Introduction to derivatives
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This document provides an overview of derivatives and forward markets. It defines derivatives as products whose value is derived from underlying variables like assets, indices, or rates. Common derivative products discussed include forwards, futures, options, and swaps. Forwards involve private contracts to buy or sell an asset at a future date, while futures are standardized exchange-traded forwards. Options provide the right but not obligation to buy or sell an asset. Swaps involve exchanging cash flows of underlying items like interest rates or currencies. The document also discusses key participants in derivatives markets like hedgers who manage risk, speculators who take positions based on price views, brokers who facilitate trades, and market makers who provide liquidity.
Introduction to derivatives
- 1. Derivatives
- 2. Derivatives Derivative is a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index, or reference rate), in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset
- 3. Derivatives For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the “underlying”.
- 4. Derivatives As per SCRA – a) A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security. b) A contract which derives its value from the prices, or index of prices, of underlying securities.
- 5. Growth of Derivatives Factors driving growth of Derivatives:- a) Increased volatility in asset prices in financial markets, b) Increased integration of national financial markets with the international markets, c) Marked improvement in communication facilities and sharp decline in their costs,
- 6. Growth of Derivatives Development of more sophisticated risk management tools, providing economic agents a wider choice of risk management strategies, and Innovations in the derivatives markets, which optimally combine the risks and returns over a large number of financial assets leading to higher returns, reduced risk as well as transactions costs as compared to individual financial assets.
- 7. Derivative Products Forwards: A 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.
- 8. Derivative Products Options: Options are of two types - calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date. Warrants: Options generally have lives of upto one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer- dated options are called warrants and are generally traded over-the-counter.
- 9. Derivative Products LEAPS: LEAPS means Long-Term Equity Anticipation Securities. These are options having a maturity of upto three years. Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average of a basket of assets. Equity index options are a form of basket options.
- 10. Derivative Products Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are: a. Interest Rate Swaps b. Currency Swaps
- 11. Derivative Products a) Interest Rate Swaps : These entail swapping only the interest related cash flows between the parties in the same currency. b) Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction.
- 12. Party A is currently paying floating rate, but wants to pay fixed rate. Party B is currently paying fixed rate, but wants to pay floating rate. By entering into an interest rate swap, the net result is that each party can ‘swap' their existing obligation for their desired obligation.
- 13. Derivative Products Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating.
- 14. Corporate Risk Management & Derivative Markets
- 15. Definition of Corporate Risk Management “… a process, effected by an corporate's board of directors, management and other personnel, applied in strategy setting and across the organization, designed to identify potential events that may affect the corporate, and manage risks to be within its risk appetite, to provide reasonable assurance regarding the achievement of corporate objectives.” 15
- 16. Classification of risk The wide array of risks that firms are exposed to can be classified into 5 categories: 1. Technological Risk: arise mostly in the R&D and Operations stage of the value chain. 2. Economic Risks: arise from fluctuations in the revenues(output price and demand) and production cost ( Raw material cost, energy cost and labor cost) 3. Financial Risks: arise from volatility of Interest rates, currency rates, commodity prices and stock prices. 4. Performance risks: arise when contracting counterparties do not fulfill their obligations. 5. Legal and Regulatory risks: change in laws and regulations
- 17. Measurement of financial Risks in firms To assess the Financial price risk we may: a) Examine the financial statements to get an idea of the risk exposure b) Assess the sensitivity of the firms value or cash flow to changes in the financial prices and c) Conduct monte carlo simulation.
- 18. Examine the financial statements Examining the Balance sheet and Profit & loss account throw light on a number of questions like: • Does the firm have a strong liquidity position as per high Current ratio and Quick ratio? A strong liquidity position cushions against the volatility of cash flows caused by changes in Financial prices. • Does the firm have a low gearing ratio (leverage)? A low gearing ratio provides greater financial flexibility to cope with volatility in financial prices. • What is the Foreign exchange transaction exposure? If the balances of receivables and payables are high, their values would change in response to shifts in the exchange rates. • Is the firm exposed to interest rate risk? If the firm relies mainly on free floating debt it has a high interest rate exposure.
- 19. Assess the sensitivity Determine the sensitivity of Firm’s Value or Cash Flow by: • Analyzing the Historical data on firm value, cash flows and financial prices
- 20. monte carlo simulation • Monte carlo methods are used in finance to value and analyze (complex) instruments, portfolios and investments by simulating the various sources of uncertainty affecting their value, and then determining their average value over the range of resultant outcomes. • The advantage of monte carlo methods over other techniques increases as the dimensions (sources of uncertainty) of the problem increase.
- 21. Principle of hedging • One way to manage these risks and uncertainties is to enter into transactions that expose the entity to risk and uncertainty that fully or partially offsets one or more of the entity’s other risks and uncertainties, transactions known as ‘hedges’. • The instrument acquired to offset risk or uncertainty is known as ‘hedging instrument’ and the risk or uncertainty hedged is known as ‘hedged item’. • There are predominantly two motivations for a company to hedge: To lock-in a future price which is attractive, relative to an organization's costs. To secure a commodity price fixed against an external contract
- 23. HEDGING WITH Forward CONTRACTS • Forward contract is an OTC agreement between two parties, to buy or sell an asset at a certain time in the future for a certain price. • The price of the underlying instrument, in whatever form, is paid before control of the instrument changes. • This is one of the many forms of buy/sell orders where the time of trade is not the time where the securities themselves are exchanged. • The forward price is commonly contrasted with the spot price, which is the price at which the asset changes hands on the spot date. • The difference between the spot and the forward price is the forward premium or forward discount, generally considered in the form of a profit or loss, by the purchasing party.
- 24. HEDGING WITH FUTURE CONTRACTS What Does Futures Contract Mean? A contractual agreement, generally made on the trading floor of a futures exchange, to buy or sell a particular commodity or financial instrument at a pre-determined price in the future. Futures contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures exchange. Some futures contracts may call for physical delivery of the asset, while others are settled in cash.
- 25. TYPES OF FUTURE CONTRACTS There are many different kinds of futures contracts, reflecting the many different kinds of "tradable" assets about which the contract may be based such as commodities, securities (such as single- stock futures), currencies or intangibles such as interest rates and indexes. 1. Foreign exchange market 2. Money market 3. Bond market 4. Equity market 5. Commodities market
- 26. HEDGING WITH SWAPS What Does Swap Mean? If firms in separate countries have comparative advantages on interest rates, then a swap could benefit both firms. For example, one firm may have a lower fixed interest rate, while another has access to a lower floating interest rate. These firms could swap to take advantage of the lower rates.
- 27. TYPES OF SWAPS • Interest rate swaps • Currency swaps • Commodity swaps • Equity swap
- 28. REASON FOR SWAPS • Spread compression • Market segmentation • Market saturation • Difference in financial norms
- 29. HEDGING WITH OPTION CONTRACTS An option contract is an agreement under which the seller of the option grants the buyer the right, but not the obligation, to buy or sell(depending on whether it is a call option or a put option) some asset at a predetermined price during the specified period. The buyer of the option has to pay a premium to enjoy the right. Forward vs options: • In forwards contract both parties agree to act in the future whereas in an option transaction occurs only if the buyer of the option chooses to exercise it. • In forward contract no money exchanges hands whereas in options the buyer of the contract pays option premium.
- 30. Types of option contracts • Option contract on debt instruments- options on treasury bill • Option contract on foreign currencies– options with US $ • Option contract on stock market indices-option on Nifty • Option contract on stocks
- 31. EVOLUTION OF RISK MANAGEMENT TOOLS The financial and operating environment today is more riskier than in the past – • Substantial increase in the average rate as well as volatility of inflation • Greater volatility in interest rates , exchange rates, and commodity prices • Increased global competition.
- 32. Volatility and Risk Management Tools • Exchange rate volatility- currency futures, currency swaps, currency options • Interest rate volatility- floating rate loans, T-Bill futures, T-Bond futures, options on T-Bonds • Petroleum prices- futures in heating oil, futures in WTI, hybrids, option in WTI • Metal price volatility- forwards, futures, options , hybrids.
- 33. WTI West Texas Intermediate (WTI), also known as Texas light sweet, is a grade of crude oil used as a benchmark in oil pricing. This grade is described as light because of its relatively low density, and sweet because of its low sulfur content. It is the underlying commodity of Chicago Mercantile Exchange's oil futures contracts
- 35. Forward Foreign Exchange Contract Definition: An agreement to exchange one currency for another, where The exchange rate is fixed on the day of the contract, but The actual exchange takes place on a pre- determined date in the future
- 36. Characteristics and Features of FX Forwards Available daily in major currencies in 30-, 90-, and 180-day maturities Forwards are entered into “over the counter” Deliverable forwards: face amount of currency is exchanged on settlement date Non-deliverable forwards: only the gain or loss is exchanged
- 37. Characteristics and Features of FX Forwards Contract terms specify: forward exchange rate term amount ‘‘value date’’ (the day the forward contract expires) locations for payment and delivery. The date on which the currency is actually exchanged, the ‘‘settlement date,’’ is generally two days after the value date of the contract.
- 38. Characteristics and Features of FX Forwards Forward Exchange Rates Forward exchange rates are different from spot rates, but they are not a prediction of what the spot rate will be when the deal settles! The difference between the forward exchange rate and the spot exchange rate is the interest differential between the two currencies
- 40. Uses of FX Forwards (1) Hedge foreign currency risk (2) Arbitrage FX rate discrepancies within and between markets (3) Speculate on future market movements (4) Profit by acting as market maker Financial institutions, money managers, corporations, and traders use these instruments for managing currency risk
- 41. What is a futures contract? A futures contract is a forward contract, which trades on an exchange. S&P CNX Nifty futures are traded on National Stock Exchange. This provides them transparency, liquidity, anonymity of trades, and also eliminates the counter party risks due to the guarantee provided by National Securities Clearing Corporation Limited.
- 42. Options An Option is a contract which gives the right, but not an obligation, to buy or sell the underlying at a stated date and at a stated price. While a buyer of an option pays the premium and buys the right to exercise his option, the writer of an option is the one who receives the option premium and therefore obliged to sell/buy the asset if the buyer exercises it on him.
- 43. A typical options transaction On July 1, 2006, 'A' sells a call option (right to buy), with strike price of Rs.500, which expires after one month on "ABC Ltd." to 'B' for a price of say Rs.3.00. Now 'B' has the right to approach 'A' on July 31, 2006 and buy 1 share of "ABC Ltd." at Rs.500. Here Rs.3.00 is called the option price, Rs.500 is the exercise price and July 31, 2006 is called the expiration date.
- 44. A typical options transaction 'B' does not have to necessarily buy 1 share of "ABC Ltd." on July 31, 2006 at Rs.500 from 'A'. 'B' may find it worthwhile to exercise his right to buy only if "ABC Ltd." trades above Rs.500. If "B” exercises his option, A has to necessarily sell "B“ one share of "ABC Ltd." at Rs.500 on July 31, 2006. So if the price of "ABC Ltd." goes above Rs.500 'B' may exercise his option, or else the option may lapse. Then 'B' loses the original option price of Rs.3.00 and 'A' has gained it.
- 45. Intermediaries in the derivatives market
- 46. Brokers For any purchase and sale, brokers perform an important function of bringing buyers and sellers together. By virtue of a member of a commodity or financial futures exchange one get a right to transact with other members of the same exchange. This transaction can be in the pit of the trading hall or on online computer terminal.
- 47. Market makers and jobbers Even in organized futures exchange, every deal cannot get the counter party immediately. It is here the jobber or market maker plays his role. They are the members of the exchange who takes the purchase or sale by other members in their books and Then Square off on the same day or the next day. They quote their bid-ask rate regularly. The difference between bid and ask is known as bid-ask spread. When volatility in price is more, the spread increases since jobbers price risk increases.
- 48. Hedgers The process of managing the risk or risk management is called as hedging. Hedgers are those individuals or firms who manage their risk with the help of derivative products. Hedging does not mean maximizing of return. The main purpose for hedging is to reduce the volatility of a portfolio by reducing the risk.
- 49. Speculators Speculators do not have any position on which they enter into futures and options Market i.e., they take the positions in the futures market without having position in the underlying cash market. They only have a particular view about future price of a commodity, shares, stock index, interest rates or currency. They take risk in turn from high returns. They help in providing the market the much desired volume and liquidity.
- 50. Arbitrageurs Arbitrage is the simultaneous purchase and sale of the same underlying in two different markets in an attempt to make profit from price discrepancies between the two markets. Arbitrage involves activity on several different instruments or assets simultaneously to take advantage of price distortions judged to be only temporary.
- 51. Arbitrageurs Arbitrage occupies a prominent position in the futures world. It is the mechanism that keeps prices of futures contracts aligned properly with prices of underlying assets. The objective is simply to make profits without risk, but the complexity of arbitrage activity is such that it is reserved to particularly well-informed and experienced professional traders, equipped with powerful calculating and data processing tools. Arbitrage may not be as easy and costless as presumed.
- 52. Commodity Producers/Consumers These participants have natural underlying outright long (producers) and short (consumers) positions in the relevant commodity. The inherent risk-exposure drives the use of commodity derivatives by producers and users.
- 53. Commodity Processors These participants have limited outright price exposure. This reflects the fact the processors have a spread exposure to the price differential between the cost of the input and the cost of the output. For example, oil refiners are exposed to the differential between the price of the crude oil and the price of the refined oil products (diesel, gasoline, heating oil, aviation fuel, etc.). The nature of the exposure drives the types of hedging activity and the instruments used.
- 54. Commodity Traders The traders act as an agent or principal to secure the sale/purchase of the commodity. Traders increasingly seek to add value to pure trading relationship by providing derivative/risk management expertise. Traders also occasionally provide financing and other services. Commodity traders have complex hedging requirements, depending on the nature of their activities.
- 55. Financial Institution/Dealers Dealer participation in commodity markets is primarily as a provider of finance or provider of risk management products. The dealers provide credit enhancement, speed, immediacy of execution and structural flexibility. Dealers frequently bundle risk management products with other financial services such as provision of finance.
- 56. Investors This covers financial investors seeking to invest in commodities as a distinct and a separate asset class of financial investment. The gradual recognition of commodities as a specific class of investment assets is an important factor that has influenced the structure of commodity derivatives markets.
- 57. Terminologies used in the derivative market - Options
- 58. Types of Options Options are of two types – 1. Calls options 2. Puts options
- 59. Calls options “Calls” give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date.
- 60. Puts options “Puts” give the buyer the right, but not the obligation to sell a given quantity of underlying asset at a given price on or before a given future date. All the options contracts are settled in cash.
- 61. Premium Premium the price that the holder of an option pays and the writer of an option receives for the rights conveyed by the option. i. The premiums are not fixed by the Exchange and are subject to fluctuations in response to market and economic forces. The factors affecting pricing of an option include ii. current value of the underlying, iii. the exercise price, iv. current values of futures on the underlying, v. style of option, vi. individual opinion and estimates of the future volatility of the underlying, vii. historical volatility of the underlying, viii. the time remaining till expiration, ix. cash dividends payable on the underlying stock, x. current interest rates, depth of the market, available information, etc.
- 62. In- the- money options (ITM) An in-the-money option is an option that would lead to positive cash flow to the holder if it were exercised immediately. A Call option is said to be in-the-money when the current price stands at a level higher than the strike price. If the Spot price is much higher than the strike price, a Call is said to be deep in-the-money option. In the case of a Put, the put is in-the-money if the Spot price is below the strike price.
- 63. At-the-money-option (ATM) An at-the money option is an option that would lead to zero cash flow if it were exercised immediately. An option on the index is said to be “at-the-money” when the current price equals the strike price.
- 64. Out-of-the-money-option (OTM) An out-of- the-money Option is an option that would lead to negative cash flow if it were exercised immediately. A Call option is out-of-the-money when the current price stands at a level which is less than the strike price. If the current price is much lower than the strike price the call is said to be deep out-of-the money. In case of a Put, the Put is said to be out-of-money if current price is above the strike price.