Derivatives

Definition- Derivative is a security or a financial asset which derives its valu e from some specified underlying asset.

Features of derivatives: 1. A derivative does not have any physical existence but emerges out of a contra ct between two parties. 1. It does not have any value of its own but its values, in turn, depend on the value of other physical assets which are called the underlying assets. 1. These underlying assets may be shares, debentures, tangible commodities, curr encies or short term or long term securities etc. 1. The value of derivative may depend upon any of theses underlying assets.

Parties to the contract of derivatives? The parties to the contract of derivatives are the parties other than the is suer or dealer in the underlying assets. Example: - A Bombay Stock Exchange share Index, called Sensex, is a Derivative, whose value (index for a particular day depends upon the prices of underlying 30 shares. The weighted average of the prices of 30 shares is the sensex.If the pr ices of all the shares increase or decrease, the sensex will also increase or de crease. So the sensex (the derivative) derives its value from the market price o f 30 shares (the underlying asset). The sensex fluctuates in line with the fluct uation in prices of the shares. What is the purpose of using derivatives? The main purpose of using derivatives in the financial markets is to man age risks attached to the organization.

How the risks are managed

The risks are managed with the help of a tool of derivative called HEDGIN G.

Types of Derivatives (1) Commodity derivatives Financial derivatives 1)Sugar 1)gilt-edged securities 2)jute 2)shares 3)pepper 3)shares indices 4)castor seeds

(2) Basic Derivatives Complex Derivatives These are the derivatives on the underlying assets. Futures and Options are the basic derivatives. Swaps can be classified as complex derivatives.

Futures A futures contract is a contract to buy or sell a stated quantity of a commodity or a financial claim at a specified price at a future specified date. Features1. In a futures contract, the parties fix the terms of the transaction and lock

in the price at which the transaction takes place between them at future date. 1. The basic motive for futures is not the actual delivery but the hedging for f uture risk or speculation. 1. In certain types of future contracts the physical asset does not exist, which is involved in the transaction. Example-In case of stock Index futures, the index is the weighted average price and cannot be delivered. So such futures must be cash settled only.

Advantages of futures 1. Futures provide a hedging facility. 2. Futures help in indicating the future price movement in the market. 3. Futures provide arbitrage opportunity to the speculators.

Forward Contracts A forward contract is an agreement to buy or sell an asset at a cer tain time in the future for a certain price (the delivery price). It can be con trasted with a spot contract, which is an agreement to buy or sell immediately. The typical usage of a forward would be to hedge the value of foreign currency denominated assets and liabilities. However, forwards can also be used for spec ulation.

Forward contract Futures 1)These are traded off-exchange and are exposed to default risk by eithe r party 1) These are traded at the exchanges. And have built in safeguards again st default risk in the form of clearing house guarantee. 2)Each forward contract is unique in terms of size, time and types of as sets etc. 2) d03)It is to be settled by delivery of the asset on the specified date 3) These can be settled even by cash payments. 4)The price fixation may not be transparent and is not publicly disclose d 4) These contracts are transparent, liquid and tradable at specified exc hanges.

Options Options are contracts which provide the holder, the right to sell or buy a specified quantity of an underlying asset, but not the obligation to buy o r sell.ie, the holder of the option can exercise the option at his discretion or may allow the option to lapse. Types of optionsCall Option- A call option provides to the holder a right to buy a specified ass et at a specified price on or before a specified date. Put Option- A put option provides to the holder a right to sell specified assets at specified price on or before a specified date. A specified price at which the option can be exercised is known as the strike price. How a call option or a put option functions? 1. The buyer of the option has to buy the right from the seller by paying an opt ion premium. 1. The option premium is not refundable ie. In case, the right is not exercised later, then the premium is not refunded by the option writer. 1. On a specified date, the actual price of the underlying asset may be differen t from the strike price of the option contract. 1. The difference between the two gives rise to the profit opportunity to the op tion holder.

Call option holder (exercises) if actual price > Put option holder (exercises) if actual price rike price. If actual price > strike price In the money If actual price < strike price - Out of money If actual price = strike price - At the money

Strike price. < St

Example-The investor buys today, the call option for one month of 100 shares by paying a premium of, say, Rs. 3 per share (strike price Rs.52 per share).So the total premium comes to Rs.300.Now, after 1 month if the actual price is more tha n Rs.52 per share (say Rs.59), the investor can exercise his option and will mak e a profit of Rs.400 i.e., [(59-52)100]300. However, if the actual price turns o ut to be less than RS.52, then he may allow the option to lapse and his loss wil l be retricted to Rs.300 only. Futures Options Futures involve obligations Options involve rights. There is no premium payable to buy the futures. Here, the option holder has to pay a premium to buy the option. Both the parties are exposed to unlimited profit or loss Here, the loss of the option holder is restricted to the premium paid bu t his gains are unlimited.Similarly, the profit of the option writer is limited to the premium received, but he is exposed to unlimited risk. Usually the maturity period is longer than options Maturity period is shorter than futures.

Options may be classified as (1) American options and European Options:In the American option, the option holder can exercise the right to bu y or sell, at any time before the expiration or on the expiration date. However in the European option, the right can be exercised only on the expiry date and not before.

(2) Naked options and Covered options:A call option is called a covered option if it is covered/written agai nst the assets owned by the option writer. In case of exercise of the call optio n by the option holder, the option writer can deliver the asset or the price differential. On the other hand, if the option is not covered by the physical asset, it is known as Naked option. SWAPS 1. It is another important type of derivative. 2. A swap is a transaction in which two or more parties swap (exchanges) one set

of pre-determined payment for another.

Swaps are of two types

(1)Interest rate swap:It is an agreement between two parties to exchange interest obliga tions or receipts for an agreed period of time. Interest rate swaps are generally used when two parties are able to borrow at different interest rate system i.e., fixed rate of interest and floating rate o f interest. Example-Suppose Xltd and Yltd, both wants to borrow $20 million. The fixed rate of interest charged by bank is 7% and 8.5% from X&Y respectively.However,in case of floating rate system, they can obtain the loan at libor+1% and libor+4%.X lt d has an absolute advantage over Yltd in case of fixed rate as well as floating rate system. But Y ltd has a comparative advantage over X ltd in case of Fixed rate system, as the former has to pay only 1.5 % extra as compared to 3% extra i n floating rate system. Both Xltd and Yltd can be benefited by arranging a swap through a broker and share this comparative advantage. However, it should be noted that swap is independent of the borrowing plann ed by Xltd and Yltd.Both will borrow money with respective bankers and pay the i nterest as usual.

(2)Currency Swap:It is an agreement between two parties to exchange (swap) payments or re ceipts in one currency for payment or receipts in another currency.

Example-An ltd and B ltd wants to borrow in dollars & pounds respectively. But A ltd can borrow pound at a cheaper rate than B ltd while B ltd can borrow dollar at cheaper rate .However both can enter in to a currency swap to share advantag e of the cheaper borrowing capacity of the other company. Swaption A swaption is an option on a swap. The option provides the holder with the ri ght to enter in to a swap at a specified future date at specified terms. This de rivative has characteristics of an option and a swap. These types of derivatives are also called multiple derivatives.