Derivatives(Introduction)A derivative is a financial instrument, whosevalue depends on the value of basic underlyingvariable The value of derivative is linked to riskor volatility in either financial asset, transaction,market rate, or contingency, and creates aproduct
T- Stocks Bill Agro CommoditiesInterest Underlying Precious MetalsRates Assets Index & Bonds Crude Oil Foreign Exchange Rate
Features of Derivatives•Traded on exchange• No compulsory physical trading of underlying assets Alltransactions in derivatives take place in future specific date•Hedging Device-Reduces risk• Derivatives has low transaction cost•Derivatives are often leveraged, such that a small movement inthe underlying value can cause a large difference in the value ofthe derivative.
ForwardTypes of Derivatives contract Forward rate agreements Swaps Over the counter(OTC) Options CreditDerivative s Futures EXCHANGE RELATED Stock options Commodity futures
Over-the-Counter Contracts:OTC derivatives are contracts that are traded (andprivately negotiated) directly between two parties,without going through an exchange or otherintermediary. Products such as swaps, forward rateagreements and exotic options are almost alwaystraded in this way. The OTC derivatives market ishuge. According to the Bank for InternationalSettlements, the total outstanding notional amount isUSD 516 trillion (as of June 2007)
Forwards A forward contract is a customized contract between two entities, where settlement takes place as a specific date in the future at predetermined price. Ex: On 10th Novem, Ram enters into an agreement to buy 100 kgs of wheat on 1st May at Rs.10000 from Shyam, a farmer. It is a case of a forward contract where Ram has to pay Rs.10000 on 1st May to Shyam and Shyam has to supply 100 kgs of wheat. Ram has taken a long position assuming the price of the wheat will rise in the future six months . Normally traded outside exchange.
Forward Pricing: Forward Price The forward price for a contract is the delivery price that would be applicable to the contract if were negotiated today (i.e., it is the delivery price that would make the contract worth exactly zero) The forward price may be different for contracts of different maturities
Forward Pricing: The Forward Price of Gold If the spot price of gold is S and the forward price for a contract deliverable in T years is F , then F = S (1+ r )t where r is the 1-year (domestic currency) risk-free rate of interest. In our examples, S = 300, T = 1, and r =0.05 so that F = 300(1+0.05) = 315
Futures A financial contract obligating the buyer to purchase an asset, (or the seller to sell an asset), such as a physical commodity or a financial instrument, at a predetermined future date and price. 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. The futures markets are characterized by the ability to use very high leverage relative to stock markets. Some of the most popular assets on which futures contracts are available are equity stocks, indices, commodities and currency. FC –commodity (OTC) Kissan co wants to procure 500 kg of tomatoes after 3 months. Prevailing 1 kg @Rs 6. View of the company– Expected to go up to Rs 8 per kg. View of the farmer- Price @ Rs 5.50. So FC between Company & Farmer.Agreed price @ Rs 6.50 . Delivery after 3 months. Situation after 3 moths – Price may be same I.e @ Rs 6 or
Swaps Swaps are private agreement between two parties to exchange cash flows in the future according to a pre-arranged formula. They can be regarded as portfolio of forward contracts. The two commonly used Swaps are- i) Interest Rate Swaps: - A interest rate swap entails swapping only the interest related cash flows between the parties in the same currency. ii) Currency Swaps: - A currency swap is a foreign exchange agreement between two parties to exchange a given amount of one currency for another and after a specified period of time, to give back the original amount swapped.
OPTIONS “ An Options contract confers the right but not the obligation to buy (call option) or sell (put option) a specified underlying instrument or asset at a specified price – the Strike or Exercised price up until or an specified future date – the Expiry date. ” The Price is called Premium and is paid by buyer of the option to the seller or writer of the option. Types of option: Call Option Put option
OPTION PREMIUM INTRINSIC TIME VALUE VALUEIntrinsic Value : When option is in-the-money we have maximumIntrinsic Value. If the option is out of the money or at the money itsIntrinsic Value is zero.For a call option intrinsic value : Max (0, (St – K) ) andFor a put option intrinsic value : Max (0, (K - St ) )
Eg. Stock ONGC TYPE PREM INTRI TIMETYPE EXPIR CALL STRIK SPOT OF IUM SIC VALU Y /PUT E OPTI VALU E ON EOPTS 25/6/2TK 006 CA 1170 1200 ITM 37 (1200- 1170= 7 30)OPTS 25/6/2 (1200-TK 006 CA 1200 1200 ATM 24 1200= 0) 24OPTS 25/6/2 (1200-TK 006 CA 1230 1200 OTM 11 1230= -30 or 11 0)
Terminology:• Spot price- the price at which an assets trades in a spotmarkets.•Future price- the price at which the future contractstrades in future markets.•Strike price- the price specified in the option contract•Expiry date- the date specified in future and optioncontracts.•Contract size- the amount of assets that has to bedelivered under one contract.•Basis= Future price- Spot Price•Initial Margin- the amount that must be deposited at thefuture contract is first entered into.•Marking to market•Maintenance Margin- A set minimum margin peroutstanding future contract that a customer must maintainin his margin account .
PARTICIPANTS Speculators - willing to take on risk in pursuit of profit. Hedgers - transfer risk by taking a position in the Derivatives Market. Arbitrageurs - aim to make a risk less profit by taking advantage of price differentials and thus bring about an alignment in prices by participating in two markets simultaneously.
Stock Index futures Stock Index futures have revolutionized the art and science of equity portfolio management as practiced by: ◦ mutual funds ◦ pension plans ◦ endowments ◦ insurance company ◦ other money managers.
•A futures contract on a stock market indexrepresents the right and obligation to buy orto sell a portfolio of stocks characterized bythe index.Stock index futures are cash settled.That is, there is no delivery of the underlyingstocks.The contracts are marked to market daily.On the last trading day, the futures price is setequal to the spot index level and there is afinal mark to market cash flow.
An interest rate future is a financial derivative (afutures contract) with an interest-bearing instrumentas the underlying asset.Examples include Treasury-bill futures, Treasury-bond futures and Eurodollar futures.Interest rate futures are used to hedge against therisk of that interest rates will move in an adversedirection, causing a cost to the company.For example, borrowers face the risk of interest ratesrising. Futures use the inverse relationship betweeninterest rates and bond prices to hedge against therisk of rising interest rates. A borrower will enter tosell a future today. Then if interest rates rise in thefuture, the value of the future will fall (as it is linked tothe underlying asset, bond prices), and hence a profitcan be made when closing out of the future (i.e.buying the future).