derivatives

Slide 1:

Derivatives

Introduction:

Introduction Derivatives are a special form of financial assets that derive their value from the value of an underlying asset. Derivative is a tool for risk management. It implies reducing the risk not eliminating it. Thus, derivative is an innovative and tradable financial instrument.

Definition:

Definition It is very difficult to define the term ‘Derivatives’ in a comprehensive way since many developments have taken place in this field in recent years. In simple words derivatives can be defined as instruments which derive their value from underlying assets.

Forwards :

Forwards Oldest of all derivatives. Agreement between two parties to exchange an agreed quantity of an asset for cash at certain date in future at predetermined price specified in the agreement.

Financial Forwards:

Financial Forwards Popular type of financial forward rate contract is the forward rate currency contract. Forward Rate Currency Contract is where exchange of currencies is promised at an agreed exchange rate at a specified future date. Forward Rate Contract on Interest Rate is a contract where parties enter into a forward interest rate agreement at a specified future date.

Futures:

Futures It is similar to a forward contract in all respects except the fact that is completely standardized one. It is legally enforceable and is always traded on an organized exchange. Types: Financial Futures Commodity Futures

Financial Futures :

Financial Futures It refers to a future contract in foreign exchange or financial instruments. It is an area where financial service companies can play a very dynamic role. They are popular in Western countries as hedging instruments.

Commodity Futures:

Commodity Futures It is a futures contract in commodities like agricultural products, metals and minerals etc. Contracts are standardized with standard qualities in organized commodity futures. They vary from commodity to commodity Have fixed delivery dates in each month or few months in a year.

Some well established commodity exchanges::

Some well established commodity exchanges: London Metal Exchange [LME] deal in Gold. Chicago Board of Trade [CBT] deal in Soyabean oil. New York Cotton Exchange [CTN] deal in Cotton. Commodity Exchange, New York [COMEX] deal in Agricultural products. International Petroleum Exchange of London [IPE] deal in Crude oil.

Option:

Option It is a contract which gives the buyer an option to buy or sell an underlying asset at a predetermined price on or before a specified time. The price is known as ‘exercise price’. Option to buy is ‘Call Option’ Option to sell is ‘Put Option’ Price paid to get this option is known as ‘Premium’ Premium is to be paid when option is exercised or when it matures.

Some Features are as follows::

Some Features are as follows: Highly flexible Involve no down payment Have no obligation to buy or sell

Swaps:

Swaps It is another exciting trading instrument. It is a combination of Forwards by Two Counterparts. It requires existence of two parting with opposite but matching interests and intermediary, to bring them together. It is arranged to reap the benefits arising from the fluctuations in the market either currency, interest rate or any other market.

Types of Swap:

Types of Swap Cross currency swap Interest rate swap Basis swap

Inhibiting Factors:

Inhibiting Factors Misconception of Derivatives Leveraging Off Balance Sheet Items Absence of proper accounting system Inbuilt speculative mechanism Absence of proper infrastructure

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

Slide 17:

“We view them as time bombs both for the parties that deal in them and the economic system. In our view derivatives are financial weapons of mass destruction(WMD), carrying dangers that, while now latent, are potentially lethal.” Warren Buffet

Slide 18:

Thank You