Derivative Markets

Introduction

Derivative:
 A security whose price is dependent upon or derived
from one or more underlying assets.

 Its value is determined by fluctuations in the

underlying asset.

 Stocks, bonds, commodities, currencies and interest

rates.
 Need for Derivatives

 Transferring risks.

 Discovery of future as well as current prices.

 Increase saving and investments in long run.

 History

 The first organized commodity exchange came into

existence in early 1700’s in japan.

 The first foreign currency future were traded on

May 16,1972 on international monetary market.

 The first call and put options were invented by an

American financier Russell Sage in 1872.
 Types of Derivatives

Forward

Futures

Derivatives Option

Swap
 Derivative Markets

 The derivatives market is the financial market

for derivatives.

Derivative
markets

Exchange Over- the-

traded counter
derivatives derivatives
 ETD vs. OTCD

Guarantee of
Regulated Settlement and
Standardization completion of
markets clearing house
operation

Non-regulated Bilateral No standard Risk of counter

markets Agreements agreement party
 Forward Contract

Agreement entered today where:

 One party agrees to buy and other agrees to sell an
asset.
 On a specified future date.
 At an agreed price.

 Contract is custom designed.

 Contract is traded in the over-the-counter market.

 Forward Contract Example

 You will be receiving dollars after 3 months.

 Present dollar rate Rs 45 per$.

 Rate after 3 months Rs 38 per $.

 You will lose Rs 7 per dollar.

 Therefore you enter into a forward contract to sell

dollar at Rs 43.
 You have locked in the dollar rate at Rs 43 .
 Pros & Cons

Pros Cons

 Unregulated market.  Lack of liquidity.

 Easy to understand.  High default risk.

 Offer a complete hedge.

 Future

 Standardized form of forward contract.

 Contracts are traded in organized exchanges.

 The future date is called the delivery date or final

settlement date.

 The pre-set price is called the futures price.

 Future Contract Example

 In January purchase 100 shares of IBM stock at $50 a

share on April 1.

 The contract has a price of $5,000.

 The price of IBM stock rises to $52 a share on March

1.

 If you sell the contract for 100 shares, you'll fetch a

price of $5,200, and make a $200 profit.
 Example Cont’d

 Sell 100 shares of IBM at $50 a share on April 1 for a

total price of $5,000.

 But then the value of IBM stock drops to $48 a share on

March 1.

 Buy the contract back on March 1, then you pay $4,800

for a contract that's worth $5,000.

 By predicting that the stock price would go down,

you've made $200.
 Prone & Cons

Prone Cons

 Easy liquidation.  No customization of

contract
 Well organized stable
market.

 Little default risk.

 Option

Is a right

But not an obligation

Option To buy or sell something

At a stated date

At a stated price
 Option Cont’d

 The price at which the asset may be bought or sold is

called the exercise price or strike price.

 The date after which an option is void is called the

expiration.

 There are two types of option:

 Call option
 Put option
 Option Types

Call option Put option

Option which gives the holder right to Option which gives the holder right to
buy an asset but not an obligation to sell an asset but not an obligation to
buy. sell.

Call option will be exercise only when Put option will be exercise only when
the exercise price is lower than the the exercise price is higher than the
market price. market price.

The owner makes a profit provided he The owner makes a profit provided he
sells at a higher current price and buys at lower current price and sells
buys at a lower future price. at a higher future price.
 Option Example

Example
Option premium $20
Current market price $1700

Exercise price $1750

Market price after 3 months Gain/loss

Situation 1 $2000 $230

Situation 2 $1730 ($20)
 Prone & Cons

Prone Cons

 Flexibility to the  It requires a close

buyers as well as to observation .
the sellers.

 They are less risky.

 Swap

 Agreements between two parties to exchange

sequences of cash flows for a set period of time.

 Two types of swap:

 Interest rate swap

 Currency swap
 Interest Rate Swap

 The interest related cash flows between the parties in

the same currency.

 This involves the exchange of fixed rate and floating

rate interest payment.

 The firm paying the floating rate is the swap seller.

 The firm paying the fixed rate is the swap buyer.

 Currency Swap

 Agreement to exchange one currency with another

,at a specific rate of exchange.
 Prone & Cons

Prone Cons

 Swap is generally  Lack of liquidity.

cheaper.
 It is subject to default
 Swap can be used to risk.
hedge risk.
 Participants in Derivatives Market
Participant Objectives

Hedgers They are the players whose

objectives is risk reduction.

Speculators They are the players who

establish position based on their
expectations of future price
movements.

Arbitrageurs They are the players whose

objective is to profit from pricing
differentials.
 Dark side of Derivatives

 A hedged position can become unhedg at the worst

times.

 Inflicting substantial losses on those who mistakenly

believe they are protected.

 The use of derivatives can result in large losses because

of the use of leverage, or borrowing.
 Loss in Derivatives Market

 American International Group (AIG) lost more than

US$18 billion through a subsidiary over the preceding
three quarters on credit default swaps.

 The loss of US$7.2 Billion by Societe General in

January 2008 through mis-use of futures contracts.

 The loss of US$1.2 billion equivalent in equity

derivatives in 1995 by Barings Bank.
• CFD’s
• SWAP – CDS , Equity SWAP
• Downside of Derivatives  Within Hedge market
• Different Strategies of derivatives  Investment strategies
in general.
• Attributes of each Derivatives.
• Key trade economics of each of the Derivatives.
• Major terminologies  collation