INTRODUCTION TO FINANCIAL DERIVATIVES :
INTRODUCTION TO FINANCIAL DERIVATIVES Presented By
Arjun Parthasarathy
28th June 2006 Introduction :
Introduction Derivatives are synthetic instruments
They derive value from an underlying asset class
Asset classes range from financial instruments to commodities to even classes such as weather and industrial effluents
However the common underlying theme of derivatives is that they are leveraged products
Derivatives are not always priced at respective asset value (fair value) Derivative Market :
Derivative Market The derivative market has its own dynamics
Though the value of the derivative is derived, the market can and does move in complete tangent to the underlying asset class
This is because the participants in the derivative market do not always hold positions in the underlying instrument and have different intentions on their positions Derivative Positions and Types of Derivative Market Players :
Derivative Positions and Types of Derivative Market Players Naked open position taking a directional call on the markets
Hedge against underlying asset class
Arbitrage position within an asset class
Speculators
Hedgers
Arbitrageurs Underlying Asset Class :
Underlying Asset Class It is important to understand the underlying asset class before using derivatives
Asset classes can be classified into two broad categories- financial which includes currencies and commodities
Financial asset classes can be broadly categorised into interest rates, equities and currencies
Commodities range from agricultural commodities to minerals and metals Financial Asset Classes :
Financial Asset Classes Broadly categorised into equity, interest rates and currencies
Equity as an asset class will include single stocks and equity indices
Interest rates as an asset class will include government bonds, government bond benchmarks and money market benchmarks.
Currencies as an asset class will include currency pairs such as USD/INR, USD/JPY etc
Credits as defined by corporate bonds can also be categorised into financial assets and derivatives on them are called credit derivatives Equity Derivatives :
Equity Derivatives Equity derivatives can be classified into single stock derivatives and index derivatives
Single stock derivatives are derivatives on specific stocks eg. Reliance
Index derivatives are derivatives on stock exchange indices eg- nifty
Hybrid derivatives on equity include convertible shares (partly or fully)
Employee stock options are also equity derivatives Interest Rate Derivatives :
Interest Rate Derivatives Interest rate derivatives have many different types
Derivatives on government bonds
Derivatives on bond indices/ benchmark
Derivatives on short term money market benchmarks
Examples are bond futures and interest rate swaps based on benchmarks such as libor/ mibor Currency Derivatives :
Currency Derivatives Currency derivatives are based on currency pairs
Currency forwards and options eg- USD/INR forwards and options
Currency derivatives are combined with interest rate derivatives to offer exotics
Exotics include principle only swaps, currency swaps Exchange Traded and OTC Derivatives :
Exchange Traded and OTC Derivatives Derivatives traded on an exchange such as NSE are exchange traded derivatives
Derivatives not traded on exchange are over the counter derivatives eg- Overnight index swaps (OIS)
Exchange traded derivatives are standardised in contract size, settlement, maturity
OTC derivatives can be structured to suit different needs
Equity and bond derivatives are usually exchange traded while interest rate swaps, currency derivatives and exotics are usually OTC derivatives Derivative Exchanges :
Derivative Exchanges Derivative exchanges are separate from stock exchanges
In US CBOT and CME are the largest exchanges for derivatives
In UK LIFFE is the premier derivative exchange
In India NSE is the largest equity derivative exchange while commodity exchanges are NCDEX and MCX
What are the derivative exchanges in Japan and Singapore? Exchange Traded and OTC Derivatives- Compare and Contrast :
Exchange Traded and OTC Derivatives- Compare and Contrast Exchange traded derivatives are standardised contracts while OTC derivatives can be both standardised and customised
The exchange takes on settlement risk in exchange traded derivatives while OTC derivatives counterparty risk is present
Margin system is followed by exchanges while OTC derivatives do not usually follow margining system Compare and Contrast Continued :
Compare and Contrast Continued Exchange traded derivatives can be accessed by retail and institutional investors while OTC derivatives is typically traded within institutions
Exchange traded derivatives come under regulatory purview while many OTC derivatives are outside the purview of regulators
More examples? Hints- Liquidity, price discovery, Hedging or Leveraging :
Hedging or Leveraging Derivatives are viewed as a hedging instrument
The holder of an underlying asset can hedge fluctuations in prices of the asset using derivatives
However derivatives are increasingly being used for taking up leveraged positions in an underlying asset
This enables higher returns for taking on higher risk Derivatives in India :
Derivatives in India The structured derivative market in India is relatively new (about 7 years old)
However derivatives have caught the fancy of the market and exchange traded equity and commodity derivatives are vibrant
Interest rate derivatives have not taken off on an exchange platform though the OTC market for Interest rate derivatives is active
Currency derivatives are dominated by currency forwards though options are starting to come of age at present Equity Derivatives in India :
Equity Derivatives in India Equity index futures are the most widely traded futures contract while single stock futures on the whole contribute to a larger percentage of the traded volumes
Equity index options are the most widely traded options contract in the exchange
FII’s are very active in the equity derivative markets in India
Retail presence is also high in the equity derivative market Interest Rate and Currency Derivatives in India :
Interest Rate and Currency Derivatives in India The market for Overnight Index Swaps (OIS) is the most active is the most active interest rate derivative
OIS is based on the overnight call money benchmark, NSE Mibor
Other interest rate derivatives include swaps on government bond benchmarks
Currency derivatives is dominated by forward market though options are picking up Homework :
Homework What are most active derivative exchanges in USA, UK, Japan, Singapore, Germany and India
What are the three most active contracts traded in these exchanges
What is the volume (average monthly volumes over the last one year) in USD Billion in these exchanges
What are the volumes (average monthly volumes) in Nifty index futures, Nifty index options, single stock futures and single stock options in the NSE over the last one year in USD Billion Introduction to Futures :
Introduction to Futures Futures are essentially deferred spot contracts
Spot is the immediate delivery for settlement of a bond or stock
Futures are purchase or sale contracted for settlement for a later date
Futures are exchange traded derivatives
Forwards are the OTC version of futures
Futures are traded on margin Futures :
Futures Futures give ability to leverage positions
Futures can also lead to large gains or losses without any floor or ceiling
How? An example
If I buy 10 contracts of Nifty index near month futures at Rs 2900
For every 1 point move in the index I stand to lose or gain Rs 1000 (10*100)
If index falls 100 points, then I have lost Rs 100,000.
My investment for 10 contracts was Rs 400,000 (margin money) Futures :
Futures Future contracts have maturities ranging from one month to one year or more
In India futures contracts have a maximum tenor of three months
Future price and spot price converge on settlement date
Futures are marked to market on a daily basis and settlement of mark to market profit or loss is also on a daily basis
Futures can be cash settled or settled by physical delivery- In India futures are cash settled Pricing of Futures :
Pricing of Futures Futures should theoretically trade at a fair price
The fair price is the price adjusted for cost of carry for delivery at a later date
The cost of carry is the interest cost on the amount actually paid for an asset on a spot purchase
Cost of carry is adjusted for any dividends receivable in case of equities
Cost of carry = Interest cost over period – expected dividend yield
The fair price of a future contract is always at a premium to the spot price Introduction to Options :
Introduction to Options Options give the right but not the obligation to buy or sell an asset at a future date
Options are either call or put options
Call options give the holder the right to buy an asset at a future date
Put options give the holder the right to sell an asset at a future date Options :
Options Options can be American or European
American options allow the buyer to exercise the option before expiry date
European options give the buyer the right to exercise the option only on expiry date
Index options in India are European options while stock options are American options Options :
Options Options protect downside risk to the buyer
The buyer of the option limits losses to the premium paid on the purchase of the options
Eg. If I buy a nifty 2900 put at Rs 34, my loss is limited to Rs 34 while gain potential is limitless
If the price goes above Rs 2900 I do not exercise the option limiting my loss to the premium paid Options :
Options Options have a buyer and a writer
The option writer receives premium for giving the buyer the right but not the obligation to sell an asset at a future date
The option writer is not protected on the downside risk
Option writers have to settle mark to market profit or loss on a daily basis
Options can be cash settled or settled by physical delivery
Options in India are cash settled Option Pricing :
Option Pricing Black Scholes formula is the most widely used for pricing options
The factors going into the pricing of options are the share price(S), time to expiry (t), risk free rate of interest r, and risk of underlying asset measured by standard deviation or volatility
These are also called the greeks as changes in any one of these variables affect the option price
Options contracts can be classified into out of the money, at the money and in the money The Greeks :
The Greeks Delta is the change in option price to the change in the underlying
Gamma is the rate at which an options delta changes as the price of the underlying changes
Theta is the time decay factor and is the rate at which option loses value as time passes
Vega or Kappa is the change in option price to change in the volatility of the option
Rho is the change in value of option to change in interest rates Interest Rate Swaps :
Interest Rate Swaps Interest rate swaps are derivatives that exchange cash flows from fixed to floating or floating to fixed
An example is the Overnight Index Swaps (OIS), the floating rate benchmark being the NSE Mibor
The payer of OIS pays fixed rate while receiving the floating rate or mibor
The receiver of an OIS receives fixed rate while paying the floating rate Currency Forwards :
Currency Forwards Currency forwards are the most widely used currency derivatives
The currency forwards are basically futures contracts where the payers or receivers of forwards contract to buy or sell a currency pair at a future date
The prices are determined by the cost of carry that is the interest payable on paying or receiving forwards Equity Derivatives in India :
Equity Derivatives in India Nifty index futures are the highest traded contracts
Single stock futures are actively traded for arbitrage
Nifty index options are also traded actively
Single stock options do not trade actively Traded Volumes in NSE F&O :
Traded Volumes in NSE F&O Nifty Index Futures :
Nifty Index Futures Factors to Study in Nifty Futures :
Factors to Study in Nifty Futures Open interest
Traded volumes as % to total derivative volumes
Basis spread
Movement of spread
Roll overs
Calendar Spreads Nifty Index Options :
Nifty Index Options Factors to Study in Nifty Options :
Factors to Study in Nifty Options Changes in price
Open interest
Implied Volatility
Put call parity Single Stock Futures :
Single Stock Futures Factors to Study in Single Stock Futures :
Factors to Study in Single Stock Futures Open interest
Basis Spread
Cost of carry
Volumes
Top traded single stock futures THANK YOU :
THANK YOU