financial derivatives BY NAGENDRA

FD : 

FD FINANCIAL DERIVATIVES

Slide 2: 

INTRODUCTION

DEFINATION : 

The Securities Contracts (Regulation) Act, 1956(SC(R)A)defines "derivative" as follows “A derivative is a financial instrument whose pay off is derived from some other asset which is called an underlying asset.” The underlying asset may be Commodities(grain, coffee, cotton, etc.,) Precious metals(gold, silver, copper etc.,) Foreign exchange rates All types of bonds T-Bills & short-term financial securities Equity shares Interest rates etc., DEFINATION

HISTORY OF DERIVATIVES MARKET : 

IN 1848 FORWARD CONTRACTS IN 1865 FUTURES CONTRACTS IN 1919 CBOT renamed as CME IN 1990 more popularized HISTORY OF DERIVATIVES MARKET

factors driving the growth of financial derivatives are: : 

1. Increased volatility in asset prices in financial markets, 2. Increased integration of national financial markets with the international markets, 3. Marked improvement in communication facilities and sharp decline in their costs, 4. Development of more sophisticated risk management tools, providing economic agents a wider choice of risk management strategies, and 5. 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. factors driving the growth of financial derivatives are:

DERIVATIVE PRODUCTS : 

Forwards Futures Options put options call options Warrants LEAPS Baskets Swaps interest rate swaps currency swaps DERIVATIVE PRODUCTS

Derivative participants : 

Derivative participants

FORWARD CONTRACTS : 

FORWARD CONTRACTS • They are bilateral contracts and hence exposed to counter-party risk. • Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality. • The contract price is generally not available in public domain. • On the expiration date, the contract has to be settled by delivery of the asset. • If the party wishes to reverse the contract, it has to compulsorily go to the same counter-party, which often results in high prices being charged.

PAYOFFS IN FORWARD CONTRACT : 

PAYOFFS IN FORWARD CONTRACT

DETERMINATION OF FORWARD PRICE : 

DETERMINATION OF FORWARD PRICE Before determining forward price first we have to discuss invest assets and consumption assets. Investment assets: Consumption assets: (Fo) = Soert. (Fo) =(So – I)ert. (Fo) =Soe(r – q)t.

LIMITATIONS OF FORWARD CONTRACT : 

LIMITATIONS OF FORWARD CONTRACT Forward markets world-wide are afflicted by several problems: • Lack of centralization of trading, • Illiquidity, and • Counterparty risk

FUTURES CONTRACTS : 

FUTURES CONTRACTS Futures markets were designed to solve the problems that exist in forward markets. 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. But unlike forward contracts, the futures contracts are standardized and exchange traded.

Trading mechanism of futures contract : 

Trading mechanism of futures contract

Entities in the trading system : 

Entities in the trading system There are four entities in the trading system. Trading members, clearing members, professional clearing members and participants

Clearing house and clearing margins : 

Clearing house and clearing margins Clearing house is an adjunct of the exchange and acts an intermediary in futures transactions. It guarantees the performance of the parties of each transaction. The main task of the clearing house is to keep track of all the transactions that take place during a day, so that it can calculate the net position of each its members. Just an investor is required to maintain a margin account with a broker; a clearing house member is required to maintain margin account with the clearing house. This is known as clearing margin.

Order types and conditions : 

Order types and conditions Time conditions Day order Immediate or Cancel (IOC): Price conditions Stop-loss Market price

Specifications in futures contract: : 

Specifications in futures contract: Underlying Asset Contract size Expiry date Delivery arrangements Delivery Months Futures price Price limits and Price positions Spot price

Margins in futures contract: : 

Margins in futures contract: An investor who enters into futures contract is required to deposit funds with the broker called a “margin”. The basic objective of margin is to provide a financial safe guard for ensuring that the investors will perform their contract obligations. The amount of margin may vary from contract to contract and even broker to broker.

Types of margin: : 

Types of margin: Initial margin Maintenance margin Variation margin

Settlement of futures contracts : 

Settlement of futures contracts MTM settlement: Final settlement for futures

Regulation of Futures : 

Options, Futures, and Other Derivatives, 7th Edition, Copyright © John C. Hull 2008 22 Regulation of Futures Regulation is designed to protect the public interest Regulators try to prevent questionable trading practices by either individuals on the floor of the exchange or outside groups

CURRENCY FUTURES : 

CURRENCY FUTURES Currency derivatives can be described as contracts between the sellers and buyers whose values are derived from the underlying which in this case is the Exchange Rate. Currency derivatives are mostly designed for hedging purposes, although they are also used as instruments for speculation.

Features Currency Futures: : 

Features Currency Futures: Traded on centralized Highly standardized contracts Size & maturity [delivery date] Clearinghouse as counter-party High leverage instrument Daily settlement Margin requirements To hedge a foreign exchange exposure, the customer assumes a position in the opposite direction of the exposure. Foreign exchange exposure is of two types: Accounting exposure a. Transaction exposure b. Translation exposure Economic exposure

Hedging With Currency Future : 

Hedging With Currency Future A customer that is long in the futures market is betting on an increase in the value of the currency, whereas with a short position they are betting on a decrease in the value of the currency.

Speculating with currency future : 

Speculating with currency future

Pricing of Futures Contracts : 

Pricing of Futures Contracts According to the interest rate parity theory, the currency margin is dependent mainly on the prevailing interest rate (for investment for the given time period) in the two currencies.

Pricing of currency futures contract : 

Pricing of currency futures contract Underlying asset is a certain units of foreign currency The cost of holding one currency is really an opportunity cost, which is measured by differences in the interest rates prevailing in two countries. Fo =So*e(r-rf)t rf: local country rf r: foreign country rf Futures Fred Thompson 28

Stock Index Futures : 

Stock Index Futures

What is an Index? : 

What is an Index? An index is, in one sense, just a number that is computed in order to measure the value of a portfolio of stocks. Other indices have been constructed to track the values of other types of securities, such as bonds and futures. Still other indices track such economic indicators as the consumer price index (CPI) or the index of leading indicators. When constructing a stock market index, three issues are of particular interest: which stocks are in the index how each stock is weighted how the average is computed

Stock Index Futures : 

Stock Index Futures Trading began on February 24, 1982, when the Kansas City Board of Trade introduced futures on the Value Line Index. About two months later, the Chicago Mercantile Exchange introduced futures contracts on the S&P 500 index. By 1986, the S&P 500 futures contract had become the second most actively traded futures contract in the world, with over 19.5 million contracts traded in that year. In May 1982, the NYSE Composite Index futures contract began trading on the New York Futures Exchange, the NYFE.

Slide 32: 

Stock Index futures have revolutionized the art and science of equity portfolio management as practiced by: mutual funds pension plans endowments insurance company other money managers.

Important Details : 

Important Details A futures contract on a stock market index represents the right and obligation to buy or to sell a portfolio of stocks characterized by the index. Stock index futures are cash settled. That is, there is no delivery of the underlying stocks. The contracts are marked to market daily. On the last trading day, the futures price is set equal to the spot index level and there is a final mark to market cash flow.

Mechanics of Options Markets : 

Mechanics of Options Markets 34

Review of Option Types : 

35 Review of Option Types A call is an option to buy A put is an option to sell A European option can be exercised only at the end of its life An American option can be exercised at any time

Option Positions : 

36 Option Positions Long call Long put Short call Short put

Long Call : 

37 Long Call Profit from buying one European call option: option price = $5, strike price = $100, option life = 2 months

Short Call : 

38 Short Call Profit from writing one European call option: option price = $5, strike price = $100

Long Put : 

39 Long Put Profit from buying a European put option: option price = $7, strike price = $70

Short Put : 

40 Short Put Profit from writing a European put option: option price = $7, strike price = $70

Payoffs from OptionsWhat is the Option Position in Each Case? : 

41 Payoffs from OptionsWhat is the Option Position in Each Case? K = Strike price, ST = Price of asset at maturity Payoff Payoff ST ST K K Payoff Payoff ST ST K K

Assets UnderlyingExchange-Traded Options : 

42 Assets UnderlyingExchange-Traded Options Stocks Foreign Currency Stock Indices Futures

Specification ofExchange-Traded Options : 

Options, Futures, and Other Derivatives 7th Edition, Copyright © John C. Hull 2008 43 Specification ofExchange-Traded Options Expiration date Strike price European or American Call or Put (option class)

Terminology : 

Options, Futures, and Other Derivatives 7th Edition, Copyright © John C. Hull 2008 44 Terminology : At-the-money option In-the-money option Out-of-the-money option