Understanding Derivative – Beyond Accounting

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Understanding Derivative – Beyond Accounting. Presented By Safwat Khalid. Session Objective. Understand characteristics of different types known derivative tools and its application How derivative instrument can be an effective tool to manage risk and enhance our investment portfolio returns - PowerPoint PPT Presentation

Transcript of Understanding Derivative – Beyond Accounting

Understanding Derivative Beyond Accounting

Understanding Derivative Beyond AccountingPresented BySafwat Khalid

Session ObjectiveUnderstand characteristics of different types known derivative tools and its application

How derivative instrument can be an effective tool to manage risk and enhance our investment portfolio returns

Provide sufficient understanding such that the user can make an informed and intelligent decision regarding the role of derivatives in a particular situation and to identify the need for better understanding before proceeding

Topic CoverageWHAT IS DERIVATIVETYPES OF DERIVATIVE DERIVATIVE UTILITYDERIVATIVE FUNDAMENTALSVALUATION BASICSDERIVATIVE MARKET

ForwardAhmad is the owner of Healthy Hen Farms

Risk Price Volatility of the chicken market. Bird Flu ScareDecision to mitigate riskTerms of the contractThe investor agrees to pay SAR 10 per bird when the birds are ready for slaughter in six months' time

Enter into Forward Contract.

Pay offMP > SAR 10 - the investor will get the benefit as he will be able to buy the birds for less than market cost and sell them on the market at a higher price for a gain.MP< SAR 10 - Ahmad will get the benefit because he will be able to sell his birds for more than the current market price.Summary

By hedging with a future contract, Ahmad is able to focus on his business and limit her worry about price fluctuations

SwapAhmed obtained huge variable interest loan for acquiring small farmsAhmed aspiration is to grow the businessAcquire loan SAR 50 million at 3 months Sibor. Interest payment quarterlyRisk Anticipates increase in varaible rate Decision to mitigate riskEnter into Swap agreement with dealer or borrower who has similar terms except interest payments is fixed

Terms Ahmed - Pay Fixed Rec. SiborDealer Rec Fixed Pay Sibor Pay offSibor > Fixed Ahmad will benefit because his cost of fund is less than the marketSibor < Fixed Dealer or other borrower will benefit because his cost is less than fixed.

OptionsHealthy Hen Farms (HEN) is a publicly traded corporationSami is one of the major investor in HEN invested SAR 1 millionRisk Sami is nervous as he anticipates dip in stocks because of bird flu scare Decision to mitigate riskEnter into Option contract with Option writerTerms Sami pay option premiumWriter protects Sami from loss if Stock price fall below SAR 25. (Put Option) Pay off

Stock price > SAR 25 Sami will not be exercise option.Stock price < SAR 25 Sami will exercise option . Similar to insurance protection

WHAT IS DERIVATIVEA derivative is a contract between two or more parties whose value / payoff is based on an agreed-upon underlying financial instrument, index or security. Common underlying instruments include bonds , commodities, currencies, interest rates, market indexes and stock

A derivative's value is based on an asset, but ownership of a derivative doesn't mean ownership of the asset.

Types of Derivatives

Most common derivative products areForward / Future ContractOptionsSwapsCredit Derivative

Derivative UtilityDerivatives can be used either for risk management (i.e. to hedge by providing offsetting compensation in case of an undesired event, insurance) or for speculation (i.e. making a financial "bet"). Enhance returns

Risk ManagementDerivatives are used for different type of risk management purpose. It includes

Currency RiskInterest Rate RiskPrice Risk i.e stocks, commoditiesCredit Risk

Market Risk

Currency Risk

A form of risk that arises from the change in priceof one currency against another. Whenever investors or companies have assets or business operations across national borders, they face currency risk if their positions arenot hedged. For example, if you are a U.S. investor and you have stocks in Canada, the return that you will realize is affected by both the change in the price of the stocks and the change in the valueof the Canadian dollaragainst the U.S. dollar.So, ifyou realize a 15% returninyour Canadianstocksbut the Canadian dollar depreciates 15% against the U.S. dollar, this will amount to no gain at all.

Interest Rate RiskThe risk that an investment's value will changedue to a change in the absolute level of interest rates, in the spread between two rates, in the shape of the yield curve or in any other interest rate relationship. Such changes usually affect securities inversely and can be reduced by diversifying (investing infixed-income securities with different durations) or hedging (e.g. through an interest rate swap). Interest rate risk affects the value ofbondsmore directly than stocks, and it is a major risk to all bondholders.As interest rates rise, bond prices fall and vice versa.The rationale is that as interest rates increase, the opportunity cost of holding a bond decreases since investors are able to realize greater yieldsby switching to other investments that reflect thehigher interest rate.For example,a 5% bond is worth more if interest rates decrease since the bondholderreceives a fixed rate of return relative to the market, which is offering a lower rate of return as a result of the decrease in rates.

Price Risk

The risk of a decline in the value of a security or a portfolio. Price risk is the biggest risk faced by all investors. Although price risk specific to a stock can be minimized through diversification,market risk cannot be diversified away. Price risk, while unavoidable, can be mitigated through the use of hedging techniques

Price risk also depends on the volatility of the securities held within a portfolio. For example, an investor whoonly holds a handful of junior mining companies in his or her portfolio may be exposed to a greater degree of price risk than an investor with a well-diversified portfolio of blue-chip stocks. Investors can use a number of tools and techniques to hedge price risk, ranging from relatively conservativedecisions such as buying put options, to more aggressive strategies including short-selling and inverse ETFs.

Credit Risk

The risk of loss of principal orloss of a financial reward stemming from a borrower's failure to repay a loan or otherwise meet a contractual obligation. Credit risk arises whenever a borrower is expecting to use future cash flows to pay a current debt. Investors are compensated for assuming credit risk by way of interest payments from the borrower or issuer of a debt obligation.The higher the perceived credit risk, the higher the rate of interest that investors will demand for lending their capital. Credit risks are calculated based on the borrowers' overall ability to repay. This calculationincludes the borrowers'collateral assets, revenue-generating ability and taxing authority (such as for governmentand municipal bonds).

Credit risks are a vital component of fixed-income investing, which is why ratings agencies such as S&P, Moody's and Fitch evaluate the credit risks of thousands of corporate issuers and municipalities on an ongoing basis.

Risk Management RiskDerivativesCurrency RiskForward FuturesOptionsInterest Rate RiskForward rate agreementFuture contractsSwapsOptions (Swaptions, Call, Floor, Collar)Price RiskForwardFutureOptionsCredit RiskCredit Derivative (Credit Options, Credit Default Swaps)Equity RiskFutureOptionsEquity Swaps

Speculation & ArbitrageSpeculation

Derivatives can be used to acquire risk, rather than to hedge against risk. Thus, some individuals and institutions will enter into a derivative contract to speculate on the value of the underlying asset, betting that the party seeking insurance will be wrong about the future value of the underlying asset. Speculators look to buy an asset in the future at a low price according to a derivative contract when the future market price is high, or to sell an asset in the future at a high price according to a derivative contract when the future market price is low.

Arbitrage

Locking the profit by simultaneously entering into contacts in multiple markets i.e. buy instrument in one market and sell in another market. Benefit from the spread in the markets.

FUTURES - FUNDAMENTALSA futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price.

These derivatives are zero sum game, yet they allow a firms to hedge risk for which they have no expertise.

The value of a forward position at maturity depends on the relationship between the delivery price ( K) and the underlying price (ST) at that time.

For a long position this payoff is: ST - K For a short position, it is: K - ST

ForwardsA forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at today's pre-agreed price.Futures A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts.

Primary difference Forwards and FuturesForwards can be tailored to meet the specific needs of counter parties but have higher default risk and less liquidity.

Futures are standardized, so they are less likely to be exactly what two parties need; however, they trade on exchange, so the risk of default is minimal. FORWARDS VS FUTURES

Future PayoffFuture Long PositionWhen an investor goes long - that is, enters a contract by agreeing to buy and receive delivery of the underlying at a set price - it means that he or he is trying to profit from an anticipated future price increase.

Future Short Position

A speculator who goes sh