derivatives final03

8/8/2019 Derivatives Final03

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Prepared by:

Nishank Gonsalves (16)

Nayantara Gore (17)

Mansingh Gorkha (18)

Krishna Gosavi (19)

Mukesh Gupta (20)


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A derivative is a contract between two parties which derives its value from an underlyingasset.

The different underlying assets are:

Currency

Exchange rate Interest rate

Equity

C

ommodities

What is a Financial Derivative?


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FEATURES OF ADERIVATIVE

A derivative instrument relates to the futurecontract between two parties

The derivative instruments have the value which derived from the values of otherunderlying assets.

In general the counter parties have specifiedobligation under the derivative contract.


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Why derivative is so important today?-Growth

Driving Factors

Increased volatility in asset prices in Financial

Markets

Increased integration between International

Markets

One of the most important services provided by thederivatives is to control, avoid, shift and manage

efficiently different types of risks through various

strategies like hedging, arbitraging, spreading, etc.


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Why derivatives are used?

To insure against changes or risk (hedgers).

To get a high profit from a certain market

behavior (speculators).

To get a quick low-risk profit (arbitrageurs).

To change the nature of an investmentwithout the costs of selling one portfolio andbuying another.


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What are the different types of traders/participants inderivatives market ?

Hedgers:They are in the position where they face risk associatedwith the price of an asset. They use derivatives to reduce oreliminate risk.

For example: A farmer may use futures or options to establishthe price for his crop long before he harvests it. Various factorsaffect the supply and demand for that crop, causing prices to

rise and fall over the growing season. The farmer can watch theprices discovered in trading at the CBOT and, when they reflectthe price he wants, will sell futures contracts to assure him of afixed price for his crop.


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Speculators:

Speculators wish to bet on the future movement in theprice of an asset. They use derivatives to get extra leverage.Aspeculator will buy and sell in anticipation of future pricemovements, but has no desire to actually own the physical

commodity.

Arbitrators:

They are in the business to take advantage of a discrepancy

between prices in two different markets. If, for example,they see the future prices of an asset getting out of line withthe cash price, they will take offsetting positions in the twomarkets to lock in a profit.


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Types of Derivatives

Forwards :

A Forward is an agreement between twoparties to purchase or sell an instrument ata fixed time in the future and at a certainprice.


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Example of a forward

contract On January 20, 2009 a trader (long

position) enters into an agreement to buy

1 million in three months at an exchangerate of 1.6196

This obligates the trader to pay $1,619,600(=K) for 1 million on April 20, 2009

If the exchange rate rose to 1.65, the spotprice S

Tis $1,650,000 and the payoff is

ST

K= $1,650,000 - $1,619,600 = $30,400


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What is Offsetting the Forward Contract

One cannot unilaterally back out from the obligation

arisen in the forward contract, but he can certainly

enter into another forward position exactly opposite

the original position. This strategy is popularly

known as offsetting the forward contract.


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EXAMPLE:

January 01, 2005, a party X enters into a forwardcontract with another party Y, in which he

agrees to buy one kg of gold onA

pril 01, 2005for Rs.5,000 per 10 grams of gold. On February01, 2005, X decides to get out of his position,and hence, enters into another forward

contract with Z which he agrees to sell one kgof gold on April 01, 2005 for Rs.5,200/- per 10gram of gold.


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The Advantage/Disadvantage ofAforward Contract

Advantage

Both partieshave limited

their risk.

Disadvantage

You must make or take deliveryof the commodity and settle onthe deliver date and honor thecontract as agreed upon.

The buyer and seller aredependent upon each other.

In a forward contract, anyprofits or losses are not realizeduntil the contract "comes due"

on the predetermined date.


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A future is a standardized derivative contractbetween two parties: a buyer and a seller.

Futures are similar to forwards but they aretraded on exchanges and their terms are

standardized.

FUTURES CONTRACTS


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When the market is bullish

y Take a long positiony When Reliance Futures is at Rs. 480

y Market rises and Reliance Futures goes to Rs. 500y Sell Reliance Futuresy Profit is = Rs 20/-


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y Take a short positiony When Reliance Future is at 480

y Sell Reliance Futuresy Market falls and Reliance Futures goes to 460/-

y Buy Reliance Futures

y Profit = Rs.20/-


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WHAT IS OPTIONS?

An option is a particular type of a contract

between two parties where one person gives

the other person the right to buy or sell a

specific asset at a specified price within a

specific time period.


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TYPES OF OPTIONS

Call and Put Options

American and European Options


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Call Options : The option to buy

Put Options : The option to sell

American Options : The option can be exercisedanytime prior tomaturity.

European Options : The option can be exercised atmaturity.

TYPES OF OPTIONS


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Example ofCall Option

An investor buys a European call option onsatyam will exercise price at RS 280 for apremium of RS.10.If the price of the sharerises and current market price is RS 350 ,the owner of the option may exercise his

option to buy the shares at Rs 280.


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Example of Put Option

The investor buys a European put option onONGC share with a strike price of Rs 850 andexpiration in June, by paying a premium ofRS 25.The investor has the right to sell ONGCshare at RS 850 before the expiry date of theoption. If the current market price of share isRS 950.The investor should not exercised hisoption.


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SWAPS

Swaps have been termed as private agreementsbetween the two parties to exchange stream of cashflows against one another.

Why? To hedge risks like floating

interest rate, Currency

fluctuations, equity returns.


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Characteristics

Two parties involved

Private agreement

Cannot be traded

Termination by mutual consent


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Types of Swaps

Interest Swaps

Currency Swaps

Equity Swaps Commodity Swaps

Credit Swaps


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Interest Swap

Parties hedge interest rate

like fixed to floating

Also called vanilla swaps

Principal is not exchanged

Most commonly used.


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Example of Interest Rate Swap

Aborrows $10 million with a floating interestrate of 11% and B borrows $10 million with a

fixed interest rate of 10%. A and B can enterinto an interest rate swap arrangement underwhich Awill pay a fixed rate of interest of 10percent and B will pay a f loating interest rateof 11%.


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Currency Swap

Parties hedge on currency

fluctuations

Across two different currencies Actual exchange of currency

Interest rates/variations

swapped Transactions are reversed later


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Example ofCurrency Swap

Company A raises 1 million by issuing 10%German mark bonds and the company Braises 2 million by issuing 13% dollar bonds.Both the company Swap the transaction.

In the beginning company A receives 2million and company B receives 1 million.Both the companies re-exchange theprincipal amounts at the time of maturity.

CompanyApays, 2,60,000 to company B andcompany B in turn pays 1,10,000 to companyAas interest during the currency of loan.


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Equity Swap

Parties hedge returns on equity withFixed interest

Generally entered to avoid tax Portfolio is not exchanged

Can be hedged against currency

fluctuations.


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Credit Swap

Debt is transferred from one

Party to other

Seller guarantees creditworthiness

Buyer will make money

if credit is recovered properly


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derivatives final03

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