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Derivatives
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- 2. INTRODUCTION CAPITAL MARKET STOCK MARKET DERIVATIVES HISTORYOF DERIVATIVES IN INDIA FUNCTIONS OBJECTIVES TYPES PARTICIPANTS
- 3. The Indian SecurityMarket, in the last decade, witnessed a significant transformation. It has developed and grown voluminously on several counts such as the number of brokers, institutional investors, number of listed companies, market capitalization, trading volumes and turnover on stock exchanges.
- 4. The CapitalMarket is a place/market where the issuance and further trading of the securities takes place. Capital Market Primary Market Secondary Market
- 5. Primary marketis a market for new issuance of the securities by new and existing companies through common method of IPOs. Secondary market,also known as Stock Market and Spot Market, is the place where “existing securities are traded for N no. of times”.
- 6. A StockExchange is an organisation which provides buying and selling facilities for traders and investors in stocks and other securities. In India there exists two major exchanges viz Bombay Stock Exchange(BSE)1875 &National Stock Exchange(NSE)1992. BSE Sensex 30 and NSE Nifty 50 are two important market index.
- 7. Derivative securityis a financial security whose payoff depends on or derives from other more fundamental .variables such as a stock price, an exchange rate, a commodity price, an interest rate. The underlying driving variable is commonly referred to as simply the underlying. .Example : The value of a gold futures contract is derived from the value of the underlying asset i.e. Gold.
- 8. The BombayCotton trade association started future Trading in 1875 In 1952 the government banned cash settlement and Option Trading In 1995 a Prohibition of trading options was lifted In 1999, the Securities Contract (Regulation) Act of 1956 was amended and derivatives could be Declared “securities” NSE Started trade in future and option by 2005
- 9. Derivatives enableprice discovery, Improve the liquidity of the underlying asset, Serve as effective hedging instruments and offer better ways of raising money. They contribute substantially in to increasing the depth of markets. Derivatives shift the risk from the buyer of the derivative product to the seller and as such are very effective risk management tools. They provide better avenues for raising money.
- 10. The mainpurpose of derivatives is to transfer risk from one person or firm to another, that is, to provide insurance For example: If a farmer before planting can guarantee a certain price he will receive, he is more likely to plant.
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- 12. A forwardcontract is a particularly simple derivative, a contract between two parties. It is an agreement to buy or sell an asset at a certain future time for a certain price. It can be contrasted with a spot contract, which is an agreement to buy or sell an asset today. A forward contract is traded in the over-the-counter market— usually between two financial institutions or between a financial institution and one of its clients. One of the parties to a forward contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price.The other party assumes a short position and agrees to sell the asset on the same date for the same price. These are not traded on exchanges because they are negotiated directly between two
- 13. Features of ForwardContracts: Over the CounterTrading (OTC). No down Payment Settlement at Maturity. Linearity (Loss of a forward buyer is the gain of the forward seller) No Secondary Market Necessity of a third party
- 14. I agree tosell 500kgs wheat at Rs.40/kg after 3 months. Farmer Bread Maker 3 months Later Farmer Bread Maker 500kgs wheat Rs.20,000
- 15. Credit Risk– Is the other party capable of making the payment? Operational Risk –Will the other party make delivery?Will the other party accept delivery? Liquidity Risk – Incase either party wants to opt out of the contract, how to find another counter party
- 16. Futures isa contract between two parties to buy and sell an underlying asset at a certain time in the future at a certain agreed price. Futures are the Standardized Forwards. Futures are traded on organised exchange.
- 17. A B C L Rs.10 SRs.12 S Rs.10 L Rs.14 L Rs.12 S Rs.14 Profit Rs.2 Loss Rs.4 Profit Rs.2 Market Price/Spot Price D1 Rs.10 D2 Rs.12 D3 Rs.14
- 18. Stock FuturesTrading-deals with shares Commodity FuturesTrading -deals with gold futures, crude oil futures Index FuturesTrading -deals with stock market indices
- 19. Most futurescontracts are not held till expiry, but closed before that. If held till expiry, they are generally settled by delivery. (2-3%) By closing a futures contract before expiry, the net difference is settled between traders, without physical delivery of the underlying.
- 20. Standardization. Intermediationby the Exchange. Price Limits. Margin requirements. Marking to market.
- 21. S.No FORWARDS FUTURES 1.EssentiallyOTC contracts involving only the buyer and the seller. A contract traded through an exchange Buyer, Seller and exchanges are involved 2. Both the parties have necessarily to perform the contract. The contract need not necessarily culminate in delivery of the underlying. 3. There is no payment of initial margins. To trade in futures contract, one has to become a member of the exchange by paying the initial margin and maintain a variable margin account too with the Futures Exchange. 4. The maturity and size of the contract may be customized. The maturity and size of contracts are standardized. 5. Settlements take place only on the date of maturity. Settlement is on a daily basis on all the outstanding contracts(marking to market on a daily basis). 6. Credit or counter-party risk is The futures exchange takes care of
- 22. An Optionis a financial security that gives the holder the right (but not the obligation)to buy or sell a specified asset at a specified price on or before a specified date. Options are traded both on exchanges and in the over-the-counter market.
- 23. It maybe classified into two categories Options are of two types - Calls and Puts options: ‘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 underlying asset at a given price on or before a given future date.
- 24. Right to buy100 Reliance shares at a price of Rs.300 per share after 3 months. CALL OPTION Strike Price Premium = Rs.25/share Amt to buy Call option = Rs.2500 Current Price = Rs.250 Suppose after a month, Market price is Rs.400, then the option is exercised i.e. the shares are bought. Net gain = 40,000-30,000- 2500 = Rs.7500 Suppose after a month, market price is Rs.200, then the option is not exercised. Net Loss = Premium amt = Rs.2500 Expiry date
- 25. Right to sell100 Reliance shares at a price of Rs.300 per share after 3 months. PUT OPTION Strike Price Premium = Rs.25/share Amt to buy Call option = Rs.2500 Current Price = Rs.250 Suppose after a month, Market price is Rs.200, then the option is exercised i.e. the shares are sold. Net gain = 30,000-20,000- 2500 = Rs.7500 Suppose after a month, market price is Rs.300, then the option is not exercised. Net Loss = Premium amt = Rs.2500 Expiry date
- 26. The othertwo types are – European style options and American style options. European style options can be exercised only on the maturity date of the option, also known as the expiry date. American style options can be exercised at any time before and on the expiry date.
- 27. BUYER=HOLDER=LONG POSITION SELLER=WRITER=SHORT POSITION The asset specified in the option contract is called the underlying asset or simply the underlying. The price specified in the contract is the strike price or the exercise price of the option. The date specified in the contract is called the maturity date or the expiration date of the option.
- 28. There are manystrategies used in the trading of options. Some of them are:- Covered calls and protective puts. Spreads: straddles, strangles, strips and straps. Others: collars,box spreads, ratio spreads and condors.
- 30. A swapis an agreement between two companies to exchange cash flows in the future.The agreement defines the dates when the cash flows are to be paid and the way in which they are to be calculated. Usually the calculation of the cash flows involves the future values of one or more market variables.
- 31. Most swapsare traded “OverThe Counter”. Some are also traded on futures exchange market. There are 2 main types of swaps: Plain vanilla fixed for floating swaps or simply interest rate swaps. Fixed for fixed currency swaps or simply currency swaps
- 32. HEDGERS: minimizingthe risk by diversifying the portfolios. Hedgers consists of corporations, investment institutions, banks and governments that want to reduce exposure to market variables such as interest rates, share values, bond prices, currency exchange rates and commodity prices
- 33. Speculators :Betson future movements in the price of an asset. Speculators are those such as hedge funds that want to bet on the prices of commodities and financial assets and on key market variables such as interest, indices, and exchange rates. It is usually much cheaper to speculate using derivatives than on the underlying. As a result, the risks and returns are much greater.
- 34. Arbitrageurs :Takesadvantage of a discrepancy between prices in two different markets. Arbitrageurs exploit mispricing in the market to create risk-free profits.
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