Derivatives Ppt

THE WORLD OF DERIVATIVES THE WORLD OF DERIVATIVES

MARKETMARKET

HOW MUCH DO YOU HOW MUCH DO YOU KNOW ABOUT CAPITAL KNOW ABOUT CAPITAL

MARKET ??MARKET ?? LIKE A CRICKET IT IS MADE UP OF LIKE A CRICKET IT IS MADE UP OF

PLAYERS, RULES AND PLAYERS, RULES AND INSTRUMENTS INSTRUMENTS

WHAT INSTRUMENTS ?WHAT INSTRUMENTS ?

BONDSBONDS DEBEUTURESDEBEUTURES GOVT. SECURESTES – LIKE TBsGOVT. SECURESTES – LIKE TBs EQUTIES / STOKS EQUTIES / STOKS ?? ??

““DERIVATIVE” ?DERIVATIVE” ?

IS IT SOMETHING DERIVED ON IS IT SOMETHING DERIVED ON THE BASIS OF SOME OTHER ??THE BASIS OF SOME OTHER ??

WHAT ARE WHAT ARE DERIVATIVES ?DERIVATIVES ?

NOT SECURITES ISSUED BY AN ENTITYNOT SECURITES ISSUED BY AN ENTITY A CONTRACTS WHICH DERIVE VALUE A CONTRACTS WHICH DERIVE VALUE

FROM THE PRICES, OR INDEX OF FROM THE PRICES, OR INDEX OF PRICES OF UNDERLYING SECURITIESPRICES OF UNDERLYING SECURITIES

A SECURITY DERIVED FROM A DEBT A SECURITY DERIVED FROM A DEBT INSTRUMENT, SHARE, LOAN OR ANY INSTRUMENT, SHARE, LOAN OR ANY OTHER FORM OF SECURITY.OTHER FORM OF SECURITY.

DERIVATIVE……

THE ‘UNDERLYING’ MAY BE ANYTHING :

STOCK COMMODITY CURRENCY INT. RATE AN INDEX, ETC.

FUNDAMENTAL FUNDAMENTAL DIFFERENCSDIFFERENCS

STOCKS / SHARES DERIVATIVES

1. SPOT DELIVERY 1. DEFERRED DELIVERY

2. ISSUED BY AN ENTITY

2. WRITEN BY PARTIES

3. VALUE IS REAL 3. VALUE IS NOTIONAL

4. TRADED IN BOTH PRIM./SEC. MARKETS

4. TRADED IN SECONDARY MARKET ONLY

5. BALANCE SHEET ITEMS

5. OFF – BALANCE SHEET ITEMS

6. LONG LIFE SPAN 6. SHORT LIFE SPAN

WHY WERE DERIVATIVES WHY WERE DERIVATIVES CREATED ?? CREATED ??

DEFINITELY NOT FOR FUN !!!DEFINITELY NOT FOR FUN !!!

WHY WERE DERIVATIVES WHY WERE DERIVATIVES CREATED ?? CREATED ??

CONVERTING PROBLEM IN TO AN CONVERTING PROBLEM IN TO AN OPPORTUNITYOPPORTUNITY

DERIVATIES MARKET WAS AN DERIVATIES MARKET WAS AN ANSWER FOR THE PHENOMENA OF ANSWER FOR THE PHENOMENA OF RISKRISK

FACTORS CONTRIBUTING TO FACTORS CONTRIBUTING TO THE GROWTH OF THE GROWTH OF

DERIVATIVESDERIVATIVES

1. Volatile exchange & internet rates 1. Volatile exchange & internet rates

1. Exchange Rates 1. Exchange Rates

(Breakdown of Bretton Woods)(Breakdown of Bretton Woods)

2. Interest Rates (Increasing inflation)2. Interest Rates (Increasing inflation)

2. Globalization of markets2. Globalization of markets

1. Commodity prices (petrol, gold, 1. Commodity prices (petrol, gold, etc.,) etc.,)

2. Stock prices 2. Stock prices

(Integration of capital markets)(Integration of capital markets)

FACTORS……………..FACTORS……………..

11. Technological Advances:. Technological Advances: Internet Internet Telecommunication Telecommunication

2. Advances in financial 2. Advances in financial theories:theories:

Options pricing modelOptions pricing model CAPMCAPM

Types of Derivatives Types of Derivatives

DerivativesDerivatives

Traded in Organised Markets Traded in Organised Markets Traded in OTC Traded in OTC Markets.Markets.

Futures Futures OptionsOptions

Interest Rate Interest Rate Currency Currency Equity Equity CommodityCommodity

Types of Derivatives Types of Derivatives

DerivativesDerivatives

Traded in Organised Markets Traded in Organised Markets Traded in OTC Traded in OTC Markets.Markets.

Forwards Forwards FRAs FRAs OptionsOptions SwapsSwaps

Interest Rate Interest Rate Currency Currency Equity Equity CommodityCommodity

Forward ContractForward Contract

An agreement between two An agreement between two partiesparties

To buy/sell an assetTo buy/sell an asset At an agreed – upon priceAt an agreed – upon price On a specified future date On a specified future date

FRAFRA

A contract between two partiesA contract between two parties To apply a specified interest rateTo apply a specified interest rate To a notional future loanTo a notional future loan For a specified periodFor a specified period

FuturesFutures

StandardisedStandardised Transferable, and Transferable, and Exchange tradedExchange traded Forward contractsForward contracts Futures contracts are ‘written’ Futures contracts are ‘written’

and put to sale on boursesand put to sale on bourses

OptionsOptions

A contract between two partiesA contract between two parties To buy / sell the underlying asset To buy / sell the underlying asset

at a specified price on a specified at a specified price on a specified future date.future date.

The writer of option is called the The writer of option is called the seller seller

The buyer of option is called the The buyer of option is called the holderholder

SwapsSwaps

Agreements between two parties Agreements between two parties To exchange assets or sets of To exchange assets or sets of

financial obligationsfinancial obligations For a specified period of timeFor a specified period of time At predetermined intervals At predetermined intervals

DISTINCTION BETWEEN EXCHANGE DISTINCTION BETWEEN EXCHANGE TRADED AND OTC DERIVATIVESTRADED AND OTC DERIVATIVES

OTC derivatives Exchange – traded derivatives

Traded on a private basis and bilaterally negotiated

Traded on the floor of an exchange

Customized to the needs of individual customers

Standardized

Prices are less transparent

Prices are transparent .

Market players known to each other.

Market players not known to each other.

Positions cannot be easily closed or transferred

Positions can be easily closed out

Contd…Contd…

Majority of the contracts result in physical delivery

Very few contracts result in physical delivery

Less liquid Highly liquid

Open to counterparty and legal risk

Do not involve counterparty and legal risk

Contd…Contd…

GLOBAL DERIVATIVES GLOBAL DERIVATIVES MARKET MARKET (Organized Exchanges)(Organized Exchanges)

Derivatives Instrument type

Notional value ( Jan 10) (in trillion $)

1. Futures a. interest rate b. Currency c. Equity index

23.50.11.0

2. Options a. Interest rate b. currency c. Equity index

51.30.25.3

Total 81.4

GLOBAL DERIVATIVES GLOBAL DERIVATIVES MARKETS (OTC MARKET)MARKETS (OTC MARKET)

Derivatives Instrument type

Notional value - Jan 10 (trillion $)

1. Fx contracts (forwards + swaps + options)

49.2

2. Interest rate (FRA + swaps + options)

449.8

3. Equity linked (forwards+ swaps + options)

6.6

4. Commodity contracts (forwards + swaps + options)

2.9

5. Credit default swaps 32.7

Total 541.2

DERIVATIVES MARKET DERIVATIVES MARKET IN INDIA IN INDIA

DERIVATIVES instrument type

Turnover (2008-09) (trillion Rupees)

1. Index futures2. Stock futures

115.4

3. Index options4. Stock options

133.3

COMMODITY FUTURES COMMODITY FUTURES MARKET IN INDIA MARKET IN INDIA

FMC is the regulatory authorityFMC is the regulatory authority Three national level com exchanges:Three national level com exchanges:

NCDEXNCDEX NMC of IndiaNMC of India Multi Comm. Exchange of IndiaMulti Comm. Exchange of India

Over 70 commodities traded (over 50 are agri-Over 70 commodities traded (over 50 are agri-commodities)commodities)

Cotton, Maize, Coffee, Sugar, etc.,Cotton, Maize, Coffee, Sugar, etc.,

ROLE OF DERIVATIVES ROLE OF DERIVATIVES MARKET MARKET

Price discoveryPrice discovery Risk managementRisk management Transactional efficiency Transactional efficiency Catalyze entrepreneurial activityCatalyze entrepreneurial activity Revitalizing the capital markets Revitalizing the capital markets

DERIVATIVES MARKET DERIVATIVES MARKET ALAS !! THERE IS OTHER ALAS !! THERE IS OTHER

SIDE TO ITSIDE TO IT

May flare up speculative May flare up speculative pressure (leverage effect)pressure (leverage effect)

Increase the risk (OTC Market)Increase the risk (OTC Market) Destabilize the financial Destabilize the financial

systemsystem

WARREN BUFFETT WARREN BUFFETT BRADED DERIVATIVEA AS BRADED DERIVATIVEA AS

WMDsWMDs

Examples of derivative debacle:Examples of derivative debacle: Lehman brothers Lehman brothers Proctor & gambleProctor & gamble Orange countyOrange county Barings bankBarings bank

CONCLUSION: GLOBAL CAPITAL CONCLUSION: GLOBAL CAPITAL MARKETS ARE NOT PERFECT; MARKETS ARE NOT PERFECT; AREN’T RATIONAL EITHER !!! AREN’T RATIONAL EITHER !!!

1. Derivatives are not ‘magic’ 1. Derivatives are not ‘magic’

instrumentsinstruments 2. They are like H.T power line2. They are like H.T power line

If used carefully – wonderful resultsIf used carefully – wonderful results If mishandled – disasterIf mishandled – disaster

3. Strong regulatory framework needed 3. Strong regulatory framework needed – to ensure safety of financial system– to ensure safety of financial system

The journey of DM has The journey of DM has just begun ; it would take just begun ; it would take long time for stabilizationlong time for stabilization

Long live DERIVATIVES. !!!Long live DERIVATIVES. !!!

Contd…Contd…

THANK YOU ALLTHANK YOU ALL