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5th December 2007

Derivatives

Prof.L. Augustin Amaladas


M.com.,AICWA.,PGDFM.,B.Ed
.

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What do you mean by rest?
Why does BSE index moves
upwards and volatile?

Mortgage market?

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Reasons
• In USA most of the banks engaged in mortgage
market by lending without seeing the client's credit
worthiness. But most of the customers fail to repay
the long term loan. The banks are allowed to recover
such loans by sale of such properties.
• The total funds have to be reinvested in profitable
way. Most of the banks see(BRIC countries)India is
one of the countries where they can get better return
and also india’s inflation is arround 4% and growth
rate is around 9%.
• BRIC-Bracil, Russia, India and China

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Leading Investment and
Commercial banks
• Banc of America Securities LLC
• Citigroup
• Credit Suisse
• Goldman Sachs
• JPMorgan Chase
• Lehman Brothers
• Merrill Lynch
• Morgan Stanley
• UBS

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banks in the international markets

• Categories of banks in the international markets:


• 1. commercial banks-JP Morgan Chase
• 2.investment banks-Goldman Sachsas, London
investment bank Morgan Grenfell Bankers Trust
in New York, Crédit Lyonnais Belgium ,Brussels
Moscow-based investment bank
United Financial Group in Russia ,the German
norisbank and Berliner Bank.
• 3.mixed banks-HSBC

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Investment And Commercial Banks
Differ?
• Commercial Banks (CB) accept
deposits and make commercial loans
as a financial intermediary.
• CB traditionally could underwrite only
low-risk securities of governments per
the Glass-Steagall Act.
• Many large firms now use the direct
financial markets to finance rather than
bank loans.
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RISK /Uncertain???
• Case-1
• An Indian Garments company has received an
order to supply I,00,000 units of shirts from USA.
The price of $ 500,000 is receivable after six
months. The current exchange rate is
Rs.39.76/$. At the current exchange rate, the
company would get: 39.76 × 500,000 = Rs
1,98,80,000. But the company anticipates
appreciation of Indian rupee over time. Does the
company loose/gain due to appreciation in the
Indian Rupee? How does company minimise the
risk?
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Alternative work is rest
Minimising risk case-1

• The company can lock in the exchange


rate by entering into an advance contract
and forget about any fluctuation in the
exchange rate. Suppose, the six-month
forward exchange rate is Rs39.00/$ The
company can make an agreement at spot
rate at 39.76 in the spot market or at a
lesser price. At the time of receiving dollar,
it will exchange $500,000 at Rs39.76= Rs
1,98,80,000. or agreed price.

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Happiness by giving/receiving?
Case 2
• You have imported machinery for $ 100,000 on 180 days
credit at zero interest. The dollar quotes at Rs 39. Is
this deal risk free?
• This deal is not free of risk because after six months
when you pay the loan, if the dollar quotes anything
more than Rs39., say Rs 40, you will end up paying
more [Rs 1 extra for every $ 1, which is equivalent to Rs
100,000 additional cost]. On the other hand, if the dollar
quotes anything less than Rs 39, you will stand to gain
• The question here is not whether you stand to gain or
loose – it is the risk you are taking

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Happiness by giving not receiving
Case 03

• You have surplus cash for investment. You


think of investing in Wipro, currently quoting at
Rs 3,500, which you believe will rise to Rs 3,950
in six months. Is this deal risk free?
• This deal is not free of risk because there is no
guarantee that Wipro’s shares would touch Rs
3,950 in six months time.
• The share prices could rise beyond Rs 3,950 or
could also fall below Rs 3,500 – giving you no
return on investment and you could stand to
loose some portion of your investment
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Old lady in a seashore!....
How do you protect yourself ?

• Use Derivative instruments.


• What is derivatives?

• See the next example.


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Picking up something?...
Example

• You [along with two friends] want to go for the


Aero India January 2008 air show, for which
tickets are sold out. Through one of your close
friends, you obtain a recommendation letter,
which will enable you to buy three tickets. The
price of a ticket is Rs 1,000.
• Which is the commodity that you are suppose to
buy?
• In order to buy the________ what are required
now?
• Money/recommendation letter (instrument) or
both?
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People walking in the seashore scared?...
Financial instruments

• The recommendation letter is a derivative


instrument. It gives you a right to buy the ticket
• The underlying asset is the ticket
• The letter does not constitute ownership of the
ticket
• It is indeed a promise to convey ownership
• The value of the letter changes with changes in
the price of the ticket. It derives its value from
the value of the ticket
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Children are scared to go near by?...
Different 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
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What was see doing? Why?...
Meaning

• Derivative instruments are called so because


they derive their value from whatever the
contract is based on
• “A derivative contract is a financial instrument
whose payoff structure is derived from the value
of the underlying asset”
• These instruments include futures contracts,
forward contracts, options contracts, swap
agreements, and cap and floor agreements

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See the next slide…
Advantages

• The derivative market helps people meet


diverse objectives such as:
– Hedging
– Profit making through price changes
– Profit making through arbitrage

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Guess what does she pick up?
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 is like an insurance company
– Derivative instruments redistribute the risk amongst market
players
– However, if you want protection against adverse price
movements, you must pay a price, ie the premium

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Children are not allowed to go near by…!
Derivative instruments on
 Stocks (Equity)
 Agri Commodities including grains, coffee beans, pepper,.
 Precious metals like gold and silver.
 Crude oil
 Foreign exchange rate
 Bonds
 Short-term debt securities such as T-bills
 Index
 Interest rate

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The old lady looked shabby…
TYPES OF DERIVATIVES

Futures
Forwards
Option
Floor
cap

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Policemen also ask the public to go away from her
Players in the market

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

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See next slide
Old lady in a seashore?
• She picked up broken glasses from
seashore?
• Picked up stones?
• Does she harm anybody?

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What is your answer?

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Broken glasses should not
harm the children

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Lesson:1 What we perceive may not
be what is real
Lesson-2

Judge not based on outlook /


colour

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Ways of making contract?

• 1. Private contracts- Known as Forwards


• 2. Through Stock - Known as
exchanges Futures, Options
Swap, Floor and
Cap

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Threat is an opportunity
How do they settle the contract?

• Daily basis -Known as Marking to market

Present strengths
www.professoraugustin.com are your threats
How does stock exchange operate?

• It collects amounts from both the parties


of contract known as Initial Margin Money.
• Stock Exchange also collect additional
margin money is known as Variation
Margin.

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Important terms
• LIBOR
• SWAP
• OPTION HODER
• EXERCISE THE CONTRACT
• CURRENCY SWAPS
• INTEREST SWAPS
• PREMIUM STRIKE PRICE
• AMERICAN OPTION SPOT PRICE
• EUROPEAN OPTION EXPIRY OF CONTRACT
• BERMUDA OPTION BASIS RISK
• OPTION HOLDER COUNTER PARTY RISK
• OPTION WRITER
• CALL OPTION
• PUT OPTION
• LONG
• SHORT

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QUESTIONS?

• Thank you for all professors & students of


II B.Com classes of SJCC .

• By Prof.Augustin Amaladas

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