Derivative

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Derivative

  1. 1. Presented by DFM Batch Thursday Evening  Roll NO starting from: 120 to 130.  To. Dr. Premraj Alva 1
  2. 2. Sr.no TOPIC Presented by, Roll no 1 Aniket salvi 2 Ritesh yadav 122 3 Daya mayekar 123 4 Rachat jajoo 124 5 Shashi yadav 125 6 Sajid khan 126 7 Manish kadam 127 8 128 9 Sandesh bhirade Lavanya shirpuram 129 10 Harshad sawant 130 2
  3. 3.   Financial instrument whose price is dependent upon or derived from the value of underlying assets.  The underlying not necessarily has to be an asset. It could be any other random/uncertain event like temperature/weather etc.  The most common  Stock  Bonds  Commodities  Currencies  Interest rates underlying assets includes: 3
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  5. 5. A derivative is a financial instrument whose derivative A ƒ the –– is derived from –– value depends on value of some other financial instrument, called the underlying asset  Common examples of underlying assets are ƒ stocks, bonds, corn, pork, wheat, rainfall, etc. 5
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  11. 11. Can be plain vanilla or exotic  Forward  Futures  Options  Swaps 11
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  14. 14.  Forward contract is a binding contract which fixes now the buying/selling rate of the underlying asset to be bought/sold at some time in future. ◦ Long Forward  Binding to buy the asset in future at the predetermined rate. ◦ Short Forward  Binding to sell the asset in future at the predetermined rate. 14
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  16. 16.  A commodity future is a futures contract in commodities like agricultural product, metals and material etc. in organised commodity future markets, contracts are standardised with standard quantities. Of course, this standard varies from commodity-tocommodity. They also have fixed delivery dates in each month or a few months in a year. In India commodity futures in agricultural products are popular. 16
  17. 17. COMMODITY EXCHANGE ARE AS FOLLOWS:  London Metal Exchange(LME) to deal in gold.  Chicago Board of Trade(CBT) to deal in soya bean oil. New York Cotton Exchange(CTN) to deal in cotton. 17
  18. 18. 4. What is the difference between Forward Contracts and Futures Contracts?  Sr.No Basis Futures Traded on organized exchange Forwards Over the Counter 1 Nature 2 Contract Terms Standardized Customised 3 Liquidity Less liquid 4 Margin Payments More liquid Requires margin payments 5 Settlement Follows daily settlement At the end of the period. Can be reversed with any member of the Exchange. Contract can be reversed only with the same counter-party with whom it was entered into. 6 Squaring off Not required 18
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  21. 21.  An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date ◦ Unlike a forward/future, this contract gives the right but not the obligation. So its not a binding contract. ◦ The holder will exercise the option only if it is profitable. 21
  22. 22. On the basis of versatility Vanilla Option  A normal option with no special or unusual features Exotic Option  A type of option that differs from common American or European options in terms of the underlying asset or the calculation of how or when the investor receives a certain payoff. 22
  23. 23. Call option A call option, often simply labeled a "call", is a financial contract between two parties, the buyer and the seller of this type of option.The buyer of the call option has the right, but not the obligation to buy an agreed quantity of a particular  commodity or financial instrument (the underlying) from the seller of the option at a certain time (the expiration date) for a certain price (the strike price). The seller (or "writer") is obligated to sell the commodity or financial instrument to the buyer if the buyer so decides. The buyer pays a fee (called a premium) for this right. 23
  24. 24. Put option A put or put option is a contract between two parties to exchange an asset (the underlying), at a specified price (the strike), by a predetermined date (the expiry or maturity). One party, the buyer of the put, has the right, but not an obligation, to re-sell the asset at the strike price by the future date, while the other party, the seller of the put, has the obligation to repurchase the asset at the strike price if the buyer exercises the option. 24
  25. 25. Pay Off = ST – K (for the long forward) Pay Off = K – ST (for the short forward) T = Time to expiry of the contract ST = Spot Price of the underlying asset at time T K = Strike Price or the price at which the asset will be bought/sold 25
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  27. 27. EXAMPLE  Counter parties:: A and B Maturity:: 5 years A pays to B : 6% fixed p.a. B pays to A : 6-month KIBOR Payment terms : semi-annual Notional Principal amount: PKR 10 million. 27
  28. 28. Advantages and Disadvantages of Swaps The advantages of swaps are as follows: 1) Swap is generally cheaper. There is no upfront premium and it reduces transactions costs. 2) Swap can be used to hedge risk, and long time period hedge is possible. 3) It provides flexible and maintains informational advantages. 4) It has longer term than futures or options. Swaps will run for years, whereas forwards and futures are for the relatively short term. 5) Using swaps can give companies a better match between their liabilities and revenues. The disadvantages of swaps are: 1) Early termination of swap before maturity may incur a breakage cost. 2) Lack of liquidity. 3) It is subject to default risk. 28
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  30. 30. RISK FACTOR Credit Risk: When one of the two parties fails to perform its role as per the agreement, this  is called the credit risk. It can also be referred to as default or counterparty risk. It varies  with different sources. Market Risk: This is a kind of financial loss that takes place due to the adverse price  movements of the underlying variable or instrument. Liquidity Risk: When a firm is unable to devise a transaction at current market rates, it can  be referred to as liquidity risk. There are two kinds of liquidity risks involved in the scenario.  First is concerned with the liquidity of separate items and second is related to supporting  the activities of the organization with funds comprising derivatives. Legal Risk: Legal issues related with the agreement need to be scrutinized well, as one can  deal in derivatives across the different judicial boundaries. Derivatives Markets in India 30
  31. 31. Financial transactions are fraught with several risk factors. Derivatives are instrumental in alienating those risk factors from traditional instruments and shifting risks to those entities that are ready to take them. Some of the basic risk components in derivatives business are:Exchange Traded Derivatives Over the Counter (OTC) Derivatives Over the Counter (OTC) Equity Derivatives Operators in the Derivatives Market There are different kinds of traders in the derivatives market. These include: Hedgers-traders who are interested in transferring a risk element of their portfolio. Speculators-traders who deliberately go for risk components from hedgers in look out for profit. Arbitrators-traders who work in various markets at the same time in order to gain profit and do away with miss-pricing 31
  32. 32. The Swaps Market Unlike most standardized options and futures contracts, swaps are not exchange-traded instruments. Instead, swaps are customized contracts that are traded in the over-the-counter (OTC) market between private parties. Firms and financial institutions dominate the swaps market, with few (if any) individuals ever participating. Because swaps occur on the OTC market, there is always the risk of a counterparty defaulting on the swap. SEE: Futures Fundamentals Plain Vanilla Interest Rate Swap The most common and simplest swap is a "plain vanilla" interest rate swap. In this swap, Party A agrees to pay Party B a predetermined, fixed rate of interest on a notional principal on specific dates for a specified period of time. Concurrently, Party B agrees to make payments based on a floating interest rate to Party A on that same notional principal on the same specified dates for the same specified time period. In a plain vanilla swap, the two cash flows are paid in the same currency. The specified payment dates are called settlement dates, and the time between are called settlement periods. Because swaps are customized contracts, interest payments may be made annually, quarterly, monthly, or at any other interval determined by the parties. 32
  33. 33. Credit default swap A credit default swap  (CDS) is a financial swap agreement that the seller of the CDS will compensate the buyer in the event of a loan default or other credit event. The buyer of the CDS makes a series of payments (the CDS "fee" or "spread") to the seller and, in exchange, receives a payoff if the loan defaults. It was invented by  Blythe Masters from JP Morgan in 1994. In the event of default the buyer of the CDS receives compensation (usually the face value of the loan), and the seller of the CDS takes possession of the defaulted loan. However, anyone can purchase a CDS, even buyers who do not hold the loan instrument and who have no direct insurable interest in the loan (these are called "naked" CDSs). If there are more CDS contracts outstanding than bonds in existence, a protocol exists to hold a credit event auction; the payment received is usually substantially less than the face value of the loan. 33
  34. 34. Differences from insurance CDS contracts have obvious similarities with insurance, because the buyer pays a premium and, in return, receives a sum of money if an adverse event occurs. However there are also many differences, the most important being that an insurance contract provides an indemnity against the losses actually suffered by the policy holder on an asset in which it holds an  insurable interest. By contrast a CDS provides an equal payout to all holders, calculated using an agreed, market-wide method. The holder does not need to own the underlying security and does not even have to suffer a loss from the default event. The CDS can therefore be used to speculate on debt objects. 34
  35. 35. insurance requires the buyer to disclose all known risks, while CDSs do not (the CDS seller can in many cases still determine potential risk, as the debt instrument being "insured" is a market commodity available for inspection, but in the case of certain instruments like CDOs made up of "slices" of debt packages, it can be difficult to tell exactly what is being insured); insurers manage risk primarily by setting loss reserves based on the  Law of large numbers and actuarial analysis. Dealers in CDSs manage risk primarily by means of hedging with other CDS deals and in the underlying bond markets; CDS contracts are generally subject to mark-to-market accounting, introducing income statement and balance sheet volatility while insurance contracts are not; Hedge accounting may not be available under US Generally Accepted Accounting Principles (GAAP) unless the requirements ofFAS 133 are met. In practice this rarely happens. to cancel the insurance contract the buyer can typically stop paying premiums, while for CDS the contract needs to be unwound. 35
  36. 36. Recent developments in regulation FIMMDA Code of Conduct for usage of NDS-OM & OTC market To enhance participation of PDs in corporate bond market PDs allowed a sub-limit of 50 per cent of net owned funds for investment in corporate bonds within overall permitted average fortnightly limit of 225 per cent of NOF for call /notice money market borrowing, PDs permitted to invest in Tier II bonds issued by other PDs, banks and financial institutions to the extent of 10 per cent of the investing PD’s total capital funds PDs allowed to borrow to the extent of 150 per cent of NOF through Inter Corporate Deposits Repo in corporate debt eligible category of collateral expanded to include short term instruments like CP, CD and NCD. 36
  37. 37. Recent developments in regulation..2 Eligible participant base increased all India Financial institution like SIDBI,NABARD,NHB and Exim bank added as users in CDS. Insurance companies and mutual funds permitted to participate as users CDS permitted on unlisted but rated corporate bonds securities with original maturity up to one year like CPs, CDs and NCDs as reference/deliverable obligations Users can unwind their CDS bought position with original protection seller at mutually agreeable or FIMMDA price in absence of an agreement, unwinding at FIMMDA price. 37
  38. 38. Recent developments in regulation..3 Enhancing foreign investment limits in G-sec and corporate bonds Limit for investment in G-sec enhanced from US$ 20 billion to US$ 25 billion. sub-limit of US$ 10 billion for investment by FIIs and the long term investors in dated G-sec enhanced by US$ 5 billion condition of three year residual maturity of G-sec at the time of first purchase for the above sub-limit not applicable. investments not be allowed in short term papers like T-Bills The limit for FII investment in corporate debt (other than infrastructure sector) enhanced by US$ 5 billion to US$ 25 billion. Investment is not allowed in CPs/CDs 38
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