Derivatives. What is Derivatives? Derivatives are financial instruments that derive their value from the underlying assets(assets it represents) Assets.

Derivatives

What is Derivatives?• Derivatives are financial instruments that derive

their value from the underlying assets(assets it represents)

• Assets which it represents can be equity, debt securities, currency, bullion, commodity, rate of interest or even livestock.

• A feature that is common to all underlying assets is that they carry the risk of change in value.

• The value of stock may rise or fall, an exchange rate may swing in favor of one currency, the price of a commodity may increase or decrease.

• Derivative contracts seek to transfer these risks from an individual who is not comfortable to the risk to the one who is.

Use of Derivatives• To hedge risk

Hedging –a risk mgmt. strategy to offset the probability of loss from fluctuations in the prices of assets (securities, commodities, currency etc.)

• To speculateSpeculation-  a method of short term investing whereby

traders essentially bet on the direction, an asset’s price will move.

• ArbitrageArbitrage-The simultaneous purchase and sale of equivalent

assets or of the same asset in multiple markets in order to exploit a temporary discrepancy in prices.

Types of Derivatives• Forwards/Futures• Options• Swaps

Forwards and Futures ContractForward Contract: It is a contractual agreement where two private parties agree to trade a particular asset with each other at a pre-determined price and time in the future.• It is traded in over-the-counter, not an exchange.

Futures contract: it is a standardized version of forward contract that is publicly traded on a futures exchange.

Forwards Futures

Traded on Over-the-counter or Off the exchange

Traded on an exchange

Delivery or cash settlement on expiry Contract usually closed out before maturity

No payments made before expiry Daily cash payments- mark to market basis

Negotiable contract Standardised contract

High counter party risk Low counter party risk

Forwards and Futures Contracts

Characteristics of Futures Contract• Standardised contract sizes and delivery dates.• Regulated Market• Low risk default• Margin required• Liquid Market

Getting to know the term:Long = PurchaseLong (purchase) the derivative contract

Short = Sell Short (sell) a derivative contract

Exchange and the Operation of Margins• If two investors get in touch directly and agree to

trade an asset in a future for a certain price, there is risk of one dishonoring the agreement.

• Key roles of the Exchange is to organize trading so that contract defaults are avoided. This is where margins come in.

Operations of Margin• Investors are to create Margin Account.• The amount that must be deposited in same is known as

Initial Margin.• At the end of each trading day, the margin account is

adjusted to reflect investor gain or loss. (mark to market)• To ensure that the balance of the margin account never gets

negative, a Maintenance Margin (mm) is set.• If balance falls below mm, investor receives Margin call and

is expected to top up the margin account to the initial margin level by the end of next day.

• Extra fund deposited are known as a Variation Margin.• If investor fails to provide variation margin, broker closes out

the position.

Example of Futures Trade

OptionsA contract that provides option holder the right, but not obligation to buy or sell agreed underlying asset at a specified price on or before a specified date.

• Option holder pays a premium for holding option right to option writer.

• Option writer is under obligation to exercise the contract if option holder is exercising the contract.

• The price specified in the contract is known as exercise or strike price.

• The date specified in the contract is known as the expiration date or maturity date.

Options are broadly divided into two types:1. Call Option2. Put Option

Call Option• Call option is an agreement between two parties,

where holder of the option has a right but not the obligation to buy underlying asset at a pre-determined price(exercise price) by a certain date.

Call Payoff Diagram

Put Option• Put option is an agreement between two parties,

where holder of the option has a right but not the obligation to sell underlying asset at a pre-determined price(exercise price) by a certain date.

Options can be either American or European in terms of time to exercise.American Option = exercised at any time up to the expiration date.European Option = exercised only at the expiration date.

Put Payoff Diagram

Swaps• Agreement to exchange cash flow in the future.• It defines the date when cash flows are to be paid

and the way they are to be calculated.

Types of Swaps• Interest rate swaps• Currency swaps• Credit default swaps

Interest Rate SwapsThe most common type of swap is ‘plain vanilla’ interest rate swap.

- company agrees to pay a cash flow equal to interest at a predetermined fixed rate on a notional principal for a predetermined number of years.

- In return, it will receive a cash flow equal to interest at variable (floating) rate on a same notional principal for the same period of time.

• Interest rate swap between Microsoft and Intel

Microsoft Intel5.0%

Libor

Currency Swaps• This involves exchanging principal and interest

payments in one currency for principal and interest payments on another.

• It requires, principal to be specified in each of the two currencies.

• Principal amounts are chosen to be approximately equivalent using the exchange rate at the swap’s initiation.

Currency swap between Reliance and Chaudhary Group

Reliance Group Chaudhary Group

INR 4% (10m)

NPR 5% (16m)

Credit Default Swaps• Swaps that insure against default of municipal

bonds, corporate debts etc.• They are sold by insurance firm, banks who

collect premium for providing the insurance.A company issues a bond (asking for a loan from whoever buys the bond). Several companies buy the bond (lend the money), but want to make sure they don't get burned in the off-chance the company goes bankrupt. They purchase a credit default swap from a third party, which guarantees the bond.