DERIVATIVES IN VARIOUS MARKETS &

CAPITAL BUDGETING

PRESENTED BY:

Sagar Thakur C-46

Manas Bendre C-45
Amit Jain C-44
Sourabh Suryawanshi C-35
Ambrish Shah P-32

PRESENTED TO:
Prof. S.Krishnan
INTRODUCTION TO DERIVATIVES

q The word derivative comes from the word ‘to derive’. It indicates
that it has no independent value. A derivative is a financial instrument
that derives its value from an underlying asset.

qThis underlying asset can be stocks, bonds, currency, commodities,

metals and even intangible, pseudo assets like stock indices.

q Different types of derivatives: Forward , future, swap, option

caps, floor, etc.
 MEANING OF DERIVATIVE
SECURITY MARKET:

q Derivative security market are the market in which derivative

securities trade. It is a financial security ( such as a future ,
forward, option or swap contract) whose payoff is linked to
another.
q Two types of derivative instrument : exchange traded

derivative & OTC derivative.

DERIVATIVES IN VARIOUS
MARKETS
q In Stock Market

q In Commodity market

q In Currency market
 DERIVATIVE INSTRUMENTS

FORWARTD FUTURE SWAP

CONTRACT OPTION
CONTRACT CONTRACT

PUT CALL
 FORWARD CONT RACT

vPrivate agreements between 2 parties to transact in

the future at terms agreed to today.

v Forward contract normally traded outside the

stock exchange. They are popular mostly on OTC
MARKET.

v Forward contracts require both parties to have

essentially opposite needs, but at the same time for
certain quantity of goods & assets.

v Useful in hedging & speculation.

 FUTURE CONTRACT

§ Essentially standardized future contracts which are backed by

an organized exchange & follow daily settlement.
§ Future contract is similar to forward contract but…
§ For financial futures the delivery of an actual asset rarely
occurs and contracts are commonly closed out before maturity,
or settled in cash at maturity.
DIFFERENCE BETWEEN FORWARD &
FUTURE CONTRACT:

vSimilar to forward but features formalized & more standardized:

1) Size of contract: 2) Grade of delivery assets:
3) Delivery date: 4) Delivery location:
v Key difference in future:

1) Standardization 2) Marked to market

3) Secondary trading-liquidity 4) Clearinghouse warrant
performance
 MAJOR PLAYERS

§ Futures contracts are used by essentially two distinct groups

of economic agents: hedgers and speculators

§ The overwhelming majority of futures positions are closed

out prior to the delivery date, or involve cash settlement for
the case of financial futures.
 HEDGING STRATEGY:

§If you are long the underlying the assets ( such that
increase in asset price increase in the firm value, then you
can enter into forward contract to sell , the asset at forward
price, this can hedge the changes in the asset price.

For example:
 TRADING PROCESS

Buyer Seller

Purchase Order Sales Order

Transaction
Broker Broker
On the floor

Clearing House

Margin Requirement:

20% of the position value

PROFIT CALCULATION ON A
FORWARD CONTRACT:

§ Profit on a forward contract is related to the difference

between the price of an underlying assets at the
forward’s maturity (time = T) and the forward price
(initially specified at the onset of the contract at time =
0).
 COMMODITY DERIVATIVE
MARKET:
Commodity Turnover in $
Millions*

Guar seed
4,432.71
Gold
4,082.15
Silver
3,869.36
Crude oil
3,380.13
Chana (chick peas)
2,100.15
Urad (Black Legume)
624.71
FUTURE HEDGING PROCESS:

If $ spot today is Rs.39 & 6 month future is available for 38, an

exporter would sell this future for Rs.38 today.

After 3 month if $ spot is 38.25 then people would expect $fall to

37.75.

Exporter can buy it & make 25 paise.

STOCK FUTURE INDEX:

§The Futures contract allows portfolio managers and

speculators to easily establish various positions in this asset.
Since it is difficult and expensive to hold S&P 500 index
through the direct purchase of the individual stocks comprising
the index,

§ This is particularly useful for investors trading SPX (S&P 500

index) options, who would like to hedge their position
 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.”
Options can be American or European

American options allow the buyer to exercise the option

before expiry date

European options give the buyer the right to exercise the

option only on expiry date
Options have a buyer and a writer

The option writer receives premium for giving the buyer

the right but not the obligation to sell an asset at a future
date

Options can be cash settled or settled by physical delivery

Options in India are cash settled

Put and Call Options

Call Option:
The right to buy a futures contract
Protects against rising price

Put Option:
The right to sell a futures contract
Provides protection against falling prices
INTRINSIC VALUE

“Positive” difference between the strike price and the

underlying commodity futures price.

FOR A CALL OPTION – strike price below

futures price

FOR A PUT OPTION – strike price exceeds

futures price
Call Option

In-the-Money (ITM)
Strike price < Spot price(current price)

At-the-Money (ATM)
Strike price = Spot price

Out-of-the-Money (OTM)
Strike price >Spot price
Put Option

In-the-Money (ITM)
Strike price > Spot price

At-the-Money (ATM)
Strike price = Spot price

Out-of-the-Money (OTM)
Strike price < Spot price
Swaps

Simultaneous purchase and sell between two parties

Spot

Forward

Discount (cheaper)

Premium (costlier)
Capital Budgeting

Should we
build this
plant?
Definition : Capital Budgeting

“ Capital Budgeting is the process of evaluating and

selecting long term investments that are consistent with
the goal of shareholders wealth maximization ”
CAPITAL INVESTMENT PROCESS

• ARR
 SAM Ltd.

ABC Project XYZ Project

Initial Outlay -$250 Initial Outlay -$50

Year 1 inflow $35 Year 1 inflow $18

Year 2 inflow $80 Year 2 inflow $22

Year 3 inflow $130 Year 3 inflow $25

Year 4 inflow $160 Year 4 inflow $30

Year 5 inflow $175 Year 5 inflow $32

 Payback Period
The payback period is the amount of time required for the
firm to recover its initial investment.

 
 
Payback = PB =  Initial Investment / Annual cash flows 
 
 

Management determines maximum acceptable payback

period.
Payback Analysis For SAM Ltd.

Management’s cutoff is 2.75 years.

ABC project: initial outflow of -$250M

But cash inflows over first 3 years is only $245 million.
SAM Ltd. will reject the project (3>2.75).

XYZ project: initial outflow of -$50M

Cash inflows over first 2 years cumulate to $40 million.
Project recovers initial outflow after 2.40 years.
● Total inflow in year 3 is $25 million. So, the project generates $10
million in year 3 in 0.40 years ($10 million  $25 million).
SAM Ltd. will accept the project (2.4<2.75).
Strengths & Weakness of the Payback Method

Benefits:

 Computational simplicity
 Easy to understand
 Focus on cash flow

Drawbacks:

 Does not account properly for time value of money.

 Does not consider cash flow after payback period.
 Does not lead to value-maximizing decisions.
Discounted Payback

Discounted payback accounts for time value.

• Apply discount rate to cash flows during payback period.
• Still ignores cash flows after payback period.
SAM Ltd. uses an 18% discount rate.
ABC Project XYZ Project

Reject (166.2 < Reject

250) (46.3<50)
3131
Average Rate Of Return (ARR)

“The ratio of the average cash flow received to the

amount of funds invested.”

Average profits after taxes

ARR = X 100
Average investment

Average profits Average annual Average

= operating cash –
after taxes annual
inflows depreciation

ARR uses accounting numbers, not cash flows;

no time value of money.
ARR Analysis of ABC Project :

( Depreciation 10% , Tax rate 50 % , All figures

Year EBIDT PBT PAT Cash Flow

1 $65 $60 $30 $35

2 $155 $150 $75 $80

3 $255 $250 $125 $130

4 $315 $310 $155 $160

5 $345 $340 $170 $175

Total $1135 $555 $580

ARR = 111 / 250 X 100 = 44.4 %

ARR Analysis of XYZ Project :

( Depreciation 10% , Tax rate 50 % , All figures are Mio )

Year EBIDT PBT PAT Cash Flow

1 $35 $34 $17 $18
2 $43 $42 $21 $22
3 $49 $48 $24 $25
4 $59 $58 $29 $30
5 $63 $62 $31 $32
Total $249 $122 $127

ARR = 24.4 / 50 X 100 = 48.8 %

Strengths & Weakness of the ARR Method

Benefits:

 Computational simplicity
 Uses readily available accounting information
 Profits for the entire life of asset are considered

Drawbacks:
 Does not account properly for time value of money.
 Based on profits and not cash flows
Net Present Value (NPV)

NPV: The sum of the present values of a project’s cash

inflows and outflows.

Discounting cash flows accounts for the time value of

money.
Choosing the appropriate discount rate accounts for
risk.
CF1 CF2 CF3 CFN
NPV = CF0 + + + + ... +
(1 + r ) (1 + r ) 2
(1 + r ) 3
(1 + r ) N
NPV Analysis of SAM Ltd. :

Assuming 18% discount rate, NPVs are:

ABC project: NPV = $75.3

million 35 80 130 160 175
NPVABC = $75.3 = −250 + + + + +
(1.18) (1.18) 2 (1.18) 3 (1.18) 4 (1.18) 5

XYZ project: NPV = $25.7

million 18 22 25 30 32
NPVXYZ = $25.7 = −50 + + + + +
(1.18) (1.18) 2 (1.18) 3 (1.18) 4 (1.18) 5

Should SAM Ltd. invest in one project or both?

Accept- Reject Rule

If Projects ABC and XYZ are mutually exclusive accept

ABC because NPVABC > NPVXYZ

If Projects ABC & XYZ are independent accept both

since NPV > 0.
Strengths & Weakness of the NPV Method

Benefits:

 It recognizes time value of money.

 It is based on cash flows.
 It maximizes shareholders wealth

Drawbacks:

 Difficult to estimate discount rate

 Not applicable if projects have unequal life
 Difference in initial investment
Profitability Index ( PI )

It measures the present value of returns per rupee

invested

PI = Present value of cash inflows

Present value of cash outflows

Also know as Benefit to Cost Ratio ( BCR )

Net benefit cost ratio = BCR – 1

 Project PV of CF (yrs1- Initial Outlay PI
5)
ABC $325.3 million $250 million 1.3

XYZ $75.7 million $50 million 1.5

Accept project with PI > 1.0

Reject project with PI < 1.0

Strengths & Weakness of the PI Method
Benefits:

 Tells whether an investment increases the firm's value

 Considers all cash flows of the project

 Considers the time value of money

 Considers the risk of future cash flows (through the cost of

Drawbacks:
capital)

 Requires an estimate of the cost of capital in order to calculate

the profitability index
 May not give the correct decision when used to compare
mutually exclusive projects
Internal Rate of Return (IRR)

“ It is that rate of return where the present value of cash

inflows are equal to present value of cash outflows.
In other words NPV is 0 at this rate ”
Internal Rate of Return

IRR: the discount rate that results in a zero NPV for a

project.

CF1 CF2 CF3 CFN

NPV = 0 = CF0 + + + + .... +
(1 + r ) (1 + r ) 2
(1 + r ) 3
(1 + r ) N

The IRR decision rule for an investing project is:

• If IRR is greater than the cost of capital, accept the project.

• If IRR is less than the cost of capital, reject the project.
IRR Analysis for SAM Ltd.

SAM Ltd. will accept all projects with at least 18% IRR.

ABC project: IRR (rabc) = 27.8%

35 80 130 160 175
0 = −250 + + + + +
(1 + r ) (1 + r ) 2 (1 + r )3 (1 + r ) 4 (1 + r ) 5

XYZ project: IRR (rxyz) = 36.7%

18 22 25 30 32
0 = −50 + + + + +
(1 + r ) (1 + r ) 2
(1 + r ) (1 + r )
3 4
(1 + r ) 5
Strengths & Weakness of IRR Method

Benefits:

Considers Time value of Money

 Cash flows for the entire life of asset are considered
 Does not use the concept of required rate of return

 It
Drawbacks:
involves tedious calculations
 Assumption of reinvestment is unrealistic
Conclusion:

Particulars ABC XYZ

ARR 44.4 % 48.8 %
( REJECT ) ( ACCEPT )
NPV $75.3 million ( ACCEPT ) $25.7 million ( REJECT )

PI 1.3 1.5
( REJECT ) ( ACCEPT )
IRR 27.8 % 36.7 %
( REJECT ) ( ACCEPT )
Bibliography &
Webliography
International Finance
- Deepak Abhyankar
Ø Financial Markets & Institution
- Mackgraw Hill Publication

q www.financialmarket.com
q www.google.com
THANK YOU !!!