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  • Financial Derivatives Derivatives are financial contracts whose value/price is dependent on the behaviour of the price of one or more basic underlying assets (often simply known as the underlying). These contracts are legally binding agreements, made on the trading screen of stock exchanges, to buy or sell an asset in future. The asset can be a share, index, interest rate, bond, rupee dollar exchange rate, sugar, crude oil, soyabean, cotton, coffee and what you have. Thus, a ‗derivative‘ is a financial instrument, or contract, between two parties that derived its value from some other underlying asset or underlying reference price, interest rate, or index. A derivative by itself does not constitute ownership, instead it is a promise to convey ownership. TYPES OF DERIVATIVES 1. 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. The rupee-dollar exchange rate is a big forward contract market in India with banks, financial institutions, corporate and exporters being the market participants. Forward contracts are generally traded on OTC. 2. 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. Unlike forward contracts, the counterparty to a futures contract is the clearing corporation on the appropriate exchange. Future often are settled in cash or cash equivalents, rather than requiring physical delivery of the underlying asset. Parties to a futures contract may buy or write options on futures. 3. Options :- An option represents the right (but not the obligation) to buy or sell a security or other asset during a given time for a specified price (the strike price). 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. 4. Complex (Swap) :- Swap 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. Swaps generally are traded OTC through swap dealers, which generally consist of large financial institution, or other large brokerage houses, there is a recent trend for swap dealers to mark to market the swap to reduce the risk of counterparty default.Other types of financial derivatives:Warrants: Options generally have lives of up to one year, the majority of options traded on options exchangeshaving a maximum maturity of nine months. Longer-dated options are called warrants and are generally tradedover-the-counter.LEAPS: The acronym LEAPS means long-term equity anticipation securities. These are options having amaturity of upto three years.Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually a movingaverage of a basket of assets. Equity index options are a form of basket options.
  • TRADERS IN DERIVATES MARKETSThose who trade or participate in derivative/underlying security transaction may be broadly classified into threecategories: - 1. Hedgers (Those who desire to off-load their risk exposure on a position) ;- Hedgers are those traders who wish to eliminate price risk associated with the underlying security being traded. The objective of these kind of traders is to safeguard their existing positions by reducing the risk. They are not in the derivatives market to make profits. 2. Speculators (Those willing to absorb risk of hedgers for a cost) : - While hedgers might be adept at managing the risks of exporting and producing petroleum products around the world, there are parties who are adept at managing and even making money out of such exogenous risks. Using their own capital and that of clients, some individuals and organizations will accept such risks in the expectation of a return. But unlike investing in business along with its risks, speculators have no clear interest in the underlying activity itself. 3. Arbitragers (Those who wish to have riskless gain in the transaction of hedgers and speculators) :- The third players are known as arbitrageurs. From the French for arbitrage or judge, these market participants look for mis-pricing and market mistakes, and by taking advantage of them, they disappear and never become too large. If you have even purchased a produce of a green grocer only to discover the same produce somewhat cheaper at the next grocer, you have an arbitrage situation.DEVELOPMENT OF DERIVATIVE MARKETS IN INDIADerivatives markets have been in existence in India in some form or other for a long time. In the area ofcommodities, the Bombay Cotton Trade Association started futures trading in 1875 and, by the early 1900s Indiahad one of the world‘s largest futures industry. In 1952 the government banned cash settlement and optionstrading and derivatives trading shifted to informal forwards markets. In recent years, government policy haschanged, allowing for an increased role for market-based pricing and less suspicion of derivatives trading. Theban on futures trading of many commodities was lifted starting in the early 2000s, and national electroniccommodity exchanges were created. In the equity markets, a system of trading called ―badla‖ involving someelements of forwards trading had been in existence for decades. However, the system led to a number ofundesirable practices and it was prohibited off and on till the Securities and Exchange Board of India (SEBI)banned it for good in 2001. A series of reforms of the stock market between 1993 and 1996 paved the way for thedevelopment of exchange traded equity derivatives markets in India. In 1993, the government created the NSE incollaboration with state-owned financial institutions. NSE improved the efficiency and transparency of the stockmarkets by offering a fully automated screen-based trading system and real-time price dissemination. In 1995, aprohibition on trading options was lifted. In 1996, the NSE sent a proposal to SEBI for listing exchange-tradedderivatives. The report of the L. C. Gupta Committee, set up by SEBI, recommended a phasedintroduction of derivative products, and bi-level regulation (i.e., self-regulation by exchanges with SEBI providinga supervisory and advisory role). Another report, by the J. R. Varma Committee in 1998, worked out variousoperational details such as the margining systems. In 1999, the Securities Contracts (Regulation) Act of 1956, orSC(R)A, was amended so that derivatives could be declared ―securities.‖ This allowed the regulatory frameworkfor trading securities to be extended to derivatives. The Act considers derivatives to be legal and valid, but only ifthey are traded on exchanges. Finally, a 30-year ban on forward trading was also lifted in 1999.
  • Types of Financial FuturesEurodollar FuturesEurodollar futures are U.S. dollars that are deposited outside the country in commercial banks mainly in Europewhich are known to settle international transactions. They are not guaranteed by any government but only by theobligation of the bank that is holding them.U.S. Treasury FuturesBecause U.S. Dollars is the reserved currency for most countries, the stability of the dollars allows for treasuryfutures market and instruments such as treasury bonds and treasury bills.Foreign Government Debt FuturesMost government issue debt that are corresponded to the futures markets that are listed around the world.Swap FuturesThis is generally agreements that are between two parties to exchange periodic interest payments.Forex FuturesThis type of futures is to manage the risks and take advantage of related forex exchange rate fluctuations.Single Stock FuturesMost popular futures contracts are related to the equity markets, they are also known as security futures. Thereare about 10 companies in Malaysia that offer single stock futures. They are Bursa Malaysia Bhd, Air Asia Bhd,AMMB Holdings Bhd, Berjaya Sports Toto Bhd, Genting Bhd, IOI Corporation Bhd, Maxis Communications Bhd,RHB Capital Bhd, Scomi Group Bhd and Telekom Malaysia Bhd.Index FuturesFutures that are based on the stock index. In the case of the Kuala Lumpur Composite Index, the index futureswill be the FTSE Bursa Malaysia KLCI Futures (FKLI). View slide
  • Improve this chart Forward Contract Futures ContractDefinition: A forward contract is an agreement A futures contract is a standardized between two parties to buy or sell an contract, traded on a futuresexchange, to asset (which can be of any kind) at a pre- buy or sell a certain underlying agreed future point in time. instrument at a certain date in the future, at a specified price.Structure & Purpose: Customized to customer needs. Usually Standardized. Initial margin payment no initial payment required. Usually used required. Usually used for speculation. for hedging.Transaction method: Negotiated directly by the buyer and Quoted and traded on the Exchange sellerMarket regulation: Not regulated Government regulated market (the Commodity Futures Trading Commission or CFTC is the governing body)Institutional The contracting parties Clearing Houseguarantee:Risk: High counterparty risk Low counterparty riskGuarantees: No guranantee of settlement until the Both parties must deposit an initial date of maturity only the forward price, guarantee (margin). The value of the based on the spot price of the underlying operation is marked to market rates with asset is paid daily settlement of profits and losses.Contract Maturity: Forward contracts generally mature by Future contracts may not necessarily delivering the commodity. mature by delivery of commodity.Expiry date: Depending on the transaction StandardizedMethod of pre- Opposite contract with same or different Opposite contract on the exchange.termination: counterparty. Counterparty risk remains while terminating with different counterparty.Contract size: Depending on the transaction and the Standardized requirements of the contracting parties. View slide
  • SwapsA swap is any agreement to a future exchange of one asset for another, one liability for another, or morespecifically, one stream of cash flows for another. A swap is a private agreement between two parties in whichboth parties are ‗obligated‘ to exchange some specified cash flows at periodic intervals for a fixed period of time.Unlike a forward or a futures contract, a swap agreement generally involves multiple future points of exchange.Evolution of SwapsCurrency loans evolved from the ‗parallel loan‘ concept which was devised by three global private sectors forpurposes of circumventing cross-border capital controls. Consider the working of a parallel loan. Let us supposethat a British company wanted to establish a subsidiary in the U.S. in 1975. At that time, it was illegal by Britishlaw for the company to raise debt in the form of British Pounds for purposes of overseas investment. The Britishgovernment‘s rationale for the control was the belief that stopping overseas investment was a way to ensure thatBritish capital be used for domestic investment, and thus to create jobs for British citizens.However, there was no law to prevent a British company from raising British pounds in England and lending themto a British subsidiary of an American firm. In return, on the other side of the Atlantic Ocean, the parent of theAmerican subsidiary could raise the equivalent amount in dollars by issuing debt in the United States and thenlend the dollars to the U.S. subsidiary of the British parent.For the British parent, its U.S. subsidiary could receive the financing it needed. Britain‘s capital export controlswould be circumvented. While the British subsidiary of the U.S. firm made future pound-denominated interest andprincipal payments to the British parent, the British parent‘s subsidiary would make dollar interest and principalpayments to the U.S. parent. Thus, in addition to the British circumvention of their capital controls, the U.S.parent would be effectively repatriating the earnings of its overseas subsidiary to the U.S. without any repatriationtaxes levied by the host government.Features of SwapsThe following are the important features of a swap: a. Basically a forward: - A swap is nothing but a combination of forwards. So, it has all the properties of forward contract. b. Double coincidence of wants: - Swap requires that two parties with equal and opposite needs must come into contact with each other. i.e. rate of interest differs from market to market and within the market itself. c. Comparative Credit Advantage: - Borrowers enjoying comparative credit advantage in floating rate debts will enter into a swap agreement to exchange floating rate interest with the borrowers enjoying comparative advantage in fixed interest rate debt, like bond. d. Flexibility: - In short term market, the lenders have the flexibility to adjust the floating interest rate (short term rate) according to the conditions prevailing in the market as well as the current financial position of the borrower. e. Necessity of an intermediary: - Swap requires the existence of two counterparties with opposite but matching needs. This has created a necessity for an intermediary to cancel both the parties. f. Settlement: - Through a specified principal amount is mentioned in the swap agreement; there is no exchange of principal. On the other hand, a stream of fixed rate interest is exchanged for a floating rate of interest, and thus, there are streams of cash flows rather than single payment. g. Long term agreement: - Generally, forwards are arranged for short period only. Long dated forward rate contracts are not preferred because they involve more risks like risk of default, risk of interest rate fluctuations etc. but, swaps are in the nature of long term agreement and they are just like long dated forward rate contracts.Categories of SwapThe two basic categories of swap contracts are – Commodity Swaps, and Financial Swaps.Types of commodity Swaps :-There are two types of commodity swaps: Fixed-floating or Commodity-for-interest 1. Fixed-floating swaps are just like the fixed-floating swaps in the interest rate swap market with the exception that both indices are commodity based indices. General market indices in the commodities market with which many people would be familiar include the Goldman Sachs Commodities Index
  • (GSCI) and the Commodities Research Board Index (CRB). These two indices place different weights on the various commodities so that they will be used according to the swap agent‘s requirements. 2. Commodity-for-interest swaps are similar to the equity swap in which a total return on the commodity in question is exchanged for some money market rate (plus or minus a spread).Types of financial swapsThe two major types are 1. Interest rate swaps :- A standard fixed-to-floating interest rate swap, known in the market jargon as a plain vanilla coupon swap (exchange borrowings) is an agreement between two parties in which each contracts to make payments to the other on particular dates in the future till a specified termination date. One party, known as the fixed rate payer, makes fixed payments all of which are determined at the outset. The other party known as the floating rate payer will make payments the size of which depends upon the future evolution of a specified interest rate index (6 month LIBOR). 2. Currency Swap: - Currency swaps are derivative products that help to manage exchange rate and interest rate exposure on long-term liabilities. A currency swap involves exchange of interest payments denominated in two different currencies for a specified term, along with exchange of principals. The rate of interest in each leg could either be a fixed rate, or a floating rate indexed to some reference rate, like the LIBOR.
  • Binomial option pricing modelIn finance, the binomial options pricing model (BOPM) provides a generalizable numerical method for thevaluation of options. The binomial model was first proposed by Cox, Ross and Rubinstein (1979). Essentially, themodel uses a ―discrete-time‖ (lattice based) model of the varying price over time of the underlying financialinstrument. In general, binomial options pricing models do not have closed-form solutions.Use of the modelThe Binomial options pricing model approach is widely used as it is able to handle a variety of conditions forwhich other models cannot easily be applied. This is largely because the BOPM is based on the description ofan underlying instrument over a period of time rather than a single point. As a consequence, it is used tovalue American options that are exercisable at any time in a given interval as well as Bermudan options that areexercisable at specific instances of time. Being relatively simple, the model is readily implementable incomputer software (including a spreadsheet).Although computationally slower than the Black–Scholes formula, it is more accurate, particularly for longer-datedoptions on securities with dividend payments. For these reasons, various versions of the binomial model arewidely used by practitioners in the options markets.For options with several sources of uncertainty (e.g., real options) and for options with complicated features(e.g., Asian options), binomial methods are less practical due to several difficulties, and Monte Carlo optionmodels are commonly used instead. When simulating a small number of time steps Monte Carlo simulation willbe more computationally time-consuming than BOPM (cf. Monte Carlo methods in finance). However, the worst- ncase runtime of BOPM will be O(2 ), where n is the number of time steps in the simulation. Monte Carlosimulations will generally have a polynomial time complexity, and will be faster for large numbers of simulationsteps. Monte Carlo simulations are also less susceptible to sampling errors, since binomial techniques usediscrete time units. This becomes more true the smaller the discrete units become.MethodThe binomial pricing model traces the evolution of the options key underlying variables in discrete-time. This isdone by means of a binomial lattice (tree), for a number of time steps between the valuation and expiration dates.Each node in the lattice represents a possible price of the underlying at a given point in time.Valuation is performed iteratively, starting at each of the final nodes (those that may be reached at the time ofexpiration), and then working backwards through the tree towards the first node (valuation date). The valuecomputed at each stage is the value of the option at that point in time.Option valuation using this method is, as described, a three-step process: 1. price tree generation, 2. calculation of option value at each final node, 3. sequential calculation of the option value at each preceding node.STEP 1: Create the binomial price treeThe tree of prices is produced by working forward from valuation date to expiration.At each step, it is assumed that the underlying instrument will move up or down by a specific factor ( or ) perstep of the tree (where, by definition, and ). So, if is the current price, then in thenext period the price will either be or .The up and down factors are calculated using the underlying volatility, , and the time duration of a step, ,measured in years (using the day count convention of the underlying instrument). From the condition thatthe variance of the log of the price is , we have:
  • Above is the original Cox, Ross, & Rubinstein (CRR) method; there are other techniques for generating thelattice, such as "the equal probabilities" tree. The Trinomial tree is a similar model, allowing for an up, down orstable path.The CRR method ensures that the tree is recombinant, i.e. if the underlying asset moves up and thendown (u,d), the price will be the same as if it had moved down and then up (d,u) — here the two paths merge orrecombine. This property reduces the number of tree nodes, and thus accelerates the computation of the optionprice.This property also allows that the value of the underlying asset at each node can be calculated directly viaformula, and does not require that the tree be built first. The node-value will be: Where is the number of up ticks and is the number of down ticks.STEP 2: Find Option value at each final nodeAt each final node of the tree — i.e. at expiration of the option — the option value is simply its intrinsic, orexercise, value. Max [ ( ), 0 ], for a call option Max [ ( – ), 0 ], for a put option:Where is the strike price and is the spot price of the underlying asset at the period.STEP 3: Find Option value at earlier nodesOnce the above step is complete, the option value is then found for each node, starting at the penultimate timestep, and working back to the first node of the tree (the valuation date) where the calculated result is the value ofthe option.In overview: the ―binomial value‖ is found at each node, using the risk neutrality assumption; see Risk neutralvaluation. If exercise is permitted at the node, then the model takes the greater of binomial and exercise value atthe node.The steps are as follows:(1) Under the risk neutrality assumption, todays fair price of a derivative is equal to the expected value of itsfuture payoff discounted by the risk free rate. Therefore, expected value is calculated using the option valuesfrom the later two nodes (Option up and Option down) weighted by their respective probabilities—―probability‖ p of an up move in the underlying, and ―probability‖ (1-p) of a down move. The expected value isthen discounted at r, the risk free rate corresponding to the life of the option. The following formula to compute the expectation value is applied at each node: Binomial Value = [ p × Option up + (1-p) × Option down] × exp (- r × Δt), or where is the options value for the node at time , is chosen such that the related binomial distribution simulates the geometric Brownian motion of the underlying stock with parameters r and σ, is the dividend yield of the underlying corresponding to the life of the option. It follows that in a risk- neutral world futures price should have an expected growth rate of zero and therefore we can consider for futures.
  • Note that for to be in the interval the following condition on has to be satisfied . (Note that the alternative valuation approach, arbitrage-free pricing, yields identical results; see ―delta- hedging‖.)(2) This result is the ―Binomial Value‖. It represents the fair price of the derivative at a particular point in time (i.e.at each node), given the evolution in the price of the underlying to that point. It is the value of the option if it wereto be held—as opposed to exercised at that point.(3) Depending on the style of the option, evaluate the possibility of early exercise at each node: if (1) the optioncan be exercised, and (2) the exercise value exceeds the Binomial Value, then (3) the value at the node is theexercise value.What is the difference between futures and options?Derivatives;derviatives is the product its price is derived from underlining asset (underlining asset my bestocks,bonds,commodities,etc)derivatives are as followsfutures and options it normally call as F&O...futures:it is a contract between two parties to purchase and sell of products for future period at pre-determindprice....options:it is the right but not the obligation to buy or sell underlining assets....call option:is the right but not the obligation to buy the underlining asset....buyer may refuse the contract beforethe maturity of contract.put option:it is opposit of call option......The primary difference lies in the obligation placed on the contract buyers and sellers.In a futures contract, bothparticipants in the contract are obliged to buy (or sell) the underlying asset at the specified price on settlementday. As a result, both buyers and sellers of futures contracts face the same amount of risk.On the other hand, theoption contract buyer has the right but not the obligation to buy (or sell) the underlying asset. Hence the term"option" and this option comes at a price in the form of a premium (more specifically, the time value of thepremium). With this "option", the option buyers risk is limited to the premium paid but his potential profit isunlimited.Sellers of options take on an additional volatility risk in exchange for the premium. However, their potential profitis then capped while their potential losses has no limit. Hence, this premium can be high if the underlying asset isperceived to be very volatile.