Introduction to financial derivatives and related terms.

Introduction to financial derivatives.

1. Introduction to derivatives

2. Risk Risk can be defined as deviations of the actual results from expected. Risk can be classified in two ways. 1)Risk of small losses with high probability- Like stock price, commodity price change and exchange rate. 2)Risk of large losses with low probability- Earthquakes and other natural clement.

3. The impact or magnitude of risk is normally estimated from following two factors The probability of an adverse event happening, and In case the event occurs the magnitude of the loss it can cause.

4. Managing risk The ways to manage risk include attempt to control potential damage, diffuse it, diversify and/or transfer risk to those willing to accept it. One can manage risk by transferring it to another party who is willing to assume risk. Risk cannot be eliminated but can be transferred.

5. Derivatives Risks of price, exchange rate and interest rate can be managed through products that are specially designed for hedging. These products are classified as derivatives. Derivatives are the products that derive their value from some other asset called underlying asset. But in other aspects they may remain distinctly different from and independent of the underlying asset.

6. Example Indian exporter is expecting to realize $ 1000 in six months time from now. The exporter had priced his product with a profit target of Rs 2000 based on the current market price of dollar at Rs 45. The actual amount that will be realized by him in Indian rupees will depend upon the exchange rate prevailing six months later. The exporter expects Rs 45000 but he might end up getting Rs 44000 or 46000. He can sell dollars to a party who needs them six months later and negotiate the exchange rate today- Forward contract. Since the price of the forward contract is determined by or derived from the spot price in the foreign currency markets, such a contract is classified as derivatives.

7. Types of derivatives Variety of derivatives are available; both standard products that are traded on an exchange as well as tailor-made, to suit various applications. Four broad types of derivative instruments are Forwards, Futures, Options, and Swaps. Prepared by Sumit Goyal- LPU

8. Forward contract A forward contract 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. Forward contracts ability to lock in a purchase or sale price without incurring much direct cost makes it attractive for hedging as well as speculation. The buyer of the forward contract is called the long and the seller of forward contract is called the short. The only risk parties of contract faces is counterparty risk.

9. Example Suppose on January 1, 2015 an Indian textile exporter receives an order to supply his product to a big retail chain in the US. Spot price of INR/US exchange rate is Rs. 45/dollar. After six months, the exporter will receive $1 million (Rs 4.5 crore ) for his products. Since all his expenditure is in rupee term therefore he is exposed to currency risk. Let’s assume that his cost of production is Rs. 4 crore . To avoid uncertainty, the exporter enters into a six-month forward contract with a bank (with some fees) at Rs. 45 to a dollar. So the exporter is hedged completely. If exchange rate appreciates to Rs. 35 after six months, then the exporter will receive Rs. 3.5 crore after converting his $1 million and the rest Rs. 1 crore will be provided by the bank. If exchange rate depreciates to Rs. 60/dollar then the exporter will receive Rs. 6 crore after conversion, but has to pay Rs. 1.5 crore to the bank. So no matter what the situation, the exporter will end up with Rs. 4.5 crore .

10. Futures It has the same concept and pricing mechanism, but some additional characteristics clearly differentiate it from a forward contract. Futures are traded on the exchange. The features of the futures contracts are standardized in terms of quality, delivery, dates, delivery places, quality of the product etc. Counterparty risk is also reduced, since both the parties have to provide margin to the exchange in which the trade has been done.

11. Marking to Market Marking to Market (MTM) means valuing the security at the current trading price. Therefore, it results in the traders’ daily settlement of profits and losses due to the changes in its market value. Prepared by Sumit Goyal- LPU

12. Mark to Margin Let us assume you have purchased one lot of reliance in the futures market at rupees 1000. The lot size of reliance futures is of 500 shares hence the contract value is equal to lot size into share price that is 500 into thousand that is rupees 5 lakhs Suppose the initial margin is 10 percent of the contract value then the initial margin you paid is 10 percent of 5 lakhs that is rupees 50 000. Prepared by Sumit Goyal- LPU

13. At the end of the trading session around 3 p.m that is just before the market is closing if the price of reliance is trading at Rs 920 the broker may ask you to pay the difference between the price you bought and the closing price that is rupees thousand minus rupees 920 which will be rupees 80 into 500 shares that is rupees 40,000 to carry the position to the next day This difference of rupees 40,000 due to closing price and the trade price is marked to market. Prepared by Sumit Goyal- LPU

14. Option A financial derivative that represents a contract sold by one party (option writer) to another party (option holder). The contract offers the buyer the right, but not the obligation, to buy (call) or sell (put) a security or other financial asset at an agreed-upon price (the strike price) during a certain period of time or on a specific date (exercise date). European Style Options: can be exercised only at expiration.   American Style Options: can be exercised at any time prior to expiration .

15. Call Option A call option gives you the right to buy a stock from the investor who sold you the call option at a specific price on or before a specified date For instance, If you bought a 35 next month call option on General Electric , the option would come with terms telling you that you could buy the stock for 35 (the strike price) any time before the the expiration date. What this means is, if GE rises anywhere above 35 before the expiration date, you can buy the stock for less than its market value. Or if you don't want to buy the stock yourself or exercise the option, you can sell your option to someone else for a profit.

16. Put Option A put option gives you the right to sell a stock to the investor who sold you the put option at a specific price, on or before a specified date. For instance, If you bought a 25 next month put option on Pfizer , the option would come with terms telling you that you could sell the stock for 25 (the strike price) any time before the expiration date. What this means is, if Pfizer falls anywhere below 25 before the expiration date, you can sell the stock for more than its market value. And if you don't want to sell the stock yourself, you can sell your option to someone else for a profit.

17. Example (Call Option)/ Bullish Profit from stock price gains with limited risk and lower cost than buying the stock outright Example: You buy one Reliance Communication (RCOM) 25 call with the stock at 25, and you pay Rs.1 as premium Rcom moves up to 28 and so your option is Rs. 3 in value Returns?

18. Example (Put Option)/ Bearish Strategy: Profit from stock price drops with limited risk and lower cost than shorting the stock Example: You buy one Reliance Communication (RCOM) 20 put with the stock at 21, and you pay Rs.0.8 as premium Rcom drops to 18 and so your option is Rs. 2 in value Returns?

19. Swaps A swap is an agreement between two parties to exchange a series of future cash flows.

20. 21 Interest Rate Swap In an interest rate swap , one firm pays a fixed interest rate on a sum of money and receives from some other firm a floating interest rate on the same sum Popular with corporate treasurers as risk management tools and as a convenient means of lowering corporate borrowing costs EXAMPLE

21. Assume that Charlie owns a $1,000,000 investment that pays him LIBOR + 1% every month. As LIBOR goes up and down, the payment Charlie receives changes. Now assume that Sandy owns a $1,000,000 investment that pays her 1.5% every month. The payment she receives never changes. Charlie decides that that he would rather lock in a constant payment and Sandy decides that she'd rather take a chance on receiving higher payments. So Charlie and Sandy agree to enter into an interest rate swap contract. Under the terms of their contract, Charlie agrees to pay Sandy LIBOR + 1% per month on a $1,000,000 principal amount (called the "notional principal" or "notional amount"). Sandy agrees to pay Charlie 1.5% per month on the $1,000,000 notional amount.

22. Why SWAP? Interest rate swaps  provide a way for businesses to hedge their exposure to changes in interest rates. If a company believes long-term interest rates are likely to rise, it can hedge its exposure to interest rate changes by exchanging its floating rate payments for fixed rate payments.

23. Example Company XYZ issues $10 million in 15-year corporate bonds with a variable interest rate of LIBOR + 150 basis points. LIBOR is currently 3%, so Company XYZ pays bondholders 4.5%. After selling the bonds, an analyst at Company XYZ decides there's reason to believe LIBOR will increase in the near term. Company XYZ doesn't want to be exposed to an increase in LIBOR, so it enters into a swap agreement with Investor ABC. Company XYZ agrees to pay Investor ABC 4.58% on $10,000,000 each year for 15 years. Investor ABC agrees to pay Company XYZ LIBOR + 1.5% on $10,000,000 per year for 15 years. Note that the floating rate payments that XYZ receives from ABC will always match the payments they need to make to their bondholders.

24. OTC Derivatives The contracts that are directly entered into between two mutually consenting parties known to each other with matching needs are called OTC products/contracts. These contracts are customized to the requirements of the counterparties. Forward contracts are OTC products that dominate the foreign exchange market. Swaps are also OTC products.

25. Exchange traded contracts Is traded on the organized exchanges where the buyer and seller need not know each other. The exchange serves as counterparty for both buyer and seller.

26. Participants in Derivative Markets Hedgers: are those who use derivatives for hedging i.e. reduce or eliminate risk. Speculators: are those take positions in derivatives to increase returns by assuming increased risk. They provide much needed liquidity to markets. Arbitrageurs: are those who exploit mispricing in different markets; They assume riskless and profitable positions. Margin trad er: Margin trading is when you buy and sell stocks or other types of investments with borrowed money. That means you are going into debt to invest. Margin trading is built on this thing called leverage, which is the idea that you can use borrowed money to buy more stocks and potentially make more money on your investment All 4 participants are essential for efficient functioning.

27. Uses of Derivatives Risk management Hedging (e.g. farmer with corn forward) Speculation Essentially making bets on the price of something Reduced transaction costs Sometimes cheaper than manipulating cash portfolios Regulatory arbitrage Tax loopholes, etc

28. Features of Forward contract

29. Forward commitment created in the over-the counter market.

30. It is not conditional - both the buyer and the seller are obliged to perform the contract as agreed.

31. Negotiated in the present and will be settled in the future.

32. Private and largely unregulated market.

33. Customized

34. Counterparty default risk

35. Terminology Long position - Buyer Short position - seller Spot price – Price of the asset in the spot market.(market price) Delivery/forward price – Price of the asset at the delivery date.

36. Features of Futures Contract Organized Exchange Highly Standardized Active Secondary Market No Default Risk Daily Settlement Highly standardized with specified underlying goods, quantity (contract size), delivery date, trading hours and trading area

37. Options Terminology

38. Terminologies Open interest refers to the total number of outstanding derivative contracts that have not been settled. Strike Price Intervals are the  various levels of strike prices for each Index and Stock option . The exchange authorities determine the strike prices and the strike intervals are also defined from time to time and modified based on the movement in prices. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 1- 40

39. Example On November 3, 2010 a person decided to enter into a futures contract. He expects the market to go up so he takes a long Nifty Futures position for November expiry. Assume that, on November 3, 2010 Nifty November month futures closes at 8000. Lot Size = 75, Expiry: November 26, 2010, 10% as initial margin Calculate the contract value and Initial margin Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 1- 41

40. On the next trading day i.e., on November 4, 2010 Nifty futures contract closes at 8100 Calculate Margin due/paid Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 1- 42