Ragumoorthy Nehrumoorthy
Presentation by,
Indian History of Derivatives
The Bombay Cotton trade association started future Trading in 1875
In 1952 the government banned cash settlement and Option Trading
In 1995 a Prohibition of trading options was lifted
In 1999, the Securities Contract (Regulation) Actof 1956 was amended and derivatives could beDeclared “securities”
NSE Started trade in future and option by 2005
A Derivative is a Financial Instrument whose value depends on – is derived from – the value of some other financial instrument, called the underlying asset.
Derivative is . . . .
The value of derivative is linked to risk or volatility inEither financial asset, transaction, market rate, orcontingency, and creates a product
Underlying AssetsStocks
Interest Rates
Precious Metals
Agricultural Commodities
Crude Oil
Bonds
Foreign Exchange Rate
T-Bill
Features of Derivatives
Traded on Exchange
All Transaction in derivatives take place in futurespecific date
Hedging Device-Reduces Risk
Derivatives are often leveraged, such that a small movement in the underlying value can cause a Large difference in the value of the derivative
Basic Purpose of Derivatives
In Derivative Transactions, one party’s loss is always another party’s gain
The main purpose of derivatives is to transfer risk from one person or firm to another, that is, to provide insurance
If a farmer before planting can guarantee a certain price he will receive, he is more likely to plant
Derivatives improve overall performance of the economy
Types of Derivatives Contract
Forwards Swaps
Options
Futures
Futures
A Financial contract obligating the buyer to purchase anasset, (or the seller to sell an Asset), such as a physicalcommodity or a financial instrument, at a predeterminedFuture date and price.
Some of the most popular assets on which futuresContracts are available are equity stocks, indices,Commodities and Currency
Margin accounts andmarking to market
Clearing Corporation requires initial deposits in amargin account
Tracks daily gains and losses and posts these to margin accounts
The contract is settled daily basis which is known as “Marking to Market”
Practical View on Futures & Clearing Corporation
Forwards
A forward contract is a customized contract between two entities, where settlement takes place as a specific date in the future at Predetermined price
Normally traded outside exchange
Forwards are also known as Private Contracts
Options
The owner of the option has option to sell or buy assetsat a given price on or before given date
American Option European Option
An option that may beexercised on any tradingDay on or before expiry
An option that may only beexercised on expiry date
Important Concepts of Option
Options
Call Option – a right to buy an asset at a predeterminedprice (strike price) on or Before a specific date
If asset price is higher than the strike price - Option is in the moneyIf asset price is exactly at the strike price - Option is at the moneyIf asset price is below the strike price
- Option is out of the money
Obviously would not exercise an option that is out of the money
Options
Put Option – a right to sell and asset at a predeterminedPrice on or before a specific date
If asset price is lower than the strike price - Option is in the moneyIf asset price is exactly at the strike price - Option is at the moneyIf asset price is higher than the strike price
- Option is out of the money
SwapsSwaps are private agreement between two parties toexchange cash flows in the future according to apre-arranged formula
They can be regarded as portfolio of forward contracts
The two commonly used Swaps are:
(i)Interest Rate Swaps : A interest rate swap entails swapping only the interest related cash flows between the parties in the same currency.
(ii) Currency Swaps : A currency swap is a foreign exchange Agreement between two parties to exchange a given amount of one currency for Another and after a specified period of time, to give back the original Amount swapped.
Practical View on SWAPS
Types of Derivatives Markets
Over-the-Counter derivatives :
Contracts that are traded between two parties directlywithout going through an exchange
Forward and Swap Contracts are OTC derivatives
Exchange-traded derivatives :
Contracts that are traded in derivatives exchanges
Market PlayersHedgers – Transfer of Risk component of their portfolio
Speculators – Intentionally taking the risk from the Hedgers in pursuit of profit
Arbitrageurs – Operating in different markets Simultaneously, in pursuit of profit and eliminatemis-pricing
Any Questions ?