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What are Derivatives?

Investments can be done in: Real Assets

Financial Assets Bonds, equity securities, derivative

security A derivative is an instrument whose value depends on, or is derived from, the value of another asset. The asset whose value determines the value of the derivative contract is known as underlying asset. Derivatives value will change depending on the changes in the value of the underlying asset Examples: futures, forwards, swaps, options, exotics Derivatives can be written on real assets(commodity derivatives) as well as on financial assets(financial derivatives)
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Derivative Markets- How Derivatives are traded?

Over the counter OR Exchange traded market

1. Over the counter(OTC):

Between private parties

Terms decided between the parties One need to search the party-for that brokers play their

role Highly unregulated and less transparent Example : Swap,forward contracts 2. Exchange traded markets: Traded on derivatives exchanges Exchange decides upon the terms of the contract Similar to trading of shares in the stock exchange Exchanges are regulated and transparent Example: Futures
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Forward Contracts
Provide the holder of contracts with the right to buy or

sell the underlying asset at a future time at a price that is agreed upon at the time of entering into the contract Both parties obligated to fulfill the contract Short-term, non-negotiable Typically over-the-counter(OTC)

Futures Contracts
Provide the holder of the contract with the right to buy or

sell the underlying asset at a future time at a price agreed upon at the time of entering into the contract
Both parties obligated to fulfill the contract
Can be short- or long-term Negotiable(Either party has the right to transfer the

contract obligation to a third party before the expiry of the contract) Traded on futures exchanges
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Options Contracts
An option buyer has the right to either buy or sell

the underlying asset at a fixed price, at a future time Major difference between options and futures or forward is that the holder of the forward or futures will have to fulfill the obligation irrespective of whether the position results in gain or loss. Option buyers have no obligation to fulfill contracts, whereas the writers have to fulfill the obligations if called upon to do so Options can be either over-the-counter or traded in exchanges

Evolution and growth of Derivatives

In past utilised by farmers and merchants in the form

of very simple contracts Later on derivatives grown rapidly when exchanges in India were allowed to trade the derivative contracts. For Derivative contract utilization there are advantages as well as disadvantages

Uses of Derivatives
For risk management-Risk includes the inherent

business risk To reduce the risk hedging is used i.e. derivatives are also used to hedge risks To speculate (take a view on the future direction of the market) To lock in an arbitrage profit(without net investment or risk)

What is Risk?
Risks that a business faces can be classified into :
Operating or business risk Event Risk Price Risk Credit Risk

Operating or Business Risk

Risk on business because of economic cycle and

business cycle which affects all businesses in an industry Economic downturn leads to reduction in lower demand for goods, services Turnaround results in increased wealth, increased demand for goods and services

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Event Risk

An unforeseen event can affect revenue and costs Foresight and appropriate strategy can help manage

these risks Price Risk Price risk is a major risk faced by businesses It refers to the price changes in inputs and outputs that have an impact on a business cash flow, cash flows can be affected by the following: There can be changes in prices of commodities(inputs and outputs), Changes in price of financial instruments Changes in interest rates Changes in currency rates
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Credit Risk
Arises when customers credit rating falls. The credit standing of a customer may change after the credit is granted and this results in unpredictability of credit worthiness of the customers and hence increases credit risk
When this occurs, the probability of default and bankruptcy increase

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Risk Management

Risk is unavoidable Operating and business, and event risk, can be managed only by formulating appropriate strategies based on anticipation Price risk, which occurs on a regular basis, can

be managed using derivative securities. For managing price risk one has to ensure that prices are fixed for buying and selling at a future time which is called as hedging the price risk. Credit risk can be managed through derivative securities
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Hedging
Hedging is undertaken to reduce the risk of unknown future prices by

trying to fix a price for a future purchase or sale of a given asset. Hedging is done using derivative securities Derivatives used are: Forward contracts Futures contracts Options contracts Swap contracts Volatility (increase/decrease in price levels)affects the gain or loss. Eg. If a company is planning to borrow money three months from today, interest rate could be any . If it increases from todays rate,the company would be required to pay more (against the interests of the company) and if it decreases, the company will be making less payment in the form of interest(in companys favour)

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Upside and Downside Risks

When prices move in favour of a company, increased

cash flow will be produced and the company will face upside risk When prices move against a company, decreased cash flow will result and the company will face downside risk When hedging, attention is placed on downside risk One should consider the implications of both upside and downside risk

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Commodity Price Risk

Commodity price risk arises when future prices of inputs and

outputs are uncertain. Eg. Consider a manufacturer which produces products in which sugar is required . The prices of sugar is uncertain, this uncertainty of the future price of sugar will have an effect on the prices of the product which is produced by the manufacturer as well as on the profits of the company. Major determinants of price risk are: Volatility of movement of the price: If volatility is low, change in price is low and if volatility is high, average price change is high . If volatility is high, it is important to take steps to reduce the risk of price changes Liquidity of the market: Liquidity means that a commodity is traded actively in the market. When market has high liquidity, price changes will be comparatively small. Thereby leading to lower volatility.
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Interest Rate Risk

Interest rate risk arises when future interest rates are not

known Investors in fixed-income securities face interest rate riskthe value of fixed-income securities are directly related to interest rate movements Borrowers and lenders face interest rate risk, as interest rate on loans depend on interest rates in the market

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Deregulation and Central Bank (RBI) Intervention

Until the 1970s, interest rates were regulated with

ceilings on interest rates on deposits and loans With deregulation, banks can offer competitive rates. The Central Bank (RBI) can use interest rates as monetary tools to determine money supply in the economy. If there is high inflation, a high interest rate can be maintained whereas the stimulation of a depressed economy will require low interest rate Because of deregulation, financial institutions started to offer floating rate loans and deposits as opposed to fixed rate loans.
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Floating Rate Loans

Floating-rate loans are loans where interest rates are not fixed

for the whole term of the loan, and are set at periodic intervals during the loan period based on basic interest rates in the economy. The interest rate is based on a reference rate, and the reference rate is set such that it takes the reset period into account. The reset period indicates, how often the interest rate is going to be reset.
Example: 6-month MIBOR + 200 points(MIBOR means

Mumbai Interbank Offer Rate) Interest rates on loans will be reset every 6 months. Interest rates will be 2% above the 6-month MIBOR at that time
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MIBOR(Mumbai Interbank Offer Rate)

MIBOR is the interest rate at which banks can borrow

funds, in marketable size, from other banks in the Indian interbank market. The Mumbai Interbank Offered Rate (MIBOR) is calculated everyday by the National Stock Exchange of India (NSEIL) as a weighted average of lending rates.

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MIBID(Mumbai Interbank Bidding Rate)

MIBID is the interest rate that a bank participating in the

Indian interbank market would be willing to pay to attract a deposit from another participant bank. The MIBID is calculated everyday by the National Stock Exchange of India (NSEIL) as a weighted average of interest rates
The MIBID rate would be lower than the interest rate

offered to those wanting to borrow funds, known as Mumbai Interbank Offered Rate (MIBOR). This is to provide the bank a profit from the spread of interest earned and paid.

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Interest rate and Inflation

Relationship provided by Irving Fisher
Nominal interest rate = (1 + real interest rate)

(1 + expected inflation rate) Nominal interest rate = real rate + expected inflation rate

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Components of Interest Rate Risk

Interest rate risk has two effects:
Risk of changes in the price of securities(with change

in interest rates) is called price risk. When interest rate increase, price of bond and debentures decreases and vice versa
Risk of changes in the rate at which cash flows

received from investment can be reinvested is called reinvestment rate risk

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Currency Risk
Currency risk, or exchange rate risk, arises when cash

flows are denominated in a foreign currency

Examples of currency risk include:
Exporter receiving foreign currency
Importer needing to pay foreign currency Investors in foreign currency securities Borrowers of foreign currency loans

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Approaches to Risk Management

Passive Hedging(Do nothing): Here, the company

will ignore all the risks. Appropriate if the exposure is very small, or if the cost of managing the risk exceeds the benefits. Active Risk management(Cover everything): It means that the company will take a position in a derivative instrument to manage every exposure, so as to manage all risks Selective hedging: Covering the exposures when the movement in prices or rates could lead to losses and uncovering when prices or rates appear to be moving in its favour
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Risks in Derivative Trading

Hedging using derivatives has its own risks Using futures and forwards to hedge:
The hedger benefits only if the price moves against

the hedger (downside risk) The hedger could face huge losses if the price moves against them (upside risk) Speculators can lose a large amount if prices move against their expectations Options can also result in losses even though they provide upside potential due to the cost of options as one needs to pay for buying the options

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Types of Traders
Hedgers: Hedgers are those who want to reduce

price risk using contracts Speculators: Take positions in the market without any underlying asset . They enter into the market by placing bets on the movements of prices in the market and expect money on the basis of their predictions Arbitrageurs: They make a riskless profit by entering into transactions into two or more market simultaneously.
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