Derivatives

FORWARD CONTRACTAn agreement to buy or sell an asset (underlying) at a certain future date (maturity) at certain time at a specified price (contract price). Entered into between two financial institutions or between a financial institutional and its client.It is normally a OTC contract.One of the party agrees to buy the underlying asset i.e., assumes a long position.The other party agrees to sell the underlying asset i.e., assumes a short position.Settled on maturity

FORWARD CONTRACT - FEATURESThey are bilateral contractsEach contract is custom designed i.e. the terms of a forward contract are mutually agreed upon between the two parties.Each contract is unique in terms of contract size, expiration date, asset type and asset qualityThe contract prices are not available on public domainThe contract has to be settled by delivery of the asset

FORWARD CONTRACTThe specified price is called delivery price.Delivery price is so chosen to ensure that the value of the FC is zero to both parties on entering the contract.The value of the FC changes as the market price change i.e., the FC may have a positive or negative value to either parties.If the value of long contract is positive, the value of short contract is negative.The forward price = delivery price at the time of the contract.After entering into contract the forward price may not be equal to delivery price.Both parties face default risk extreme form of credit risk

FORWARD CONTRACT - EXAMPLESpot price = SoForward price = StDelivery price = KSuppose So = 44.25 S30 = 44.20 S60 = 44.50 S90 = 45.00 You are an exporter and you expect to receive $1 million in 3 months. You would like to hedge your risk and take a forward cover by taking a short position at a delivery price of Rs.45/$ in 90 days.

FORWARD CONTRACT - EXAMPLECase 1:- On due date the So = Rs.44.50/$ You have gained 0.5/$ by entering the contract, thus you will make a profit of Rs.0.5 million from the short position. The party with the long contract will lose Rs.0.5 million.Case 2:- On due date the So = Rs.45.50/$ You have lost Rs.0.5million from the short position. The party with the long contract will gain Rs.0.5 million.

FORWARD CONTRACT - PAYOFFPay off from long contract = St K Pay off from short contract = K - StKStProfitoKStProfitoLong positionShort position

FORWARDS - ADVANTAGESNo cost in forward markets as against spot market.Spot market involves storage and insurance cost especially in commodity.

FORWARD DISADVANTAGESCounter party risk/ credit riskFinding counter partySettlement procedure

WHEN WOULD YOU ENTER INTO ONEWhen you have assets which you may want to sell into the future, but lock in the price today

Or you are a trader who believes that prices of the commodity you are buying through the contract are likely to be higher than what is agreed as per the contract

FUTURES CONTRACTStandardized contract for deferred delivery.Traded on organized futures exchange.There is a clearing association that acts as middle man between the contracting parties.The contract seller is called short. The contract buyer is called long.Both parties post a performance bond called margins initial margins and variation margins.Margins are held by the clearing association. Margins Buyer Broker Clearing house member Clearing house

FUTURES CONTRACTDaily profit/loss known as marking to market is calculated.Profit/loss is adjusted against margins.If margins fall below the certain level, additional margins are asked for/margin call are required to be put.Margins of buyers and brokers cannot fall below maintenance margin. Members maintain original margins based on gross/net basis. Parties need not know each other.

TYPES OF FUTURE CONTRACTCommodity futures1) Metals like Tin, steel, Copper, gold, silver etc.2) Agriculture products like wheatCoffee, pepper, meat, live stock.

Quality specifications must.Delivery place and time specifiedFinancial futuresStocks, indices, currencies, interest rate.

PROBLEM ON MARGINSContact : Oct Long futures Initial margin : 5% No of contracts : 2Commodity : GoldContract size : 100 gmsOpening price : Rs.400Maintenance margin : 75% of initial margin

DayFu priceDaily G/LCum G/LMargin a/c balanceVariation marginOp pri400.00Aug 10397.0011 396.1012398.2013397.1015396.7016395.4017393.3018393.6019391.8022392.7023387.0024387.0025388.10

DayFu priceDaily G/LCum G/LMargin a/c balanceMargin a/c balanceOp pri400.004000Aug 10397.00(600)(600)340011 396.10(180)(780)322012398.20420(360)364013397.10(220)(580)342015396.70(80)(660)334016395.40(260)(920)308017393.30(420)(1340)2660134018393.6060(1280)406019391.80(360)(1640)370022392.70180(1460)388023387.00(1140)(2600)2740126024387.000(2600)400025388.10220(2380)4220

WHEN WOULD YOU CONSIDER

ORYou hold a stock, you believe it will fall in the near term, but you dont want to sell the stock. You can sell the future and benefit from the fall.There is a huge difference between the spot price and the future price and wish to benefit from this differential called the cash future arbitrage

FORWARD VS FUTURES

FORWARDParties known to each other.OTC contract.Contract is not liquid.Margins not requiredContract closed by meeting obligationContract closed only on due date.Customized contractNo long and short on same contract

FUTURE Parties may not know each other Exchange tradedliquidMargins required.Alternatives to close contract.Exit from contract Standardized contractContract is any time.Can square up deals.

OPTIONSAn option is a legal contract which gives the holder the right to buy or sell a specialized amount of underlying asset at a fixed price with in a specified period of time.

you want to buy an asset sometime into the futureyou believe that the price of the asset might rise into the future, but not very sure, you will want to lock in a price today. What if the price in the open market is much lower than what you anticipated, you still want to benefit !A call option gives you a right to buy

CALL OPTION EXAMPLEYou want to buy BOB shares next month.You have a feeling that BOB shares will rise from here on but not very sureIf it doesnt rise, great!. You can buy BOB shares at the prevailing low price.If it rises fantastic! You can buy BOB shares at the agreed lower price from the option seller and sell them in the open market for a profit.If it falls, you dont want to buy at the agreed price, you would rather go to the open market and buy at the prevailing lower prices

PUT OPTIONI believe a particular asset I hold will fall into the future but not very sure.How do I ensure that I get a goo d price even when the asset falls

PUT OPTIONI can buy a put option Gives me a right to sellBut I dont want to sell at a lower price if the asset doesnt fall or if it rises.Dont worry, the put option, when I buy gives me the right only and not the obligation. If I want to sell at the agreed price I sell, else I am free to ignore the contract!

OPTIONS MEANING1. Legal contract2. Buyers & Seller of the options contract3. Option exchange or over the counter exchange7. Contract should be completed on or within a specified time.4. Buyer will have a right to buy / sell the underlying asset at a fixed price5. Seller will have an obligation to buy / sell the underlying asset6. Buyer will have to pay a price called option premium to buy the right

Call Right to buy asset Obligations to sell assetOption BuyerSellerTypes (Long position) (Short position)Put Rights to sell asset Obligations to buy assetOPTION TYPES

OPTION TYPESAMERICANOPTIONSEUROPEANOPTIONSCan be exercised at any time on or before expirationCan be exercised on the expiration date

1. Expiration Date (a) Date on which option expires (b) Expiration dates are in cycles2. Strike price (a) Price at which options are written (b) Strike prices are specified by the exchange (c) Strike prices differ with expiration periodSPECIFICATIONS OF OPTIONS

PROFIT AND LOSS OF CALL OPTIONS

S > X

S = X

S < XCall OptionIn the Money

At the Money

Out of the MoneyPut OptionOut of the Money

At the Money

In the MoneyPROFITABILITY OF OPTIONS

PROFITABILITY OF OPTIONS

Stock

Price

ST

Strike

Price

X

Conditions

Status for Call

Status

for Put

270

300

360

400

450

500

360

360

360

360

360

360

SWAPSThe word swap means exchange.An interest rate swapTwo parties agree to exchange interest rate cash flows, based on a specified notional amount from a fixed rate to a floating rate (or vice versa) or from one floating rate to another.Interest rate swaps are commonly used for both hedging and speculating.

SWAPS (CONTD.)

SWAPS (CONTD.)

FORWARD RATE AGREEMENT (FRA)FRA is a contract where a borrower (long) agrees to borrow in future at a certain interest rate a certain amount (notional or otherwise) from a lender.The agreement entered at time to The agreement commences from time t1 and valid till t2.The price is the interest rate.

FORWARD RATE AGREEMENT (FRA)If the interest rate increases at time t1 the lender is required to pay the amount equivalent to differential interest rate or lend at agreed interest rate up to time t2.

If the interest rate decreases at time t1 the borrower is required to pay the amount equivalent to differential interest rate or borrow at agreed interest rate up to time t2.

FRA - EXAMPLEReliance communication is planning to borrow Rs.100 crores from the market in 6 months time for one year. The interest rate market is highly volatile and reliance is worried of the interest rate on its borrowing.Reliance enters into a FRA with BOB for 100 crores at 7%, commencing 6 months from now. Reliance borrows in the market at the end of 6 months for one year at LIBOR.The LIBOR rates during the one year period is :

Time from months) Beginning Time to (months) EndingLIBOR1 47.25%586.80%9127.25%

MonthsInterest pay (Rs) CroresCF from BOB (Rs)CroresNet CF (Rs)crores10.604120.020790.5833320.604120.020790.5833330.604120.020790.5833340.604120.020790.5833350.56667(0.01666)0.5833360.56667(0.01666)0.5833370.56667(0.01666)0.5833380.56667(0.01666)0.5833390.604120.020790.58333100.604120.020790.58333110.604120.020790.58333120.604120.020790.58333Total7.099640.099647

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