2. Derivatives
Derivative is a product whose value is
derived from the value of one or more basic
variables, called bases (underlying asset,
index, or reference rate), in a contractual
manner.
The underlying asset can be equity, forex,
commodity or any other asset
3. Derivatives
For example, wheat farmers may wish to
sell their harvest at a future date to
eliminate the risk of a change in prices by
that date. Such a transaction is an example
of a derivative. The price of this derivative
is driven by the spot price of wheat which is
the “underlying”.
4. Derivatives
As per SCRA –
a) A security derived from a debt instrument,
share, loan whether secured or unsecured,
risk instrument or contract for differences
or any other form of security.
b) A contract which derives its value from
the prices, or index of prices, of underlying
securities.
5. Growth of Derivatives
Factors driving growth of Derivatives:-
a) Increased volatility in asset prices in
financial markets,
b) Increased integration of national financial
markets with the international markets,
c) Marked improvement in communication
facilities and sharp decline in their costs,
6. Growth of Derivatives
Development of more sophisticated risk
management tools, providing economic
agents a wider choice of risk management
strategies, and
Innovations in the derivatives markets, which
optimally combine the risks and returns over a
large number of financial assets leading to
higher returns, reduced risk as well as
transactions costs as compared to individual
financial assets.
7. Derivative Products
Forwards: A forward contract is a customized
contract between two entities, where settlement
takes place on a specific date in the future at
today's pre-agreed price.
Futures: A futures contract is an agreement
between two parties to buy or sell an asset at a
certain time in the future at a certain price.
Futures contracts are special types of forward
contracts in the sense that the former are
standardized exchange-traded contracts.
8. Derivative Products
Options: Options are of two types - calls and puts. Calls
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 given future date. Puts give the buyer the
right, but not the obligation to sell a given quantity of the
underlying asset at a given price on or before a given
date.
Warrants: Options generally have lives of upto one year,
the majority of options traded on options exchanges
having a maximum maturity of nine months. Longer-
dated options are called warrants and are generally
traded over-the-counter.
9. Derivative Products
LEAPS: LEAPS means Long-Term Equity
Anticipation Securities. These are options
having a maturity of upto three years.
Baskets: Basket options are options on
portfolios of underlying assets. The
underlying asset is usually a moving
average of a basket of assets. Equity index
options are a form of basket options.
10. Derivative Products
Swaps: Swaps are private agreements
between two parties to exchange cash flows
in the future according to a prearranged
formula. They can be regarded as portfolios
of forward contracts. The two commonly
used swaps are:
a. Interest Rate Swaps
b. Currency Swaps
11. Derivative Products
a) Interest Rate Swaps : These entail
swapping only the interest related cash flows
between the parties in the same currency.
b) Currency swaps: These entail swapping both
principal and interest between the parties,
with the cash flows in one direction being in
a different currency than those in the
opposite direction.
12. Party A is currently paying floating rate, but wants to pay fixed rate. Party B is currently
paying fixed rate, but wants to pay floating rate. By entering into an interest rate swap,
the net result is that each party can ‘swap' their existing obligation for their desired
obligation.
13. Derivative Products
Swaptions: Swaptions are options to buy or sell a swap
that will become operative at the expiry of the options.
Thus a swaption is an option on a forward swap. Rather
than have calls and puts, the swaptions market has
receiver swaptions and payer swaptions.
A receiver swaption is an option to receive fixed and pay
floating.
A payer swaption is an option to pay fixed and receive
floating.
15. Definition of Corporate Risk
Management
“… a process, effected by an corporate's board of
directors, management and other personnel,
applied in strategy setting and across the
organization, designed to identify potential events
that may affect the corporate, and manage risks to
be within its risk appetite, to provide reasonable
assurance regarding the achievement of corporate
objectives.”
15
16. Classification of risk
The wide array of risks that firms are exposed to can be
classified into 5 categories:
1. Technological Risk: arise mostly in the R&D and
Operations stage of the value chain.
2. Economic Risks: arise from fluctuations in the
revenues(output price and demand) and production cost (
Raw material cost, energy cost and labor cost)
3. Financial Risks: arise from volatility of Interest rates,
currency rates, commodity prices and stock prices.
4. Performance risks: arise when contracting counterparties
do not fulfill their obligations.
5. Legal and Regulatory risks: change in laws and regulations
17. Measurement of financial Risks in firms
To assess the Financial price risk we may:
a) Examine the financial statements to get an idea of
the risk exposure
b) Assess the sensitivity of the firms value or cash
flow to changes in the financial prices and
c) Conduct monte carlo simulation.
18. Examine the financial statements
Examining the Balance sheet and Profit & loss account throw
light on a number of questions like:
• Does the firm have a strong liquidity position as per high
Current ratio and Quick ratio? A strong liquidity position
cushions against the volatility of cash flows caused by changes
in Financial prices.
• Does the firm have a low gearing ratio (leverage)? A low gearing
ratio provides greater financial flexibility to cope with volatility
in financial prices.
• What is the Foreign exchange transaction exposure? If the
balances of receivables and payables are high, their values
would change in response to shifts in the exchange rates.
• Is the firm exposed to interest rate risk? If the firm relies mainly
on free floating debt it has a high interest rate exposure.
19. Assess the sensitivity
Determine the sensitivity of Firm’s Value or Cash Flow by:
• Analyzing the Historical data on firm value, cash flows and
financial prices
20. monte carlo simulation
• Monte carlo methods are used in finance to
value and analyze (complex) instruments,
portfolios and investments by simulating the
various sources of uncertainty affecting their
value, and then determining their average value
over the range of resultant outcomes.
• The advantage of monte carlo methods over
other techniques increases as the dimensions
(sources of uncertainty) of the problem increase.
21. Principle of hedging
• One way to manage these risks and uncertainties is to enter into
transactions that expose the entity to risk and uncertainty that fully or
partially offsets one or more of the entity’s other risks and
uncertainties, transactions known as ‘hedges’.
• The instrument acquired to offset risk or uncertainty is known as
‘hedging instrument’ and the risk or uncertainty hedged is known as
‘hedged item’.
• There are predominantly two motivations for a company to hedge:
To lock-in a future price which is attractive, relative to an
organization's costs.
To secure a commodity price fixed against an external
contract
23. HEDGING WITH Forward CONTRACTS
• Forward contract is an OTC agreement between two
parties, to buy or sell an asset at a certain time in the future
for a certain price.
• The price of the underlying instrument, in whatever form,
is paid before control of the instrument changes.
• This is one of the many forms of buy/sell orders where the
time of trade is not the time where the securities
themselves are exchanged.
• The forward price is commonly contrasted with the spot
price, which is the price at which the asset changes hands
on the spot date.
• The difference between the spot and the forward price is
the forward premium or forward discount, generally
considered in the form of a profit or loss, by the purchasing
party.
24. HEDGING WITH FUTURE CONTRACTS
What Does Futures Contract Mean?
A contractual agreement, generally made on the trading floor
of a futures exchange, to buy or sell a particular commodity or
financial instrument at a pre-determined price in the future.
Futures contracts detail the quality and quantity of the underlying
asset; they are standardized to facilitate trading on a futures
exchange.
Some futures contracts may call for physical delivery of the asset,
while others are settled in cash.
25. TYPES OF FUTURE CONTRACTS
There are many different kinds of futures contracts,
reflecting the many different kinds of "tradable"
assets about which the contract may be based
such as commodities, securities (such as single-
stock futures), currencies or intangibles such as
interest rates and indexes.
1. Foreign exchange market
2. Money market
3. Bond market
4. Equity market
5. Commodities market
26. HEDGING WITH SWAPS
What Does Swap Mean?
If firms in separate countries have comparative
advantages on interest rates, then a swap could
benefit both firms.
For example, one firm may have a lower fixed
interest rate, while another has access to a lower
floating interest rate. These firms could swap to
take advantage of the lower rates.
28. REASON FOR SWAPS
• Spread compression
• Market segmentation
• Market saturation
• Difference in financial norms
29. HEDGING WITH OPTION
CONTRACTS
An option contract is an agreement under which the seller of the option grants
the buyer the right, but not the obligation, to buy or sell(depending on whether
it is a call option or a put option) some asset at a predetermined price during
the specified period. The buyer of the option has to pay a premium to enjoy the
right.
Forward vs options:
• In forwards contract both parties agree to act in the future whereas in an option
transaction occurs only if the buyer of the option chooses to exercise it.
• In forward contract no money exchanges hands whereas in options the buyer of
the contract pays option premium.
30. Types of option contracts
• Option contract on debt instruments- options on treasury
bill
• Option contract on foreign currencies– options with US $
• Option contract on stock market indices-option on Nifty
• Option contract on stocks
31. EVOLUTION OF RISK MANAGEMENT
TOOLS
The financial and operating environment today is
more riskier than in the past –
• Substantial increase in the average rate as well as
volatility of inflation
• Greater volatility in interest rates , exchange
rates, and commodity prices
• Increased global competition.
32. Volatility and Risk Management Tools
• Exchange rate volatility- currency futures, currency
swaps, currency options
• Interest rate volatility- floating rate loans, T-Bill
futures, T-Bond futures, options on T-Bonds
• Petroleum prices- futures in heating oil, futures in
WTI, hybrids, option in WTI
• Metal price volatility- forwards, futures, options ,
hybrids.
33. WTI
West Texas Intermediate (WTI), also
known as Texas light sweet, is a grade of
crude oil used as a benchmark in oil pricing.
This grade is described as light because of
its relatively low density, and sweet because
of its low sulfur content. It is the underlying
commodity of Chicago Mercantile
Exchange's oil futures contracts
35. Forward Foreign Exchange Contract
Definition:
An agreement to exchange one currency
for another, where
The exchange rate is fixed on the day of the
contract, but
The actual exchange takes place on a pre-
determined date in the future
36. Characteristics and Features of FX
Forwards
Available daily in major currencies in 30-, 90-, and
180-day maturities
Forwards are entered into “over the counter”
Deliverable forwards: face amount of currency is
exchanged on settlement date
Non-deliverable forwards: only the gain or loss is
exchanged
37. Characteristics and Features of FX
Forwards
Contract terms specify:
forward exchange rate
term
amount
‘‘value date’’ (the day the forward contract expires)
locations for payment and delivery.
The date on which the currency is actually exchanged, the
‘‘settlement date,’’ is generally two days after the value
date of the contract.
38. Characteristics and Features of FX
Forwards
Forward Exchange Rates
Forward exchange rates are different from spot rates, but they
are not a prediction of what the spot rate will be when the deal
settles!
The difference between the
forward exchange rate and the spot exchange rate
is the interest differential
between the two currencies
40. Uses of FX Forwards
(1) Hedge foreign currency risk
(2) Arbitrage FX rate discrepancies within and
between markets
(3) Speculate on future market movements
(4) Profit by acting as market maker
Financial institutions, money managers,
corporations, and traders use these instruments
for managing currency risk
41. What is a futures contract?
A futures contract is a forward contract,
which trades on an exchange. S&P CNX Nifty
futures are traded on National Stock
Exchange. This provides them transparency,
liquidity, anonymity of trades, and also
eliminates the counter party risks due to the
guarantee provided by National Securities
Clearing Corporation Limited.
42. Options
An Option is a contract which gives the
right, but not an obligation, to buy or sell the
underlying at a stated date and at a stated
price. While a buyer of an option pays the
premium and buys the right to exercise his
option, the writer of an option is the one
who receives the option premium and
therefore obliged to sell/buy the asset if the
buyer exercises it on him.
43. A typical options transaction
On July 1, 2006, 'A' sells a call option (right to
buy), with strike price of Rs.500, which expires
after one month on "ABC Ltd." to 'B' for a price of
say Rs.3.00. Now 'B' has the right to approach 'A'
on July 31, 2006 and buy 1 share of "ABC Ltd." at
Rs.500. Here Rs.3.00 is called the option price,
Rs.500 is the exercise price and July 31, 2006 is
called the expiration date.
44. A typical options transaction
'B' does not have to necessarily buy 1 share of
"ABC Ltd." on July 31, 2006 at Rs.500 from 'A'.
'B' may find it worthwhile to exercise his right
to buy only if "ABC Ltd." trades above Rs.500. If
"B” exercises his option, A has to necessarily
sell "B“ one share of "ABC Ltd." at Rs.500 on
July 31, 2006. So if the price of "ABC Ltd." goes
above Rs.500 'B' may exercise his option, or
else the option may lapse. Then 'B' loses the
original option price of Rs.3.00 and 'A' has
gained it.
46. Brokers
For any purchase and sale, brokers perform an
important function of bringing buyers and
sellers together.
By virtue of a member of a commodity or
financial futures exchange one get a right to
transact with other members of the same
exchange. This transaction can be in the pit of
the trading hall or on online computer
terminal.
47. Market makers and jobbers
Even in organized futures exchange, every deal cannot
get the counter party immediately. It is here the jobber
or market maker plays his role.
They are the members of the exchange who takes the
purchase or sale by other members in their books and
Then Square off on the same day or the next day.
They quote their bid-ask rate regularly. The difference
between bid and ask is known as bid-ask spread. When
volatility in price is more, the spread increases since
jobbers price risk increases.
48. Hedgers
The process of managing the risk or risk
management is called as hedging. Hedgers are
those individuals or firms who manage their
risk with the help of derivative products.
Hedging does not mean maximizing of return.
The main purpose for hedging is to reduce the
volatility of a portfolio by reducing the risk.
49. Speculators
Speculators do not have any position on which they
enter into futures and options Market i.e., they take
the positions in the futures market without having
position in the underlying cash market.
They only have a particular view about future price of
a commodity, shares, stock index, interest rates or
currency. They take risk in turn from high returns.
They help in providing the market the much desired
volume and liquidity.
50. Arbitrageurs
Arbitrage is the simultaneous purchase and sale
of the same underlying in two different
markets in an attempt to make profit from
price discrepancies between the two markets.
Arbitrage involves activity on several different
instruments or assets simultaneously to take
advantage of price distortions judged to be
only temporary.
51. Arbitrageurs
Arbitrage occupies a prominent position in the futures
world. It is the mechanism that keeps prices of futures
contracts aligned properly with prices of underlying
assets.
The objective is simply to make profits without risk, but the
complexity of arbitrage activity is such that it is reserved
to particularly well-informed and experienced
professional traders, equipped with powerful calculating
and data processing tools.
Arbitrage may not be as easy and costless as presumed.
52. Commodity
Producers/Consumers
These participants have natural underlying
outright long (producers) and short
(consumers) positions in the relevant
commodity.
The inherent risk-exposure drives the use of
commodity derivatives by producers and
users.
53. Commodity Processors
These participants have limited outright price
exposure. This reflects the fact the processors have a
spread exposure to the price differential between
the cost of the input and the cost of the output.
For example, oil refiners are exposed to the differential
between the price of the crude oil and the price of
the refined oil products (diesel, gasoline, heating oil,
aviation fuel, etc.).
The nature of the exposure drives the types of hedging
activity and the instruments used.
54. Commodity Traders
The traders act as an agent or principal to secure the
sale/purchase of the commodity.
Traders increasingly seek to add value to pure trading
relationship by providing derivative/risk
management expertise.
Traders also occasionally provide financing and other
services. Commodity traders have complex hedging
requirements, depending on the nature of their
activities.
55. Financial Institution/Dealers
Dealer participation in commodity markets is
primarily as a provider of finance or provider
of risk management products.
The dealers provide credit enhancement, speed,
immediacy of execution and structural
flexibility. Dealers frequently bundle risk
management products with other financial
services such as provision of finance.
56. Investors
This covers financial investors seeking to
invest in commodities as a distinct and a
separate asset class of financial investment.
The gradual recognition of commodities as a
specific class of investment assets is an
important factor that has influenced the
structure of commodity derivatives
markets.
59. Calls options
“Calls” 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 given future date.
60. Puts options
“Puts” give the buyer the right, but not the
obligation to sell a given quantity of
underlying asset at a given price on or
before a given future date. All the options
contracts are settled in cash.
61. Premium
Premium the price that the holder of an option pays and the writer of an
option receives for the rights conveyed by the option.
i. The premiums are not fixed by the Exchange and are subject to
fluctuations in response to market and economic forces. The factors
affecting pricing of an option include
ii. current value of the underlying,
iii. the exercise price,
iv. current values of futures on the underlying,
v. style of option,
vi. individual opinion and estimates of the future volatility of the
underlying,
vii. historical volatility of the underlying,
viii. the time remaining till expiration,
ix. cash dividends payable on the underlying stock,
x. current interest rates, depth of the market, available information, etc.
62. In- the- money options (ITM)
An in-the-money option is an option that would lead
to positive cash flow to the holder if it were
exercised immediately.
A Call option is said to be in-the-money when the
current price stands at a level higher than the strike
price.
If the Spot price is much higher than the strike price, a
Call is said to be deep in-the-money option. In the
case of a Put, the put is in-the-money if the Spot
price is below the strike price.
63. At-the-money-option (ATM)
An at-the money option is an option that
would lead to zero cash flow if it were
exercised immediately. An option on the
index is said to be “at-the-money” when the
current price equals the strike price.
64. Out-of-the-money-option (OTM)
An out-of- the-money Option is an option that would
lead to negative cash flow if it were exercised
immediately.
A Call option is out-of-the-money when the current
price stands at a level which is less than the strike
price.
If the current price is much lower than the strike price
the call is said to be deep out-of-the money. In case
of a Put, the Put is said to be out-of-money if current
price is above the strike price.
