DIFFERENT ASSET CLASSES

Equity  Debt  Gold & other commodities  Real Estate  Foreign Exchange & Currency  Derivatives

RISK
 What

do you mean by Risk ?

Financial risk is defined as the unexpected variability of returns & thus includes both potential worse-than-expected as well as betterthan-expected returns

 How

do you reduce risk ?

DERIVATIVES

Derivative is a product whose value is derived from the value of the underlying asset. Underlying asset can be equity, forex, commodity, or any other asset.

HISTORY OF DERIVATIVES
Chicago Board of Trade (1848) is the first recognised Futures Exchange  Next 100 years Futures Exchanges were dominated by trading in futures of Agricultural commodities  1970 saw the introduction of futures on Financial instruments (equity, bonds & currency)

 Commodity Derivatives at about USD 9 trillion (1.  Credit Default Swaps at about USD 58+ trillion (10%).5 trillion (1.  Foreign Exchange Derivatives at about USD 56+ trillion (9%).  Listed credit derivatives: USD 548 trillion.144 Trillion.  Over-The-Counter  (OTC) derivatives: face value at USD 596 trillion and included: Interest Rate Derivatives at about USD 393+ trillion (66%).CURRENT STATUS According to various distinguished sources the amount of outstanding derivatives worldwide as of Dec 2007 crossed USD 1.  Unallocated Derivatives at about USD 71+ trillion (12%) .5%).  Equity Linked Derivatives at about USD 8.5%).

 The entire US money supply is also about USD 15 trillion.144 trillion is 22 times the GDP of the whole world..WHAT WOULD BE THE RELATIVE POSITIONING OF USD 1.144 TRILLION FOR OUTSTANDING DERIVATIVES.  The GDP of the entire world is USD 50 trillion.000 per person on the planet.  The population of the whole planet is about 6 billion people.E.  . So the derivatives market alone represents about USD 190.  The real estate of the entire world is valued at about USD 75 trillion. I. WHAT IS THEIR SCALE ??? The entire GDP of the US is about USD 14 trillion.  The world stock and bond markets are valued at about USD 100 trillion. USD 1.

Features: Defined & limited life  Bilateral Agreement  Purpose: Price Discovery  Risk Management / Hedging  Making Markets more efficient  Lowering Transaction costs  Derivatives are often criticised as being Dangerous for unknowledgeable investors & have been inappropriately linked to Gambling .

85 bn USD 3.38 bn USD 2.8 bn Source of Loss European Index Futures Gas Futures Interest Rate and Equity Derivatives Copper Futures Interest Rate Derivatives FX Options Foreign Exchange Trading Oil Futures Foreign Exchange Trading Nikkei Futures Year 2008 2006 1998 1996 1994 2008 2000 1993 2008 1995 .1 bn USD 1.7 bn USD 5.44 bn USD 2.96 bn USD 1.9 bn USD 1.1 bn USD 6.97 bn USD 1.TOP ON THE CHARTS Company Société Générale Amaranth Advisors Long Term Capital Management Sumitomo Corporation Orange County Aracruz BAWAG Metallgesellschaft CITIC Pacific Barings Bank Amount Lost USD 7.

TYPES OF DERIVATIVES Forwards Futures Derivatives Swaps Options .

CLASSIFICATION OF DERIVATIVES Derivatives Contingent Claims Exchange Traded OTC Forward Commitment Exchange Traded OTC Standard Options Standard Options Forward Contract Int Rate Options Warrants Options on Futures Callable Bonds Convertible Bonds Int Rate Options Convertible Bonds Exotic Options Warrants Asset Backed Sec Swaps .

 Oil  Gas  power  Commodities  Freight derivatives  Inflation derivatives  Insurance derivatives  Weather derivatives  Credit derivatives  Economic derivatives  .OTHER EXAMPLES OF UNDERLYING EXCHANGEABLE Property derivatives  Energy derivatives that pay off according to a wide variety of indexed energy prices.

Money Buyer Security Seller . This is a contract between two parties.FORWARD CONTRACT Forward Contract – A forward contract is a simple derivative that involves an agreement to buy/sell an asset on a certain date at an agreed price.

FEATURES  Delivery & Settlement of a Forward Contract Default Risk Termination of a Forward Contract   .

TYPES OF FORWARD CONTRACT  EQUITY FORWARDS:    Forward Contracts on Individual Stock Forward Contracts on Stock Portfolios Forward Contracts on Stock Indices  BOND & INTEREST RATE FORWARD CONTRACTS:   Forward Contracts on Individual Bonds & Bond Portfolio Forward Contracts on Interest Rates: Forwards Rate Agreements   Currency Forward Contracts Commodity Forwards .

PRICING A FORWARD CONTRACT We use the principle of No-arbitrage for pricing a Forward contract. The principle assumes the following  Transaction cost is Zero  There are no restrictions on short sales or on use of short sales proceeds  Borrowing & Lending for unlimited amount at risk free rate Forward price = price that would not permit risk less arbitrage in frictionless market .

PRICE OF A FORWARD CONTRACT FP = S0 x (1+Rf)T • • • • FP = Forward price of an asset S0 = Spot price Rf = Risk free rate T = Forward Contract term in years S0 = FP / (1+Rf)T .

VALUATION OF A FORWARD CONTRACT  Value of the Long Forward Contract at Zero day V0 = S0 – FP / (1+Rf)T  Value of the Long Forward Contract at any day ‘t’ Vt = St – FP / (1+Rf)(T-t)  Value of the Long Forward Contract at Expiry Vt = St – FP .

VALUATION OF A FORWARD CONTRACT  Value of the short Forward Contract at Zero day V0 = FP / (1+Rf)T – S0  Value of the short Forward Contract at any day ‘t’ Vt = FP / (1+Rf)(T-t) – St  Value of the short Forward Contract at Expiry Vt = FP – St .

FVD FP (on an equity security) PVD = Present Value of Expected Dividends  FVD = Future Value of Expected Dividends  .EQUITY FORWARD CONTRACT FP (on an equity security) = (S0 – PVD) x (1+Rf)T = [S0 x (1+Rf)T] .

VALUE OF EQUITY FORWARD CONTRACT  For a long contract Vt = [St – PVDt] – [FP / (1+Rf) (T-t) ]  For a short contract Vt = [FP / (1+Rf) (T-t) ] – [St – PVDt] .

FORWARD CONTRACTS ON FIXED INCOME SECURITIES & RATES  Forward price on a coupon paying bond is similar to dividend paying stock FP(fixed income security) = (S0 – PVC) x (1+Rf)T  For a long contract Vt = [St – PVCt] – [FP / (1+Rf) (T-t) ] PVC = Present Value of Expected Coupon payments .

FORWARD RATE AGREEMENTS (FRA) Forward price in a FRA is actually a forward interest rate Today 3m FRA 1x4 Today FRA initiation 1m FRA Expiration & Loan Initiation 4m Loan Maturity .

he can enter into a Forward contract to buy USD 12 months from now at a predetermined rate .  Hence.  However.CURRENCY FORWARDS  Consider a importer who has to make a USD payment 12 months from now he would have to buy USD exactly 12 months from now he is not sure what the USD/INR rate would be???  Thus.

000 Places Deposit @ 2.00%.020.020.687.00% Borrows at 7.000 Pays INR 45.50.500 Forward rate: 45. US Int rates: 2.500.000 = 44.50 Borrows INR 42. Indian Interest rates: 7.687.500 / 1.50% Gets USD 1.29 .50% Bank buys USD at 42.79 Forward premium: 2.Calculated as follows: Combination of spot exchange rate and interest rates over a period of time in the future USD / INR: 42.

FP • (currency forward contract ) = S0 x[(1+RDC)T/(1+RFC)T] F and S are quoted in domestic currency per unit of foreign currency • RDC = Domestic currency interest rate • RFC = Foreign currency interest rate .

FUTURES Similarity to Forwards:  Deliverable contracts obligate the long to buy & short to sell a certain quantity of an asset for a certain price on specified future date  Cash settlements are settled in cash on expiration date  Both futures & forwards are priced to have zero value at the time of initiation .

FUTURES VS FORWARDS CRITERION Buyer-Seller Interaction Contract Terms Unilateral Reversals Default risk borne by FUTURES Via Exchange Standardised Possible Exchange FORWARDS Direct Tailor made Not Possible Individual Parties Collaterals Default Controlled Margin Accounts by .

PAYOFF PROFILE OF FUTURES CONTRACTS 100 50 Gain / Loss Profit 0 5000 -50 5050 5100 5150 5200 Buyer Seller Loss Price -100 .

If the market price of ABC Ltd. (28. 3.000 i. 4. 2. Let us assume that ABC Ltd. Is Rs.e.400.28. If ABC Ltd.000 * 0. will be declaring a dividend of Rs.20 per share after 15 days of purchasing the contract. Has a weight of 7% in Nifty. two and three-month contracts. 5. Since Nifty is traded in multiples of 100. Current value of Nifty is 4000 and Nifty trades with a multiplier of 100. i.000/140). What will be the price of a new two-month futures contract on Nifty? 1. Money can be borrowed at a rate of 10% per annum.140.07).PRICING INDEX FUTURES DIVIDEND AMOUNT GIVEN EXPECTED Nifty futures trade on NSE as one. then a traded unit of Nifty involves 200 shares of ABC Ltd. . its value in Nifty is Rs.e.(400. value of the contract is 100*4000 = Rs.000.

The dividend is received 15 days later and hence compounded only for the remainder of 45 days. To calculate the futures price we need to compute the amount of dividend received per unit of Nifty. 7. Thus. (200*20). Hence we divide the compounded dividend figure by 100. futures price . we need to reduce the cost-of-carry to the extent of dividend received.6.4000 i. The amount of dividend received is Rs.e. To calculate the futures price.

FUTURE MARGINS & MTM  Initial Margin Requirement Maintenance Margin   Variation Margin .

80 -3.00 103.50 -0.00 -32.20 96. No of Contracts:10 Day Beginning Balance (Margin) Funds Deposited Settlement Price Futures Price Change Gain / Loss Ending Balance (Margin) 0 1 2 0 50 42 50 0 0 100.3.00 125.50 1.00 104.100.00 -0.00 50.00 50.00 99.00 10.00 .00 -5.00 5. Initial Margin: Rs.00 3 4 5 6 10 100 125 120 40 0 0 0 101.20 -8. Maintenance Margin Requirement: Rs.00 10.00 100.CALCULATION OF MARGIN FOR A LONG POSITION Initial Futures prices: Rs.00 25.50 103.00 120.00 130.00 42.00 2.5.

MONETARY & NON MONETARY BENEFITS & COSTS OF HOLDING THE UNDERLYING  Recall: FP = S0 x (1+Rf)T Any positive costs associated with holding the asset in a cash & carry arbitrage will increase the no arbitrage Futures price A monetary benefit from holding the asset will decrease the no arbitrage Futures price   .

FV (NB) Net benefits (NB) = Convenience Yield – storage cost .FP = S0 x (1+Rf)T + FV (NC) Net Cost (NC) = Storage cost – convenience yield FP = S0 x (1+Rf)T .

For this to occur. BACKWARDATION: refers to a situation where the futures price is below the spot price. either monetary or non-monetary.  CONTANGO: refers to a situation where the futures price is above the spot price . there must be significant benefit to holding the asset.

has no storage cost.2.0. illustrate how an arbitrage transaction could be executed if the futures contract is trading at Rs. Risk free interest rate is 8% & the futures contract expires in 45 days.75 Find the appropriate futures price if the future value of the net overall cost of carry on the underlying asset equals Rs.3.55 Using Part D above. cash flows or convenience yield Find the appropriate futures prices if the future value of storage cost on the underlying at the futures expiration equals Rs.25 Find the appropriate futures price if the future value of positive cash flow on the underlying asset equals Rs. e.50. c. Find the appropriate futures price if the underlying asset b.Consider an asset priced at Rs. a. d.60 .

the right to buy specified quantity of the underlying asset at the strike price on or before expiration date. has the obligation to sell the underlying asset if the buyer of the call option decides to exercise his option to buy. .  The seller (one who is short call) however.OPTIONS Call Options  A call option gives the holder (buyer/ one who is long call).

2800. If the market price of Infosys on the day of expiry is more than Rs. 100. the option will be exercised and the investor will buy 1 share of Infosys from the seller of the option at Rs 2500 and sell it in the market at Rs 2800 making a profit of Rs. stock price is Rs. 2500 at a premium of Rs.Premium}  The  Suppose . 2600 (Strike Price + Premium i. investor will earn profits once the share price crosses Rs. 200 {(Spot price . 2500. the option will be exercised. An investor buys One European call option on Infosys at the strike price of Rs. 2500+100).e.Strike price) .

 The seller of the put option (one who is short Put) however. . the right to sell specified quantity of the underlying asset at the strike price at expiry date. has the obligation to buy the underlying asset at the strike price if the buyer decides to exercise his option to sell.Put Options  A Put option gives the holder (buyer/ one who is long Put).

the option can be exercised as it is 'in the money'.& exercises his option selling the Reliance share at Rs 2300 to the option writer thus making a net profit of Rs.. 125/-.premium paid) i. If the market price of Reliance. 2160/. investor will earn profits if the market falls below 2175. An investor buys one European Put option on Reliance at the strike price of Rs.  The investor's Break-even point is Rs. at a premium of Rs. 15 {(Strike price Spot Price) . on the day of expiry is less than Rs. 2160. 2300. stock price is Rs. 2175/ (Strike Price .e..Premium paid}  Suppose . the buyer of the Put option immediately buys Reliance share in the market @ Rs. 2300/.

No.Limited.Buy underlying at strike price.  Premium paid or received .  Trader’s obligations.  Margin requirements . .Nil.  Profit potential .Unlimited.  Risk profile .  Breakeven point . to the extent of the premium paid.Strike price + Premium.POSITION OF CALL OPTION BUYER  Trader’s rights.Paid. if prices go up.

 Breakeven point .Nil.Received. . if prices go up. to the extent of the premium received.  Profit potential .  Risk profile .Limited .Strike price + Premium.  Premium paid or received .Yes.  Trader’s obligations.  Margin requirements .Sell underlying at strike price.POSITION OF CALL OPTION SELLER  Trader’s rights.Unlimited.

PAYOFF PROFILE OF CALL OPTIONS Strike : 100 & Premium : 5 20 Profit / Loss 15 10 5 0 -5 -10 -15 -20 Price 90 95 100 105 110 115 120 Buyer Writer .

 Trader’s obligations.  Risk profile . to the extent of the premium paid.POSITION OF PUT OPTION BUYER  Trader’s rights.Limited.Unlimited*.Sell underlying at strike price. if prices go down (BEP = Strike price .No.  Profit potential . profit = Strike price – Premium paid) .  Margin requirements .  Practically.  Premium paid or received . Put option buyer’s profit is limited as the price of the asset can not go below zero (Max.Premium).Nil.Paid.

 Margin requirements .  Trader’s obligations. Put option seller’s risk is limited as the price of the asset can not go below zero (Maximum loss = Strike price – Premium received)  .Buy underlying at strike price.  Premium paid or received .POSITION OF PUT OPTION SELLER Trader’s rights.Limited.Nil. to the extent of the premium received (BEP = Strike price .Premium)  Practically.  Risk profile . if prices go down.Unlimited*.Yes.  Profit potential .Received.

PAYOFF PROFILE OF PUT OPTIONS Strike : 100 & Premium :5 15 10 Profit / Loss 5 Buyer 85 90 95 100 105 110 115 Writer 0 -5 -10 -15 Price .

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