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Financial Risk Management

3. Introduction to Derivatives

suresh.suralkar@gmail.com, Phone: 40434399, 25783850


 Course Content - Syllabus


Sr Title Book

1 Introduction to Risk Management ICMR Ch. 1, 2


2 Corporate Risk Management ICMR Ch. 3


3 Introduction to Derivatives ICMR Ch. 4


4 Futures

5 Options Mid Semester Portion: up to half chapter of Options


6 Swaps

7 Credit Derivatives

8 Weather Derivatives

9 Value at Risk

10 Current Developments
 Introduction to Derivatives

Book Reference

1. Financial Risk Management, ICMR Book and ICMR


workbook
2. Derivatives and Risk Management, J. R. Varma, 2008,
Publisher: Tata McGraw-Hill
3. Options, Futures and Other Derivatives, Hull, John C,
Publisher: Pearson Education
4. Futures and Options, Sridhar, A. N., Shroff Publishers
5. Foreign Exchange, International Finance & Risk
Management, Rajwade, A. V., Publisher: Academic
Business Studies
6. Options and Futures, Dubufsky, David A., Publisher:
McGraw Hill
7. Financial Derivatives, Redhead, Keith, Publisher: Prentice
Hall
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 Syllabus – Introduction to Derivatives

1. Historical Perspective

2. Exchanges: the Mechanics of Derivative Markets


3. The role of Clearing Houses


4. Market Players in Derivative Market


5.
 Trading Techniques

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 1. Historical Perspective

History of derivatives traces back to the ages before Jesus


Christ (B.C.). Some texts find the existence in the


incidents of Mahabharata.
However, the advent of modern day derivative contracts is

attributed to the need for farmers to protect themselves


from any decline in the price of their crops due to
delayed monsoon or overproduction.
The first 'futures' contracts is traced to rice market in

Osaka, Japan around 1650.


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 1. Historical Perspective

The Chicago Board of Trade (CBOT), the largest


derivative exchange in the world, was established in


1848. There the contracts on various commodities were
standardized and first derivatives trading started in
1865.
In 1975, Chicago Mercantile Exchange (CME) launched

currency futures and CBOT launched interest rate


futures.

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 1. Historical Perspective

Derivatives have had a long presence in India. The


commodity derivative market has been functioning in
India since the establishment of Cotton Trade
Association in 1875. Exchange traded financial
derivatives were introduced in India in June 2000 at the
two major stock exchanges, NSE and BSE.
National Commodity & Derivatives Exchange (NCDEX)

and Multi Commodity Exchange (MCX) started its


operations in 2003 for commodities trading.
The derivatives market in India has grown exponentially,

especially at NSE. Stock Futures are highly traded


contracts on NSE accounting for more than half of the
total turnover of derivatives at NSE.
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 1. Historical Perspective

In last 20 years there has been most extraordinary growth


in derivatives market. In 1980s, the process of
liberalization and deregulation of financial markets
started from US and UK, later spread worldwide.
Advent of computers, information and communication

technologies (ICT), internet and mobiles have facilitated


the integration process. Financial activities increased
within countries and cross-border. Transaction costs
greatly reduced. Capital adequacy norms (Basel)
increased costs of banking activity and banks found
securitization and fee based income activities.
With integration of financial markets and free mobility of

capital increased risks substantially. This led to risk


hedging mechanisms.
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 1. Historical Perspective

After US, derivatives markets flourished in Europe,


followed by emerging economies. Value of derivatives


market worldwide was about $50 trillion in 1995 and
over $600 trillion in 2007.

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 1. Historical Perspective

• The process of developments in derivatives market still


continues. There are also derivatives whose underlying
assets are derivatives.
• Derivative is a financial instrument that is derived from
some other asset, index, event, value or condition
(known as the underlying asset).
• Derivatives are often leveraged, such that a small
movement in the underlying value can cause a large
difference in the value of the derivative.

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 1. Historical Perspective

• The word 'derivative' originates from mathematics and


refers to a variable, which has been derived from
another variable. Derivatives are so called because they
have no value of their own. They derive their value
from the value of some other asset, which is known as
the underlying.

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 Classification of Derivatives

Classification of Derivatives by:


• Nature of Contract (Relationship between underlying


and the derivative): forward, future, option, swap
• Type of underlying: equity derivatives, foreign exchange
derivatives, credit derivatives, interest rates (interest
bearing financial assets), commodity
• Market mechanisms (in which they trade): exchange
traded or over-the-counter

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 2. Exchanges: the Mechanics of Derivative
Markets

Some derivatives are traded on exchanges while others are


traded only in OTC market.
OTC market remains predominantly a telephone /

computer connected market. It is a significant market in


volume and innovations.
OTC derivatives have credit risk, in which one party is

exposed to the risk that his counterparty may default on


the contract.
Exchange protects by taking deposits and margins and

ensure settlement.

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 Difference between Futures and Forward Contracts

Future Contracts Forward Contracts


1. These are traded on stock exchanges This is over-the-counter product
2. Terms of contract are highly Terms are structured to suit both
standardized
3. Contracts are cleared by a separate contracting parties
No such facility exists
clearing house
4. Clearing house guarantees the No organization guarantees the
performance of the
5. Traders have contractinitial margin
to deposit performance
No compulsion of the counterparty
to make such deposits
irrespective of their
6. Traders have to paytrading
dailyposition
settlement No such provisions are in vogue
margin depending
7. Futures contractsoncanthebeprice of closed
easily Quite difficult to do so
underlying stock are monitored and
8. Futures markets Regulation is not as tight as in futures
regulated
9. Mark toby special
market is agencies
done at the end of markets
No such adjustments are carried out
every trading day

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 3. The Role of Clearing Houses

A clearing house is a key institution in the derivatives


market. It performs two critical functions: Offsetting the


customer dealings and assuring the financial integrity of
the transaction that takes place in the exchange.
The clearing house could be part of the exchange or a

separate body co-ordinating with the exchange.

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 Important Features of Derivatives

• Relation between the values of derivatives and their


underlying assets.
• It is easier to take short position in derivatives than in
other assets.
• Exchange traded derivatives are liquid and have low
transaction cost.
• It is possible to construct portfolio which is exactly
needed, without having the underlying asset.

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 4. Market Players in Derivative Market:
Hedgers, Speculators and Arbitragers

• Hedgers: A transaction in which an investor seeks to


protect a position or an anticipated position in the spot
market by using an opposite position in derivatives is
known as hedge. Traders can use derivatives to hedge
or mitigate risk in the underlying, by entering into a
derivative contract whose value moves in the opposite
direction to their underlying position and cancels part
or all of it out. For example an exporter whose
receivable is in US dollars is exposed to the risk of
adverse movements in US dollars. To hedge the risk,
he can take a position in the derivatives market.
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 4. Market Players in Derivative Market:
Hedgers, Speculators and Arbitragers

• Speculators: A person who buys and sells contracts in


the hope of profiting from subsequent price
movements is known as speculator. Derivatives can be
used by investors to speculate and to make a profit if
the value of the underlying moves the way they expect
(e.g. moves in a given direction, stays in or out of a
specified range, reaches a certain level).

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 4. Market Players in Derivative Market:
Hedgers, Speculators and Arbitragers

• Arbitrageurs: Arbitrage means obtaining risk-free


profits by simultaneously buying and selling identical
or similar instruments in different markets.
 Suppose that The spot price of oil is US$95. The
quoted 1-year futures price of oil is US$80. 1-year US$
interest rate is 5% per annum. The storage costs of oil
are 2% per annum. Is there an arbitrage opportunity?

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 5. Trading Techniques

• Cash Market
• External environment
• Speculators
• Derivatives Markets
• Arbitrageurs

 *****

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