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8/8/2019 Derivative Market Word 2003
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INDEX
Srno
Pageno
Topic Remarks Sign
1.0 1 8 Introduction to
derivative market
1.1 4 4 Derivative chart
1.2 5 8 Forward/future contracts
2.0 9 30 Introduction to options
2.1
2.1.
1
2.1.
2
10
17
18
18
18
18
Call option.
Graphs.
Exercising the call option
and what are the
implications on the buyer
and seller.
2.2
2.2.
1
19
21
21
21
Put option
graph
2.3 22 23 Market player
2.4 24 24 Option undertaking
2.5 24 25 Option classification
2.6
2.6.
26 30 Option pricing
Effect of increase in the
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1
2.6.
2
2.6.
3
2.6.
4
2.6.
5
27
29
2929
30
28
29
2929
30
relevant parameter of option
price.
Time to expiration
volatility
risk free rate of interest
dividends
3.0 31 32 History of derivatives
3.1 31 32 Important aspects in the
history of derivative market
4.0 33 39 International derivatives
4.1 33 34 Major equity derivativeexchanges in the world
4.2 35 35 Other financial derivative
exchange in the world
4.3 36 39 Popular stock index future in
the world
5.0 40 46 Benefits of derivatives
6.0 47 58 Introduction of futures in
india
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6.1 47 47 What are index futures
6.2 48 49 Frequently used terms in
the index futures
6.3 49 49 Concept of basis in the
futures market
6.4 50 51 Pricing futures
6.5 51 55 Index future cost and
futures model.
6.6
6.6.
1
6.6.
2
55
55
56
56
55
56
Risk management through
futures
Some specific use of index
futures
Speculation in the futures
market
6.7 56 58 Margining in the futures
market
7.0 59 62 Derivative markets today
7.1 60 60 Operators in the derivative
market
7.2 60 62 Equity derivative exchange
in the world
8.0 63 71 Introduction to indexes
8.1 63 63 Whats an index
8.2 63 63 Whats an stock index
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8.3 64 64 Why do we do need an
index
8.4 64 64 What does the number
mean
8.5 65 65 How are the stocks in the
portfolio weighted?
8.6 65 65 What is better weighing
option
8.7 66 66 Who owns the index? Who
computes it ?
8.8 66 66 Who decides what stocks to
include? How?
8.9 67 67 Selection criteria
8.1
0
68 68 What is benchmark index
8.1
1
68 68 What are the popular
indexes in india?
8.1
2
69 69 What are sectoral indexes
8.1
3
69 71 What are the uses of index
in india?
9.0 7
2
76 Financial risk
management
9.1 76 72 Four steps in risk
management
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DERIVATIVE MARKET IN INDIA
Warren Buffett - (Chairman & CEO of Hathaway,Investor)
- It takes 20 years to build a reputation and five minutes to
ruin it. If you think about that, you'll do things differently.
- Rule No.1: Never lose money. Rule No.2: Never forget rule
No.1.
- Derivatives are financial weapons of mass destruction.
[1] INTRODUCTION TO DERIVATIVE
MARKET
http://www.brainyquote.com/quotes/quotes/w/warrenbuff108887.htmlhttp://www.brainyquote.com/quotes/quotes/w/warrenbuff108887.html8/8/2019 Derivative Market Word 2003
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A Derivative is a financial instrument whose value
depends on other, more basic, underlyingvariables. The variables underlying could be prices
of traded securities and stock, prices of gold or
copper. Derivatives have become increasingly
important in the field of finance,
Broadly Derivatives markets can be classified intotwo categories, those that are traded on the
exchange and those traded one to one or over the
counter. They are hence known as;
1
Exchange Traded Derivatives
Exchange-traded derivative contracts are
standardized derivative contracts (e.g. futures
contracts and options) that are transacted on an
organized futures exchange. Their traded on an
organized stock exchange.
OTC Derivatives (Over The Counter)
Derivatives not traded on a futures exchange are
traded on over-the-countermarkets, also known as
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the OTC market. These consist ofinvestment
banks who have traders who make markets in
these derivatives, and clients such as hedge
funds, commercial banks, government sponsoredenterprises, etc.
Derivative is a product/contract which does nothave any value on its own i.e. it derives its valuefrom some underlying. The underlying asset can be
equity, forex,Commodity or any other asset.
2
For example, wheat farmers may wish to sell theirharvest at a future date to eliminate the risk of achange in prices by that date.
http://en.wikipedia.org/wiki/Investment_bankhttp://en.wikipedia.org/wiki/Investment_bankhttp://en.wikipedia.org/wiki/Market_makerhttp://en.wikipedia.org/wiki/Hedge_fundhttp://en.wikipedia.org/wiki/Hedge_fundhttp://en.wikipedia.org/wiki/Commercial_bankhttp://en.wikipedia.org/wiki/Government_sponsored_enterprisehttp://en.wikipedia.org/wiki/Government_sponsored_enterprisehttp://en.wikipedia.org/wiki/Investment_bankhttp://en.wikipedia.org/wiki/Investment_bankhttp://en.wikipedia.org/wiki/Market_makerhttp://en.wikipedia.org/wiki/Hedge_fundhttp://en.wikipedia.org/wiki/Hedge_fundhttp://en.wikipedia.org/wiki/Commercial_bankhttp://en.wikipedia.org/wiki/Government_sponsored_enterprisehttp://en.wikipedia.org/wiki/Government_sponsored_enterprise8/8/2019 Derivative Market Word 2003
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The price of this derivative is driven by the spotprice of wheat which is the underlying.
Derivative products initially emerged as hedging
devices against fluctuations in commodity prices ,and commodity linked derivatives remained thesole form of such products for almost threehundred years. Derivatives are securities under theSCA and hence the trading of derivatives isgoverned by the regulatory framework under theSC(R)A.
In the Indian context the securities contracts(regulation) Act, 1956 (SC(R)A) defines derivativeto include:
1. A security derived from a debt instrument,share, loan whether secured or unsecured,risk instrument or contract for differences or
any other form of security.
2. A contract which derives its value fromthe prices, or index of prices, of underlying
securities.
3
[1.1] Derivative chart
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Derivative
s
Future Option Forward Swaps
TYPES OF DERIVATIVES MARKET
Exchange Traded Derivatives Over The
Counter Derivatives
National Stock Exchange Bombay Stock Exchange National Commodity & Derivative
exchange
Index Future Index option Stock option Stock future
TYPES OF DERIVATIVES
4
[1.2 ] Forward / Future Contracts
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5
Forward contractsA forward contract is an agreement to buy
or sell an asset on a specified date for a
specified price. One of the parties to the
contract assumes a long position and agrees to
buy the underlying asset on a certain specified
future date for a certain specified price. The
other party assumes a short position and agrees
to sell the asset on the same date for the same
price. Other contract details like delivery date,
price and quantity are negotiated bilaterally by
the parties to the contract. The forward
contracts are normal ly traded outside the
exchanges.
Th e salien t feature s o f forwar d contract s
are:
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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.
6
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.
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Future contractsIn finance, a futures contract is a
standardized contract, traded on a futures
exchange, to buy or sell a certain underlying
instrument at a certain date in the future, at
a pre-set price. A futures contract gives the
holder the right and the obligation to buy or
sell, which differs from an options contract, which
gives the buyer the right, but not the obligation,
and the option writer (seller) the obligation, but not
the right. .
7
Futures contracts are exchange traded derivatives.
The exchange acts as counterparty on all
contracts, sets margin requirements, etc.
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Future contracts are organized/ standardized
contracts, which are traded on the exchanges.
These contracts, being standardized and
traded on the exchanges are very liquid in
nature.
In futures market, clearing corporation/ house
provides the settlement guarantee.
8Donald trump - (Chairman and CEO of the Organization, a US-based real-estatedeveloper.)
http://en.wikipedia.org/wiki/Chairmanhttp://en.wikipedia.org/wiki/CEOhttp://en.wikipedia.org/wiki/Real-estate_developerhttp://en.wikipedia.org/wiki/Real-estate_developerhttp://en.wikipedia.org/wiki/Chairmanhttp://en.wikipedia.org/wiki/CEOhttp://en.wikipedia.org/wiki/Real-estate_developerhttp://en.wikipedia.org/wiki/Real-estate_developer8/8/2019 Derivative Market Word 2003
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- Every time you walk down the street people are screaming,'You're fired!'- I try to learn from the past, but I plan for the future by focusingexclusively on the present. That's were the fun is.- As long as your going to be thinking anyway, think big.
[2.0] Introduction to Options
Options are instruments whereby the right is
given by the option seller to the option buyer
to buy or sell a specific asset at a specificprice on or before a specific date.Options: Is it
just Another Derivative.
Options on stocks were first traded on an organized
stock exchange in 1973. Since then there has been
extensive work on
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9
these instruments and manifold growth in the field
has taken
the world markets by storm. This financialinnovation is present in cases of stocks, stock
indices, foreign currencies, debt instruments,
commodities, and futures contracts.
There are two types of options i.e., CALL OPTION
AND PUT OPTION.
[2.1] CALL OPTION:
A contract that gives its owner the right but
not the obligation to buy an underlying
asset-stock or any financial asset, at a
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specified price on or before a specified date
is known as a Call option. The owner makes a
profit provided he sells at a higher current priceand buys at a lower future price.
10
The following example would clarify the basics on
Call Options.
Illustration :
An investor buys one European Call option on one
share of Reliance Petroleum at a premium of Rs. 2
per share on 31 July . The strike price is Rs.60 and
the contract matures on 30 September . Thepayoffs for the investor on the basis of fluctuating
spot prices at any time are shown by the payoff
table (Table 1). It may be clear form the graph that
even in the worst case scenario, the investor would
only lose a maximum of Rs.2 per share which
he/she had paid for the premium. The upside to ithas an unlimited profits opportunity.
On the other hand the seller of the call option has a
payoff chart completely reverse of the call options
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buyer. The maximum loss that he can have is
unlimited though a profit of Rs.2 per share would
be made on the premium payment by the buyer.
11
Payoff from Call Buying/Long (Rs.)
S Xt c Payoff NetProfit
57 60 2 0 -2
58 60 2 0 -2
59 60 2 0 -2
60 60 2 0 -2
61 60 2 1 -1
62 60 2 2 0
63 60 2 3 1
64 60 2 4 2
65 60 2 5 3
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66 60 2 6 4
A European call option gives the followingpayoff to the investor: max (S - Xt, 0).
The seller gets a payoff of: -max (S - Xt,0)
or min (Xt - S, 0).
Notes:
S - Stock Price
Xt - Exercise Price at time 't'
C - European Call Option Premium
Payoff - Max (S - Xt, O )
15
[ 2.1.1 ] Graphs
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[2.1.2] Exercising the Call Optionand what are its implications for theBuyer and the Seller?
The Call option gives the buyer a right to buy
the requisite shares on a specific date at a
specific price. This puts the seller under theobligation to sell the shares on that specific
date and specific price. The Call Buyer
exercises his option only when he/ she feels it
is profitable. This Process is called "Exercising
the Option".
17
This leads us to the fact that if the spot price
is lower than the strike price then it might be
profitable for the investor to buy the share in
the open market and forgo the premium
paid.
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The implications for a buyer are that it is
his/her decision whether to exercise the
option or not. In case the investor expects
prices to rise far above the strike price in the
future then he/she would surely be interestedin
buying call options.
On the other hand, if the seller feels that his
shares
are not giving the desired returns and they
are not going to perform any better in the
future, a premium can be charged and
returns from selling the call option can be
used to make up for the desired returns. At
the end of the options contract there is an
exchange of the underlying asset. In the real
world, most of the deals are closed with
another counter or reverse deal. There is no
requirement to exchange the underlying
assets then as the investor gets out of the
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contract just before its expiry.
18
[2.2] PUT OPTION:
A contract that gives its owner the right but not the
obligation to sell an underlying asset-stock or any
financial asset, at a specified price on or before a
specified date is known as a Put option. The
owner makes a profit provided he buys at a lower
current price and sells at a higher future price.
Hence, no option will be exercised if the future
price does not increase. Put and calls are almost
always written on equities, although occasionally
preference shares, bonds and warrants become the
subject of options.
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The following example would clarify the basics on
put option.
Illustration 2:An investor buys one European Put Option on one
share of Reliance Petroleum at a premium of Rs. 2
per share on 31 July. The strike price is Rs.60 and
the contract matures on 30 September. The payoff
table shows the fluctuations of net profit with a
change in the spot price.
19
The payoff for the put buyer is :max (Xt - S,
0)
The payoff for a put writer is : -max(Xt - S, 0)
or min(S - Xt, 0)
Payoff from Put Buying/Long (Rs.)
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S Xt p Payoff Net Profit
55 60 2 5 3
56 60 2 4 257 60 2 3 1
58 60 2 2 0
59 60 2 1 -1
60 60 2 0 -2
61 60 2 0 -2
62 60 2 0 -263 60 2 0 -2
64 60 2 0 -2
20
[2.2.1] Graph
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These are the two basic options that form
the whole gamut of transactions in the
options trading. These in combination with
other derivatives creat a whole world of
instruments to choose form depending on
the kind of requirement and the kind ofmarket expectations.
21
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.They are traders with a view and objective
of making profits. They are willing to take
risks and they bet upon whether the
markets would go up or come down.
22
Arbitrageurs:
Riskless Profit Making is the prime goal of
Arbitrageurs. Buying in one market andselling in another, buying two products in
the same market are common. They could
be making money even without putting
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there own money in and such opportunities
often come up in the market but last for
very short timeframes. This is because assoon as the situation arises arbitrageurs
take advantage and demand-supply forces
drive the markets back to normal.
23
[2.4] Options undertakingsStocks
Foreign Currencies
Stock Indices
Commodities
Others - Futures Options, are options on the
futures contracts or underlying assets arefutures contracts. The futures contract
generally matures shortly after the options
expiration
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[ 2.5 ] Options ClassificationsOptions are often classified as ;
In the money - These result in a positive
cash flow towards the investor.
At the money - These result in a zero-cash
flow to the investor.
Out of money - These result in a negative
cash flow for the investor.
24
Example:
Calls
Reliance 350 Stock Series
Other uncommon options include ;
Naked Options: These are options which
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are not combined with an offsetting contract
to cover the existing positions.
Covered Options: These are option
contracts in which the shares are already
owned by an investor (in case of covered
call options) and in case the option is
exercised then the offsetting of the deal can
be done by selling these shares held.
25
[2.6] OPTIONS PRICING ;
Unlike futures which derives there prices
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primarily from prices of the undertaking.
Option's prices are far more complex. The table
below helps understand the affect of each of
these factors and gives a broad picture of option
pricing keeping all other factors constant. The
table presents the case of European as well
as American Options.Changes in the
underlying security price can increase or
decrease the value of an option. These price
changes have opposite effects on calls andputs. For instance, as the value of the underlying
security rises, a call will generally increase and
the value of a put will generally decrease in
price. A decrease in the underlying security's
value will generally have the opposite effect.
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26
[2.6.1] EFFECT OF INCREASE IN THE
RELEVANT PARAMETRE ON OPTION PRICES
EUROPEANOPTIONS
Buying
AMERICANOPTIONS
BuyingPARAMETERS CALL PUT CALL PUTSpot Price (S)Strike Price
(Xt)
Time toExpiration (T)
? ?
Volatility ()Risk Free
Interest Rates
(r)Dividends (D)
Favourab
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strike price would reduce the profits for the
holder of the call option.
28
[2.6.2] TIME TO EXPIRATION:
More the time to Expiration more favorable is the
option. This can only exist in case of American
option as in case of European Options the
Options Contract matures only on the Date of
Maturity.
[2.6.3]VOLATILITY
:
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More the volatility, higher is the probability of
the option generating higher returns to the
buyer. The downside in both the cases of call
and put is fixed but the gains can be unlimited. If
the price falls heavily in case of a call buyer then
the maximum that he loses is the premium paid
and nothing more than that. More so he/ she can
buy the same shares form the spot market at a
lower price. Similar is the case of the put option
buyer.
[2.6.4] RISK FREE RATE OF INTEREST
:
In reality the r and the stock market is inversely
related. But theoretically speaking, when all
other variables are fixed and interest rateincreases this leads to a double effect: Increase
in expected growth rate of stock prices
Discounting factor increases making the price
fall.
29
In case of the put option both these factors
increase and lead to a decline in the put value. A
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higher expected growth leads to a higher price
taking the buyer to the position of loss in the
payoff chart. The discounting factor
increases and the future value becomes
lesser.
In case of a call option these effects work in the
opposite direction. The first effect is positive as
at a higher value in the future the call option
would be exercised and would give a profit. Thesecond affect is negative as is that of
discounting. The first effect is far more dominant
than the second one, and the overall effect is
favorable on the call option.
[2.6.5] DIVIDENDS
:
When dividends are announced then the stock
prices on ex-dividend are reduced. This is
favorable for the put option and unfavorable for
the call option.
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contracts, stating what is to be delivered for a fixed price
at a specified place on a specified date, existed in ancient
Greece and Rome. Roman emperors entered forward
contracts to provide the masses with their supply of
Egyptian grain. These contracts were also undertaken
between farmers and merchants to eliminate risk arising
out of uncertain future prices of grains. Thus, forward
contracts have existed for centuries for hedging price
risk.
31
[3.1] The important aspects in the history of
derivative market
The first organized commodity exchange came into existence
in the early 1700s in Japan.
The first formal commodities exchange, the Chicago Board of
Trade (CBOT), was formed in 1848 in the US to deal with
the problem of credit risk and to provide centralizedlocation to negotiate forward contracts.
On April 26, 1973, the Chicago Board options Exchange (CBOE)
was set up at CBOT for the purpose of trading stock
options. It was in 1973 again that black, Merton, and
Scholes invented the famous Black-Scholes Option
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Formula. This model helped in assessing the fair price of
an option which led to an increased interest in trading of
options.
The collapse of the Bretton Woods regime of fixed parties andthe introduction of floating rates for currencies in the
international financial markets paved the way for
development of a number of financial derivatives which
served as effective risk management tools to cope with
market uncertainties.
The most traded stock indices include S&P 500, the Dow Jones
Industrial Average, the Nasdaq 100, and the Nikkei 225.
(The market in late seventeenth-century London)
32
Richard Branson - (British industrialist, best known for his Virgin brand of over 360companies.)
http://en.wikipedia.org/wiki/British_Peoplehttp://en.wikipedia.org/wiki/Business_magnatehttp://en.wikipedia.org/wiki/Virgin_Grouphttp://en.wikipedia.org/wiki/British_Peoplehttp://en.wikipedia.org/wiki/Business_magnatehttp://en.wikipedia.org/wiki/Virgin_Group8/8/2019 Derivative Market Word 2003
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EurexEurex is owned jointly by Deutsche Borse AG and TheSwiss Exchange, each of which hold 50% stake in thecompany. It was formed by merger of German Deutsche
Terminborse (DTB) and Switzerlands SOFFEX. It has afully electronic trading platform.
Hongkong Futures ExchangeThe Exchange operates futures and options markets on abroad range of products including equity index, stock,interest rate and foreign exchange products. Theseproducts are traded either on the Exchange's trading
floor via open outcry or electronically on its Hong KongFutures
The London International Financial Futures andOptions Exchange (LIFFE)LIFFE offers the most extensive range of derivativeproducts of any exchange in the world providing futures
and options contracts across six different currencies andacross four product lines bonds, short term interestrates, equity indices & individual stocks and commodities.
The London Clearing House (LCH) acts as centralcounterparty to all transactions on LIFFE, and offers theworlds most diverse range of margin offsets.
Singapore ExchangeSingapore exchange is the first demutualised integratedsecurities and derivatives exchange in Asia Pacific.Inaugurated on 1st December 1999, It operates throughseveral subsidiaries
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34
[4.2] Other Financial Derivative Exchanges in the
World
American Stock Exchange
MATIF (France)
Warsaw Stock Exchange (Poland)
Chicago Board Options Exchange
Commodities and Futures Exchange (Brazil)
Commodity and Monetary Exchange of Malaysia
Hong Kong Futures Exchange
Italian Derivatives Market (IDEM)
MICEX (Russia)
Kansas City Board of Trade (USA)
Korea Stock Exchange
New Zealand Futures & Options Exchange Ltd.
Oporto Derivatives Exchange (Portugal)
Oslo Stock Exchange (Norway)
Pacific Exchange (USA)
Philadelphia Stock Exchange
Rio de Janeiro Stock Exchange
Taiwan International Mercantile Exchange
Sao Paulo Stock Exchange
Toronto Futures Exchange
AEX-Options Exchange (Netherlands)
MONEP (France)
Belgian Futures & Options Exchange
Budapest Stock Exchange
Chicago Board of Trade
Helsinki Exchange
Copenhagen Stock Exchange
MICEX (Russia)
Montreal Exchange
New York Board of Trade
New York Mercantile Exchange
OM London Exchange
Osaka Securities Exchange (Japan)
South African Futures Exchange
Spanish Financial Futures Market
Spanish Options Exchange
Swedish Futures & Options Market
Santiago Stock Exchange
Tokyo Stock Exchange
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35[4.3]Popular Stock Index Futures in the World
NYSE Composite :
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The NYSE composite was amongst the first stock indexfutures contract to be listed on May 6, 1982 at the New
York Futures Exchange (NYFE) a subsidiary of NYSE. It isbroadest of the broad stock indexes available
representing every common stock traded on the NYSE. Italso has three choices in terms of its contract sizedepending on the multiplier that best suits an investor.
The regular contract launched on May 6, 1982 has amultiplier of $500 times the index. The NYSE LargeComposite Index Contract has multiplier at $ 1000 whilethe NYSE small Composite Index uses a $ 250multiplier.NYSE large contract was aimed at institutional
users who could reduce their commission costs.
S&P 500
It is a market-cap index representing 500 leadingcompanies in leading industries in U.S. in large cap bluechip stocks. It is most often used as the benchmark by
fund managers for judging their performance in USmarkets.S&P 500 futures contract dominates stock indextrading in the US. Fifteen years later share rise in indexvalue and consequently contract size led to reduction incontract multiplies to $ 250.
Dow Jones Industrial Average
It is the oldest and most well known stock measure in theworld. Dow Jones & Company started it in May 26, 1896.
The next index in US came only 60 years later. Thelongevity accounts for its continued popularity today as apreferred measure of the market.
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36
It is a price-weighted index of 30 of the largest mostliquid blue chip US stocks, a number that has held steady
since 1928.
RUSSEL 1000
This is sub set of the broader Russel 3000 index whichtracks only U. S. companies. NYBOT ( New York Board of
Trade ) started futures and options based on Russel 1000
is march 99, offering two contract size one with $500multiplier and another with a $1000 multiplier.Russel1000 is a market capitalization index, but each onesweighting in the index is based on available marketcapitalization. It is the stocks with the most tradableoutstanding shares at the highest price that will hold themost influence on the index movement.
S & P Midcap 400
It is a capitalization weighted index of 400 U.S. stocksrepresenting companies whose capitalization is in themiddle range of all firms. None of the stocks in S&P 500can be in S&P Midcap 400 and vice versa. Futures &Options on this index are traded at CME with a Contract
multiplier of $500.
NASDAQ 100
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It comprises of top 100 non-financial stocks, domestic aswell as foreign, listed on NASDAQ. It trades on CME withtwo different contract multipliers - $100 and $20. It is amarket cap index with modified capitalization to reduce
the overwhelming influence of its top stocks likemicrosoft.
37
Hang Seng Index
This index is market capitalization weighted index of 33stocks, representing about 70% of the stock marketstotal capitalization. Futures on Hang Seng Index aretraded on Hong Kong futures Exchange with a contractmultiplier of H. K. $50.
Nikkei 225 Average
It is Japans longest running stock index. It is a priceweighted stock index. Future contracts on NIKKEI 225trade or three exchange CME, OSE (Osaka) and Simexwith contract multiples of $5, Yen 1000 & Yen 500respectively.
DAX
It is Germanys blue chip index of 30 leading stocks. It iscalculated on total returns basis and not just on pricebasis.Income from dividends and rights issues arereinvested in the index portfolio and are reflected in the
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company formed in 1995 and jointly owned by LSE andthe Financial times. It is a market capitalization index.Futures & options on the index are traded on LIFFE with acontract multiplier of Pound 10.
(Chicago board of trade building) ( NASDAQ building )
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Robert Kiyosaki - (Investor, entrepreneur, author, motivational )
-Your future is created by what you do today, not tomorrow
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- The size of your success is measured by the strength of your
desire; the size of your dream; and how you handle
disappointment along the way
-The only difference between a rich person and poor person is
how they use their time
[5.0] BENEFITS OF DERIVATIVES
Derivative markets help investors in many different ways:
RISK MANAGEMENT
Futures and options contract can be used for altering the
risk of investing in spot market. For instance, consider
an investor who owns an asset. He will always be
worried that the price may fall before he can sell the
asset. He can protect himself by selling a futures
contract, or by buying a Put option. This will help offset
their losses in the spot market. Similarly, if the spotprice falls below the exercise price, the put option can
always be exercised.
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PRICE DISCOVERY
Price discovery refers to the markets ability to determine
true equilibrium prices. Futures prices are believed to
contain information about future spot prices and help in
disseminating such information. As we have seen,
futures markets provide a low cost trading mechanism.
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EASE OF SPECULATION
Derivative markets provide speculators with a cheaper
alternative to engaging in spot transactions. Also, the
amount of capital required to take a comparable
position is less in this case. This is important becausefacilitation of speculation is critical for ensuring free
and fair markets. Speculators always take calculated
risks. A speculator will accept a level of risk only if he is
convinced that the associated expected return is
commensurate with the risk that he is taking.
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Steve Jobs (Chairman and CEO, Apple Inc. Board of Directors, Walt Disney Company)
- You can't just ask customers what they want and then try togive that to them. By the time you get it built, they'll wantsomething new.- Why join the navy if you can be a pirate?- Be a yardstick of quality. Some people aren't used to anenvironment where excellence is expected.
[6.0] Introduction of futures in India
The first derivative product to be introduced in the Indian
securities market is going to be "INDEX FUTURES".
In the world, first index futures were traded in U.S. on
Kansas City Board of Trade (KCBT) on Value Line
Arithmetic Index (VLAI) in 1982.
[6.1] What are Index Futures ?
Index futures are the future contracts for which
underlying is the cash market index.
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For example: BSE may launch a future contract on "BSE
Sensitive Index" and NSE may launch a future contract on
"S&P CNX NIFTY".
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[6.2] Frequently used terms in Index Futures
market
Contract Size - The value of the contract at a specific
level of Index. It is Index level Multiplier.
Multiplier - It is a pre-determined value, used to arrive
at the contract size. It is the price per index point.
Tick Size - It is the minimum price difference between
two quotes of similar nature.
Contract Month - The month in which the contract will
expire.
Expiry Day - The last day on which the contract is
available for trading.
Open interest - Total outstanding long or short positionsin the market at any specific point in time. As total long
positions for market would be equal to total short
positions, for calculation of open Interest, only one side of
the contracts is counted.
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Volume - No. of contracts traded during a specific period
of time. During a day, during a week or during a month.
Long position- Outstanding/unsettled purchase position
at any point of time.
Short position - Outstanding/ unsettled sales position at
any point of time.
Open position - Outstanding/unsettled long or short
position at any point of time.
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Physical delivery - Open position at the expiry of the
contract is settled through delivery of the underlying. In
futures market, delivery is low.
Cash settlement - Open position at the expiry of the
contract is settled in cash. These contracts are
designated as cash settled contracts. Index Futures fall in
this category.
[6.3] Concept of basis in futures market
Basis is defined as the difference between cash and
futures prices:
Basis can be either positive or negative (in Index
futures, basis generally is negative).
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Basis may change its sign several times during the
life of the contract.
Basis turns to zero at maturity of the futures contract
i.e. both cash and future prices converge at maturity
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[6.4] Pricing Futures
Cost and carry model of Futures pricing
Fair price = Spot price + Cost of carry Inflows
FPtT = CPt + CPt (RtT - DtT) (T-t)/365
FPtT - Fair price of the asset at time t for time T.
CPt - Cash price of the asset.
RtT - Interest rate at time t for the period up to T.
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DtT - Inflows in terms of dividend or interest between t
and T.
Cost of carry = Financing cost, Storage cost andinsurance cost.
If Futures price > Fair price; Buy in the cash
market and simultaneously sell in the futures
market.
If Futures price < Fair price; Sell in the cash
market and simultaneously buy in the futures
market.
This arbitrage between Cash and Future markets will
remain till prices in the Cash and Future markets get
aligned.
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Set of assumptions
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- No seasonal demand and supply in the underlying
asset.
- Storability of the underlying asset is not a problem.
- The underlying asset can be sold short.- No transaction cost; No taxes.
- No margin requirements, and so the analysis relates to
a forward contract, rather than a futures contract.
[6.5] Index Futures and cost and carry model
In the normal market, relationship between cash andfuture indices is described by the cost and carry model offutures pricing.
Expectancy Model of Futures pricing
S - Spot prices.
F - Future prices.
E(S) - Expected Spot prices.
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Expectancy model says that many a times it is not the
relationship between the fair price and future price but
the expected spot and future price which leads the
market. This happens mainly when underlying is not
storable or may not be sold short. For instance in
commodities market.
E(S) can be above or below the current spot prices. (This
reflects markets expectations)
[6.6] Risk management through Futures
Which risk are we going to manage through Futures ?
Basic objective of introduction of futures is to manage the
price risk.Index futures are used to manage the systemic risk,
vested in the investment in securities.
Hedge terminology
Long hedge- When you hedge by going long in futures
market.
Short hedge - When you hedge by going short in futuresmarket.
Cross hedge - When a futures contract is not available
on an asset, you hedge your position in cash market on
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another asset whose prices are closely associated with
that of your underlying.
[6.6.1] Some specific uses of Index Futures
Portfolio Restructuring - An act of increasing or
decreasing the equity exposure of a portfolio, quickly,
with the help of Index Futures.
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Index Funds - These are the funds whichimitate/replicate index with an objective to generate the
return equivalent to the Index. This is called Passive
Investment Strategy.
[6.6.2] Speculation in the Futures market
Speculation is all about taking position in the futuresmarket without having the underlying. Speculators
operate in the market with motive to make money. They
take:
Naked positions - Position in any future contract.
Spread positions - Opposite positions in two future
contracts. This is a conservative speculative strategy.Speculators bring liquidity to the system, provide
insurance to the hedgers and facilitate the price
discovery in the market.
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[6.7] Margining in Futures market
Whole system dwells on margins:
Daily Margins
Initial Margins
Maintenance margin
Daily Margins
Daily margins are collected to cover the losses which
have already taken place on open positions.Price for daily settlement - Closing price of futures index.
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Price for final settlement - Closing price of cash index.
For daily margins, two legs of spread positions would be
treated independently.Daily margins should be received by CC/CH and/or
exchange from its members before the market opens for
the trading on the very next day.
Daily margins would be paid only in cash.
Initial MarginsMargins to cover the potential losses for one day.
To be collected on the basis of value at risk at 99% of the
days.
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Maintenance margin
This is somewhat lower than the initial margin. This is set
to ensure that the that the balance in the margin accountnever becomes negative. If the balance in the margin
account falls below the maintenance margin, the investor
receives a margin call and is expected to top up the
margin account to the initial margin level before trading
commences on the next day.
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Striking an intelligent balance between safety and
liquidity while determining margins, is a milliondollar point.
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Jehangir Ratanji Dadabhoy Tata(pioneeraviator,Industrialistand was awardedIndia's highest civilian award, the Bharat Ratna in 1992)
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- Money is like manure. It stinks when you pile it; it growswhen you spread it.
- When you work, work as if everything depends on you. Whenyou pray, pray as if everything depends on God.
- Making steel may be compared to making a chappati(tortilla). To make a good chappati, even a golden pin willnot work unless the dough is good.
[7.0] Derivative Markets today
The Reserve Bank of India has permitted options, interest
rate swaps, currency swaps and other risk reductions OTC
derivative products.
Forward Markets Commission has allowed the setting upof commodities futures exchanges. Today we have 18
commodities exchanges most of which trade futures.
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In the equity markets both the National Stock Exchange
of India Ltd. (NSE) and The Stock Exchange, Mumbai
(BSE) have applied to SEBI for setting up their derivatives
segments.
BSE's and NSEs plans
Both the exchanges have set-up an in-house segment
instead of setting up a separate exchange for derivatives.
BSEs Derivatives Segment, will start with Sensex futures
as its first product.NSEs Futures & Options Segment will be launched with
Nifty futures as the first product.
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Product Specifications BSE-30 Sensex Future
Contract Size - Rs. 50 times the Index Active
contracts - 3 nearest months
Tick Size - 0.1 points or Rs. 5
Settlement basis - cash settled
Expiry day - last Thursday of the month Contract
cycle - 3 months
Product Specifications S&P CNX Nifty Futures
Contract Size - Rs. 200 times the Index Active
contracts - 3 nearest months
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Tick Size - 0.05 points or Rs. 10
Settlement basis - cash settled
Expiry day - last Thursday of the month Contract
cycle - 3 months
Membership
Membership for the new segment in both the exchanges
is not automatic and has to be separately applied for.
Membership is currently open on both the exchanges.
All members will also have to be separately registered
with SEBI before they can be accepted.
Trading Systems
NSEs Trading system for its futures and options segment
is called NEAT F&O. It is based on the NEAT system for
the cash segment.
BSEs trading system for its derivatives segment is called
DTSS. It is built on a platform different from the BOLT
system though most of the features are common.
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Settlement and Risk Management systems
Systems for settlement and risk management are
required to satisfy the conditions specified by the L.C.
Gupta Committee and the J.R. Verma committee. These
include upfront margins, daily settlement, online
surveillance and position monitoring and risk
management using the Value-at-Risk concept.
Certification programs
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The NSE certification programme is called NCFM (NSEs
Certification in Financial Markets). NSE has outsourced
training for this to various institutes around the country.
The BSE certification programme is called BCDE (BSEsCertification for the Derivatives Exchange). BSE conducts
its own training run by its training institute. Both these
programmes are approved by SEBI.
Rules and Laws
Both the BSE and the NSE have been give in-principle
approval on their rule and laws by SEBI. According to the
SEBI chairman, the Gazette notification of the Bye-Laws
after the final approval is expected to be completed by
May 2000.
Expected advantages of derivatives to the cash
market
Availability of risk management products attracts
more investors to the cash market.
Arbitrage between cash and futures markets fetches
additional business to cash market.
Improvement in delivery based business.
Lesser volatility
Improved price discovery.
Higher liquidity.
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Late Mr. Enzo Anselmo Ferrari (was an Italian race car driver andentrepreneur, Founder ofFerrari )
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- I use a derivative of this one, "If you buy the engine, I'll give you
everything else for free.
- I don't sell cars; I sell engines. The cars I throw in for free since
something has to hold the engines in.
- If you can dream it you can do it.
[8.0] INTRODUCTION TO INDEXES
[8.1]Whats an Index?
An Index is a number used to represent the changes in a set of
values between a base time period and another time period.
[8.2]Whats a Stock Index?
A Stock Index is a number that helps you measurethe levels of the market. Most stock indexesattempt to be proxies for the market they exist in.Returns on the index thus are supposed torepresent returns on the market i.e. the returnsthat you could get if you had the entire market inyour portfolio.
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[8.3] Why do we need an Index?
Students of Modern Portfolio Theory will appreciatethat the aim of every portfolio manager is to beat
the market.
In order to benchmark the portfolio against themarket we need some efficient proxy for themarket.
Indexes arose out of this need for a proxy.
[8.4] What does the number mean?
The index value is arrived at by calculating theweighted average of the prices of a basket of
stocks of a particular portfolio.This portfolio is called the index portfolio andattempts a high degree of correlation with themarket.
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Most index providers have a index committee of
some sort that decides on the composition of the
index based on standardised selection and
elimination criteria.The criteria for selection of course depends on the
philosophy of the index and its objective.
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[8.9] Selection Criteria
Most indexes attempt to strike a balance between
the following criteria.
Better Industry representation
Maximum coverage of market
capitalisation
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Higher Liquidity or Lower Impact cost.
Industry Representation
Since the objective of any index is to be a proxy for
the market it becomes imperative that the broad
industry sectors are faithfully represented in the
Index too.Though this seems like an easy enough
task, in practice it is very difficult to achieve due to
a number of issues, not least of them being the
basic method of industry classification.
Market Capitalisation
Another objective that most index providers strive
to achieve is to ensure coverage of some minimumlevel of the capitalisation of the entire market. As a
result within every industry the largest market
capitalisation stocks tend to select themselves.
However it is quite a balancing act to achieve the
same minimum level for every industry.
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Liquidity or Impact Cost
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It is important from the point of usability for all the
stocks that are part of the index to be highly liquid.
The reasons are two-fold. An illiquid stock has stale
prices and this tends to give a flawed value to theindex. Further for passive fund managers, the entry
and exit cost at a particular index level is high if
the stocks are illiquid. This cost is also called the
impact cost of the index.
[8.10] What is a Benchmark Index?
An index which acts as the benchmark in themarket has an important role to play.While it has to
be responsive to the changes in the market place
and allow for new industries or give up on dead
industries, at the same time it should also maintain
a degree of continuity in order to survive as an
benchmark index.
[8.11] What are the popular indexes in India?
BSE-30
Sensex
BSE-100
Natex
BSE Dollex
BSE-200
BSE-500
S&P CNX Nifty
S&P CNX Nifty
Jr.
S&P CNX Defty
S&P CNX
Midcap
S&P CNX 500
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[8.12] What are Sectoral Indexes?
These indexes provide the benchmark for sector
specific funds.Fund managers and other investors
who track particular sectors of the economy like
Technology, Pharmaceuticals, Financial Sector,
Manufacturing or Infrastructure use these indexes
to keep track of the sector performance.
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[8.13] What are the uses of an Index ?
Index based funds
These funds tend to replicate the index as it is in
order to match the returns on the market. This is
also know as passive management. Their argument
is that it is not possible to beat the market over a
sustained period of time through active
management and hence its better to replicate the
index. Example in India areUTIs fund on the Sensex , IDBI MFs fund on
the Nifty
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Exchange traded funds (ETFs)
These are similar to index funds that are traded onan exchange.
These are pretty popular world wide with non-
resident investors who like to take an exposure to
the entire market.
S&Ps SPDRs and MSCIs WEBS products are
amongst the most popular products.
Index futures
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Index futures are possibly the single most popular
exchange traded derivatives products today.The
S&P 500 futures products is the largest traded
index futures product in the world.In India both theBSE and NSE are due to launch their own index
futures product on their benchmark indexes
the Sensexand the Nifty.
What is the trend abroad?
Although we have a whole host of popularexchange owned indexes abroad including the DAX
30, the CAC 40 and the Hang Seng we see an
increasing trend where global index providers are
seen to have more influence among the foreign
funds and investing community.
What do Global Index providers bring ?
In the age of cross border capital flows and global
funds, global index provider provide the uniformity
and standardization in their index philosophy and
methodologies that allows a global
70fund to compare performance across regions or
sectors.
By following a common industry classification
standard in all the countries that they operate in,
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index providers hope to wean away liquidity from
the more popular and home grown indexes.Also
global providers are currently, the only ones in a
position to provide pan-continental or pan-globalindexes.
What does the future look like?
The future in India looks pretty exciting with Index
futures being launched and Index options expectedto follow. Hopefully with the growing popularity of
ETFs we might see SEBI allowing them in India
too.Globally while the debate between active and
passive fund management still rages, we see
standardised indexes growing in popularity.
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71Sir Winston Leonard Spencer-Churchill ( Prime Minister of the UnitedKingdom { 26 October1951 7 April 1955 } )
- The price of greatness is responsibility
- I am always ready to learn although I do not always like being
taught.
- We shall fight on the beaches. We shall fight on the landing
grounds. We shall fight in the fields, and in the streets, we shall
fight in the hills. We shall never surrender.
[9.0] Financial Risk Management
[9.1] Four Steps in Risk Management
1. Understand the nature of various risks.2. Define a risk management policy for the
organization and quantifying maximum risk thatorganization is willing to take if quantifiable.
3. Measure the risks if quantifiable and enumerateotherwise.
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4. Build internal control mechanism to control andmonitor all the risks.
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Step 1 Understand the nature of variousrisks
Risks can be classified into four categories.
Price or Market RiskCounterparty or Credit Risk
Dealing Risk
Settlement Risk
Operating Risks
Price or market RisksThis is the risk of loss due to change in marketprices. Price risk can increase further due toMarket Liquidity Risk, which arises when largepositions in individual instruments or exposuresreach more than a certain percentage of the
market, instrument or issue. Such a large positioncould be potentially illiquid and not be capable ofbeing replaced or hedged out at the currentmarket value and as a result may be assumed tocarry extra risk.
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Counterparty or credit risk RisksThis is the risk of loss due to a default of the
Counterparty in honoring its commitment in atransaction (Credit Risk). If the Counterparty issituated in another country, this also involvesCountry Risk, which is the risk of theCounterparty not honoring its commitmentbecause of the restrictions imposed by thegovernment though counterparty itself is capableto do so.
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Dealing RiskDealing Riskis the sum total of all unsettledtransactions due for all dates in future. If the
Counterparty goes bankrupt on any day, allunsettled transactions would have to be redone inthe market at the current rates. The loss would bethe difference between the original contract rateand the current rates. Dealing risk is thereforelimited to only the movement in the prices and ismeasured as a percentage of the total exposure.
Settlement RiskSettlement riskis the risk of Counterpartydefaulting on the day of the settlement. The risk inthis case would be 100% of the exposure if the
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corporate gives value before receiving value fromthe Counterparty. In addition the transaction wouldhave to be redone at the current market rates.
Operating RisksOperational risk is the risk that the organizationmay be exposed to financial loss either throughhuman error, misjudgment, negligence andmalfeasance, or through uncertainty,misunderstanding and confusion as toresponsibility and authority.
Step 2 - Define Risk PolicyDecide the basic risk policy that the organisationwants to have. This may vary from taking norisk(cover all) to taking high risks (open all). Mostorganisations would fall somewhere in between the
two extremes. Risk and reward go hand in hand.
Cost Center Vs. Profit Center
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A cost centre approach looks at exposuremanagement as insurance against adverse
movements. One is not looking for optimisation ofcost or realisation but meeting certain budgeted ortargeted rates. In a profit centre approach, thebusiness is taking deliberate risks to make moneyout of price movements.
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Step 3- Risk MeasurementThere are a number of different measures of price
or market risk which are mainly based on historicaland current market values Examples are Value atRisk (VAR), Revaluation, Modelling, Simulation,Stress Testing, Back Testing, etc.
Step 4- Risk Control
Control of Price RiskPosition limits are established to control the levelof price or market risk taken by the organization.Diversification is used to reduce systematic risk ina given portfolio.
Control of Credit Risk
Credit limits are established for each counterpartyfor both Dealing Risk and Settlement Riskseparatelydepending upon the risk perception ofthe counterparty.
Control of Operating RiskEstablishment of an effective and efficient internal