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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
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
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.
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) =
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.
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
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 [email protected]
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
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.)
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.
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.
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. [email protected]
Benefits of Structured ProductsPrincipal Protection
• 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.
- 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
• 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
• 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:
• 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