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Module 1: Introduction
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CONTENTS
• Defnition o derivative contracts• Types o derivatives
• Underlying assets• Derivative ar!ets in India• "egulation o derivatives in India
• "easons or derivatives trading
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#$at is a Derivative%
• A derivative is an instrument whose valuedepends on, or is derived from, the valueof an asset that underlies the contract.
• Examples: futures, forwards, swaps,options, exotics…
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#$y Derivatives &reI portant
• Ris !ransfer: "erivatives pla# a e# role in transferrin$ ris sin the econom#
• %ar$e &ariet# of 'nderl#in$ Assets: !he underl#in$ assetsinclude stoc s, currencies, interest rates, commodities, de(tinstruments, electricit#, insurance pa#outs, weather, etc
• Em(edded "erivatives: )an# financial transactions haveem(edded derivatives
• Real *ptions + apital -ud$etin$: !he real options approachto assessin$ capital investment decisions has (ecomewidel# accepted
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'o( Derivatives &re Traded
• *n exchan$es such as the hica$o -oard*ptions Exchan$e, /0E, -0E
• n the over the counter *! 4 mar etwhere traders wor in$ for (an s, fundmana$ers and corporate treasurerscontact each other directl#
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Si)e o OTC and E*c$ange+Traded Mar!ets,-igure 1.1/ 0age 2
Source: Bank for International Settlements. Chart shows total principal amounts forOTC market and value of underlying assets for exchange market
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T$e 3an!ruptcy o 4e$ an 3ros.
• %ehman -ros. filed for (an ruptc# on 0eptem(er 15,2778. !his was the (i$$est (an ruptc# in '0 histor#
• %ehman was an active participant in the *!derivatives mar ets and $ot into financial difficulties(ecause it too hi$h ris s and found it was una(le toroll over its short term fundin$
• t had hundreds of thousands of transactions
outstandin$ with a(out 8,777 counterparties• 'nwindin$ these transactions has (een challen$in$for (oth the %ehman li9uidators and theircounterparties
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-or(ard Contracts
• &n agree ent to 5uy6sell an asset at aspecifed uture date at a specifedprice
• T$e party ($o agrees to 5uy t$e assetis said to $ave a long position
• T$e party ($o agrees to sell t$e assetis said to $ave a s$ort position
• In OTC or(ards are traded 5et(eenfnancial institutions
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-or(ard Contracts7
Originated pri arily to protect cos. ro :• "evenue+side ris!s
• Cost+side ris!s
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-oreign E*c$ange 8uotes or 930/May ;/
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-or(ard 0rice
• !he forward price ma# (e different forcontracts of different maturities as shown (#
the ta(le4
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0ayo=s ro -or(ards
• 0ayo=s can 5e >ve or ?ve• &s t$ere is no cost o entering into a
or(ard contract t$e payo= itsel is t$etrader@s net gain 6 loss
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E*a ple 1
• *n )a# 2 , 2717 the treasurer of an )/enters into a lon$ forward contract to (u# <
• !his o(li$ates the corporation to pa#=1, 2,277 for
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0roft ro a 4ong -or(ard 0osition,AB -or(ard price/ S T B 0rice at aturity2 B S T + A
0roft
0rice o Underlyingat Maturity/ S T K 7
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0roft ro a 4ong -or(ard
• 0arty $aving a long position $asli ited do(nside 5ut unli itedupside
• 0rice o t$e asset at aturitycannot 5e <
• In suc$ case t$e long party loses aa*i u a ount B -or(ard price,A2 agreed earlier
• 0rice at aturity can increase 15
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0roft ro a S$ort -or(ard 0osition ,AB-or(ard price/ S T B 0rice at aturity2 B A + S T
0roft
0rice oUnderlying
at Maturity/S
T
K 7
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0roft ro a S$ort -or(ard
• 0arty $aving a s$ort or(ardposition $as li ited upside 5utunli ited do(nside
• 0rice o t$e asset at aturitycannot 5e <
•In suc$ case t$e s$ort party gainsa a*i u a ount B -or(ardprice ,A2 agreed earlier
• 0rice at aturity can increase 1
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-utures Contracts
• A$reement to (u# or sell an asset for aspecified price at a specified future time
• A standardised forward contract• A forward contract is traded *! , while a
futures contract is traded on an exchan$e
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#$y are -utures "e uired%
• Counterparty ris!• E*it ec$anis
• Standardised uantity
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E*c$anges Trading -utures
• '0: )E roup formerl# hica$o)ercantile Exchan$e and hica$o -oardof !rade4, /B)EC
• -raDil: -)+• ! E !o #o4ndia:
• "erivative 0e$ment of -0E• +* 0e$ment of /0E
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E*a ples o -utures Contracts
A$reement to: F -u# 177 oD. of $old G '0=1 77>oD. in
"ecem(er F 0ell ((l. in
April
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Options
• An option contract $ives the holder theri$ht to (u#>sell the underl#in$ asset (# aspecified future date for a specified price
• 2 t#pes: all + Hut options• A call option $ives the holder ri$ht to (u#• A put option $ives the holder ri$ht to sell
• !he writer of the option has the o(li$ationto ta e the opposite position of the holder
• !he holder ma# not exercise the ri$ht22
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9oogle Call Option 0rices , une 1F/
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9oogle 0ut Option 0rices , une 1F/
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Options vs -utures6-or(ards
• A futures>forward contract o(li$ates (othparties to (u# or sell at a specified price
• An option o(li$ates onl# one part#, writer, to(u# or sell at a specified priceJ $ives theholder onl# the ri$ht to (u# or sell + not theo(li$ation
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Types o Traders
• Ked$ers• 0peculators•
Ar(itra$eurs
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'edging E*a ples ,pages 1
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Kalue o Microso t S$ares (it$ and(it$out 'edging ,-ig 1.;/ page 1 2
27 22 2 26 28 37 32 3 36 3827,777
25,777
37,777
35,777
7,777
/o Ked$in$
Ked$in$
Stock Price ($)
Value of Holding ($)
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Speculation Strategies: xample !• & ore* ar!et player e*pects in -e5ruary t$at
t$e 930 (ill appreciate against t$e USD in t$ene*t ont$s. 'e (ants to invest USD orcreating a position in 930 F
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Speculation Strategies: xample !
1. 0urc$ase 930 F
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Speculation Strategies: xample !
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O"servations on Speculation Strategies: g. !
• T$e frst strategy re uires an initial invest ent oUSD F11 F< ,B F
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Speculation Strategies: xample B
• An investor has /R 2,777 for investment andexpects that the price of a stoc will increase over thenext 2 months. !he current price of the stoc is /R
27. urther the price of a 2 month call option with astri e of /R 22.57 is /R1.77. 1 call option contractincludes 177 options with 1 call option for 1 share.
• "iscuss alternative strate$ies + evaluate them whenthe endin$ stoc price is /R 2 + /R15.
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Speculation Strategies: xample B
1. -u# 177 shares in the cash mar et + hold theshares until the end of the 2 month period.
After 2 months li9uidate the holdin$.2. -u# 27 call option contracts 1 contract L 177
call options, with 1 call option for 1 share4 L27C177 L 2777 call options on 2777 shares4
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Speculation Strategies: xample B
Profts (Losses) rom Strategies 1 & 2Ending 0rice a ter ont$s
Strategy IN" 1F IN" "ange1. 3uy 1
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O" ti S l ti St t i
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O"servations on Speculation Strategies
• T$e profts losses o t$e call option strategy are
uc$ $ig$er t$an t$e $olding+t$e+stoc! strategy• T$e volatility o profts in t$e call option strategyis uc$ ore t$an t$e $olding+t$e+stoc! strategy
• #$en t$e stoc! price rises t$e $olding+t$e+stoc!
strategy starts earning proft 5e ore t$e calloption strategy• #$en t$e stoc! price rises t$e proft in t$e call
option strategy increases uc$ aster t$an t$e
$olding+t$e+stoc! strategy• T$e upside potential i pact o t$e call option
strategy is uc$ ore t$an t$e do(nsidepotential i pact co pared to t$e $olding+t$e+stoc! strategy 3
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Speculation Strategies: Caution
• 'olding+t$e+stoc! is aconservative strategy t$e calloption strategy is an aggressivestrategy
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!r"itrage: #hy $
#hat%
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!r"itrage&
• All theories on asset pricin$ or derivativespricin$ create a set of conditions for arrivin$
at the price such that /* AR- !RA E willta e place• /* AR- !RA E */" ! */
• !he price thus derived will (e theoreticall#4the most sta(le price
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!r"itrage
• Ar(itra$e is the economic process whichtries to eep the prices where the# should (e
(# eliminatin$ all differences• Kowever Must (ecause the possi(ilit# of
ar(itra$e is there, the prices will not alwa#s
(e where the# should (e
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!r"itrage: ! Simple xample
• A stoc is 9uoted as -H177 in %0E +'0"1 7 in /B0E
• !he current '0" -H exchan$e rate is1. 377
• s there an# ar(itra$e opportunit#@
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!r"itrage&
0ome conditions in which price distortions ma#still (e there:• !axes
• !ransportation costs• /e$li$i(le ar(itra$e $ains compared to otherforms of (usiness opportunities
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'ossi"ilities (eading to )olatility
• !raders can switch from (ein$ hed$ers tospeculators or from (ein$ ar(itra$eurs tospeculators
•t is important to set up controls to ensure thattraders use derivatives onl# for their intended
purpose
* d l i
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*nderlying
• T$e value t$e utility o a derivative arisesout o t$e underlying
• T$e underlying could 5e a real asset li!e aco odity/ or a fnancial asset li!e e uities
or currencies or so et$ing a5stract li!estoc! inde*/ interest rates/ (eat$er orelectricity
• &ccordingly t$ere are ? co odityderivatives/ stoc! derivatives/ currencyderivatives/ inde* derivatives/ interest ratederivatives/ credit derivatives (eat$er
derivatives 5
i i B d * d l i
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+erivatives Based on *nderlying
1.Co odity derivatives:• Operators try to $edge t$eir interests ro t$e
rise 6 all in co odity prices due to supply+de and variations caused 5y various actors
• May result in cas$ 6 p$ysical settle ent
.Stoc! derivatives:•
Derivatives 5ased on e uity s$ares o verygood co panies or $edging volatility inar!et values
• 3ot$ utures options are traded6
i i B d * d l i &
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+erivatives Based on *nderlying&
. Currency derivatives:• -or(ards/ -utures and Options on aPor
currencies• Mainly or $edging e*c$ange rate volatility
;. Inde* derivatives:• -utures contracts on aPor stoc! indices
• Used to $edge 6 anage volatility o ar!etvalues
• -utures contracts ust $ave ini u
contract value as prescri5ed 5y t$e regulators
i i B d * d l i &
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+erivatives Based on *nderlying&
F. Interest "ate Derivatives:• T$ese derivatives are designed to $edge
e*posure to interest rate volatility• Mainly used to protect 5ond port olios or
lending+5orro(ing transactions• types: -"& ,OTC2/ Interest rate utures
,e*c$ange traded2
L. Credit Derivatives:• Designed or 5an!ers lenders to protect
ro credit ris!s6de ault ris!s ? Credit
De ault S(ap 8
+ i ti k t i I di
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+erivative ,arkets in India
• Types o derivatives: Co odityderivatives/ e*c$ange traded e uityderivatives/ interest rate derivatives
currency derivatives• Introduction o inde* utures in NSE 3SE in une
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+erivative ,arkets in India&
• Co odity derivatives (ere reintroduced inIndia in t$e early
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+erivative ,arkets in India&
• Currency utures introduced in NSE in&ugust
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-egulation of +erivatives in India
• Defnition o securities in t$eSC"&/ 1HFL $as 5een a endedto include derivative contracts
• So e uity 5ased derivatives areregulated in India 5y SC"&/ 1HFL
SE3I &ct/ 1HH• Currency derivatives ,e*c$angetraded2 are regulated 5y "3I as(ell as SE3I 52
egulation of +erivatives in India
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-egulation of +erivatives in India• &ll co odity derivatives in India
are 5ased on agriculturalco odities
• Co odity or(ard contracts areregulated 5y -or(ard Mar!etsCo ission ,-MC2 under t$e-or(ard Contracts ,"egulation2 &ct/1HF
• Ministry o Consu er &=airs/ -ood
0u5lic Distri5ution is t$e ulti ate 53
f d
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-easons for +erivatives Trading
• !o hed$e ris s• !o speculate on the (asis of future trends ofthe mar et
• !o profit from ar(itra$e opportunities• !o alter the nature of a lia(ilit# + still holdin$ it• !o alter the nature of an investment > portfolio
without (earin$ the costs of sellin$ theexistin$ one + (u#in$ another
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Interest -ates
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Interest -ates
• n derivatives pricin$ $enerall# principlesof continuous compoundin$ are followed
• !his is (ecause in practical terms thetradin$ of securities>assets happensmore>less at continuous intervals of time
• ontinuous compoundin$ allows for
situations in which cash flows can occur atan# time on a continuous time frame• )athematicall# continuous rates are
easier to deal with than discrete rates55
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Conversion ormulae
"efineR
c : nterest rate pa with continuous compoundin$R
m : nterest rate pa with compoundin$m
timesper #ear
( )
R m R
m
R m e
cm
m R mc
= +
= −
ln
/
0
0
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C i l &
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Conversion ormulae&
E$. 1: An interest rate is 9uoted at 17Npa withhalf #earl# compoundin$. ?hat will (e thee9uivalent rate with continuous compoundin$@
E$. 2: An interest rate is 9uoted at 8Npa withcontinuous compoundin$. ?hat will (e thee9uivalent rate with a4 Ouarterl# compoundin$
(4 )onthl# compoundin$
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T1!23 4O*
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T-!2S!CTIO2 COSTS 5 CO,'O2 2TS
• 3ro!erage , a*. . F 2• Service Ta* on 3ro!erage ,1 . L 2• Securities Transaction Ta* ,