DERIVATIVES BLESSY A VARGHESE GUEST LECTURER CHRISTIAN COLLEGE

DERIVATIVES BLESSY A VARGHESE GUEST LECTURER CHRISTIAN COLLEGE CHENGANNUR

DERIVATIVES

DERIVATIVES

DERIVATIVE • Financial contract with a value that is derived from an underlying asset • No direct value independently • Value is based on the expected future price movements of their underlying asset. • Instrument to hedge risk for one party of a contract, while offering the potential for high returns for the other party • Risks include ; - (i)fluctuations in stock, bond, commodity, and index prices (ii)changes in foreign exchange rates (iii) changes in interest rates

WHY DERIVATIVES ? ? ?

WHY DERIVATIVES • EARN MONEY WITHOUT PHYSICAL SETTLEMENT Helps in taking advantage of price fluctuations in the short term. Allows you to conduct transactions without actually selling your shares. • MARGIN BASED TRADING (ARBITRAGE) When you buy low in one market and sell high in the other market, it called arbitrage trading. Simply put, you are taking advantage of differences in prices in the two markets. • HEDGING AGAINST PRICE FLUCTUATIONS The derivative market offers products that allow you to hedge yourself against a fall in the price of shares that you possess. It also offers products that protect you from a rise in the price of shares that you plan to purchase. • TRANSFER OF RISK The most important use of these derivatives is the transfer of market risk from risk-averse investors to those with an appetite for risk. Risk-averse investors use derivatives to enhance safety, while risk-loving investors like speculators conduct risky, contrarian trades to improve profits. This way, the risk is transferred.

PLAYERS IN DERIVATIVE MARKET

ARBITRAGEURS • Price difference between two different markets is exploited. • Trader simultaneously buys an asset at a cheaper rate from one market and sells it at a higher price in another market. • Low Risk Trade • Available only for a brief period Example : - The cash market price of ABC Ltd is trading at Rs. 100 per share, but is quoting at Rs. 102 in the future market. An arbitrageur would buy 100 shares at Rs. 100 in the cash market & simultaneously, sell 100 shares at Rs. 102 in Future markets, thereby making a profit of Rs. 2 per share.

HEDGERS • Hedging means buying insurance in order to minimize the risk. • HEDGER - Investor/trader who wants to protect himself from unfavorable price movements. • Limits exposure to risk by creating an exact opposite position in derivatives market • Example : - If you buy homeowner's insurance, you are hedging yourself against fires, break-ins, or other unforeseen disasters.

SPECULATORS • Willing to take high risk in the anticipation of making higher gains in a short span of time • Buy stocks with the expectation that the price will rise, and hope to eventually sell stocks at a higher level • Possibilities of either making large profit or losing principal amount • Example : - If a speculator feels that the price of ABC company is likely to fall in a few days due to some upcoming market developments, he would short sell the ABC company’s share in a derivatives market. If the stock price falls as expected, then he would make a good profit depending on his holding. However, if stock prices go up against the expectation, then his loss would be equivalent.

TYPES OF DERIVATIVES

COMMODITY DERIVATIVES • Underlying Asset is a Commodity • Includes Rice, Pepper, Cotton, Gold, Silver etc.

FINANCIAL DERIVATIVES • Underlying Asset includes Financial Instruments viz, stocks, bonds, tbills, foreign currencies etc. • Transacted at different exchanges • Includes Forward, Future, Options, Swap etc.

FINANCIAL DERIVATIVES - NOMENCLATURE Long Position – Buyer Short Position – Seller Spot Price – Market Price Delivery Or Forward Price – Price of the asset on delivery date • Exercise Price – Price at which transaction is to be settled on future date • Clearing House – Arranges for delivery of asset & payment of money • •

FORWARD CONTRACT • Simple customized contract between 2 parties to buy or sell an asset at a certain time in future for a certain price. • Traded in Over The Counter (OTC) market between financial institutions or between a financial institution and its client. • Non – Standardised Contracts customized to owner specifications. • Not traded in an Exchange

FORWARD CONTRACT

FORWARD RATE CONTRACTS CURRENCY CONTRACTS ON INTEREST RATE (FRA) Exchange of currencies is promised at an agreed rate at specified future date Holder or User of this Contract is protected against future rise in interest rates

FORWARD CONTRACT - RISKS CREDIT OPERATIONAL LIQUIDITY

FUTURES CONTRACT • Agreement between 2 parties to buy or sell an asset at a certain time in the future at a certain price • Standardised Forward Contract in terms of Quantity, Quality, Delivery Time & Place of Settlement on any Future Date • Traded in an Organized Exchange • Buyers and sellers are required to deposit margin with stock exchange

FUTURES CONTRACT • Future transactions are available for minimum 1 month & maximum 3 months • NSE commenced trading in index futures on June 12, 2000 • Value Date : - Last Thursday of corresponding month in India & Last Friday world over. • No expiration of future contracts • Long Position : - Buying of futures • Short Position : - Selling of Futures • Clearing House facilitates delivery of Asset & Payment of Cash

SPECULATION FUTURE- OBJECTIVES HEDGING

FUTURE CONTRACT TRADING PROCESS

CLEARING HOUSE • GUARANTEES PERFORMANCE • ACTS AS AN INTERMEDIARY BETWEEN BUYER & SELLER • BOTH BUYER & SELLER HAS TO PERFORM OBLIGATIONS • IF ONE PARTY DEFAULTS THE CLEARING CORPORATION FULFILLS PERFORMANCE • PARTIES ARE REQUIRED TO MAINTAIN A MARGIN • MARGIN CHANGES WITH CHANGES IN DAILY PRICES

CLEARING HOUSE

MARGIN • A margin is an amount of a money that must be deposited with the clearing house by both buyers and sellers in a margin account in order to open a futures contract. • It ensures performance of the terms of the contract. • Its aim is to minimise the risk of default by either counterparty. • Initial Margin - Deposit that a trader must make before trading any futures. Usually, 10% of the contract size. • Maintenance Margin - When margin reaches a minimum maintenance level, the trader is required to bring the margin back to its initial level. The maintenance margin is generally about 75% of the initial margin. • Variation Margin - Additional margin required to bring an account up to the required level. • Margin call – If amount in the margin A/C falls below the maintenance level, a margin call is made to fill the gap.

MARKING TO MARKET • Practice of periodically adjusting the margin account by adding or subtracting funds based on changes in market value to reflect the investor’s gain or loss. • Leads to changes in margin amounts daily. • Ensures that there are no defaults by the parties.

FUTURES COMMODITY FINANCIAL INDEX

OPTIONS • Contracts that give the holder the option to buy/sell specified quantity of the underlying assets at a particular price on or before a specified time period • Option = Right to buy/sell Underlying Assets • Strike/Exercise Price : - Price at which option holder can buy/sell the underlying asset • Manages heavy fluctuation in asset prices • Premium : - Price paid for exercising option

OPTION RIGHT STYLE COVERAGE OF PHYSICAL ASSET UNDERLYING ASSET COVERED OPTION AMERICAN OPTION EUROPEAN OPTION CAPPED OPTION NAKED OPTION STOCK/EQUITY OPTION STOCK INDEX OPTION CURRENCY OPTION CALL OPTION COMMODITY OPTION PUT OPTION

OPTION - STYLE • AMERICAN OPTION : - OPTION CAN BE EXERCISED AT ANY TIME BEFORE OR ON THE EXPIRATION DATE. EG: STOCK OPTION • EUROPEAN OPTION : - OPTION CAN BE ONLY EXERCISED ON EXPIRATION DATE EG: INDEX OPTION • CAPPED OPTION : - WILL BE EXERCISED ONLY WHEN UNDERLYING ASSET CLOSES AT OR ABOVE (CALL) OR AT OR BELOW (PUT) CAP PRICE : - BELOW STRIKE PRICE (PUT OPTION) ABOVE STRIKE PRICE (CALL OPTION)

OPTION – COVERAGE OF ASSETS • COVERED OPTION: - WRITTEN AGAINST ASSETS OWNED BY OPTION WRITER(ONE WHO SELLS OPTION). OPTION HOLDER(ONE WHO BUYS OPTION) WILL BE DELIVERED WITH ASSET OR PRICE DIFFERENTIAL ( DIFF. BW STRIKE PRICE & SPOT PRICE) BY OPTION WRITER.