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DERIVATIVES

S.CLEMENT


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Derivatives traders at the Chicago Board of Trade


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Financial RisksFinancial RisksFinancial RisksFinancial RisksMarket risk isMarket risk is

exposure to theexposure to the

uncertainuncertain marketmarket

valuevalue of a portfolio. Aof a portfolio. A

trader holds atrader holds aportfolio ofportfolio of

commoditycommodityforwardsforwards..

She knows what itsShe knows what its

market value is today,market value is today,

but she is uncertainbut she is uncertain

as to its market valueas to its market value

a week from today.a week from today.

She faces marketShe faces market

risk.risk.

Market risk isMarket risk is

exposure to theexposure to the

uncertainuncertain marketmarket

valuevalue of a portfolio. Aof a portfolio. A

trader holds atrader holds aportfolio ofportfolio of

commoditycommodityforwardsforwards..

She knows what itsShe knows what its

market value is today,market value is today,

but she is uncertainbut she is uncertain

as to its market valueas to its market value

a week from today.a week from today.

She faces marketShe faces market

risk.risk.


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Steps to manageSteps to manageSteps to manageSteps to manage

Avoidance

Loss control

Diversification

Transfer

Avoidance

Loss control

Diversification

Transfer

Identification ofrisk

Quantification ofrisks

Framing Risk Appetite

Implementation and control

Identification ofrisk

Quantification ofrisks

Framing Risk Appetite

Implementation and control

Strategies to deal withStrategies to deal withStrategies to deal withStrategies to deal with


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Hedging

Establishing a position in the derivatives

market that is equalandopposite to the

risky position in

the physical market..


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HEDGING TOOL

S

Take out finance

Securitisation

Derivatives


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TAKE OUT FINANCE

Project bridge over Narmada river at Bharuchin Gujarat

Type : toll road

Sponsor: L & TConcession period 20 years

Project cost Rs 144 cr

Loans RS 96 cr

Lenders IDFC,IDBI &SBI

IDFC to take over(unconditional) RS 21 cr fromSBI after 5 years


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DERIVATIVES MEANS Derivative are financial instruments whose value

depends upon the value of underlying assetFeatures are:

It has no independent value. Its value depends onthe value of an asset.

Under lying asset could be Int. rates, commodities,

stocks, index , currency,etc Pre determined life

It is independent of underlying contract

It is a hedging tool.

DerivativeDerivative meansmeans aa forward,forward, future,future, optionoption oror anyany otherother

hybridhybrid contractcontract ofof prepre determineddetermined fixedfixed duration,duration, linkedlinked forforthethe purposepurpose ofof contractcontract fulfillmentfulfillment toto thethe valuevalue ofof aa specifiedspecifiedrealreal oror financialfinancial assetasset oror toto anan indexindex ofof securitiessecurities..


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Features of derivatives

Bench mark rates

Strikeprice

Contractperiod Viewof contracting partiees


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Fourmost common examples ofFourmost common examples of

derivative instruments are:derivative instruments are:

Fourmost common examples ofFourmost common examples of

derivative instruments are:derivative instruments are:


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Genesis It is not new wine in the new bottle. Itis nothing but old wine In new bottle

It is 2000 years old . Olive farmers inGreece used forward contract fordelivery on a specified date betweenseller & buyer

Bombay traders used to have FC withfarmers in Gujarat & Maharashtra forsupplying cotton even in 17 th century


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TYPES OF DERIVATIVES

Over the

counter(OTC)

Forward contract

Forward rate

agreements

Swaps

Options Credit

EXCHANGE

RELATED

Futures

Stock options

Commodity futures


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OTC COTRACTS Bilateral contract

Customized contract

No quotes in the market

Settlement by delivery

Reversal/ cancellation with counter party

E.g.. FC Forex transactions & Commodity

Problems- No standardization & counter party risk

(OTC) derivatives are contracts that are traded (andprivately negotiated) directly between two parties,without going through an exchange or otherintermediary. Products such as swaps, forward rateagreements and exotic options are almost alwaystraded in this way.

The OTC derivatives market is huge. According to theBank for International Settlements, the totaloutstanding notional amount is USD 516 trillion (as ofJune 2007)


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ExchangeTraded Contracts

Theworld's largest derivatives exchanges (bynumberoftransactions) aretheKorea Exchange(which lists KOSPIIndex Futures & Options),

Eurex (which lists a widerangeofEuropean

products such as interestrate & indexproducts),and

CME Group (madeupofthe 2007 mergeroftheChicagoMercantileExchange and theChicago

Board ofTrade and the 2008 acquisition oftheNewYork MercantileExchange).

According toBIS, the combined turnover in theworld's derivatives exchanges totalled USD 344trillion during Q4 2005.


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Some common examples of these derivatives are:

UNDERL

YING

CONTRACT TYPE

Exchange-

traded futures

Exchange-traded

options

OTC swap OTC forward OTC option

Equity

Index

DJIA Index

future

NASDAQ Index

future

Option on DJIA Index

future

Option on NASDAQ

Index future

Equity swap Back-to-back n/a

Money

market

Eurodollar future

Euribor future

Option on Eurodollar

future

Option on Euribor

future

Interest rate

swap

Forward rate

agreement

Interest rate cap

and floor

Swaption

Basis swap

Bonds Bond future Option on Bond future n/a Repurchase

agreement

Bond option

Single

Stocks

Single-stock

future

Single-share option Equity swap Repurchase

agreement

Stock option

Warrant

Turbo warrant

Credit n/a n/a Credit

default swap

n/a Credit default

option


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FC commodity (OTC)

Kissan co wants to procure 500 kg oftomatoes after 3 months. Prevailing 1 kg@Rs 6.

View of the company Expected to go up toRs 8 per kg.

View of the farmer- Price @ Rs 5.50.

So FC between Company & Farmer.Agreed

price @ Rs 6.50 . Delivery after 3 months. Situation after 3 moths Price may be same

I.e @ Rs 6 or more or less than strike price


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Hedging CaseStudy

ABCLtd having order in hand to supply copperwire

worth 500 MTof copperto be delivered 2 months fromnow

CaseI Priceof copper is fixed at current spotprice

CaseII

Thepriceof copperwould be fixed based on flexibility:

on any dates atthe hands ofthe buyerafterone monthoftheorderor

On any dates in the delivery month

What should your hedging strategy be?


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Hedging

Hedging Options evaluation

Option I

Buy in the spot market at current price

Buying in the spot market blocks the working capital

Increased inventory carrying cost

Copper available in the spot market priced at last months averageprice

which is higher than landed spot price

Option II

Lock in the price on the futures market at one month forward

This gives flexibility in terms of pricing spot market purchases

Increases negotiation capacity with the supplier Option III

Leave the position un-hedged and buy copper when actually

required for production leaving to vagaries of volatile copper

price risk Risk Management


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CURRENCY -FORWARD

CONTRACTS (OTC)

Exporttransaction

Export forUSD 10,000/- expected date3months later.SpotrateRs 46

View Dollarwill depreciate by Re 1.

FC (sale by exporter) for USD 10,000 @45.75 for3 months.

Situation I After3 months rate@ 46 Situation II After3 months rate @ 45

It is a notional loss butexportermanaged

pricerisk.


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FORDWARD RATE

AGREE

ME

NTS

It is a financial contract between two partiesto exchange steam of interest payments onnotional principal amount on settlement date

Features-n Bilateral contract Notional principal amount

Exchange of cash flows on settlement dateor periodically reset dates

Between the strike price & market price Object- Hedging to IRR


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FC- INT.RATES (FRA) Object- Hedging against INT.RATERISK

ABC co ltd borrowed Rs 50 lacs for 1 year @11% (floating) from SBI

View INT.rate will go up FRA with CITI bank for 1 year. Strike price @

11%

Situation- After 1 year INT @ 13% . CITI will

pay 2%(13-11) to ABC who will in turn pay13% to lender SBI.

Situation II-- If INT at 10% ,ABC will pay 1% toCITI.

For ABC -- interest cost stays at 11%


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Interest Rate Swaps

A swap a transaction is one where two

or more parties agree to receive or pay

on a notional principal for an agreed

period of time

Swap may be for interest,

currency,Commodity etc


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FUTURES(Exchangerelated)

Agreement between two parties at an agreedprice on a specified date . It may relate tocommodities, Index, share etc.

Feature- Bilateral contract

Designated future date at a price agreed today It is traded in the exchange

Standardized- Quantity,price,period etc

No counter party risk as SE itself counter

party Transparent functioning

Price discovery


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FUTURES (Equity) E.G. X wants to buy 100 shares ofXYZ CO

after 3 months @ Rs 250 per share. Hencefutures contract

Situation I After 3 moths if the price is Rs300, then X will get Rs 5000(300-250*100).There is no exchange of shares butonly the difference agreed price and marketprice.

Situation II If the price is RS 200, X will pay Rs5000 (250-200 * 50)

In both situations, X is able to manage price

risk


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Index futures Futures contract on a stock or financial index. For each index there

may be a different multiple for determining the price of the futurescontract.

For example, the S&P 500 Index is one of the most widelytraded index futures contracts in the U.S. Stock portfolio managerswho want to hedge risk over a certain period of time often useS&P500 futures to do so.

By shorting these contracts, stock portfolio managers can protectthemselves from the downside price risk of the broader market.

However, by using this hedging strategy, if perfectly done, themanager's portfolio will not participate in any gains on the index;instead, the portfolio will lock in gains equivalent to the risk-freerate of interest.

Alternatively, stock portfolio managers can use index futures toincrease their exposure to movements in a particular index,essentially leveraging their portfolios.


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Index Futures

Portfoliovalue Re 4,00,000

Beta factor 1.5 (i.e. if index drops by 10%,porfoliovaluewill drop by 15%).Portfoliovaluewill drop by toRe 3,40,000

(4000 X 10 X 1.5)

To hedgetheportfolio, index futures to beused by going in

forbuying contracts on index. Formula (4000 X1.5) / (4000 X 50 ) =

6,00,000/ 2,00,000 = 3 contracts to sold.

Situation A if index drops by 10% i.e.to 3600,

Profiton futures contract = 10% ofRe 2.00 lac for3contracts will beRe 60,000.Cash market loss will beoff set

by gain in derivative segment.

Long Hedge foracquiring shares at a future date.

ShortHedge forselling the shares at a future date.


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commodity futures

Commitmentto makeortake delivery of a

specific commodity ofSpecific quantity&quality

At a pre determined price and placeIn future

with all terms of contracts standardized

It is to hedgepricerisk on accountof demand &

supply, govt.policy,natural calamities etc

Hedging tool fortraders/exporters Price discovery


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Agri.commodity- Sugar,cotton,coffee, Soyabean, Mustard seed, Mustard oil Crude palm oil ,Pepperetc

Metallurgical precious (Gold , Silver etc) & basemetals

Energy crude oil ,gasoline etc

Objective manage price risk.

Major exchanges National Commodity &Derivatives Exchange (NCDEX)& Multicommodity Exchange of India.

Regulator Forwards Markets Commission

(FMC)

commodity futurescommodity futures


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Howt is useful forhedging ?

An exporterexporting Agroproducts (E.g.

Basmati rice).Price fluctuations betweendateofreceiving theorderand execution

oforder i.e dateofexports

An importer importing gold forselling in

theratail marketormaking jewellery for

exports.

commodity futurescommodity futures


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At present , MCX ( Multi commodity

Exchange of India) offers futures on 60

commodities.It recently entered in to

strategic alliance with Malaysian commodityexchange for offering futures on Crude

Palm Oil(CPO )

CPO traded in Malaysian exchange will be

offered by MCX to Indian traders who areimporting CPO form South East Asia.

It will help to hedge the price risk.

FUTURES commodityFUTURES commodity


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OPTIONS It is a bilateral contract where by the buyer

has the right perform or not to perform anobligation. It maybe a call (buy) or a put (sell)

option. In short. the buyer has the option tobuy or sell

American option An option exercisable atany time before due date

E

uropean option- Option exercisable only ondue date

SEBI issued guidelines for trading inderivative I.e. stock option


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Why buy options?Why buy options?Why buy options?Why buy options?


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OPTION TERMINOLOGIES

Call/Put

Volatility

Strike Price American/European

In the money

Out of money At the money


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Open interest

Open interest (also known as open contracts oropen commitments) denotes thetotal numberof

derivative contracts, like futures and options, that

are currently activeon a specific underlying

security, having specific terms. Open Interest is thetotal numberofoutstanding

contracts that are held by marketparticipants atthe

end ofthe day.

It can also be defined as thetotal numberof futurescontracts oroption contracts that have not yet been

exercised (squared off), expired, or fulfilled by

delivery


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Open Interest Foroption traders, open interest is an indication of how intensetrading

theoptions in an underlying security may be.

Forinstance, ifopen interest increases suddenly from one day tothenext, it is likely that new information abouttheunderlying security hasbeen revealed, which may indicate a near-term rise in theunderlyingsecurity's volatility.

In theory there's nothing which can be said on the future direction oftheunderlying, becausethere are as many contracts bought as sold

Increasing open interest means that new money is flowing intothemarketplace.Theresultwill bethatthepresenttrend ( up, down orsideways) will continue.

Declining open interest means thatthe market is liquidating and impliesthattheprevailing pricetrend is coming to an end.

A knowledgeofopen interest can proveuseful toward theend of major

market moves.


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SWAPTIONS

A swaption is a contract by which aparty acquires an option to enter into aswap

It is to used to hedge uncertainties incash flows

E.g..A company bids for a tender . It is

not sure whether tender will beawarded. So a swaption is entered sayfor interest on borrowing.


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OPTIONS ( CONTD) STOCK OPTION

Share price of ABC co Rs 386.X wants tobuy 1200 share on after one month as heexpects cash flow on that day. He buys calloption with a broker @ Rs 395 per share by

paying a premium ofR

s 15 per share Situation I

After 1 month- MP Rs 350. X will notexercise the option . He will buy from the

market. Cost will be- Rs 350 * 1200 = Rs4.20 lacs + premium

18000=Rs 4.38 lacs.cost of exercising optionis rs 4.92 (395*1200+0.18)


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OPTIONS (CONTD) Situation II

After 1 month M.P. Rs 420 * 1200=

5,04,000+18000=5.22 lacs

X

will exercise the option. Then cost willbe Rs 395*1200+ Rs 18000 = Rs4,92,000.

Profit X will be Rs 5.22 4.92= Rs

30,000. So depending upon market condition, X

will decide to exercise the option or not.


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OPTION PAY OFFA sells a European call option on a share of XYZ COMAPNYat a premium ofRs. 3 per share on March 01, 2009. The strike price is Rs.65 and the contractmatures on June 30, 2009.. It is clear from the graph that the upsidepotential is limited to a maximum of Rs.3 per share, which has been receivedas option premium. However, the downside risk is unlimited and the investormay experience huge losses, if the market does not move according to hisexpectations.

S Xt C Payoff Net Profit

62 65 3 0 3

63 65 3 0 3

64 65 3 0 3

65 65 3 0 3

66 65 3 -1 267 65 3 -2 1

68 65 3 -3 0

69 65 3 -4 -1

70 65 3 -5 -2

71 65 3 -6 -3


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straddles and strangles

strangle is an investment strategy involving thepurchaseorsaleofparticularoption derivatives

that allows the holdertoprofit based on how

much thepriceoftheunderlying security moves,

with relatively minimal exposuretothedirectionofprice movement.

Thepurchaseofparticularoption derivatives is

known as a long strangle, whilethe saleofthe

option derivatives is known as a short strangle.Itis related to a similaroption strategy known as a

straddle.


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Long strangle

Thelong strangle involves going long (buying) both acall option and a putoption ofthe sameunderlyingsecurity.

Like a long straddle, theoptions expire atthe sametime,butunlike a straddle, theoptions have different strike

prices.Theownerof a long strangle makes a profit iftheunderlying price moves farenough way from the currentprice, eitheraboveorbelow.

Thus, an investormay take a long strangleposition if hethinks theunderlying security is highly volatile, but does

not knowwhich direction it is going to move. This position is a limited risk, sincethe most a purchaser

may lose is the costof both options.Atthe sametime,there is unlimited profitpotential.


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Short strangle

Theshort strangle is the converseofthe

long strangle.

The call and putoptions arewritten (sold)instead of bought.

The investor loses iftheunderlying

security increases ordecreases enough;

but ifthe stock priceremains stablethen

theoptions expire and the investorgets to

keepthepremiums


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straddle

The difference between a straddle and a

strangle is the strikepriceoftheoptions.

In a straddle, theoptions are boughtwith

the same strikeprice.

In a strangle, theoptions are boughtwith

different strikeprices.


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Option strategies

Calls increase in value as theunderlying stock increasesin value.

Likewiseputs increase in value as theunderlying stockdecreases in value.Buying both a calland aputmeansthat iftheunderlying stock moves upthe call increasesin value and likewise iftheunderlying stock moves downtheput increases in value.

The combined position can increase in value ifthe stockmoves significantly in eitherdirection. (Theposition losesmoney ifthe stock stays atthe samepriceorwithin a

rangeofthepricewhen theposition was established.)This strategy is called a straddle.

It is oneof many options strategies that investors canemploy.


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straddles and strangles

With Infosys Results coming in tomorrow, themarket is expected to be highly volatile.Howeverwith rightuseof stock options,investors can actually profit from this volatility.

There areoption strategies likestraddles andstrangles which let investors profit from hugeoneway movements

So in cases where you knowthe stock prices will

move heavily oneway, eitherupordown, butyou dont knowwhich way this huge movementis going totakeplace, stradles and strangles canbeused to make decentprofit.


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When touse straddle and strangles

Straddle when there is no clue abouthe

direction in the market.

S

trangle when youtake a definiteviewaboutthe direction in the market i.e.upor

down.


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Regulatory framework S/E

Securities contracts (regulation) Act 1956

SEBIAct 1992

The forwards Contract (regulations) Act1952


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REGULATORS- INDIA

RBI - OTC

SEBI - Exchange related ( Stockmarket)

Forward Markets Commission Commodity Futures


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DERIVATIVES IN INDIA 1998 L.C. GUPTACommittee

recommended for introduction of derivatives

SEBIwill grant approval forclearing

corporation and theirbye laws

Trading members toregisterwith SEBI

Margin to be maintained as perSEBIrules

BSE & NSE launched Index future in June

2000 /Index &stock option in July2001/Stock futures in Nov 2001

Commodity futures already exist for

Pepper,Coffeeetc


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DERIVATIVES IN INDIA

commodity futures Commodities traded coffee, pepper,

cotton,soyabean ,petroleum,rubber,Gold etc

Actively traded cotton, coffee ,cotton& castor

oil 23 commodity exchanges- majorexchanges at

Mumbai(cotton &oil seeds), Bangalore

(Coffee),Cochin (pepper), Kolkata (Jute) etc

CurrentTurnoverof all 23 exchanges increased

toRe 20 lakh crore from 6 lakh crore (2004-05)


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Current Issues

Threeregulators- SEBI forSE , RBI for

OTC contacts & Forward Markets

Commission Commodity Futures

Documentation

Stamp duty

Poorresponse from GOVT. banks

Accounting standards


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Derivatives a doubleedged sword

Derivatives areoften subjecttothe followingcriticisms:

Theuseof derivatives can result in large lossesduetotheuseof leverage.Derivatives allow

investors toearn largereturns from smallmovements in theunderlying asset's price.

However, investors could lose large amounts ifthepriceoftheunderlying moves againstthem

significantly

. There have been several instances of massive

losses in derivative markets, including: The Nick Leesonaffair in 1994.


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THANK YOU

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