Download Contd…

MEANING
• A Derivative is a financial
instrument that offers a return,
based on the return of some
other underlying assets.
CONTD…
In nutshell, Derivatives are contracts
which derive values from the value
of one or more other (underlying)
assets.
The underlying assets?
• Shares
• Debentures
• Stocks
• Scrips and
• Bonds etc.,
DEFINITION
• “The term ‘Derivative’ has been
defined as a contract which
derive its value from the
underlying assets”.
• In short, the product or contract
which derive its value from
some other assets.
Classification of Derivatives
Exchange Traded
Future contract
• OTCEI
Forward contract
CONTINGENT CLAIM
• Exchange Traded and OTCEI
Options
Warrants
Future Vs Forward
Future
• 1. Traded on exchange
Between two parties.
• 2. Standardized contract
• 3. Range of delivery dates
• 4. Settled daily
• 5. Contract usually closed
cash, prior to maturity of
date.
Forward
1. Private contract
2. Non – Standardized
3. Specified delivery
Dates.
4. Settled at the end
the contract.
5. Delivery or final
settlement usually
takes place.
ADVANTAGES OF DERIVATIVES
1.Leverage
You can control a large holding in
an asset for a small amount of
money. Since you participate in the
gain from the price movement of the
underlying asset for a fraction of the
cost of the asset, you can
significantly increase your rate of
return.
Contd…
2. Reduce the risk
We can make money when the
market goes up or when it goes
down, by predicting the
direction of movement of the
underlying asset
Contd…
3. A tool for hedging
Derivatives provides an
excellent mechanism to hedge
the future price risk.
Contd…
4. Risk management
Derivatives provide an excellent
mechanism to Portfolio
Managers for managing the
portfolio risk and to Treasury
Managers for managing interest
rate risk.
Contd…
5. Better avenues for raising
money
 With the introduction of
currency & interest rate swaps,
Indian corporate will be able to
raise finance from global
markets at better terms.
Contd…
6. Price discovery
Derivative instruments make the
spot price discovery more reliable
using different models like Normal
Backwardation hypothesis. These
instruments will cause any arbitrage
opportunities to disappear & will
lead to better price discovery.
Contd…
7. Increasing the depth of financial
markets
When a financial market gets such
sort of risk-management tools, its
depth increases since the
Institutional Investors get better
ways of hedging their risks against
unfavorable market movements.
Disadvantages:
1.Speculation
Many people fear that these
instruments will unnecessarily
increase the speculation in the
financial markets, which can
have far reaching
consequences.
Contd…
2. Market efficiency
These instruments require a
well functioning & mature spot
market. Indian equity markets
to the NASDAQ makes the
functioning of derivatives
market all the more difficult.
Contd…
3. Volatility
The increased speculation &
inefficient market will make the
spot market more volatile with
the introduction of derivatives.
Risks in derivatives
1. Operational and legal risks
The most concrete source of
concern is how the trade is
conducted in practice. The
explosive increase in the
number of contracts, routines
and handling procedures have
lagged behind.
Contd…
2. COUNTERPARTY RISKS
Counterparty risks exist in
most financial agreements, but
as the credit derivatives market
is so young and growth is so
rapid, there is particular reason
to be aware of them.
Contd…
3. Liquidity risks
There is reason to be aware of
possible liquidity risks.
Problems may arise if the
market actors rely on the
market always being liquid and
assume this when making their
deals.
Contd…
4. Risk of mispricing
The interest rate differences
between high-risk and low-risk bonds
have therefore declined, that is,
credit spreads have shrunk. The
price of credit derivatives has fallen
correspondingly
Derivative Markets
Derivative markets are a relatively
new phenomenon, but are one of the
most rapidly growing asset classes.
Currently, there are approximately
300 million derivative contracts
outstanding with a market value of
around $50 Trillion
While equity trading is centered in
New York (NYSE, NASDAQ),
derivative markets are centered in
Chicago (CME, CBOT, CBOE)
What is a Derivative?
A derivative is simply a contract
which entitles the holder to buy or
sell a commodity at some future
date for a predetermined price.
Therefore, while a stock or a bond
has intrinsic value (a stock or a bond
represents a claim to some asset or
income stream), a derivative has no
intrinsic value. Its value is “derived”
from the underlying asset.
Why is a middleman
required?
Recall that, unlike stocks or
bonds, derivatives have future
obligations attached to them.
The clearinghouse is just an
efficient way to insure
compliance with the terms of
the contract
Options vs. Futures
• Recall that a futures contract is an
obligation to deliver or purchase a specific
commodity as a predetermined time &
price
• An option contract gives the holder the
option to buy or sell a specific commodity
at a predetermined time & price
• Only the purchaser (long position) of the
contract gets the option. The seller (short
position) has to obligation to buy/sell if the
option is exercised.
• An option, however, does have an up front
cost (the price of the option)
“Vanilla” Options
• Any option is defined by four
characteristics: commodity,
size, exercise (strike) price, and
term.
• A call option gives the holder
the option to purchase a
commodity at the strike price
• A put option fives the holder
the option to sell a commodity
at the strike price
Why use options?
Hedging: as with futures,
options can be used to insure
against many different types of
risk
Speculation: as with futures, an
option is basically a bet as to
the direction/magnitude of a
commodity price.
A Protective Put
• A protective put involves the
purchase of a stock and a put
on that stock in equal quantities
• The combined value of the
stock/put will never be lower
than the strike price of the put.
• A protective put is like buying
insurance against price
declines.
Protective Put
60
40
30
20
10
0
40
20
50
43
36
29
22
15
50
43
36
29
22
15
8
the right is the payout to buying a put with a strike price of $30.
1
On
8
1
0
FUTURE
• What Does Futures Contract Mean?
A contractual agreement, generally made
on the trading floor of a futures exchange,
to buy or sell a particular commodity or
financial instrument at a predetermined price in the future. 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.
Contd…
• In short,
The terms "futures contract" and "futures"
refer to essentially the same thing. For
example, you might hear somebody say
they bought "oil futures", which means the
same thing as "oil futures contract". If you
want to get really specific, you could say
that a futures contract refers only to the
specific characteristics of the underlying
asset, while "futures" is more general and
can also refer to the overall market as in:
"He's a futures trader."
Future Value Of An Annuity
• The value of a group of payments at a
specified date in the future.
These payments are known as an annuity,
or set of cash flows. The future value of an
annuity measures how much you would
have in the future given a specified rate of
return or discount rate. The future cash
flows of the annuity grow at the discount
rate, and the higher the discount rate,
the higher the future value of the annuity.
Contd…
• This calculation is useful for determining
the actual cost of an annuity to the issuer:
•
C = Cash flow per period
i = Interest rate
n = Number of payments
This calculates the future value of an
ordinary annuity. To calculate the future
value of an annuity due, multiply the result
by (1+i). (Payments start immediately
instead of one period into the future.)
AN INTRODUCTION to FUTURE CONTRACT:
 A contractual agreement, generally made on
the trading floor of a futures exchange, to buy
or sell a particular commodity or financial
instrument at a pre-determined price in the
future. 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.
Contd…
 IN SHORT…………
The terms "futures contract" and "futures" refer
to essentially the same thing. For example,
you might hear somebody say they bought "oil
futures", which means the same thing as "oil
futures contract". If you want to get really
specific, you could say that a futures contract
refers only to the specific characteristics of the
underlying asset, while "futures" is more
general and can also refer to the overall market
as in: "He's a futures trader."
Contd…
So, A Future contract is an obligation to buy/sell
an instrument whose value is derived from an
underlying assets/security.
Ex: A wood cutter and carpenter story
WC is worried that the price of wood might go

down.
 Carpenter is worried that the price of wood

might be go up.
 To solve their worries both parties enter into
the contract (called Future) to lock the price.
Types of Futures Trading
Contracts
 There are mainly two types of futures
trading contracts. They are futures
contracts which are traded for physical
delivery, known as commodities and
futures contract which are end with a
cash settlement, known as financial
instruments. Both types of futures
contracts are traded electronically and
directly.
Contd…
 Futures contracts which are traded for physical
delivery includes agricultural commodities like
wheat, oats, sugar etc, energy products like
crude oil, heating oil, natural gas etc, or
animals. Note that very commodity futures
contracts actually end in delivery. Often these
contracts are traded just like shares of a stock
market, according to the changes in price
trends. Online futures traders include both
speculators and hedgers.
Contd…
 Futures contracts which are traded for cash
settlement involve treasury notes, bonds, etc.
These futures are also known as currency
futures and are often traded just like
commodity futures though electronic platforms.
 A forward price involves a future payment date.
Thus in a multi-period setting, one could have
a one-year forward price for a given set of
time-state claims, a two-year forward price for
the same set of claims, etc..
Contd…
 The first would indicate an amount that would
have to be paid in one year to purchase the set
of claims. The second would indicate an
amount that would have to be paid in two years
to purchase the set of claims, etc.. In each
case, the price would be determined at the
present time and the agreed-upon amount
would have to be paid at the specified future
time, regardless of the nature of ensuing
events.
Future Value – FV
 The value of an asset or cash at a specified date in the
future that is equivalent in value to a specified sum
today. There are two ways to calculate FV:
1) For an asset with simple annual interest: = Original
Investment x (1+(interest rate*number of years))
2) For an asset with interest compounded annually: =
Original Investment x ((1+interest rate)^ number of
years)
 Examples:
 1) $1000 invested for 5 years with simple annual
interest of 10% would have a future value of $1,500.00.
2) $1000 invested for 5 years at 10%, compounded
annually has a future value of $1,610.51
Synthetic Futures Contract
 A position created by combining call and put
options for the purpose of mimicking the
payout schedule and characteristics of a
futures contract.
IN SHORT: A synthetic long futures contract is
created by combining long calls and short puts.
A synthetic short futures contract is created by
combining short calls and long puts. In order
for both combinations to be identical to a
futures position, the options must have the
same expiry dates and strike prices.
Differentiate the Future with Forward
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Future
1. Traded on exchange
2. Standardized contract
3. Range of delivery dates
4. Settled daily
5. Contract usually closed
and prior to maturity of
the date.
Forward
1. Private contract
Between two parties.
2. Non – Standardized
3. Specified delivery
Dates.
4. Settled at the end of
the contract.
5. Delivery or final cash
settlement usually
Takes place.
FORWARD
 Forward Contract
A cash market transaction in
which delivery of the commodity is deferred
until after the contract has been made.
Although the delivery is made in the future, the
price is determined on the initial trade date.
 Most forward contracts don't have standards
and aren't traded on exchanges. A farmer
would use a forward contract to "lock-in" a
price for his grain for the upcoming fall harvest.
Forward Price
 The predetermined delivery price for an
underlying commodity, currency or
financial asset decided upon by the long
(the buyer) and the short (the seller) to
be paid at predetermined date in
the future.
 At the inception of a forward contract, the
forward price makes the value of the
contract zero.
Contd…
 At the inception of a forward contract, the forward price
makes the value of the contract zero.
 The Forward Price can be determined by the following
formula:
where:
S0 represents the current spot price of the asset
F0 represents the forward price of the asset at time T
er represents a mathematical exponential function
IN SHORT:
 Taking positions in a forward contract is a zerosum game. For example, if Joe takes a long
position in a pork belly forward agreement and
Jane takes a short position in a forward
agreement, any gains that Joe makes in the
long position equal the losses that Jane incurs
from the short position. By initially setting the
value of the contract's value to zero, both
parties are on equal ground at inception of the
contract.
Contd…
 The number of basis points added to or
subtracted from the current spot rate to
determine the forward rate. When points
are added to the spot rate, there is a
forward point’s premium; when points are
subtracted from the spot rate, there is a
point’s discount.
Forward Market
 Forward contracts are personalized
between parties and therefore
not frequently traded on exchanges. The
forward market is a general term used
to refer to the informal market in which
these contracts are entered and exited.
Forward Discount
 In a foreign exchange situation where the
domestic current spot exchange rate is
trading at a higher level then the current
domestic futures spot rate for a maturity
period. A forward discount is an indication
by the market that the current domestic
exchange rate is going to depreciate in
value against another currency.
IN SHORT:
 A forward discount means the market
expects the domestic currency to
depreciate against another currency, but
that is not to say that will happen.
Although the forward expectation's theory
of exchange rates states this is the case,
the theory does not always hold.
Forward Earnings:
 A company's forecasted, or estimated,
earnings made by analysts or by the
company itself. Forward earnings differ
from trailing earnings (which is the figure
that is quoted more often) in that they
are a projection and not a fact. There
is are many methods used to calculate
forward earnings and no single
established way.
IN SHORT:
 Forward earnings are nothing more than
a figure reflecting predictions made by
analysts or by the company itself. More
often than not they aren't very accurate.
This is the problem: trailing earnings are
known but are relatively less important
since investors are more interested in the
future earning potential of a company.
Forward Premium
 When dealing with foreign exchange (FX), a
situation where the spot futures exchange rate,
with respect to the domestic currency, is
trading at a higher spot exchange rate then it is
currently. A forward premium is frequently
measured as the difference between the
current spot rate and the forward rate, but any
expected future exchange rate will suffice.
IN SHORT:
 It is a reasonable assumption to make
that the future spot rate will be equal to
the current futures rate. According to the
forward expectation's theory of exchange
rates, the current spot futures rate will be
the future spot rate. This theory is routed
in empirical studies and is a reasonable
assumption to make in the long term.
Forward Swap
 A swap agreement created through the
synthesis of two swaps differing in
duration for the purpose of fulfilling the
specific time-frame needs of an investor.
Also referred to as a "forward start
swap," "delayed start swap," and a
"deferred start swap."
For example,
 if an investor wants to hedge for a fiveyear duration beginning one year from
today, this investor can enter into both a
one-year and six-year swap, creating the
forward swap that meets the needs of his
or her portfolio. Sometimes swaps don't
perfectly match the needs of investors
wishing to hedge certain risks.
Forward Integration:
 A business strategy that involves a form
of vertical integration whereby activities
are expanded to include control of the
direct distribution of its products.
 A good example of forward integration is
when a farmer sells his/her crops at the
local market rather than to a distribution
center.
Forward Rate Agreement FRA
 An over-the-counter contract between
parties that determines the rate of interest,
or the currency exchange rate, to be paid or
received on an obligation beginning at a future
start date. The contract will determine the rates
to be used along with the termination date and
notional value. On this type of agreement, it is
only the differential that is paid on the notional
amount of the contract.
 Also known as a "future rate agreement".
IN SHORT:
 Typically, for agreements dealing with
interest rates, the parties to the contract
will exchange a fixed rate for a variable
one. The party paying the fixed rate is
usually referred to as the borrower, while
the party receiving the fixed rate is
referred to as the lender.
Example
 assume Company A enters into an FRA with Company
B in which Company A will receive a fixed rate of 5%
for one year on a principal of $1 million in three years.
In return, Company B will receive the one-year LIBOR
rate, determined in three years' time, on the principal
amount. The agreement will be settled in cash in three
years.
 If, after three years time, the LIBOR is at 5.5%, the
settlement to the agreement will require that Company
A pay Company B. This is because the LIBOR is higher
than the fixed rate. Mathematically, $1 million at 5%
generates $50,000 of interest for Company A while $1
million at 5.5% generates $55,000 in interest for
Company B. Ignoring present values, the net difference
between the two amounts is $5,000, which is paid
to Company B.
Swaps
A swap is simply a contract in which one
payment stream is traded (swapped) for
another
 The most common swap is a variable/fixed
rate interest swap in which interest rate
payments on a variable rate loan are
traded for interest rate payments on a
fixed rate loan

Contd…
Swaps can also be created for currencies,
commodities, stocks, etc.
 Recall, that a swap is basically a zero
spread collar. Therefore, the same
principles used for pricing options are
used for pricing swaps.
 Currently there exists currency, interest,
commodities, credit default, inflationary,
etc…

Types of Swaps

Interest rate swap: counterparties
exchange one set of payments for another
(in the same currency)
 One
counterparty has an initial floating-rate
obligation, the other has an initial position in
a fixed-rate obligation
 1st counterparty can reduce its exposure to
risk by swapping with 2nd counterparty, who
will bear the risk in anticipation of a return
Contd…

Currency swap: counterparties exchange
principal amounts denominated in
different currencies