Presentation on Derivatives by Mr. Nayan Parikh to L&t baroda

Introduction to DerivativesL&T Vadodara

2121stst April, 2010 April, 2010

Presented By,Presented By,

Nayan ParikhNayan Parikh

CEO, Nayan Parikh & ConsultantsCEO, Nayan Parikh & Consultants

Ahmedabad.Ahmedabad.E mail: E mail: npcinfra@vsnl.net

Website: nayanparikh.comWebsite: nayanparikh.com

Derivatives

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Origin of DerivativesOver 2000 years ago, contracts for delivery in the

future was commonly used with Greek olive farmers

In the 1600s, Tulip derivatives were used by the Dutch and it was more or less only as Louis Bachelier in 1900 formally introduced futures pricing when people began to take derivatives at more than just face value.

More systematic derivative products initially emerged as hedging devices against fluctuations in commodity prices. Commodity linked derivatives remained the sole form of such product for almost 3 centuries.

Emergence of Financial Derivatives in the post-1970 period. These products are extremely popular and account for 2/3 of the total derivatives transactions.

What are derivatives?Derivatives really on a fundamental level

are:

– Merely pieces of paper or

– In modern days, electronic contracts

To give you a right or an obligation, or a combination of the two to receive or give something in the future

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OTC Derivatives Characteristics of OTC Derivatives market:– The management of counter-party

(credit) risk is located within individual institutions. No formal limit on individual positions, leverage, or margining.

– No formal rules of risk and burden sharing – No formal rules for ensuring market

stability and integrity – Lack of regulator, although they are

affected indirectly by national legal systems, banking supervision and market surveillance.

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Derivative is a product whose value is derived from the value of the underlying asset.

Underlying asset can be equity, forex, commodity, or any other asset say an agreement with your neighbour for 2 bags of sugar next week.

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Government RuleSecurity Contract (Regulation) Act,1956

[SC(R)A] defines derivative to include

A security derived from a debt instrument, share, loan (secured/unsecured), risk instrument or contract for differences or any other form of security

A contract which derives its value from prices, or index of prices, of underlying securities

Derivatives thus are securities under the SC(R)A and hence the trading of derivatives is governed by the regulatory framework under SC(R)A

Types of Derivatives

Future

Optionnpcinfra@vsnl.net

Future

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ForwardsForwards A forward contract is a customized contract A forward contract is a customized contract between two entities, where settlement takes place on a between two entities, where settlement takes place on a specific date in the future at today’s pre-agreed pricespecific date in the future at today’s pre-agreed price

Futures Futures A future contract is an agreement between A future contract is an agreement between two parties to buy or sell an asset at a certain time in the two parties to buy or sell an asset at a certain time in the future at a certain price. Futures are special types of future at a certain price. Futures are special types of forward contracts in the sense that futures are forward contracts in the sense that futures are standardized exchange-traded contracts.standardized exchange-traded contracts.

Forward Contracts An agreement to buy/ sell an asset on a

specified date for a specified price A bilateral contract with counter-party

risk exposure Each contract is custom designed Contract price is generally not available

publicly Reversing the contract needs mutual

agreement

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Meaning of FuturesExample:- Forwards Farmer growing any commodity Uncertainty about price- Supply and

demand function Merchant requires commodity Oversupply- he/she is having negotiation

power Years/time of scarcity- exposed to price risk

Example:- Futures Trade on MCX/ NCDEX/ NMCE

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Definition of Futures It is an agreement between the parties to

buy/ sell an asset at a certain price in future

A futures contract is a forwards contract which is traded on an exchange

Unlike forwards, they are standardized as in terms of: quantity, quality, and liquidity

Generally contracts are offset by an equal and opposite transaction

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Difference Between Forwards and FuturesFutures MarketFutures Market Forwards MarketForwards Market

LocationLocation Futures ExchangeFutures Exchange OTC/ Not FixedOTC/ Not Fixed

Size of ContractSize of Contract StandardStandard DependsDepends

Maturity/Expiry/ Maturity/Expiry/ Payment DatePayment Date

StandardStandard DependsDepends

CounterpartyCounterparty Clearing HouseClearing House Bank or clientBank or client

Market PlaceMarket Place Central Exchange with wide Central Exchange with wide networknetwork

Over the Phone with Over the Phone with worldwide networkworldwide network

ValuationValuation Marked-to-MarketMarked-to-Market No unique methodNo unique method

Variation MarginsVariation Margins DailyDaily NoneNone

RegulationsRegulations Regulated by ExchangeRegulated by Exchange Self-regulatedSelf-regulated

Credit RiskCredit Risk NoneNone CounterpartyCounterparty

SettlementSettlement Through Clearing houseThrough Clearing house DependsDepends

LiquidationLiquidation Offsetting the positionsOffsetting the positions Actual delivery Actual delivery

Transaction CostTransaction Cost Commission, charges, etc.Commission, charges, etc. Direct costs are lowDirect costs are low

Margins Buyers/ sellers are required to deposit a margin

on the contract Typically 5-10% of the contract value,

determined by the exchange & the clearing house based on expected volatility

Gains/ losses are netted against the initial margin: marking-to-market

In case the margin becomes too low, investors is required to replenish with maintenance margin (75% of initial margin)

If balance falls below the maintenance margin, investor receives a margin call and is required to deposit additional funds called variation margin

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S&P CNX Nifty Futures Instrument Type : FUTIDX Underlying : NIFTY Trading cycle: 3-month trading cycle - the near

month (one), the next month (two)& far month (three).

A new contract is introduced on the trading day following the expiry of the near month contract. The new contract will be introduced for a three month duration

Expiry day: on the last Thursday of the expiry month

Contract size: may not be less than Rs. 2 lakhs at the time of introduction. The permitted lot size for futures contracts & options contracts shall be the same for a given underlying or such lot size as may be stipulated by the Exchange from time to time.

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Permitted Lot Sizes of Contracts UnderlyingUnderlying SymbolSymbol Market LotMarket Lot

S&P CNX Nifty NIFTYNIFTY 5050

CNX IT CNXITCNXIT 100100

BANK Nifty BANKNIFTYBANKNIFTY 5050

Derivatives on Individual SecuritiesDerivatives on Individual Securities

ABB Ltd. ABBABB 250250

Associated Cement Co. Ltd. ACCACC 250250

Allahabad Bank ALBKALBK 20002000

Alok Industries Ltd. ALOKTEXTALOKTEXT 33503350

Andhra Bank ANDHRABANKANDHRABANK 20002000

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Clearing House Each contract between buyer-seller is

substituted by 2 contracts such that the clearing house become buyer to every seller and seller to every buyer

BUYER – Clearing House – SELLER

This removes counterparty risk

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Importance of Clearing House Entirely different but, works closely with

exchange for its smooth functioning and as ‘de facto’ guarantor for all transactions

Increases confidence of the traders, volume and liquidity

Maintenance of delivery schedules, delivery of underlying assets, delivery points, etc.

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Important Functions of Clearing House Ensuring adherence to system and

procedures for smooth trading Minimizing credit risk by being a

counterparty to all traders. Accounting for all the gains/losses on

daily basis. Monitoring the speculation margins. Ensuring delivery of payment for the

assets on the maturity date for all outstanding contracts.

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NSE Clearing House National Securities Clearing Corporation

Ltd. (NSCCL)

Clearing Members Clearing Banks Clearing & settlement process has three

main activities Clearing Settlement Risk management

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Arbitraging It is simultaneous purchase and sale of

similar assets in different markets to take advantage of price discrepancy.

Transaction cost reduces the profit of the arbitrageur to the minimum.

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Continue…… Arbitrage

Arbitragers work at making profits by taking advantage of discrepancy between prices of the same product across different markets.

Practitioners working within risk finance or quantitative finance often develop models to price various assets being traded across the markets

Upon finding price discrepancies, one can make use of a specific combination of derivatives in order to make a risk less profit.

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Types of Futures An index

Foreign Currency

An Interest-earning asset

A physical commodity

Futures on individual stock

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Hedging with Currency Futures An US exporter is exporting to Germany

On 01 May exported. Got confirmation that he would get DM 625,000 on 01 July

Risk: If DM depreciates there will be a loss

Hedge with selling DM futures

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Illustration 01 July: spot rate $/DM is 0.4407 1 July spot cash flow is $275,437.5 Sell 1 July DM 6,25,000 @ $/DM 0.4407 01, July: Dollar depreciates and spot

exchange rate is 0.4508 $ value of DM is (625,000*0.4508) =

281,750 Gain on the spot mkt is $281,750 –

$275,437.5 = $6312.5

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Commodity Futures Types of Commodity Futures:

- Agricultural Commodities

- Metallurgical Commodities

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OPTION

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Types of DerivativesTypes of Derivatives

Option Options are of two types:

– Calls & Puts

Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date.

Puts give the buyer the right but not the obligation to sell a given quantity of the underlying asset, at a given price on or before a given future date.

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Buyer of CallPremium – Rs. 40Ex. Price/St. Price – Rs. 400

Spot PriceSpot Price Exercise Exercise optionoption

Pay-OffPay-Off PremiumPremium P/(L)P/(L)

Up to Rs. Up to Rs. 399399

NoNo -- (40)(40) (40)(40)

Rs. 400Rs. 400 Yes/NoYes/No -- (40)(40) (40)(40)

Rs. 440Rs. 440 YesYes 4040 (40)(40) --

Rs. 500Rs. 500 YesYes 100100 (40)(40) 6060

Seller of CallSpot Spot PricePrice

Exercise Exercise OptionOption

Pay-OffPay-Off PremiumPremium P/(L)P/(L)

Up to Rs. Up to Rs. 399399

NoNo -- 4040 4040

Rs. 400Rs. 400 Yes/NoYes/No -- 4040 4040

Rs. 440Rs. 440 YesYes (40)(40) 4040 --

Rs. 500Rs. 500 YesYes (100)(100) 4040 (60)(60)

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Buyer of Put

Spot Spot PricePrice

Exercise Exercise OptionOption

Pay-OffPay-Off PremiumPremium P/(L)P/(L)

240 & UP240 & UP NoNo -- (24)(24) (24)(24)

Rs. 216Rs. 216 YesYes 2424 (24)(24) --

Rs. 0Rs. 0 YesYes 240240 (24)(24) 216216

Premium – Rs. 24Premium – Rs. 24Ex. Price – Rs. 240Ex. Price – Rs. 240

Seller of Put

Spot Spot PricePrice

Exercise Exercise PricePrice

Pay-OffPay-Off PremiumPremium P/(L)P/(L)

240 & 240 & UpwardUpward

NoNo -- 2424 2424

Rs. 216Rs. 216 YesYes (24)(24) 2424 --

Rs. 0Rs. 0 YesYes (240)(240) 2424 (216)(216)

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Hedging a long position in StockBuy stock in the spot mktRisk: price declineHedge the above risk by buying put

An investor buys a share for Rs. 100. Buys a put for Rs. 16 with an exercise price of Rs. 110. Profit/ Loss…

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Types of DerivativesSwaps – Interest Rate Swaps – Currency Swaps Swaptions are options to buy or sell a

swap that will become operative at the expiry of the options. Swaption is nothing but an option on a forward swap.Receiver Swaption is an option to receive fixed

and pay floating. Payer Swaption is an option to pay fixed and

receive floating.

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Types of Derivatives Warrants. Longer -dated options are called

warrants and are generally traded over-the-counter (OTC)

LEAPS Long-Term Equity Anticipation Securities. These are options having a maturity of up to three years.

Baskets Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average of a basket of assets. Equity index options are a form of basket options.

Swaps are private agreements between two parties to exchange cash flows in the future– Agreement on formula to be used for exchange of cash-flows is determined in advance npcinfra@vsnl.net

Exchange Traded Derivatives Market

Individuals trade standardized contracts that have been defined by the exchange. (First Futures contract were traded in 1865 in CBOT)

NSE’s derivatives marketCommencement of derivative trading withS & P CNX Nifty Index futures on 12/06/2000.Trading in index options commenced on 04/06/2001.Single Stock trading in options started on 02/07/2001Single Stock trading in futures started on 09/11/2001

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Derivatives Market-NSEThree Contracts are available for trading

with 1,2,3 month expiry. A new contract is introduced on the next trading day following the expiry of the near month contract.

Participants and Functions Self Clearing Member (SCM) Trading Member Clearing Member (TM-CM)Professional clearing Member (PCM)

Trading Mechanism Turnover

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Economic Functions of Derivative MarketDerivatives help in discovery of future

as well as current prices. The derivatives market helps to transfer

risks from those who have them but may not like them in comparison to those who have an appetite for them.

Speculative trades shift to a more controlled environment of derivatives market.

Act as a catalyst for new entrepreneurial activity.

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Uses of Derivatives Hedging

Done by parties who seek to offset their existing risks by entering into a derivatives transaction.

Existing risks could be an investment portfolio, price changes in oil for a petroleum mining company or perhaps investments in a foreign country.

Speculating Speculation is more commonly used by hedge

funds or traders who aim to generate profits with only a marginal investment

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Growth Driving FactorsIncreased volatility in asset prices in Financial

Markets

Increased integration between International Markets

Exponential improvement in communication at exceptionally reduced costs

Development of more sophisticated Risk Management tools, providing economic agents a wider choice of Risk Management strategies

Innovations in the derivatives markets, which optimally combine the risks and returns over a large number of financial assets leading to higher returns, reduced risk as well as transactions cost as compared to individual financial assets

Growth in Derivative Trading: NSEAverage Daily Turnover (Rs. cr.)

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Are Derivatives Dangerous?- "We view them as time bombs both for the parties

that deal in them and the economic system .. In our view ... derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.“

- Warren Buffett, the Chairman of Berkshire Hathaway and his critique of the derivatives market.

-Are derivatives dangerous?

-That's almost like asking if water is dangerous.

-Derivatives can be dangerous if used incorrectly - as several large companies and individuals have found out in recent history.

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Continue………Derivatives contribute to the 'completeness'

of the global markets, and without them, loopholes within the financial industry would exist.

Even through numerous financial disasters ala Barings, LTCM, Enron and others related to the mismanagement of derivatives

It is key to consider that it has not been the use of derivatives as a tool which has led to the downfall of these companies - but rather, the misuse and compromise of such instruments.

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STRUCTURED PRODUCTS

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Structured investments arose from the needs of companies which want to issue debt more cheaply.

Combinations of derivatives and financial instruments create structures targeted investments tied to their specific risk profiles, returns requirements and market expectations.

In India, equity related structured products seem to be in violation of the Securities Contract Regulation Act (SCRA). SCRA prohibits the issue and trade of equity derivative except those which trade on nationally recognized stock and derivatives exchange. npcinfra@vsnl.net

Benefits of Structured ProductsPrincipal Protection

Tax-efficient access to fully taxable investments

Enhanced returns within an investment

Reduced volatility (or risk) within an investment

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State Highways of MP :

From the Government’s perspective

Projects with government subsidy

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• Conditions of roads in MP has substantially deteriorated over last few years.

• The bad conditions of roads led to lower traffic

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Bad roads

Projects not viable on BOT

basis

Reduced Traffic

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• To make an impact, 14 roads of 2000 kms of length were taken up for reconstruction / widening

• These were the highest traffic density state highways of MP

• The DPRs of these roads were prepared and the total capital expenditure for the projects was around Rs. 1000 crores

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• The GoMP decided to raise Rs. 500 crores through Government guaranteed bonds for road reconstruction projects. The repayment of the bonds would happen through the deduction from budgetary allocation to MPPWD in five years.

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• The initial idea was to reconstruct all these roads by the MPPWD only. However this approach had following limitations:

- Only 1000 kms of seven roads could be reconstructed

- It was not possible to raise more than Rs. 500 crores as MPPWD budgetary allocation did not have more debt servicing capacity

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- As the road condition had deteriorated substantially, the capital expenditure could not be reduced without compromising on the quality of reconstructed roads

- After reconstruction the regular maintenance of the roads would again be with MPPWD and had the risk of poor maintenance in years to come

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• In the above scenario the following options were considered:

- To reconstruct only seven roads of 1000 kms that can be completed in Rs. 500 crores

- To reconstruct some roads completely and on the remaining roads only very bad patches to be repaired

- To maintain these roads from the toll to be collected by MPPWD on completed roads

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• As all the above options were not found very suitable the following option was developed

- To take up all roads on BOT basis with maintenance on BOT developer for the concession period with a provision of capital subsidy from MPPWD to make the projects viable

- Rs.500 crores were to be utilized by MPPWD to provide capital subsidy to BOT developers

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• After a lot of deliberation the option of BOT with MPPWD subsidy was chosen. It was estimated that though subsidy would differ from road to road, in aggregate for all roads 50-60% of project costs will come from MPPWD as subsidy and the remaining would come from BOT developers. The BOT developers would then maintain the roads for the concession period as per the decided standards

• Project cost on an average of Rs. 50 lacs per km.

• Total road length 1700 kms

• Concession Period : 15 years

• Roughness index during concession Period : 3500mm/km

• Subsidy : ______ bid criterion

• IRR : 20 %

• Bad patches to be repaired in four months of signing concession agreement to create positive atmosphere among road users

• GoMP adopted uniform toll rates for the state.The rates are:

Category Rates/km/trip

Car / Jeep Rs. 0.25

LCV/ Mini Bus Rs. 0.60

Bus Rs. 1.25

Truck Rs. 1.50

Multi axle Rs. 3.00

Toll rates to increase @ 7 % per year

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• Toll booths at locations to cover homogeneous sections

• For part/full travel on homogeneous sections, the toll for that section would be charged.

• Local traffic/traffic during important social religious event exempt

• Toll can start on a completed homogeneous section

• Seven roads of 983 kms of length already awarded on BOT basis

• Total Project Cost Rs. 522 crores

• Total subsidy asked Rs. 245 crores

• Concession Agreements signed

• Work on sites commenced

• Financial closure expected in coming two months.

• Roads likely to be completed in 15-18 months by the last quarter of year 2002

• This is for the first time in India that a state has awarded around 1000 kms of important state highways on BOT basis. This was possible by structuring the commercially unviable projects on viable format with the help of government subsidy

• Looking to this success many Governments are likely to follow the public-private partnership for reconstruction and maintenance of important state highways

THANK YOUTHANK YOUNayan ParikhNayan ParikhNayan Parikh & Consultants,Nayan Parikh & Consultants,303-B, Shapath- III, Nr. GNFC Info. Tower303-B, Shapath- III, Nr. GNFC Info. TowerAhmedabad.Ahmedabad.Ph- +91-79-2684 0022Ph- +91-79-2684 0022Fax- +91-79-2685 1183Fax- +91-79-2685 1183Email – Email – npcinfra@vsnl.netWebsite-www.nayanparikh.comWebsite-www.nayanparikh.com

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