Derivative

The Magic of Financial Derivatives

someone

Financial Derivatives have been called. ..

• . . .Engines of th e Econom y. . . Alan Greenspan (long-time chair of the Federal Reserve)

• . . .Weap ons of Mass Destr uc tion . . .

Warren Buffett

(chair of investment fund Berkshire Hathaway)

Famous Calamities

• 1994: Orange County, CA: losses of $1.7 billion • 1995: Barings Bank: losses of $1.5 billion • 1998: LongTermCapitalManagement (LTCM) hedge fund, founded by Meriwether, Merton and

• September 2006: the Hedge Fund Amaranth closes after losing $6 billion in energy derivatives. • January 2007: Reading (PA) School District has to pay $230,000 to Deutsche Bank because of a bad derivative investment • October 2007: Citigroup, Merrill Lynch, Bear Stearns, Lehman Brothers, all declare billions in losses in derivatives related to

On the Other Hand • In November 2006, a hedge fund with a large stake (stocks and options) in a company, which was being bought out, and whose stock price jumped 20%, made $500 million for the fund in the process • The head trader, who takes 20% in fees, earned $100

So, what is a Financial Derivative? 



A derivative is a contract between two parties which derives its value from an underlying asset. The different underlying assets are:  Currency  Exchange

rate  Interest rate  Stocks & stock indices  Bonds & bond indices  Commodities

FEATURES OF A DERIVATIVE • A derivative instrument relates to the future contract between two parties • The derivative instruments have the value which derived from the values of other underlying assets. • In general the counter parties have specified obligation under the derivative contract.

Economic functions of Derivative market • Derivatives help in discovery of future

as well as current prices.

• Speculative trades shift to a more controlled environment of derivatives market. • Act as a catalyst for new

Why derivative is so important today?Growth Driving Factors Increased volatility in asset prices in Financial Markets Increased integration between International Markets Development of more sophisticated Risk Management tools, providing economic agents a wider choice of Risk Management strategies Innovations in the derivatives markets, which optimally combine the risks and returns over a large number of financial

One of the most important services provided by the derivatives is to control, avoid, shift and manage efficiently different types of risks through various strategies like hedging, arbitraging, spreading, etc. Derivatives serve as barometers of the future trends in prices which result in the discovery of new prices both on the spot and futures markets. The derivatives assist the investors, traders and managers of large pools of funds to devise such strategies so that they may make proper asset allocation increase their yields and achieve other investment goals.

Ways derivatives are • To insure against changes or risk (hedgers). • To get a high profit from a certain market behavior (speculators). • To get a quick low-risk profit (arbitrageurs). • To change the nature of an investment without the costs of selling one portfolio and buying another.

What are the different types of traders/participants in derivatives market ?

There are three types of traders in the Derivative market namely                                                      Hedgers: They are in the position where they face risk associated with the price of an asset. They use derivatives to reduce or eliminate risk. For example, a farmer may use futures or options to establish the price for his crop long before he harvests it. Various factors affect the supply and demand for that crop, causing prices to rise and fall over the growing season. The farmer can watch the prices discovered in trading at the CBOT and, when they reflect the price he wants, will sell futures contracts to assure him of a fixed price for his crop.

Speculators: Speculators wish to bet on the future movement in the price of an asset. They use derivatives to get extra leverage. A speculator will buy and sell in anticipation of future price movements, but has no desire to actually own the physical commodity.  

Arbitrators: They are in the business to take advantage of a discrepancy between prices in two different markets. If, for example, they see the future prices of an asset getting out of line with the cash price, they will take offsetting positions in the

Types of Derivatives Forwards A Forward is an agreement between two parties to purchase or sell an instrument at a fixed time in the future and at a certain price

FEATURES OF A

FORWARD

CONTRACT

Forward contracts are bilateral contracts It specifies the future date at which the payment are to be made.

delivery and

The specified price in a forward contract is refer to as the delivery price. It obligates the seller to deliver the asset obligates the buyer to buy the asset.

and also

In forward contract, one of the parties takes along position to buy the asset at specified future date and one party takes a short position to sell the same assets at the same date.

Example of a forward contract

• On January 20, 2009 a trader (long position) enters into an agreement to buy £1 million in three months at an exchange rate of 1.6196 • This obligates the trader to pay $1,619,600 (=K) for £1 million on April 20, 2009 • If the exchange rate rose to 1.65, the spot price ST is $1,650,000 and the payoff is

Long and short forward position profits Long position (buyer)

Profi t

Short position (seller)

Profi t

ST

ST

PAY OFF FROM THE FORWARD CONTRACT Example: It is a Gold Forward Contract. On January 01, 2005, two parties enter into forward contract for delivery of one kg of gold on April 01, 2005 at a price of Rs. 5,200/- per 10 grams of gold. If the spot price of gold on April is 5400. Who will the gainer or looser?

1000 gm = I kg t = January T = April 1, 2002 FtT = Rs.5, 200/- per 10 grams of gold If the spot price of the gold is Rs.5, 400/- gain to long position per contract: No. Of Units X (FSP – Forward Price) = 100 x (5,400 – 5,200) = 100 x 200 = 20,000 The long position gains by having purchased gold worth Rs.5, 400/- per 10 gram at the forward price of Rs.5, 200/- per 10 grams. There will be a loss to the person holding short position. Loss to Short Position per Contract : No. of Units X (Forward Price – Future Spot Price) = 100 x (5,200 – 5,400) = 100 x –200 = -Rs.20, 000/-

What is `Offsetting the Forward Contract’ One cannot unilaterally back out from the obligation arisen in the forward contract, but he can certainly enter into another forward

position

exactly

opposite

the

original position. This strategy is popularly known as `offsetting the forward contract’.

EXAMPLE: January 01, 2005, a party X enters into a forward contract with another party Y, in which he agrees to buy one kg of gold on April 01, 2005 for Rs.5,000 per 10 grams of gold. On February 01, 2005, X decides to get out of his position, and hence, enters into another forward contract with Z which he agrees to sell one kg of gold on April 01, 2005 for Rs.5,200/- per 10

Value of forward contracts • Let r be the risk-free interest rate, F0 the forward price for a contract and K the delivery price. • The value f of the contract with time to maturity T is: f = (F0 - K)e-rT • At a general time t, 0 <= t <= T: f = (F0 - K)e-r(T-t) Example – six month long forward contract on stock • Risk-free interest rate is 10% • The forward price is $25, the delivery

The Advantage/Disadvantage of A forward Contract Disadvantage

Advanta ge • Both parties have limited their risk

• You must make or take delivery of the commodity and settle on the deliver date and honor the contract as agreed upon •  The buyer and seller are dependent upon each other. • In a forward contract, any profits or losses are not realized until the contract "comes due" on the predetermined date.

FUTURES CONTRACTS A future is a standardized derivative contract between two parties: a buyer and a seller. Futures are similar to forwards but they are traded on exchanges and their terms are standardized.

Being a standardized contract means that the buyer and seller do not contract directly with each other.  Instead, they contract with the intermediary known as the clearinghouse.  The clearinghouse protects their potential liability by requiring that margin be deposited and all positions are marked-to-market on at least a daily basis Marking to market : Their value is settled daily Underlying assets are generally currencies, commodities , treasury bonds, stock indices

THE CLEARING HOUSE What is clearing House? The functions of the Clearing House Funds

Buyer

Buyer (Member)

Goods (Asset)

Clearing house

Seller Goods (Asset) Funds

Seller (Member)

(b) Obligations with a clearing house

TYPES OF MARGIN

•

The Initial Margin

•

The Maintenance Margin

•

The Variation Margin

Margin • Initial margin: Initial deposit of funds required to be deposited. • Amount required in this account varies from broker to broker • Minimum margin requirements for a particular futures contract at a particular time are set by the exchange on which the contract is traded. They are typically five to 10 percent of the value of the futures contract • Margin calls may bring the value of your margin account to original initial margin level. Small loss allowed before margin calls. • Maintenance margin is the loss level which initiates a margin call..    

Note that once a trader receives a margin call, he must meet that call, even if the price has subsequently moved in his favor. If no money is deposited on the day of the margin call or early the next morning, the commodity broker will automatically make an offset trade to terminate the client’s futures position. Brokers

Example: Gold future contract size = 100 grams Investor buy one December gold futures contract on 1st November at on 400/per grams Value of contract 400 x 100 gm = Rs.40,000/Initial margin 10% = 40,000 x 10/100 = 4,000/Maintenance margin 75% of initial margin 75/100 x 4000 = Rs.3,000/-

Marking to Markets: Buyers Margin

Marking to Markets: Sellers Margin

WHAT IS OPTIONS? An option is a particular type of a contract between two parties where one person gives the other person the right to buy or sell a specific asset at a specified price within a specific time period.

PAY OFF PROFILE OF OPTION

TYPES OF OPTIONS

Call and Put Options American and European Options Exchange-traded traded Options

and

OTC-

TYPES OF OPTIONS Call The option to buy Put Options: The option to sell American :The option can be exercised anytime prior to maturity European Options: The option can be exercised at maturity

Longer -dated options are called warrants and are generally traded over-the-counter (OTC) Long-Term Equity Anticipation Securities. These are options having a maturity of up to three years. Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average of a basket of

Strike Price: The parties agree upon a price at which the underlying asset may be bought or sold. This price is referred to as exercise price or strike price Exercise date: The date at which contract matures is called exercise date. Expiration period: At the time of option contract the exchange specifies the period during which the option can be exercised or

Example of Call Option

An investor buys a European call option on satyam will exercise price at RS 280 for a premium of RS.10.If the price of the share rises and current market price is RS 350 , the owner of the option may exercise his option to buy the shares at Rs 280.

Example of a call option • A trader (option holder) buys a European call option with 1,000 shares in deCode with a strike price of $14 and an expiration date of one year. The option price is $0.5, so the holder pays $500 (V) for the contract. • If the deCode share rises to $17, the option holder has a margin of $2.5 per share and makes a profit of P = ST – K - V = ($17 - $14)*1,000 - $500 = $2,500. • If the share rises to only $14.2, the option holder still exercises the contract, since instead of losing the $500, he only loses $500 - ($14.2 – $14.0)*1,000 = $300 • In general, a call option is exercised if -V < ST – K

Example of Put Option

The investor buys a European put option on ONGC share with a strike price of Rs 850 and expiration in June, by paying a premium of RS 25.The investor has the right to sell ONGC share at RS 850 before the expiry date of the option. If the current market price of share is RS 950.The investor should not exercised his option.

Test your intuition: a concrete example • Current stock price of Microsoft is $19.40.

(as of

last night)

• A call-option with strike $20 and 1-year maturity would pay the difference between the stock price on January 22, 2009 and the strike (as long the stock price is higher than the strike.) • So if MSFT is worth $30 then, this option would pay $10. If the stock is below $20 at maturity, the contract expires worthless. . . . . . • So, what would you pay to hold this contract? • What would you want for it if you were the writer?

Price can be determined by • The market (as in an auction) • Or mathematical analysis: in 1973, Fischer Black and Myron Scholes came up with a model to price options. It was an instant hit, and became the foundation of the options market.

for the value of European Call and Put-options, Black and Scholes solved by formula:

• Where N is the cumulative distribution function for a standard normal random variable, and d1 and d2 are parameters depending on S, E, r, t, σ • This formula is easily programmed into Maple or other programs

SWAPS Swaps have been termed as private agreements between the two parties to exchange stream of cash flows against one another.

Why? • To hedge risks like floating interest rate, Currency fluctuations, equity returns

Example

Housing Loan from ICICI Bank 10 Lakhs Floating 8.5 %

KP Agrees to pay Floating rate to Rahul if He agrees to pay 9% fixe

Characteristics • • • • •

Two parties involved Private agreement OTC derivatives Cannot be traded Termination by mutual consent

Types of Swaps • • • • • •

Interest Swaps Currency Swaps Total Return Swaps Equity Swaps Commodity Swaps Credit Swaps

Interest Swap • Parties hedge interest rate like fixed to floating • Also called vanilla swaps • Principal is not exchanged • Most commonly used

Example of Interest Rate Swap

A borrows $10 million with a floating interest rate of Libor + 1% and B borrows $10 million with a fixed interest rate of 10%. A and B can enter into an interest rate swap arrangement under which A will pay a fixed rate of interest of 10 percent and B will pay a floating interest rate of Libor + 1%.

Currency Swap • Parties hedge on currency fluctuations • Across two different currencies • Actual exchange of currency • Interest rates/variations swapped • Transactions are reversed later

Example of Currency Swap Company A raises 1 million by issuing 10% German mark bonds and the company B raises 2 million by issuing 13% dollar bonds. Both the company Swap the transaction. In the beginning company A receives 2 million and company B receives 1 million. Both the companies reexchange the principal amounts at the time of maturity. Company A pays, 2,60,000 to company B and company B in turn

Equity Swap • Parties hedge returns on equity with Fixed interest • Generally entered to avoid tax • Portfolio is not exchanged • Can be hedged against currency fluctuations.

Credit Swap • Debt is transferred from one Party to other • Seller guarantees credit worthiness • Buyer will make money if credit is recovered properly

Risks • Bilateral agreements can be broken • Risks beyond repayment - Sub prime Termination: Both parties should agree and close or can reassign to a third party.

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