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Derivative
Submitted to : Prof. Deepak Dhanak Submitted by : Shalin Shah Yogesh Dalal Ishwar Dubey
RISK /Uncertainty???
Case : An Indian Garments company has received an order to supply I,00,000 units of shirts from USA. The price of $ 100,000 is receivable after six months. The current exchange rate is Rs.55/$ At the current exchange rate, the company would get after 6 months : 55 100,000 = Rs 55,00,000 But the company anticipates appreciation of Indian rupee over time i.e rupee will be at Rs. 50/ usd after 6 months Does the company loose/gain due to appreciation in the Indian Rupee? Can company minimise such risk?
movement.
The instruments that can be used to provide such protection are called derivative instruments
What is a Derivative?
Derivative comes from the word to derive A derivative is a contract whose value is derived from the value of another asset called underlying
asset
If the price of underlying asset/security changes the price of derivative security also changes. The underlying asset can be equity, fixed income instruments, interest rates, foreign exchange or commodities. The price movements of derivative products are related to that of the underlying securities. These instruments include futures contracts, forward contracts, options contracts
Underlying Asset/Security
Commodity derivative
Underlying is wheat, cotton, pepper, corn, oats, soyabean, crude oil, natural gas, gold, silver, turmeric etc. Underlying is stocks, bonds, indexes, foreign exchange, Eurodollar etc.
Financial derivatives
Derivative minimises the risk of owning things that are subject to unexpected price fluctuations like foreign currencies, bulk of wheat, stocks & bonds.
Derivative instruments on
Stocks (Equity) Agri Commodities including grains, coffee beans, pepper,. Precious metals like gold and silver. Crude oil Foreign exchange rate Short-term debt securities such as T-bills Index Interest rate
HEDGING
SPECULATION
Advantages
The derivative market helps people meet diverse objectives such as: Hedging
Derivatives - Uses
Price discovery Most price changes are first reflected in the derivative market. That way derivative market feeds the spot market For instance, if the dollars are going down, it means that the professional investors are expecting dolor price to go down in the future this is a good sign for you to buy in the spot market Risk transfer A derivative market provides protection against risk Derivative instruments redistribute the risk amongst market players
FORWARDS
It is a contract between two parties to buy or sell an underlying asset at todays preagreed price (known as Forward Price) on a specified date in the future.
It is the most basic form of derivative contract. These contracts are not standardized, the end users can tailor make the contracts to fit their very specific needs.
Example
An Indian Company has ordered machinery from USA. The price of $ 1,00,000 is payable after six months. The current exchange rate is 55 as on date. At the current rate the company needs 55*1,00,000 = 55,00,000 If the company anticipates depreciation of Indian rupee over time i.e expect the rupee to reach up to Rs. 60 / use The company can enter into a forward contract at 55& forget about any exchange rate fluctuations. Suppose the exchange rate becomes 60, then also the company has to pay Rs. 55,00,000 for buying $ 1,00,000 though the value is 6,00,000.
Different Types of Forward Contracts Depending on the underlying asset, the most common types of forward contracts are:
FUTURES
Futures are financial contracts to eliminate the risk of change in price in the future date. Futures are highly standardized exchange traded contracts to buy or sell specified quantity of financial instruments/commodity in a designated future month at a future price. Futures Price : The price agreed by the two traders on the floor of exchange. In simple terms, a futures contract is a contract that allows the counterparties to exchange the underlying assets in future at a price agreed upon today. Following are the features of a futures contract-
Contract through an exchange To exchange obligations on a future date At a price decided today For a quantity / quality standardized by the exchange
Types of Futures
Types of Futures Commodity futures (Wheat, corn, etc.) and Financial futures Financial futures include: Foreign currencies Interest rate Market index futures (Market index futures are directly related with the stock market) Individual stock.
Forwards Futures
Standardized Clearing house of exchange
Exists Poor
Not Required
Valuation
Not Done
Margin
It is the initial deposit required to open a trading account in a futures trading exchange. The initial margin is fixed by the broker, but has to satisfy an exchange minimum.
The variation margin i.e. the change in the amount of an account on a given
day in response to a market to-market process, is settled on daily basis.
Margin - Process
The exchange requires both parties to put up an initial amount of cash, the margin. Additionally, since the futures price will generally change daily, the difference in the prior agreed-upon price and the daily futures price is settled daily The exchange will draw money out of one party's margin account and put it into the other's so that each party has the appropriate daily loss or profit. If the margin account goes below a certain value, then a margin call is made and the account owner must replenish the margin account. This process is known as marking to market.
Initial Margin The amount that must be deposited in the margin account when establishing a position. The margin requirement is about 12% futures & 8% for options. Marking to Market In the futures market at the end of each trading day, the margin account is adjusted to reflect the investors gain or loss depending upon the futures closing account. Maintenance Margin This is set to ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin, the investor is expected to top up the initial level before trading commences on the next day.
For example say you have bought 100 shares of XYZ at Rs.100 and Threshold MTM Loss is 20% and the applicable
margin % is 35%. You would be having a margin of Rs.3500 blocked on this position. The current market price is now say Rs.75. This means the MTM loss is 25% which is more than the threshold MTM loss % of 20% and hence additional margin to be called in for. Additional margin to be calculated as follows:
(a) Margin available (b) Less : MTM Loss (c) Effective available margin (d) Required Margin (e) Additional Margin required
OPTIONS
An option is a contract between two parties in which one party has the right but not the obligation to buy or sell some underlying asset on a specified date at a specified price. The option buyer has the right not an obligation to buy or sell. If the buyer decides to exercise his right the seller of the option has an obligation to deliver or take delivery of the underlying asset at the price agreed upon. Hence, option is like general insurance
Options - characteristics
Options or option contracts are instruments Right, but not the obligation, is given To buy or sell a specific asset At a specific price On or before a specified date Options can be exchange traded derivatives or even over the counter derivatives.
Option Classifications
Call Option : an option which gives a right to buy the underlying asset at a strike price.
Put Option : an option which gives a right to sell the underlying asset at strike price.
CALL OPTIONS
A call option is a contract that gives the option holder the right to buy some underlying asset from the option seller at a specified price on or before a specified date. Eg. The current market price Ashok Leyland is Rs.69. o An option contract is created and traded on this share. o A call option on the share would give the right to buy the share at a specified price (Rs.75) during April 2013. o This call option would be traded between two parties P (the purchaser and S ( the seller). The purchaser P would be prepared to pay a small price known as option premium (Rs.2) to S, the seller of the option.
PUT OPTIONS
A put option is a contract which gives its owner the right to sell some
Types of Options
On the basis of maturity pattern of options, option contracts are
European Style Options Options which can be exercised only date of the option or on the expiry date. American Style Options Options which can be exercised at any including the expiry date.
on
the
maturity
time
up
to
and
Most of the exchange traded options are American style. In India stock options are American style while index options are European style.
Option Terminologies
Strike Price or Exercise Price Expiration Date Exercise Date Option Buyer Option Seller American option European option Option Premium
Option Writer or Option Grantor: The seller of option. Strike price or Exercise price : The price at which the option holder may purchase the underlying asset from the option seller.
Time to Expiration or Time to Expiry : The period of time specified for exercising
the option.
Expiration Date : The precise date on which the option right expires. Option Premium : The price to be paid by option purchaser to option seller
Moneyness of Options
Moneyness of an option describes the relationship between the strike price of
the option and the current stock price. This takes three forms:
1. In the Money
2.
3.
At the Money
Out of the Money
Call Option
Put Option
At the Money
At the Money
Option Premium
Both the Call and Put option buyers are buying the rights, that is they are transferring their risks to the sellers of the option. For this transfer of risk to the sellers, buyers have to compensate by paying Option Premium. Option premium is also known as Price of the option, Cost or Value of the option.
Settlement of Options
Physical Delivery Cash settlement
Unlimited upside and downside for both buyer and seller Limited downside (to the extent of premium paid) for buyer and unlimited upside. For seller (writer) of the option, profits are limited whereas losses can be unlimited. Futures contracts prices are affected mainly by the prices Prices of options are however, affected by (a) prices of of the underlying asset. the underlying asset, b) time remaining for expiry of the contact and c) volatility of the underlying asset.
FAQS
A. Why banks will provide derivative instruments : To earn brokerage income they will also transfer the risk to thrid counter party and keep a margin in hedge costs Many times natural hedge e.g. may give derivative to an importer as well to an exporter thereby nullifies risk of both instruments