Derivatives AFM

8/8/2019 Derivatives AFM

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DERIVATIVES AND RISKMANAGEMENT

Submitted By,

Ambar R. Kumar Nagpal- 32

Abhinav Nair- 33

Nitin V. Shukla- 47

Samarth R. Singh- 49


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Flow Of Presentation

Derivatives?Forwards

Futures

Options

Swap

Derivatives: Risk Management Tool

Risk Management by Exchange

New developments


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A Derivative is a contract whose value isderived from the value of its underlying.

Underlying product can be a commodity,currency, equity, interest rate, foreignexchange rate, electricity, etc.

Derivatives are risk management tools.

hat are Derivatives?


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Why Total Risk Matters?

Unsystematic Risk is unique risk and is diversifiable,whereas Systematic risk is market risk and notdiversifiable

Unsystematic risk are not priced in the financial marketand has no bearing on the required rate of return

Systematic risk is priced, and hence has an influence onthe required rate of return


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FORWARDS

It is an agreement to buy or sell an asset ata certain future time for a certain price.

It can be contrasted from a spot contractwhich is an agreement to buy or sell anasset today.

Traded in OTC


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Long Position- Agree to buy

Short Position- Agree to sell


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EXAMPLE OF FORWARD

Bid OfferSpot-1 month forward-3 month forward-6 month forward

.2 0558

.2 0547

.2 0526

.2 0483

.2 0562

.2 0552

.2 0531

.2 0489

&Spot Forward quotes for the/ ( )USD GBP Sterling exchange rate


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PAYOFFS FROM FORWARDCONTRACT

The payoff from the contract is the traderstotal gain or loss from the contract.

The payoff from a long position in a forward

contract on one unit of an asset is ST K

The payoff from a short position in a forwardcontract on one unit of an asset is

K ST


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In the last example, if K=2.0489 & if a corporation

has a long contract. When ST =2.1000, the payoff is $0.0511 per 1

When ST = 1.9000, the payoff is $-0.1489 per

1

Bid OfferSpot

-1 month forward-3 month forward-6 month forward

.2 0558

.2 0547.2 0526

.2 0483

.2 0562

.2 0552.2 0531

.2 0489

PAYOFF FROM LONG


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PAYOFF FROM LONGPOSITION

K ST

Payoff

0


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PAYOFF FROM SHORTPOSITION

Payoff

K ST0


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FUTURE CONTRACTS

It is an agreement between two parties tobuy or sell an asset at a certain time in thefuture for a certain price

Unlike forward contracts, future contractsare traded on an exchange


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EXAMPLE OF FUTURESCONTRACT

When the market is bullish

Take a long position

When Reliance Futures is at Rs. 480 Market rises and Reliance Futures goes to Rs. 500 Sell Reliance Futures Profit is = Rs 20/-


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When the market is bearish Take a short position

When Reliance Future is at 480 Sell Reliance Futures

Market falls and Reliance Futures goes to 460/- Buy Reliance Futures

Profit = Rs.20/-


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FUTURE PRODUCTS IN INDIA

Equity Index FuturesSingle Stock FuturesInterest Rate FuturesCommodity FuturesCurrency Futures

DIFFERENCE BETWEEN FORWARDS &


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Parameters Forwards Futures

ContractSpecifications

Customized Contract asper the needs of theparties involves

Standardized as per thespecifications laid down bythe exchange

Counter

Party Risk

There is a risk of

counterparty default

The clearing corporation is

the counterparty. Nocounterparty riskLiquidity Less Liquid Highly Liquid due to theparticipation of multiplepartiesDelivery

dateUsually one specifieddelivery date

Range of delivery date

Transparency

Opaque instruments ascontract specificationsare not reported in themedia

Highly transparent. Priceinformation isdisseminated almostinstantaneously.Settlement Settlement takes place

on the date of maturity ofthe contract

Settlement takes place

daily due to mark tomarket rovisions

DIFFERENCE BETWEEN FORWARDS &FUTURES


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Option Contracts

Options are deferred delivery contracts thatgive the buyers the right, but not the obligation, tobuy or sell a specified underlying at a set price on

or before a specified date.


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TYPES OF OPTIONS


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Option Terminology

Call OptionOption to buy

Put OptionOption to sell

Option Buyerhas the right but not the obligationOption Writer/Seller

has the obligation but not the right


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Option Terminology

Option PremiumPrice paid by the buyer to acquire the right

Strike Price OR Exercise PricePrice at which the underlying may be purchased or

soldExpiration DateLast date for exercising the option

Exercise DateDate on which the option is actually exercised


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Types of Options

American Optioncan be exercised any time on or before the

expiration date

European Option

can be exercised only on the expiration date


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In the Money Option : Positive cashflow to holder

At the Money Option : Zero Cashflow to holder

Out of the Money Option: Negative Cash flow to holderOption Premium:

Intrinsic Value :Call : Max [0,Spot Price- Strike Price]Put : Max [o, Strike Price- Spot Pice]

Time Value of an option


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Settlement Type

Derivatives Contracts are settled in cash - final settlement results in flow of cash from one party to another.


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Example of a Call Option

Bought a Reliance March 500 Call option bypaying a premium of Rs 10/-.

Spot Price (Rs.) Profit / Loss (Rs.)

490 -10

500 -10

510 0520 10

530 20


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Example of a Put Option

Bought a Reliance March 500 Put option bypaying a premium of Rs 10/-

Spot Price (Rs.) Profit / Loss (Rs.)

470 20

480 10

490 0

500 -10

510 -10

S ik P i I l f


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Strike Price Intervals forOptions

Sr. No. Price of the Strike Price Underlying (Rs.) Interval

(Rs.)1. Less than or equal to Rs. 50 Rs. 22. > Rs. 50 to < Rs. 250 Rs. 53. > Rs. 250 to < Rs. 500 Rs. 10

4. > Rs. 500 to < Rs. 1000 Rs. 205. > Rs. 1000 to < Rs. 2500 Rs. 306. > Rs. 2500 Rs. 50


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CALL OPTION (BUY)

TYPE STRIKE PREMIUM BREAKEVEN

BUY CALL 110 -20 130 (110 + 20)


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PUT OPTION (BUY)


BUY PUT 110 -20 90 (110 - 20)


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CALL OPTION (SELL)


SELL CALL 110 20 130 (110 + 20)


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PUT OPTION (SELL)


SELL PUT 110 20 90 (110 - 20)


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SWAPS


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SwapsMeaning:

An Agreement between two parties toexchange one set of cash flows for another

Major two types of Swaps

Interest Rate Swaps

Currency Swaps


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Features Interest Rate Swaps

Effectively translates a floating rate borrowing into afixed rate borrowing and vice versa

No exchange of principal repayment obligation

Translate an asset

Life 2 years to 15 years


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Plain Vanilla Interest Rate Swap

Meaning:

Company agrees to pay cash flows equal

to interest at a predetermined fixed rateon a notional principal for a number ofyears. In return, if receives interest at afloating rate on the same notional

principal for the same period of time


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Example

Consider a hypothetical 3 year swap initiatedon March 1, 2004, between Microsoft andIntel. We suppose Microsoft agrees to pay toIntel an interest rate 5% per annum on anotional principal of $100 million, and inreturn Intel agrees to pay Microsoft the 6month LIBOR rate on the same notionalprincipal.


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Date Libor Floating

Cash Flow(in million)

Fixed Cash

Flow (inmillion)

Net Cash

Flow ( inmillion)Mar 1,2004

4.2

Sept 1,2004

4.8 +2.10 -2.5 -0.4

Mar 1,

2005

5.3 +2.40 -2.5 -0.1

Sept1,2005

5.5 +2.65 -2.5 +0.15

Mar 1,20065.6 +2.75 -2.5 +0.25

Sept

1,2006

5.9 +2.8 -2.5 +0.30

Mar 1,20076.4 +2.95 -2.5 +0.45


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Transaction

Intel Microsoft. %5 2+ . %LIBOR 0 8

%5

LIBOR


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Payoffs

Microsoft Pays LIBOR + 0.8% to

outside lenders

Receives LIBOR underthe terms of Swaps Pays 5% under the

terms of Swaps Effectively net cash

outflow of 5.8%

Intel Pays 5.2% to its outside

lenders

Pays LIBOR under theterms of Swaps Receives 5% under the

terms of Swaps Effectively net cash

outflow of LIBOR+0.2%


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Uses

SpeculationReducing funding costs

Hedging interest rate exposure

Risk management


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Company A Company BFinancial Institution

Role of Intermediary

. %5 2 . %4 985

Libor

. %5 015

Libor

+Libor. %0 8


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Currency Swaps

Meaning:

A currency swap is a contract which commits twocounter parties to an exchange, over an agreedperiod, two streams of payments in differentcurrencies, each calculated using a different interestrate, and an exchange, at the end of the period, ofthe corresponding principal amounts, at an exchange

rate agreed at the start of the contract.


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Features Currency Swaps

An exchange of cash flows in twodifferent currencies

Exchange of principal amount at the

beginning or at the end of the contract

Calculated using different interest rates

The agreed exchange rate need not be

related to the market


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Example

USD AUD

General Motors 5.0% 12.6%

Qantas Airways 7.0% 13.0%


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Transaction

o

o

USD 5.0% USD 6.3%

AUD 11.9%

GeneralMotors

QantasAirwaysFinancial Institution

%USD 5

USD AUD

General Motors 5.0% 12.6%

Qantas Airways 7.0% 13.0%

%AUD 13

%AUD 13


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Payoffs

General MotorsPays 5% in USD to the

outside lender

Pays 11.9% AUD underswap agreement

Receives 5% USD underswap agreement

Effectively net cash outflowof AUD 11.9% (12.6%)

Qantas AirwaysPays 13% AUD to the

outside lender

Pays 6.3% USD under theswap agreement

Receives 13% AUD underthe swap agreement

Effectively net cash outflow

of USD 6.3% (7%)


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Uses

Switching loan from one currency to anothercurrency

Tap Foreign Capital Markets for Low Cost

Financing

Lower Financing Costs for Foreign Subsidiaries


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Comparison of Interest Rate Swaps and CurrencySwaps

Interest Rate SwapsAn exchange of

payment in singlecurrency

No exchange of

principal amountsince it is notional

Currency Swaps

An exchange ofpayment in twocurrencies

An exchange ofprincipal amount


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Derivatives: RiskDerivatives: RiskManagement ToolManagement Tool

M k t P ti i t i


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Market Participants inDerivatives

Hedgers

Speculators

Arbitrageurs

Hedgers: Forward


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Hedgers: ForwardContracts

Hedgers using forward contracts to safeguardfrom currency risk

Example:Import Co. has to pay 10 million on 3rd Sept,

2010 i.e. after 3 monthsPayment to British supplier

Type of payment Bid Offer

Spot 1.6281 1.6285

1-month forward 1.6248 1.6253

3- month forward 1.6187 1.6192


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Hedgers: Options

1000 Microsoft shares: MayCurrent Price $28/ share

Expectation of fall in the next 2 months

Buy 10 July put options, Strike Price: $27.50

Cost of Buying: $1000, considering eachcontract is $1

Guarantee that stock will be bought at $27.50

Net Returns, if

Share price goes down Exercising the option $26500


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Speculators: Options

Money in hand: $2000Speculation: Amazon.com going , Current

Price: $20

2-month Call option, Strike Price: $22.50

$ 2 0 0 0

O p tio n 1B u y 1 0 0 sh ares for $ 2 0 0 0S u p p ose th e p rice g o es u p to $ 2 7

: * =P ro fit 1 0 0 $ 7 $ 7 0 0

O p tio n 2 ,B u y 2 0 callo p tio n con tra cts fo r $ 2 0 0 0 a ssu m i

,N o w p rice g o e s u p b y $ 2 7 : * . =P ro fit 2 0 0 0 $ 4 5 $ 9 0 0 0 =N e t Pro fit $ 7 0 0 0


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Risk Management:Exchange Regulations

Levels of Risk


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Levels of RiskManagement

Liquid Net worth of a member

Security Deposit (Collateral)

Margining

Position Limits

Liquid Networth of a Member


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Liquid Networth of a Memberof the Derivatives Segment

Clearing Member - Rs. 300 lacsTrading Member - Rs. 25 lacs

Limited Trading Member Rs. 25 lacs


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Minimum Security Deposit

By a Clearing Member - Rs. 50 lacs - To be deposited with the Exchange.

By a Trading Member / Limited TradingMember - Rs. 7.5 lacs

- To be deposited with the Clearing

Member


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Margins

Initial Margin

Mark to Market Margin

Exposure Margin (Capital Adequacy)


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Initial Margin

It is to be collected upfront

Calculated on a portfolio basis

At client level

On trade executed basisBased on VAR

Calculated using SPAN (Standard PortfolioAnalysis of Risk)


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Mark to Market Margin

Charged for Futures Contract i.e. - Index Futures

and Stock Futures

No M-T-M in case of Options

Collected in Cash on T + 1 basis


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New Developments in theDerivatives Segment

Introduction of Weekly Options in Stocksand Index.

Introduction of F & O on BSE-Tec

kIndexIntroduction of additional stocks for F &

O trading.

Marketing of Derivatives to FIIs

Currency Options: Permission granted bySEBI


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THANK YOU

Documents

Derivatives AFM