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Derivatives

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  • 1. Derivatives Roy Thomas
  • 2. Meaning  Financial instrument whose value is based on one or more underlying assets.  A contract between two parties that specifies conditions under which payments are to be made between the parties.
  • 3.  In other words, derivatives means a forward, future, option or any other hybrid contract of pre-determined fixed duration, linked for the purpose of contract, fulfillment to the value of a specified real or financial asset or to an index of securities.  It should be understood that derivatives themselves are not to be considered investments since they are not an asset class. They simply derive their values from assets such as bonds, equities, currencies etc. and are used to either hedge those assets or improve the returns on those assets.
  • 4. Definition  A security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for difference or any other form of security.  A contract which derives it’s value from the prices, or index of prices of underlying securities or stocks.
  • 5. Usage of Derivatives  Provide leverage (or gearing), such that a small movement in the underlying value can cause a large difference in the value of the derivative  Speculate and make a profit if the value of the underlying asset moves the way they expect.  Obtain exposure to the underlying where it is not possible to trade in the underlying.
  • 6.  Hedge or mitigate risk in the underlying, by entering into a derivative contract whose value moves in the opposite direction to their underlying position and cancels part or all of it out  Create option ability where the value of the derivative is linked to a specific condition or event.
  • 7. Uses Hedging. Speculation. Arbitrage.
  • 8. Hedging  Process of risk reduction.  Uses derivatives to reduce the risk of price movement.  The buying and selling of future contracts to offset the risks of changing prices in the cash markets.  Seek price protection by hedging the commodity.  Could be framers, investors, producers, exporters etc…
  • 9. Speculations  Facilitating the marketing of commodities and trading in financial instruments.  It do not create risk; they assume it in the hope of making profit.  They not reduce risk; rather they buy and sell derivatives to make profit.  Ensure the stability of market.
  • 10.  Help in price stability and ensure accurate pricing.  Speculators fill the gap between the sale and purchase by hedgers.  Speculators add to market liquidity.  Improve informational efficiency of market.
  • 11. Arbitrage  Involves in making profit from the difference in prices prevailing in the two markets(cash market and derivative market).  Automatically adjusts the under pricing and over pricing in cash market relative to the derivative market and vice versa.
  • 12. Underlying Assets Commodities. Stocks. Bonds. Interest rates. Currencies.
  • 13. Derivatives Market 80.10% 0.60% 1.90% 17.30% Product wise Breakdown of Derivatives Market, 2002 (Data released by the Bank of Settlement) Intrest rate Commodities Equity Foreign Exchange
  • 14. 52% 31% 13% 4% Product wise Turnover of F&O at NSE from 2000-2008 Index Futures Stock Futures Index Options Stock Options
  • 15. Types of Derivatives Forwards Futures Options Swaps
  • 16. Forward Contracts  One to one bi-partite contract  To be performed in future at terms decided today.  Offer flexibility to design the contract  Suffer from poor liquidity and risk.
  • 17. Future Contracts  Every future contract is a forward contract.  Legally binding agreement to buy or sell the underlying security on a future date.  Expires on a pre-specified date.
  • 18. Forward vs. Future Features Forward Contracts Future Contracts Operational Mechanism Not traded on exchange Traded on Exchange Contract Specifications Differs from trade to trade Standardized Contracts Counterparty Risk Exists Exists, but assumed by clearing house Liquidation Profile Poor liquidity High liquidity Price Discovery Poor Better
  • 19. Trading in Future Contracts Daily Margins Maintenance Margins Initial Margins
  • 20. Financial Futures  Financial future is a commitment to buy or sell, or a specified future date, a standard quantity of the underlying instrument at a future price determined in the present.  No facility for the exchange of the underlying instrument.  Means of Hedging  Position in the future markets can be taken easily than the positions in the underlying spot markets
  • 21. Interest Rate Futures  Commitments to borrow or deposit for a pre-determined period from the date of the contract.  Both borrowers and lenders can hypothetically determine the interest rates for the future.  To reduce risk
  • 22. Stock Index Futures  Built on any market index  Stock index and futures are matched by compensatory cash flows  BSE Sensex and S&P Nifty  To reduce stock market risk
  • 23. Currency Futures  Exchange of a standard amount of a particular currency on a specific future date, at a fixed exchange rate.  Have the advantage of tradability
  • 24. Options  Gives the buyer/holder the right to buy/sell the underlying asset at a predetermined price with in or at the end of a specified period.  Purchases the right from the seller for a consideration called “premium”.  Types of Options.  Call Options.  Put Options.  Writing Options.  Exotic Options.
  • 25. Call Options  A call gives the holder the right, but not the obligation, to buy the underlying instrument.  Gives the investor a specific locked-in price for a future time.
  • 26. Put Option  A put option gives the holder the right, but not the obligation, to sell the underlying instrument.  Gives the investor a specific locked-in price to sell a contract on a commodity or a financial instrument which is expected to decrease its value.
  • 27. Writing Options  The seller of the option is also known as the writer  The buyer of the option have a longer option position  The writer of the option have a shorter option position  On expiry of the option, the profit/loss is the exact mirror image of the long option
  • 28. Call Option Premium Received Strike Price Buyer’s Position Writer’s Position Stock Price Premium Paid Profit/Loss 0  The buyer of a call option has a loss potential limited to the premium paid, but unlimited profit potential.  The writer of a call has a maximum profit equal to the premium received, but unlimited loss potential.
  • 29. Stock Price Premium Paid Premium Received Buyer’s Position Writer’s Position Profit/Loss 0 Put Option  The buyer of the put option has a maximum loss equal to the premium  The maximum profit of the put buyer occurs at a share price of zero
  • 30. Exotic Options  Different derivations of the basic options characteristics.  Types Lookback options Asian options Barrier options Knock-in Knock-out Double barrier Options on an options.
  • 31. SWAPS  It’s a spot purchase  Simultaneous futures sale or a spot sale with a simultaneous buy from the future market.  An agreed exchange of future cash flows with spot cash flows.  Types  Equity Swaps  Interest rate Swaps  Currency Swaps
  • 32. Equity Swaps • Agreement to exchange the returns on a stock index portfolio for a return of fixed interest payments Return on BSE 100 Portfolio Libor + 1% Investor A US Dollar DepositIndian Share Portfolio Investor B
  • 33. Interest Rate Swaps  Enables exchange of fixed to floating rates of return. Currency Swaps  Enables exchange of currency between international market
  • 34. News on Derivatives On 15th November, 2007 Sebi board okays 7 new derivative products Intended to expand the domestic market and make it largely onshore and safe for investors. Relate to mini-contracts on equity indices, options with longer life/tenures, volatility index and F&O (futures & options) contracts, options on futures, bond indices, exchange traded currency (foreign exchange.
  • 35. On 1st December, 2011 New Index Derivatives on NSE: CNX PSE and CNX Infrastructure CNX PSE An opportunity to invest in "Navratna" Public Sector companies through the use of derivatives Comprises of 20 Public Sector companies which is a combination of 16 Navaratna PSEs and 4 Miniratna PSEs of India
  • 36. Features Both Futures and Options are available for trading. Companies only with positive net worth are part of the index. Index is computed using free float market capitalization weighted method Contracts available are of maximum three months- the next month, near month and the far month.
  • 37. Advantages Investors can easily take positions in stocks of 20 well known public companies with the help of derivative products Waiver of transaction charges till six months from the commencement of trading. They can be used for hedging and arbitrage purposes.
  • 38. Snapshot of returns on CNX infrastructure Index since inception:
  • 39.  CNX Infrastructure  Allows you to invest in 25 well known infrastructure stocks  Features  Companies only with positive net worth are part of the index.  Both Futures and Options are available for trading.  Index is computed using free float market capitalization weighted method.  Contracts available are of maximum three months- the next month, near month and the far month
  • 40.  Advantages  Investors can easily take positions in stocks of 25 well known infrastructure stocks with the help of derivative products  They can be used for hedging and arbitrage purposes.  Waiver of transaction charges till six months from the commencement of trading.
  • 41. Snapshot of returns on CNX infrastructure Index since inception:
  • 42. On July 28th, 2012  New derivative product by BSE - Cash-Future Spread (CFS)  Aimed at eliminating trade execution risk by offering interest rate type of a product  CFS is in operation from August 6 and is made available for all stocks in BSE's derivative segment  Cash futures arbitrage is a combination of a short/long position in an asset such as a stock and its future contract, which seeks to exploit pricing inefficiencies for the same underlying stock in the cash (or spot) and futures markets in order to make risk-less profits.
  • 43. Reference  www.sebi.gov.in  www.finance.mapsofworld.com  www.hedgefund.com  Dr. Inderpal Singh-Kalyani Publishers  M. Ranganatham-Investment Analysis and Portfolio Management  www.thehindubusinessline.com  www.business-standard.com  www.rediff.com  www.kotaksecurities.com  International Research Journal of Finance and Economics
  • 44. Thank You.