€ What

is a derivative?: a financial product which has been derived from another financial product or commodity. Without the underlying product or market, the derivative would have no independent existence. Common types of derivatives are Forwards, Swaps and Options.

€ Derivatives

have risen from the need to manage the risk arising from movements in markets beyond our control, which may severely impact the revenues and costs of the firm

marine insurance) € For . loss of stock.€ Firms are exposed to several risks in the ordinary course of operations and borrowing funds some risks. management can obtain protection from an insurance company (fire. loss of profit .

The instruments that can be used to provide such protection are called derivative instruments . - - - there are capital market products available to protect against certain risks.€ Similarly. 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 An adverse exchange rate movement.

€A Derivatives is any security whose price is determined by the value of another asset. the ´Underlyingµ UNDERLIYING PRICE CHANGE DERIVATIVE PRICE CHANGE . --. or simply .This asset is called the underlying security .

TWO PURPOSES HEDGING SPECULATION .

but not the obligation.g Movie ticket SWAPS A contract to exchange stream of cash flows based on certain events Intrest rates .to buy or sell a security for e. Stanardised . Not standardised or regulated FUTURES Similar to Forwards . regulated and traded on exchanges OPTIONS A contract giving the right .FORWARDS A contract to make or take delivery of product in future . at a price set in present. CREDIT DEFAULT SWAPS .Currencies . Commodities prices.

€ Variants of swaps . € . equity € Financial swaps are a funding technique. The global financial markets present borrowers and investors with a wide variety of financing and investment vehicles in terms of currency and type of coupon . currency.interest rate. which permit a borrower to access one market and then exchange the liability for another type of liability.fixed or floating. commodities. a popular financing tool.A swap. is a contract between two parties (counter parties) to exchange two streams of payment for an agreed period of time.

€ It must be noted that swaps by themselves are not a funding instrument. they are a device to obtain the desired form of financing indirectly. The borrower might otherwise have found this too expensive or even inaccessible. .

€A SWAP transaction is one where two or more parties exchange one set of predetermined payments for another 1 Interest payment SWAP 2 Currency SWAP .

COMPANY FIXED FLOATING A B 7.5% 9% MIBOR + 0 .5% A borrows Rs 10000 from a bank at floating rate B borrows Rs 10000 from a bank at fixed rate .5% MIBOR + 3 .

5) +7 .5) SWAP OUTFLOWS ON LOAN FROM BANK (%) -(MIBOR+.(1) A will pay B a fixed rate of 7% ( ) B will pay A a floating rate of MIBOR +.5) TOTAL OUTFLOW -7 B -(MIBOR+.5% To under stand the benefits from the swap consider the net cash flows of A and B PARTY SWAP OUT FLOWS % SWAP IN FLOWS % A -7 +(MIBOR+.5) .% -(MIBOR+ .

( 1) For A. A Gains .5% which a would have paid if it would have directly taken a fixed loan.5% ) B Gains 1% .5% (this is better than MIBOR + 3.5% (2) For B . a fixed rate obligation at 7% ( this is better than 7. a floating rate obligation at MIBOR +2.

Sovereign and Public Sector Institutions. parties with low credit rating have difficulty in entering the swap market. However. € Participants: MNCs. € Facilitators: Dealers and Brokers € .Lowering financing cost: use comparative advantage € Hedge exposure to interest rate risks € Restructuring the debt in the balance sheet € Swaps are privately negotiated products. Banks. etc.

€ Swaps can be used to transform floating rate assets into fixed rate assets. € Swaps . € Swaps can transform the currency behind any asset or liability into a different currency. € Swaps can transform floating rate liabilities into fixed rate liabilities.can be used to lower borrowing costs and generate higher investment returns. and vice versa. and vice versa.

The "buyer" of protection pays a premium for the protection.Credit default swaps allow one party to "buy" protection from another party for losses that might be incurred as a result of default by a specified reference credit (or credits). and the "seller" of protection agrees to make a payment to compensate the buyer for losses incurred upon the occurrence of any one of several specified "credit events." .

Bank A pays a fixed periodic payments to C.Suppose Bank A buys a bond which issued by a Steel Company. To hedge the default of Steel Company: Bank A buys a credit default swap from Insurance Company C. . in exchange for default protection.

Credit Default Swap Credit Risk Bank A Buyer Premium Fee Credit Event Insurance Company C Contingent Payment On Seller Steel company Reference Asset .

€ It is an agreement to buy or sell an asset (of a specified quantity) at a certain future time for a certain price. € No cash is exchanged when the contract is entered into.€A forward contract is the simplest mode of a derivative transaction. .

which costs Rs 10. € He can only buy it 3 months hence. .000 but he has no cash to buy it outright. He. € So in order to protect himself from the rise in prices Shyam enters into a contract with the TV dealer that 3 months from now he will buy the TV for Rs 10.€ Shyam wants to buy a TV.000. however. fears that prices of televisions will rise 3 months from now.

€ The .€ What Shyam is doing is that he is locking the current price of a TV for a forward contract. The forward contract is settled at maturity. dealer will deliver the asset to Shyam at the end of three months and Shyam in turn will pay cash equivalent to the TV price on delivery.

€ In order to meet his payment obligation he has to buy dollars six months from today. € However. . he is not sure what the Re/$ rate will be then.€ Ram is an importer who has to make a payment for his consignment in six months time.

€ In order to be sure of his expenditure he will enter into a contract with a bank to buy dollars six months from now at a decided rate. € As he is entering into a contract on a future date it is a forward contract and the underlying security is the foreign currency. .

to be delivered to you in July.€ If you agree in April with your Aunt that you will buy five kgs of tomatoes from her garden for Rs 75. you just entered into a futures contract! .

€ A future contract is a standardised forward contact between two parties where one of the parties commits to sell and other to buy a stipulated quantity of a security or an index at an agreed price on or before a given date in the future Seller A Buyer CLEARING HOUSE B € Future price = spot price +carry cost .

Futures Individual stock future Index futures Underlying asset is the individual stock Underlying asset is the stock Index Bombay Sensex future Nifty Future .

€ If the price is unchanged Ram will receive nothing. € If the stock price of Infosys falls by Rs 800 he will lose Rs 800.€ Let us take an example of a simple derivative contract: € Ram buys a futures contract. € He will make a profit of Rs 1000 if the price of Infosys rises by Rs 1000. .

€ Settlement through Clearing House v/s settlement between buyers and sellers € Exchange .traded & transparent v/s Private contract. € futures contracts are traded on an exchange whereas forward contracts are generally traded off an exchange € Standardised v/s customised.

€ Require margin payment v/s no margins € Mark to market margins v/s no margins € Counter party risk is absent in futures ( settlement of trade is guaranteed ) .

.€ Options are special contractual arrangements giving the owner the right to buy or sell an asset at a fixed price anytime on or before a given date. but not the obligation to exercise the contract. € They give the buyer the right.

€Call option €Put option .

and you are not obligated to.€A call is the right but not an obligation to buy an underlying assest for a specified price by a specified date you buy a Call option. secures your right to buy that certain stock at a specified price called the strike price. € When . called the option premium. your only cost is the option premium. If you decide not to use the option to buy the stock. the price you pay for it.

if the stock has risen to Rs 1200.call option allows you to guarantee a maximum price you will have to pay. When the contract expires. € For example: suppose that the stock is currently at Rs 1000 and you protect yourself by purchasing a call option with strike price Rs 1000. you have the right to buy it for Rs 1000 €A .

€ That is he has purchased the right to buy that share for Rs 40 in March. . € Suppose the stock does not rise and instead falls he will choose not to exercise the option and forego the premium of Rs 15 and thus limiting his loss to Rs 15. € If the stock rises above Rs 55 (40+15) he will break even and he will start making a profit.€ Ram purchases a March call option at Rs 40 for a premium of Rs 15.

€ Put Options are options to sell a stock at a specific price on or before a certain date. € In this way. Put options are like insurance policies .€A put is the right but not obligation to sell an underlying asset for a specified price by a specified date .

. but to keep the unlimited upside.Suppose you hold a stock and want to sell it in a year·s time. you can sell it for Rs 1200. you have the right to sell it for Rs 1000. But if it has fallen to Rs800. € . € For example: suppose that the stock is currently at Rs 1000 and € you protect yourself by purchasing a put option with strike price Rs1000. . € A put option allows you to ¶lock-in· a minimum price for your stock. if the stock has risen to Rs1200. When the contract expires.

but he does not want to take the risk in the event of price rising so purchases a put option at Rs 70 .€ Raj is of the view that the a stock is overpriced and will fall in future. By purchasing the put option Raj has the right to sell the stock at Rs 70 but he has to pay a fee of Rs 15 (premium he will breakeven only after the stock falls below Rs 55 (70-15) and will start making profit if the stock falls below Rs 55. € So .

the exercise price is above the prevailing spot price. i.e. and in the case of a Put Option. € At-the-Money: The Option exercise price equals the prevailing price of the underlying asset € Out-of-the-Money: The Option price lies above the prevailing price of the underlying asset in the case of a Call or below in the case of a Put € . in the case of a Call Option the exercise price is below the spot price.In-the-Money: The option has an exercisable value.

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