence.

Options . .characteristics • • • • • • Options or option contracts are instruments Right. but not the obligation. is given To buy or sell a specific asset At a specific price On or before a specified date Options can be exchange traded derivatives or even over the counter derivatives.

Option Classifications • Call Option : an option which gives a right to buy the underlying asset at a strike price. . • Put Option : an option which gives a right to sell the underlying asset at strike price.

CALL OPTIONS  A call option is a contract that gives the option holder the right to buy some underlying asset from the option seller at a specified price on or before a specified date. o A call option on the share would give the right to buy the share at a specified price (Rs. o An option contract is created and traded on this share. the seller of the option. o This call option would be traded between two parties P (the purchaser and S ( the seller).69. Eg. .2) to S.75) during April 2013. The current market price Ashok Leyland is Rs. The purchaser P would be prepared to pay a small price known as option premium (Rs.

. if the owner of the option decides to exercise the option. • The seller of the put option has the obligation to take delivery of the underlying asset.PUT OPTIONS • A put option is a contract which gives its owner the right to sell some underlying asset at a specified price on or before a specified date.

They are: • European Style Options • American Style Options .Types of Options On the basis of maturity pattern of options. option contracts are categorized in to two.

In India stock options are American style while index options are European style. . on the maturity time up to and Most of the exchange traded options are American style. European Style Options Options which can be exercised only date of the option or on the expiry date.  American Style Options Options which can be exercised at any including the expiry date.

Option Terminologies • • • • • • • • Strike Price or Exercise Price Expiration Date Exercise Date Option Buyer Option Seller American option European option Option Premium .

• Expiration Date : The precise date on which the option right expires.• Option Writer or Option Grantor: The seller of option. • Option Premium : The price to be paid by option purchaser to option seller . • Time to Expiration or Time to Expiry : The period of time specified for exercising the option. • Strike price or Exercise price : The price at which the option holder may purchase the underlying asset from the option seller.

This takes three forms: 1.Moneyness of Options Moneyness of an option describes the relationship between the strike price of the option and the current stock price. At the Money Out of the Money . 3. In the Money 2.

there will be an immediate cash inflow. . the option is said to be in the money. • This is because the owner of the option has the right to buy the stock at a price which is lower than the price which he has to pay if he had to buy it from the open market. • If an in the money option is exercised. • Similarly in the case of put option. the option is said to be in the money.In the Money Options • When the strike price of a call option is lower than the current stock price. when the strike price is greater than the stock price.

the put option is said to be at the money.At the Money Options  When the strike price of a call option is equal to the current stock price.  In the case of a put option if the strike price of the option is equal to the stock price. . the option is said to be at the money option.

Out of the Money  When the strike price of a call option is more than the stock price.  In the case of put option. the option is termed as out of the money option. the option is said to be out of the money option. if the strike price is less than the stock price. .

is Trading at Rs.) 420 430 440 450 460 470 480 Out of the Money In the Money In the Money Out of the Money Call Option Put Option At the Money At the Money .When the Shares of A Ltd.450 Strike Price (Rs.

• Option premium is also known as Price of the option. Cost or Value of the option. . that is they are transferring their risks to the sellers of the option.Option Premium • Both the Call and Put option buyers are buying the rights. buyers have to compensate by paying Option Premium. • For this transfer of risk to the sellers.

• Volatility –higher the volatility. calls gain in value while puts lose value. higher the value of the options. higher the value of the options.Factors influencing Option Pricing • Time to expiration – greater the time to expiration. • Risk free Rate of Interest – If interest rate goes up. .

Settlement of Options • Physical Delivery • Cash settlement .

Unlimited upside and downside for both buyer and seller Limited downside (to the extent of premium paid) for buyer and unlimited upside. affected by (a) prices of of the underlying asset. by the buyer and seller. on or before a specified time.DIFFERENCE BETWEEN FUTURES FUTURES OPTIONS AND OPTIONS Futures Contract is an agreement to buy or sell specified In options the buyer enjoys the right and not the quantity of the underlying assets at a price agreed upon obligation. . to buy or sell the underlying asset. profits are limited whereas losses can be unlimited. For seller (writer) of the option. b) time remaining for expiry of the contact and c) volatility of the underlying asset. the underlying asset. Futures contracts prices are affected mainly by the prices Prices of options are however. Both the buyer and seller are obliged to buy/sell the underlying asset.

g. Why banks will provide derivative instruments :  To earn brokerage income – they will also transfer the risk to thrid counter party and keep a margin in hedge costs  Many times natural hedge e. What if eventually fluctuation turns out favorable but company can not benefit as it has already hedged by derivative instrument :  Company to earn from core business and not from volatility  If company has a view of higher probability of positive fluctuations. then hedging through option contract can serve dual purpose – company is protected against unfavorable fluctuations while can benefit from favorably fluctuations . may give derivative to an importer as well to an exporter thereby nullifies risk of both instruments – will earn commission on both transactions.  To protect their clients against any forex risk and thereby protecting their own credit risks B.FAQS A.