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Derivatives

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  • 1. DERIVATIVES PRESENTATION BY S.K.VAZE
  • 2. DERIVATIVES DERIVATIVES IS THE FUTURE !! WHY ???
  • 3. DERIVATIVES INTRODUCTION
    • FIVE DIFFERENT MARKETS
      • 1) MONEY MARKET
      • 2) STOCK MARKET
      • 3) FOREX MARKET
      • 4) COMMODITY MARKET
      • 5) REAL ESTATE MARKET
  • 4. DERIVATIVES
    • RISKS FACED BY A BANK
    • 1) CREDIT RISK
    • 2) MARKET RISK
    • 3) LEGAL RISK
    • 4) OPERATIONAL RISK
  • 5. DERIVATIVES INTRODUCTION
    • DERIVATIVE IS A PRODUCT WHICH DOES NOT HAVE ANY VALUE OF ITS OWN
    • IT DERIVES ITS VALUE FROM THE UNDERLYING ASSET
  • 6. DERIVATIVES
    • TRANSACTIONS CAN BE BROADLY CLASSIFIED INTO FOUR TYPES DEPENDING ON THE PERIOD ALLOWED FOR SETTLEMENT OF CURRENCIES / COMMODITIES
      • VALUE CASH
      • VALUE TOM
      • VALUE SPOT
      • VALUE FORWARD
  • 7. DERIVATIVES
    • 1) VALUE CASH ARE THOSE TRANSACTIONS IN WHICH RATE IS FIXED TODAY AND SETTLEMENT IS COMPLETED ON THE SAME DAY.
  • 8. DERIVATIVES
    • 2) VALUE TOM ARE THOSE TRANSACTIONS IN WHICH RATE IS FIXED TODAY AND SETTLEMENT CAN BE COMPLETED WITHIN ONE WORKING DAY
  • 9. DERIVATIVES
    • 3) VALUE SPOT ARE THOSE TRANSACTIONS IN WHICH RATE IS FIXED TODAY AND SETTLEMENT CAN BE COMPLETED WITHIN TWO WORKING DAYS
  • 10. DERIVATIVES
    • 4) VALUE FOWARD ARE THOSE TRANSACTIONS IN WHICH RATE IS FIXED TODAY AND SETTLEMENT CAN BE COMPLETED ANYTIME BEYOND TWO WORKING DAYS
  • 11. DERIVATIVES FORWARD CONTRACT
    • ASSUME THAT KIRLOSKAR IS AN EXPORTER OF PUMPS AND FORD IS IMPORTER IN USA.
    • FORD ASKS KIRLOSKAR TO GIVE QUOTATION FOR PUMPS
    • KIRLOSKAR KNOWS SELLING PRICE OF PUMPS IN TERMS OF RUPEES.
  • 12. DERIVATIVES FORWARD CONTRACT
    • TO ARRIVE AT THE PRICE IN TERMS OF US $, KIRLOSKAR WILL DIVIDE THE RUPEE PRICE BY EXCHANGE RATE BETWEEN US $ AND RUPEES PREVAILING ON THAT DAY.
    • IF RATE IS ACCEPTABLE TO FORD, THEY WILL FIX THE RATE AND PLACE THE ORDER ON KIRLOSKAR
  • 13. DERIVATIVES FORWARD CONTRACT
    • HOWEVER THE EXCHANGE OF PUMPS AND US $ WILL TAKE PLACE SOME TIME IN FUTURE. SAY AFTER 3 MONTHS.
    • HENCE THIS IS A VALUE FORWARD TRANSACTION
    • KIRLOSKAR IS EXPOSED TO RISK DUE TO FLUCTUATION OF RATES.
  • 14. DERIVATIVES FORWARD CONTRACT
    • TO HEDGE THIS RISK A DERIVATIVE IS AVAILABLE IN FOREX MARKET CALLED AS FORWARD CONTRACT.
    • KIRLOSKAR WILL APPROACH THE BANK ON THE DAY THE ORDER IS PLACED AND ASK RATE OF EXCHANGE FOR A TRANSACTION TO BE UNDERTAKEN AFTER 3 MONTHS.
  • 15. DERIVATIVES FORWARD CONTRACT
    • DEPENDING ON THE SITUATION THE BANK WILL QUOTE A FORWARD RATE FOR THIS TRANSACTION.
    • IF THE RATE IS ACCEPTABLE TO KIRLOSKAR THEY WILL ENTER INTO A CONTRACT –
    • “ FORWARD CONTRACT”
  • 16. DERIVATIVES FORWARD CONTRACT
    • THREE MAIN INGREDIENTS OF FORWARD CONTRACT ARE
        • 1) FIXED AMOUNT
        • 2) FIXED FUTURE DATE
        • 3) FIXED RATE OF EXCHANGE
    • LET US ASSUME THE VALUES OF ABOVE 3 FACTORS AS UNDER:
      • 1) US $ 100/ 2) SEPTEMBER 03 3) Rs.46 / $
  • 17. DERIVATIVES FORWARD CONTRACT
    • IN FORWARD CONTRACTS THERE IS A LIKELIHOOD OF COUNTERPARTY RISK / LIQUIDITY RISK HENCE A NEW DERIVATIVE WAS INTRODUCED KNOWN AS “ FUTURES CONTRACT ”.
    • IT HAS SAME FEATURES AS THOSE OF FORWARD CONTRACT BUT FEW DIFFERENCES AS UNDER:
  • 18. DERIVATIVES DIFFERENCES BETWEEN FORWARD CONTRACT AND FUTURES 15 % TO 30 % NIL MARGIN ON THE EXCHANGES OVER THE COUNTER TRADING NONE MAY EXIST COUNTERPARTYLIQUIDITY RISK STANDARD FLEXIBLE MATURITY STANDARD FLEXIBLE AMOUNT FUTURES FORWARD CONTRACT
  • 19. DERIVATIVES FUTURES CONTRACT
    • COMMODITY FUTURES:
    • THE UNDERLYING ASSET IS A COMMODITY e.g. WHEAT, CORN etc.
    • CONSIDER A FARMER WHO IS PRODUCING CORN & IT WOULD BE READY FOR HARVEST IN ANOTHER 3 MONTH’S TIME. HE IS WORRIED ABOUT PRICES GOING DOWN.
  • 20. DERIVATIVES FUTURES CONTRACT
    • HENCE HE CAN SELL FUTURES CONTRACT NOW.
    • HE WILL DELIVER CORN TO FULFILL HIS OBLIGATION UNDER THE FUTURES.
    • REGARDLESS OF HOW PRICES OF CORN CHANGES, HE IS GUARANTEED TO BE PAID THE PRICE OF FUTURES.
  • 21. DERIVATIVES FUTURES CONTRACT
    • ON THE OTHER SIDE OF THE TRANSACTION MIGHT BE CEREAL MANUFACTURER SUCH AS KELLOG WHO NEEDS TO BUY LOTS OF CORN.
    • KELLOG IS WORRIED THAT PRICES OF CORN WILL GO UP.
  • 22. DERIVATIVES FUTURES CONTRACT
    • TO PROTECT AGAINST THIS, KELLOG CAN BUY FUTURES CONTRACT.
    • IT WILL TAKE DELIVERY OF CORN TO FULFILL ITS OBLIGATION UNDER FUTURS CONTRACT.
    • REGARDLESS OF HOW PRICES OF CORN CHANGES, KELLOG WILL PAY NO MORE THAN PRICE AGRRED IN FUTURES.
  • 23. DERIVATIVES FUTURES CONTRACT
    • LET US PRESUME THAT US IMORTER DECIDES TO BUY GERMAN GOODS WORTH DEM 125000/ & PAYABLE IN A MONTH’S TIME. THE SPOT RATE IS $ / DEM = 0.3984. FIRTHER US IMPORTER IS APPREHENSIVE THAT DEM WILL APPRECIATE AGAINST USD PUSHING UP HIS DOLLAR COST.
  • 24. DERIVATIVES FUTURES CONTRACT
    • TO HEDGE HE MAY BUY A FUTURES CONTRACT WORTH DEM 125000 AT CHICAGO MERCANTILE EXCHANGE AT FUTURES RATE OF $ 0.4010 / DEM.
    • AFTER A MONTH PRESUME SPOT RATE HAS MOVED TO $ 0.4114 & FUTURES PRICE TO $ 0.4130.
  • 25. DERIVATIVES FUTURES CONTRACT
    • THERFORE THE RISE IN COST OF GOODS IS ( $ 0.4114 – 0.3984) * 125000 = $ 1625 /
    • HE MAY CLOSE HIS FUTURES POSITION AT A PROFIT OF ($0.4130 –0.4010) * 125000 = $ 1500/
    • THEREBY HE CAN REDUCE HIS LOSS TO $ 125
  • 26. FUTURES CONTRACT
    • CLEARING HOUSE: ON THE TRADING FLOOR A FUTURES CONTRACT IS AGRRED BETWEEN TWO PARTIES A & B.
  • 27. FUTURES CONTRACT
    • WHEN IT IS RECORDED BY THE EXCHANGE, THE CONTRACT BETWEEN A & B IS REPLACED BY TWO CONTRACTS, ONE BETWEEN A & THE CLEARINGHOUSE AND ANOTHER BETWEEN B & CLEARINGHOUSE.
  • 28. FUTURES CONTRACT
    • THUS THE EXCHANGE INTERPOSES ITSELF IN EVERY DEAL, BEING BUYER TO EVERY SELLER AND SELLER TO EVERY BUYER.
    • THIS ELIMINATES THE NEED FOR A & B TO INVESTIGATE EACH OTHER’S CREDITWORTHINESS AND GUARANTEES FINACIAL INTEGRITY.
  • 29. FUTURES CONTRACT
    • THE EXCHANGE ENFORCES DELIVERY OF CONTACTS HELD TILL MATURITY.
    • IT PROTECTS ITSELF BY IMPOSING MARGIN REQUIREMENTS ON TRADERS AND A SYSTEM KNOWN AS MARKING TO MARKET.
  • 30. FUTURES CONTRACT MARKING TO MARKET
    • THE DAILY SETTLEMENT PROCESS CALLED "MARK-TO-MARKET" PROVIDES FOR COLLECTION OF LOSSES THAT HAVE ALREADY OCCURRED
    • WHEREAS INITIAL MARGIN SEEKS TO SAFEGUARD AGAINST POTENTIAL LOSSES ON OUTSTANDING POSITIONS.
    • THE MARK-TO-MARKET SETTLEMENT IS DONE IN CASH.
  • 31. FUTURES CONTRACT MARKING TO MARKET
    • A CLIENT PURCHASES 200 UNITS OF FUTIDX NIFTY 29JUN2001 AT RS 1500 PER UNIT.
    • THE INITIAL MARGIN PAYABLE 15%.
    • TOTAL LONG POSITION = RS 3,00,000 (200*1500)
    • INITIAL MARGIN (15%) = RS 45,000
  • 32. FUTURES CONTRACT MARKING TO MARKET
    • ASSUMING THAT THE CONTRACT WILL CLOSE ON DAY + 3 THE MARK-TO-MARKET POSITION WILL LOOK AS FOLLOWS:
    • POSITION ON DAY 1 SE Price
    • Loss
    • Margin released
    • Net cash outflow
    17000 3000 -20000 280000 NET CASH OUTFLOW MARGIN RELEASED LOSS CLOSE PRICE
  • 33. FUTURES CONTRACT MARKING TO MARKET
    • New position on Day 2
    • Value of new position = 1,400*200= 2,80,000
    • Margin = 42,000
    18700 3300 22000 302000 NET CASH INFLOW ADDITIONMARGIN LOSS / GAIN CLOSE PRICE
  • 34. FUTURES CONTRACT MARKING TO MARKET
    • Position on Day 3
    • Value of new position = 1510*200 = Rs 3,02,000
    • Margin = Rs 3,300
    63600 (18000+45300) 18000 320000 NET CASH INFLOW LOSS / GAIN CLOSE PRICE
  • 35. FUTURES CONTRACT MARKING TO MARKET
    • Margin account*
    • Initial margin                =       Rs 45,000
    • Margin released (Day 1) =  (-) Rs  3,000
    • Position on Day 2                  Rs 42,000
    • Addn margin                =  (+) Rs  3,300
    • Total margin in a/c                Rs 45,300*
  • 36. FUTURES CONTRACT MARKING TO MARKET
    • Net gain/loss
    • Day 1 (loss)                =     (Rs 17,000)
    • Day 2 Gain                  =      Rs 18,700
    • Day 3 Gain                  =       Rs 18,000
    • Total Gain                   =        Rs 19,700
    • The client has made a profit of Rs 19,700 at the end of Day 3 and the total cash inflow at the close of trade is Rs 63,300.
  • 37. FUTURES CONTRACT MARKING TO MARKET
    • THE MOST COMMON WAY OF LIQUIDATING AN OPEN POSITION IS TO EXECUTE AN OFFSETTING FUTURES TRANSACTION BY WHICH THE INITIAL TRANSACTION IS SQUARED UP.
  • 38. FUTURES CONTRACT
    • MOST OF THE FUTURES CONTRACTS ARE EXTINGUISHED BEFORE MATURITY BY ENTERING INTO A MATCHING CONTRACT IN THE OPPOSITE DIRECTION.
  • 39. FUTURES CONTRACT
    • IN A FORWARD CONTRACT, THE LONG ACQUIRES UNDERLYING COMMODITY ON THE MATURITY DATE AT THE PRICE WRITTEN INTO THE CONTRACT.
  • 40. FUTURES CONTRACT
    • IN A FUTURES CONTRACT THE PRICE PAID FOR ACQUISITION OF COMMODITY IS THE FUTURES PRICE ON THE MATURITY DAY WHICH MUST EQUAL THE SPOT PRICE ON THAT DAY.
  • 41. FUTURES CONTRACT
    • THIS PRICE MINUS THE ALGEBRAIC SUM OF ALL CASHFLOWS THROUGHOUT THE LIFE OF THE CONTRACT EQUALS ORIGINAL FUTURES PRICE AT WHICH LONG BOUGHT THE CONTRACT.
  • 42. FUTURES CONTRACT
    • BECAUSE OF THE FLEXIBILITY IN
      • VALUES OF FORWARD CONTRACTS
      • IN MARGIN REQUIREMENT
      • FUTURE DATE
      • ABSENCE OF MARK TO MARKET RISK
  • 43. FUTURES CONTRACT
      • FORWARD ONTRACTS ARE PREFERRED BY IMPORTERS, EXPORTERS, BORROWERS, LENDERS WHO WISH TO PRECISELY HEDGE FOREX RISK AND EXPOSURE
      • FUTURES CONTRACT ARE PREFERRED BY SPECULATORS BECAUSE GAINS CAN BE TAKEN AS CASH & THE TRANSACTION COSTS ARE SMALL.
  • 44. DERIVATIVES INVESTMENT IN DERIVATIVES IS LESSER THAN IN CASE OF CASH DELIVERY
  • 45. DERIVATIVES
    • MR. GANGULY WANTS TO BUY 1200 SHARES OF SATYAM @ RS. 280/ SHARE. HE WILL HAVE TO INVEST 336000/-
    • INSTEAD IF HE BUYS FUTURES, HIS INVESTMENT WOULD BE RS. 50400/ ONLY (CONSIDERING A MARGIN OF 15 %)
  • 46. DERIVATIVES
    • IF THE SPOT RISES TO Rs. 300/ PER SHARE,
    • DELIVERY WILL MAKE A PROFIT OF Rs. 24000/- AND FUTURES WILL ALSO MAKE SAME PROFIT BUT REMEMBER, INVESTMENT WAS ONLY 15 %
  • 47. DERIVATIVES 47.61 % 24000 50400 FUTURES 7.14 % 24000 336000 DELIVERY RETURN PROFIT Rs. INVESTMENT Rs. STRATEGY
  • 48. FORWARD & FUTURES CONTRACT -DRAWBACKS
    • 1) IT IS RIGHT AS WELL AS AN OBLIGATION FOR THE PARTIES
    • 2) ONCE THE CONTRACT IS BOOKED THE PURCHASER CAN NOT TAKE ADVANTAGE OF FAVOURABLE SPOT RATES PREVAILING IN THE MARKET ON THE ACTUAL DATE OF TRANSACTION
  • 49. FORWARD & FUTURES CONTRACT -DRAWBACKS
    • 3) EVEN IF THE UNDERLYING TRADE TRANSACTION GETS CANCELLED, THE FORWARD CONTRACT MUST BE HONOURED
  • 50. DERIVATIVES
    • HENCE THE PLAYERS IN THE MARKET WERE LOOKING FOR A DERIVATIVE WHICH CAN TO SOME EXTENT TAKE CARE OF THESE DRAWBACKS
    • HENCE A NEW DERIVATIVE KNOWN AS ‘ OPTIONS ’ WAS INTRODUCED.
  • 51. DERIVATIVES OPTIONS
      • THERE ARE TWO PARTIES TO OPTION
      • 1) OPTION SELLER
      • 2) OPTION BUYER
      • THERE ARE TWO TYPES OF OPTIONS
      • 1) CALL OPTION
      • 2) PUT OPTION
  • 52. DERIVATIVES OPTIONS
    • OPTION IS THE RIGHT GIVEN BY THE OPTION SELLER TO THE OPTION BUYER TO BUY OR SELL A SPECIFIC ASSET AT A SPECIFIC PRICE ON OR BEFORE A SPECIFIED DATE
  • 53. DERIVATIVES OPTIONS
    • STRIKE PRICE : THE PRE-DETERMINED PRICE AT WHICH THE UNDERLYING ASSET CAN BE BOUGHT OR SOLD
    • PREMIUM: THE PRICE PAID BY THE BUYER TO THE SELLER TO ACQUIRE THE RIGHT TO BUY OR SELL
  • 54. DERIVATIVES OPTIONS
    • EXPIRATION DATE: THE DATE ON WHICH THE OPTION EXPIRES IS KNOWN AS EXPIRATION DATE
    • EUROPEAN STYLE: WHICH CAN BE EXERCISED ONLY ON THE EXPIRY DATE
    • AMERICAN STYLE: WHICH CAN BE EXERCISED ANY TIME UPTO EXPIRY DATE
  • 55. DERIVATIVES OPTIONS
    • THE OPTION BUYER CAN EITHER “ EXERCISE THE OPTION ” OR “ WALK OUT OF THE OPTION” DEPNDING ON THE SPOT RATE PREVAILING IN THE MARKET AT EXPIRY DATE
    • IN-THE-MONEY
    • OUT-OF-THE-MONEY
    • AT-THE-MONEY
  • 56. DERIVATIVES OPTIONS
    • CONSIDER THAT YOU HAVE BOUGHT A CALL OPTION ON INFOSYS SHARES WITH A STRIKE PRICE OF Rs. 4000/ PER SHARE AND PAY A PREMIUM OF Rs. 300/ PER SHARE. YOUR GAIN / LOSS AT TIME T IN FUTURE, DEPENDS ON VALUE OF SPOT RATE S_t AT THAT TIME
  • 57. DERIVATIVES OPTIONS
    • S_t
    • 3500
    • 3600
    • 3700
    • 3800
    • 3900
    • 4000
    • 4100
    • GAIN(+) / LOSS(-)
    • -300
    • -300
    • -300
    • -300
    • -300
    • -300
    • -200
  • 58. DERIVATIVES OPTIONS
    • S_t
    • 4200
    • 4300
    • 4400
    • 4500
    • 4600
    • 4700
    • 4800
    • GAIN(+) / LOSS(-)
    • -100
    • 0
    • +100
    • +200
    • +300
    • +400
    • +500
  • 59. DERIVATIVES OPTIONS
    • CONSIDER THAT YOU HAVE BOUGHT A PUT OPTION ON INFOSYS SHARES WITH A STRIKE PRICE OF Rs. 4000/ PER SHARE AND PAY A PREMIUM OF Rs. 300/ PER SHARE. YOUR GAIN / LOSS AT TIME T IN FUTURE, DEPENDS ON VALUE OF SPOT RATE S_t AT THAT TIME
  • 60. DERIVATIVES OPTIONS
    • S_t
    • 3500
    • 3600
    • 3700
    • 3800
    • 3900
    • 4000
    • 4100
    • GAIN(+) / LOSS(-)
    • +200
    • +100
    • 0
    • -100
    • -200
    • -300
    • -300
  • 61. DERIVATIVES OPTIONS
    • S_t
    • 4200
    • 4300
    • 4400
    • 4500
    • 4600
    • 4700
    • 4800
    • GAIN(+) / LOSS(-)
    • -300
    • -300
    • -300
    • -300
    • -300
    • -300
    • -300
  • 62. DERIVATIVES CALL OPTION
    • CONSIDER THAT AN IMPORTER HAS BOUGHT A CALL OPTION ON USD WITH A STRIKE PRICE OF Rs. 48.50 / PER $ AND PAYS A PREMIUM OF Rs. 0.30/ PER $. HIS GAIN / LOSS AT TIME T IN FUTURE, DEPENDS ON VALUE OF SPOT RATE S_t AT THAT TIME
  • 63. DERIVATIVES CALL OPTION
    • S_t
    • 48.00
    • 4810
    • 48.20
    • 48.30
    • 48.40
    • 48.50
    • GAIN(+) / LOSS(-)
    • -0.30
    • -0.30
    • -0.30
    • -0.30
    • -0.30
    • -0.30
  • 64. DERIVATIVES CALL OPTION
    • S_t
    • 48.60
    • 4870
    • 48.80
    • 48.90
    • 49.00
    • GAIN(+) / LOSS(-)
    • -0.20
    • -0.10
    • 0.00
    • +0.10
    • +0.20
  • 65. DERIVATIVES CALL OPTION
    • DENOTING STRIKE PRICE BY ‘X’, PREMIUM BY ‘c’ & SPOT RATE BY S_t WE GET,
    • FOR VALUES OF S_t > X,
    • OPTION BUYER’S PROFIT = S_t –X –c
    • OPTION SELLER’S PROFIT= -(S_t- X – c)
  • 66. DERIVATIVES CALL OPTION
    • FOR VALUES OF S_t < X,
    • OPTION BUYER’S PROFIT = – c
    • OPTION SELLER’S PROFIT = + c
  • 67. DERIVATIVES PUT OPTION
    • CONSIDER THAT AN EXPORTER HAS BOUGHT A PUT OPTION ON USD WITH A STRIKE PRICE OF Rs. 48.50 / PER $ AND PAYS A PREMIUM OF Rs. 0.30/ PER $. HIS GAIN / LOSS AT TIME T IN FUTURE, DEPENDS ON VALUE OF SPOT RATE S_t AT THAT TIME
  • 68. DERIVATIVES PUT OPTION
    • S_t
    • 48.00
    • 4810
    • 48.20
    • 48.30
    • 48.40
    • 48.50
    • GAIN(+) / LOSS(-)
    • + 0.20
    • +0.10
    • 0.00
    • -0.10
    • -0.20
    • -0.30
  • 69. DERIVATIVES PUT OPTIONS
    • S_t
    • 48.60
    • 4870
    • 48.80
    • 48.90
    • 49.00
    • GAIN(+) / LOSS(-)
    • -0.30
    • -0.30
    • -0.30
    • -0.30
    • -0.30
  • 70. DERIVATIVES PUT OPTIONS
    • DENOTING STRIKE PRICE BY ‘X’, PREMIUM BY ‘c’ & SPOT RATE BY S_t WE GET,
    • FOR VALUES OF S_t > X,
    • OPTION BUYER’S PROFIT = – c
    • OPTION SELLER’S PROFIT= + c
  • 71. DERIVATIVES PUT OPTIONS
    • FOR VALUES OF S_t < X,
    • OPTION BUYER’S PROFIT = X – S_t – c
    • OPTION SELLER’S PROFIT= -(X– S_t– c)
  • 72. DERIVATIVES OPTIONS
    • 1) OPTION SELLER / WRITER
    • 1) HAS TO OBLIGE OPTION BUYER
    • 2) RECEIVES THE PREMIUM FROM
    • BUYER BUT HAS TO PAY THE
    • MARGIN FOR SELLING OPTION
    • 3) RISK PROFILE IS UNLIMITED
    • 4) RETURNS PROFILE IS LIMITED
  • 73. DERIVATIVES OPTIONS
    • OPTION BUYER
    • 1) HAS RIGHT BUT NOT THE
    • OBLIGATION TO EXERCISE OPTION
    • 2) PAYS THE PREMIUM TO SELLER
    • FOR BUYING OPTION
    • 3) RISK PROFILE IS LIMITED
    • 4) RETURNS PROFILE IS UNLIMITED
  • 74. INR / USD OPTIONS PREMIUM QUOTATIONS 0.25 0.10 0.04 0.01 PUT 0.60 0.48 O.39 0.33 CALL 49.00 48.25 47.75 47.50 STRIKE PRICE 12M 6M 3M 1M EXPIRY (INR / $) premium
  • 75. INR / USD OPTIONS PREMIUM QUOTATIONS
    • HENCE FOR BUYING AN OPTION CONTRACT OF USD 100 OF FOLLOWING DESCRIPTION :
    • CALL ON USD FOR 3 MONTHS EXPIRY WITH STRIKE PRICE OF Rs 47.75 / $, THE PURCHASER WILL PAY A PREMIUM OF Rs. 39.00 SINCE
    • 100 * 0.39
  • 76. DERIVATIVES OPTIONS
      • HEDGING WITH CURRENCY OPTIONS
      • THE OBJECTIVE CURRENCY OPTIONS HAS OBVIOUSLY TO BE TO GET THE BEST PROTECTION AVAILABLE AT THE LEAST POSSIBLE COST. THIS IS EASIER SAID THAN DONE.
  • 77. DERIVATIVES OPTIONS
      • HOWEVER, A CORPORATE WITH FOREIGN CURRENCY PAYABLES SAY IN EURO COULD USE THE FOLLOWING DECISION TREE AS A GUIDE:
  • 78. View of currency View of risk Action Very bullish Risk averse Buy currency forward Very bullish Risk tolerant Buy currency forward Bullish Risk averse Buy currency forward Bullish Risk tolerant Buy atm call Flat market Risk averse Buy ootm call   Flat market Risk tolerant Do nothing * No view Risk averse Buy atm call No view Risk tolerant Do nothing * Bearish Risk averse Buy ootm call Bearish Risk tolerant Do nothing * Very bearish Risk averse Buy far ootm call Very bearish Risk tolerant Do nothing *
  • 79. CAP
    • A SELLER CONTRACTS TO REIMBURSE THE BUYER SHOULD A CHOSEN REFERENCE RATE EXCEED THE CAPS INTEREST RATE LEVEL
    • BUYER HAS TO PAY UPFRONT PREMIUM TO COMPENSATE THE SELLER FOR THE RISK HE HAS TAKEN
  • 80. CAP
    • BUYER SELECTS MATURITY, INTEREST RATE LEVEL OR STRIKE PRICE, REFERENCE FLOATING RATE (PLR), RESET PERIOD AND NOTIONAL PRINCIPAL AMOUNT
  • 81. CAP
    • PRESUME A CORPORATE HAS AVAILED A LOAN OF RS. 5 LACS FOR A PERIOD OF 2 YEARS AT PRIME LENDING RATE (QUARTERLY RESETTING) FROM A BANK ON 01-01-2004.
  • 82. CAP
    • THE PRINCIPAL AMOUNT IS TO BE REPAID AT THE END OF 2 YEARS, BUT INTEREST IS TO BE PAID AT THE END OF EVERY QUARTER. SUPPOSE AT THE TIME OF AVAILING LOAN ,THE PLR IS 10%.
  • 83. CAP
    • NOW, HE BELIEVES THAT PLR IS LIKELY TO RISE AFFECTING HIM ADVERSELY. HENCE HE WANTS TO HEDGE FROM SUCH ADVERSE EFFECT.
  • 84. CAP
    • THEREFORE HE ENTERS CAPS OPTION MARKET & CHOOSES A 2 YEAR 10 % P.A., RUPEE CAP, RESET QUARTERLY, WITH PLR AS REFERENCE RATE.
  • 85. CAP
    • TO PURCHASE THIS CAP, HE PAYS UPFRONT PREMIUM OF RS. 0.0117 / RS. 5850
    • PREMIUM = 500000 * 0.0117=Rs 5850
  • 86. CAP
    • IN THE EVENT PLR MOVES ABOVE 10% LEVEL ON ANY OF THESE RESET DAYS, THE SELLER WOULD COMPENSATE THE BUYER, WITH CASH PAYMENT AS PER FORMULAE :
    • (PLR – STRIKE PRICE) * PRINCIPAL * NUMBER OF DAYS / 36000
  • 87. CAP
    • IN OUR EXAMPLE, LET US ASSUME THAT IN THE SECOND QUARTER OF 2004, THE PLR OF LENDER BANK MOVES TO 10.50 %., THEN THE SELLER WOULD PAY Rs 625 TO BUYER. (10.50 – 10.00) * 500000 * 90 / 36000
  • 88. FLOOR
    • A SELLER CONTRACTS TO COMPENSATE THE BUYER SHOULD A CHOSEN REFERENCE RATE FALL BELOW THE FLOORS INTEREST RATE LEVEL.
  • 89. FLOOR
    • BUYER HAS TO PAY UPFRONT PREMIUM TO COMPENSATE THE SELLER FOR THE RISK HE HAS TAKEN
  • 90. FLOOR
    • NOW, HE BELIEVES THAT MIBID IS LIKELY TO FALL AFFECTING HIM ADVERSELY. HENCE HE WANTS TO HEDGE FROM SUCH ADVERSE EFFECT.
  • 91. FLOOR
    • BUYER SELECTS MATURITY, INTEREST RATE LEVEL OR STRIKE PRICE, REFERENCE FLOATING RATE (MIBID), RESET PERIOD AND NOTIONAL PRINCIPAL AMOUNT
  • 92. FLOOR
    • PRESUME A CORPORATE HAS INVESTED RS. 5 LACS FOR A PERIOD OF 2 YEARS WITH A BANK ON 01-01-2004, AT MIBID - 1 %, WITH QUARTERLY RESETTING.
    • SUPPOSE ON 01-01-2004, THE MIBID IS 6% P.A.
  • 93. FLOOR
    • THEREFORE HE ENTERS OPTION MARKET & CHOOSES A 2 YEAR 6.00% RUPEE FLOOR, RESET QUARTERLY, WITH MIBID AS REFERENCE RATE.
  • 94. FLOOR
    • TO PURCHASE THIS FLOOR HE PAYS UPFRONT PREMIUM OF RS. 0.0117 / Rs. 5850
    • PREMIUM = 500000 * 0.0117=Rs 5850
  • 95. FLOOR
    • IN THE EVENT MIBID MOVES BELOW 6.00 % LEVEL ON ANY OF THESE RESET DAYS, THE SELLER WOULD COMPENSATE THE BUYER WITH CASH PAYMENT AS PER FORMULAE:
    • (STRIKE PRICE - MIBID) * PRINCIPAL * NUMBER OF DAYS / 36000
  • 96. FLOOR
    • IN OUR EXAMPLE, LET US ASSUME THAT DURING SECOND QUARTER OF 2004, MIBID MOVES TO 5.50 %, THEN THE SELLER WOULD PAY Rs 625 TO BUYER. (6.00 – 5.50) * 500000 * 90 / 36000
  • 97. INTEREST RATE SWAP
    • DEFINITION
    • “TO EXCHANGE ONE THING FOR ANOTHER”
  • 98. INTEREST RATE SWAP
    • RELIANCE BY VIRTUE OF THEIR HIGH CREDIT RATING CAN RAISE A LOAN AT 10.40% P.A. FIXED RATE WHEREAS STAR & CO. GETS LOAN @ 11.50 P.A.
  • 99. INTEREST RATE SWAP
    • IN TERMS OF FLOATING RATE OF INTEREST RELIANCE GETS LOAN @ PLR+0.25% WHILE STAR & CO. GETS @ PLR+0.75%
  • 100. INTEREST RATE SWAP
    • THERE EXISTS A POTENTIAL FOR AN INTEREST RATE ARBITRAGE BETWEEN THE TWO.
    • TO TAP THIS POTENTIAL WHAT COMPANIES HAVE TO DO IS:
  • 101. INTEREST RATE SWAP
    • RELIANCE BORROWS AT FIXED RATE @ 10.40% P.A. WHILE STAR & CO. BORROWS AT FLOATING RATE I.E. PLR +0.75 %
    • BOTH THESE COMPANIES SHALL ENTER INTO A INTEREST RATE SWAP REQUIRING PAYMENTS FROM ONE TO THE OTHER AS UNDER:
  • 102. INTEREST RATE SWAP
    • RELIANCE STAR & CO
    • credit rating AAA BBB
    • Cost of funds
    • Fixed 10.40 % 11.50 %
    • Floating PLR +0.25 % PLR + 0.75%
    • Initially 10.40 % PLR + 0.75%
  • 103. INTEREST RATE SWAP
    • SWAP PAYMENTS REL STAR
    • RELIANCE pays STAR PLR
    • STAR pays RELIANCE 10.45 %
    • All in cost PLR – 0.05 % 11.20 %
    • direct funding cost PLR + 0.25 % 11.50 %
    • Saving 0.30 % 0.30 %
  • 104. CURRENCY SWAPS
    • HDFC HAS OBTAINED LINES OF CREDIT FROM US MARKET AGAINST THE GUARANTEE OF US AGENCY FOR INTERNATIONAL DEVELOPMENT
  • 105. CURRENCY SWAPS
    • HENCE THIS FACILITY RESULTS IN HDFC BEING ABLE TO BORROW IN US MARKETS AT A VERY FINE RATE OF INTERESTS
  • 106. CURRENCY SWAPS
    • BUT HDFC NEEDED LONG TERM RUPEE RESOURCES AT FIXED RATE OF INTEREST FOR ON-LENDING TO BUILDERS IN INDIA .
  • 107. CURRENCY SWAPS
    • THEREFORE HDFC BORROWED $ AT A CHEAPER RATE OF INTEREST AND SWAPPED IT WITH A DOMESTIC FINANCIAL INSTITUTIONS FOR RUPEE LOAN.
  • 108. CURRENCY SWAPS
    • WHAT IS THE RESULT?
  • 109. CURRENCY SWAPS
    • 1) FINANCIAL INSTITUTION GOT US $ LOAN AT A FLOATING RATE OF INTEREST THEY WOULD NOT HAVE BEEN ABLE TO PROCURE
    • &
  • 110. CURRENCY SWAPS
    • 2) HDFC GOT RUPEE LOAN FROM FINANCIAL INSTITUTION AT A FIXED RATE OF INTEREST WHICH OTHERWISE IT WOULD NOT HAVE GOT.
  • 111. DERIVATIVES INTRODUCTION
    • DERIVATIVES PROVIDE 3 IMPORTANT ECONOMIC FUNCTIONS:
      • 1) RISK MANAGEMENT
      • 2) PRICE DISCOVERY
      • 3) TRANSACTION EFFICIENCY
  • 112. DERIVATIVES INTRODUCTION
    • RISK MANAGEMENT INVOLVES STRUCTURING OF FINANCIAL CONTRACTS TO PRODUCE GAINS THAT COUNTERBALANCE LOSSES ARISING OUT OF MOVEMENTS IN PRICES.
  • 113. DERIVATIVES INTRODUCTION
    • PRICE DISCOVERY REPRESENTS ABILITY TO ACHIEVE AND DISSEMINATE PRICE INFORMATION.
  • 114. DERIVATIVES INTRODUCTION
    • WITHOUT PRICE INFORMATION, INVESTORS, CONSUMERS & PRODUCERS CAN NOT MAKE INFORMED DECISIONS.
  • 115. DERIVATIVES INTRODUCTION
    • DERIVATIVES HELP TO DETERMINE VALUE / PRICE (PROJECT EXPORTS)
  • 116. DERIVATIVES INTRODUCTION
    • DERIVATIVES INCREASE MARKET LIQUIDITY.
    • AS A RESULT TRANSACTION COSTS ARE LOWERED, EFFICIENCY INCREASED
    • COST OF RAISING CAPITAL IS LOWERED.

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