Diploma In Management Adani Group Financial Management

Derivative
Submitted to : Prof. Deepak Dhanak Submitted by : Shalin Shah Yogesh Dalal Ishwar Dubey

RISK /Uncertainty???
Case : An Indian Garments company has received an order to supply I,00,000 units of shirts from USA. The price of $ 100,000 is receivable after six months. The current exchange rate is Rs.55/$ At the current exchange rate, the company would get after 6 months : 55 100,000 = Rs 55,00,000 But the company anticipates appreciation of Indian rupee over time i.e rupee will be at Rs. 50/ usd after 6 months Does the company loose/gain due to appreciation in the Indian Rupee? Can company minimise such risk?

Minimizing risk case

The company can lock in the exchange rate by entering into an advance contract and forget about any fluctuation in the exchange rate. Suppose, company can enter into contract to sell USD after 6 months at exchange rate is Rs55.50/$ At the time of receiving dollar, it will exchange $100,000 at Rs55.50= Rs 55,50,000 Thus company can eliminate further volatility of exchange rate in future by entering forward contract rate.

Types of Risk - Coverage

Firms are exposed to several risks in the ordinary course of operations and borrowing funds. For some risks, management can obtain protection from an insurance company(fire, loss of profit / loss of stock, marine insurance) Similarly, there are capital market products available to protect against certain risks. Such risks include risks associated with a rise in the price of commodity purchased as an input, a decline in a commodity price of a product the firm sells, a rise in the cost of borrowing funds and an adverse exchange rate

movement.

The instruments that can be used to provide such protection are called derivative instruments

What is a Derivative?
Derivative comes from the word to derive A derivative is a contract whose value is derived from the value of another asset called underlying

asset
If the price of underlying asset/security changes the price of derivative security also changes. The underlying asset can be equity, fixed income instruments, interest rates, foreign exchange or commodities. The price movements of derivative products are related to that of the underlying securities. These instruments include futures contracts, forward contracts, options contracts

Underlying Asset/Security
Commodity derivative
Underlying is wheat, cotton, pepper, corn, oats, soyabean, crude oil, natural gas, gold, silver, turmeric etc. Underlying is stocks, bonds, indexes, foreign exchange, Eurodollar etc.

Financial derivatives

Derivative minimises the risk of owning things that are subject to unexpected price fluctuations like foreign currencies, bulk of wheat, stocks & bonds.

Derivative instruments on
Stocks (Equity) Agri Commodities including grains, coffee beans, pepper,. Precious metals like gold and silver. Crude oil Foreign exchange rate Short-term debt securities such as T-bills Index Interest rate

Various types of Derivatives

Why Derivatives exist

Two Purposes

HEDGING

SPECULATION

Factors Driving The Growth Of Derivatives

Increased volatility in commodity prices, currencies, stock prices etc Increased integration with the international markets

Development of more sophisticated risk management tools.

Advantages
The derivative market helps people meet diverse objectives such as: Hedging

Profit making through arbitrage

Derivatives - Uses
Price discovery Most price changes are first reflected in the derivative market. That way derivative market feeds the spot market For instance, if the dollars are going down, it means that the professional investors are expecting dolor price to go down in the future this is a good sign for you to buy in the spot market Risk transfer A derivative market provides protection against risk Derivative instruments redistribute the risk amongst market players

Players in the market

Banks-Citi Bank Deutsche Bank Goldman Saches JP Morgan Chase HSBC ICICI

Participants in Forward Contracts

Hedgers They participate in the forward market with a view to protect or cover an existing exposure in the spot market. Speculators These dealers based on their opinion about the market movements take an exposure in the forward market with a view to make profits from the expected movement in the underlying element. Arbitrageurs These players neither hedge nor speculate. They try to take advantage of the price differences in the spot and forward markets.

Types of Financial Derivatives

Forwards Futures Options Swaps

FORWARDS
It is a contract between two parties to buy or sell an underlying asset at todays preagreed price (known as Forward Price) on a specified date in the future.

This forward price is set at the inception of contract

It is the most basic form of derivative contract. These contracts are not standardized, the end users can tailor make the contracts to fit their very specific needs.

Traded at Over The Counter exchange.

Example

An Indian Company has ordered machinery from USA. The price of $ 1,00,000 is payable after six months. The current exchange rate is 55 as on date. At the current rate the company needs 55*1,00,000 = 55,00,000 If the company anticipates depreciation of Indian rupee over time i.e expect the rupee to reach up to Rs. 60 / use The company can enter into a forward contract at 55& forget about any exchange rate fluctuations. Suppose the exchange rate becomes 60, then also the company has to pay Rs. 55,00,000 for buying $ 1,00,000 though the value is 6,00,000.

Different Types of Forward Contracts Depending on the underlying asset, the most common types of forward contracts are:

Currency Forwards Interest Rate Forwards, and Commodity Forwards

FUTURES

Futures are financial contracts to eliminate the risk of change in price in the future date. Futures are highly standardized exchange traded contracts to buy or sell specified quantity of financial instruments/commodity in a designated future month at a future price. Futures Price : The price agreed by the two traders on the floor of exchange. In simple terms, a futures contract is a contract that allows the counterparties to exchange the underlying assets in future at a price agreed upon today. Following are the features of a futures contract-

Settlement guaranteed by the clearing corporation of the exchange

Contract through an exchange To exchange obligations on a future date At a price decided today For a quantity / quality standardized by the exchange

Types of Futures
Types of Futures Commodity futures (Wheat, corn, etc.) and Financial futures Financial futures include: Foreign currencies Interest rate Market index futures (Market index futures are directly related with the stock market) Individual stock.

Difference between forwards and futures

Forwards Futures
Nature of the contract Counterparty Customized Any entity

Forwards Futures
Standardized Clearing house of exchange

Credit Risk Liquidity

Margins

Exists Poor
Not Required

Assumed by the exchange Very High

Received / Paid on daily basis Done on daily basis

Valuation

Not Done

Margin
It is the initial deposit required to open a trading account in a futures trading exchange. The initial margin is fixed by the broker, but has to satisfy an exchange minimum.

The variation margin i.e. the change in the amount of an account on a given
day in response to a market to-market process, is settled on daily basis.

Margin - Process
The exchange requires both parties to put up an initial amount of cash, the margin. Additionally, since the futures price will generally change daily, the difference in the prior agreed-upon price and the daily futures price is settled daily The exchange will draw money out of one party's margin account and put it into the other's so that each party has the appropriate daily loss or profit. If the margin account goes below a certain value, then a margin call is made and the account owner must replenish the margin account. This process is known as marking to market.

 Initial Margin The amount that must be deposited in the margin account when establishing a position. The margin requirement is about 12% futures & 8% for options. Marking to Market In the futures market at the end of each trading day, the margin account is adjusted to reflect the investors gain or loss depending upon the futures closing account. Maintenance Margin This is set to ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin, the investor is expected to top up the initial level before trading commences on the next day.

For example say you have bought 100 shares of XYZ at Rs.100 and Threshold MTM Loss is 20% and the applicable
margin % is 35%. You would be having a margin of Rs.3500 blocked on this position. The current market price is now say Rs.75. This means the MTM loss is 25% which is more than the threshold MTM loss % of 20% and hence additional margin to be called in for. Additional margin to be calculated as follows:

(a) Margin available (b) Less : MTM Loss (c) Effective available margin (d) Required Margin (e) Additional Margin required

100*100*35% (100-75)*100 (a-b) 75*100*35% (d-c)

Rs.3500 Rs.2500 Rs.1000 Rs.2625 Rs.1625

OPTIONS
An option is a contract between two parties in which one party has the right but not the obligation to buy or sell some underlying asset on a specified date at a specified price. The option buyer has the right not an obligation to buy or sell. If the buyer decides to exercise his right the seller of the option has an obligation to deliver or take delivery of the underlying asset at the price agreed upon. Hence, option is like general insurance

Options - characteristics
Options or option contracts are instruments Right, but not the obligation, is given To buy or sell a specific asset At a specific price On or before a specified date Options can be exchange traded derivatives or even over the counter derivatives.

Option Classifications
Call Option : an option which gives a right to buy the underlying asset at a strike price.

Put Option : an option which gives a right to sell the underlying asset at strike price.

CALL OPTIONS
A call option is a contract that gives the option holder the right to buy some underlying asset from the option seller at a specified price on or before a specified date. Eg. The current market price Ashok Leyland is Rs.69. o An option contract is created and traded on this share. o A call option on the share would give the right to buy the share at a specified price (Rs.75) during April 2013. o This call option would be traded between two parties P (the purchaser and S ( the seller). The purchaser P would be prepared to pay a small price known as option premium (Rs.2) to S, the seller of the option.

PUT OPTIONS
A put option is a contract which gives its owner the right to sell some

underlying asset at a specified price on or before a specified date.

The seller of the put option has the obligation to take delivery of the

underlying asset, if the owner of the option decides to exercise the

option.

Types of Options
On the basis of maturity pattern of options, option contracts are

categorized in to two. They are:

European Style Options

American Style Options

 European Style Options Options which can be exercised only date of the option or on the expiry date. American Style Options Options which can be exercised at any including the expiry date.

on

the

maturity

time

up

to

and

Most of the exchange traded options are American style. In India stock options are American style while index options are European style.

Option Terminologies
Strike Price or Exercise Price Expiration Date Exercise Date Option Buyer Option Seller American option European option Option Premium

 Option Writer or Option Grantor: The seller of option. Strike price or Exercise price : The price at which the option holder may purchase the underlying asset from the option seller.

Time to Expiration or Time to Expiry : The period of time specified for exercising
the option.

Expiration Date : The precise date on which the option right expires. Option Premium : The price to be paid by option purchaser to option seller

Moneyness of Options
Moneyness of an option describes the relationship between the strike price of

the option and the current stock price. This takes three forms:
1. In the Money

2.
3.

At the Money
Out of the Money

In the Money Options

When the strike price of a call option is lower than the current stock price, the option is said to be in the money. This is because the owner of the option has the right to buy the stock at a price which is lower than the price which he has to pay if he had to buy it from the open market. Similarly in the case of put option, when the strike price is greater than the stock price, the option is said to be in the money. If an in the money option is exercised, there will be an immediate cash inflow.

At the Money Options

When the strike price of a call option is equal to the current stock price, the option is said to be at the money option. In the case of a put option if the strike price of the option is equal to the stock price, the put option is said to be at the money.

Out of the Money

When the strike price of a call option is more than the stock price, the option is termed as out of the money option. In the case of put option, if the strike price is less than the stock price, the option is said to be out of the money option.

When the Shares of A Ltd. is Trading at Rs.450

Strike Price (Rs.) 420 430 440 450 460 470 480
Out of the Money In the Money In the Money Out of the Money

Call Option

Put Option

At the Money

At the Money

Option Premium
Both the Call and Put option buyers are buying the rights, that is they are transferring their risks to the sellers of the option. For this transfer of risk to the sellers, buyers have to compensate by paying Option Premium. Option premium is also known as Price of the option, Cost or Value of the option.

Factors influencing Option Pricing

Time to expiration greater the time to expiration, higher the value of the options. Volatility higher the volatility, higher the value of the options. Risk free Rate of Interest If interest rate goes up, calls gain in value while puts lose value.

Settlement of Options
Physical Delivery Cash settlement

DIFFERENCE BETWEEN FUTURES FUTURES OPTIONS AND OPTIONS

Futures Contract is an agreement to buy or sell specified In options the buyer enjoys the right and not the quantity of the underlying assets at a price agreed upon obligation, to buy or sell the underlying asset. by the buyer and seller, on or before a specified time. Both the buyer and seller are obliged to buy/sell the underlying asset.

Unlimited upside and downside for both buyer and seller Limited downside (to the extent of premium paid) for buyer and unlimited upside. For seller (writer) of the option, profits are limited whereas losses can be unlimited. Futures contracts prices are affected mainly by the prices Prices of options are however, affected by (a) prices of of the underlying asset. the underlying asset, b) time remaining for expiry of the contact and c) volatility of the underlying asset.

FAQS
A. Why banks will provide derivative instruments : To earn brokerage income they will also transfer the risk to thrid counter party and keep a margin in hedge costs Many times natural hedge e.g. may give derivative to an importer as well to an exporter thereby nullifies risk of both instruments

will earn commission on both transactions.

To protect their clients against any forex risk and thereby protecting their own credit risks B. What if eventually fluctuation turns out favorable but company can not benefit as it has already hedged by derivative instrument : Company to earn from core business and not from volatility If company has a view of higher probability of positive fluctuations, then hedging through option contract can serve dual purpose company is protected against unfavorable fluctuations while can benefit from favorably fluctuations