MOD1-INTRO.pptx

8/16/2019 MOD1-INTRO.pptx

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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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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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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

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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

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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

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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

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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

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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* ,

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