INTRODUCTION TO DERIVATIVES & RISK MANAGEMENT

tool to manage Financial Risk

derivatives are something like electricity: dangerous if mishandled, but bearing the potential to do good

------Arthur Leavitt

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What is a Derivative?

Derivative comes from the word to derive A derivative is a contract whose value is derived from the value of another asset called underlying asset If the price of underlying asset/security changes the price of derivative security also changes.

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What is Derivatives?

A derivative can be defined as a financial instrument whose value depends on (or derives from) the values of other, more basic underlying variables. --John C. Hull A derivative is simply a financial instrument (or even more simply an agreement between two people) which has a value determined by the price of something else. -Robert L. McDonald The Securities Contracts (Regulation) Act, 1956 defines "derivatives" to include: 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. A contract which derives its value from the prices, or index of prices, of underlying securities.

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Derivative contd.

Derivative markets neither create nor destroy wealth - they provide a means to transfer risk

zero sum game in that one partys gains are equal to another partys losses participants can choose the level of risk they wish to take on using derivatives with this efficient allocation of risk, investors are willing to supply more funds to the financial markets, enables firms to raise capital at reasonable costs

Derivatives are powerful instruments - they typically contain a high degree of leverage, meaning that small price changes can lead to large gains and losses this high degree of leverage makes them effective but also dangerous when misused.

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Features of Derivatives

Traded on exchange No compulsory physical trading of underlying assets All transactions in derivatives take place in future specific date Hedging Device-Reduces risk Derivatives has low transaction cost Derivatives are often leveraged, such that a small movement in the underlying value can cause a large difference in the value of the derivative.

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Why Derivatives ???

Speculate Hedge a portfolio of shares, bonds, foreign currency. Undertake arbitrage- i.e. benefits from mispricing. Engineer or structure desired positions.

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Need / Purpose of Derivatives

First; prices in an organised derivatives market reflect the perception of the market participants about the future level. The prices of derivatives converge with the prices of underlying at the expiration of the derivatives contract. Thus derivatives help in the discovery of the future as well as current prices Second; the derivatives market helps to transfer risks from those who have an appetite for them.

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Need / Purpose of Derivatives

Third; the derivatives, due to their inherent nature, are linked to the underlying cash market. With the introduction of derivatives, the underlying market witnesses a higher trading volume. Because of participation by more players who, would not otherwise participate for lack of an arrangement to transfer risk. Fourth; an important incidental benefit that flows from derivatives trading is that its act as a catalyst for new entrepreneurial activity. Finally, derivatives markets help increase savings and investment in the long run. Transfer of risk enables market participants to expand their volume of activity.

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Role of Derivatives

Provide global diversification in financial instruments and currencies. Help hedge against inflation and deflation. Generate returns that are not correlated with more traditional investments. Allow fast product innovation because new contracts can be introduced rapidly and can be tailored to the specific needs of any user

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Applications / Uses of Derivatives

Derivatives are used by investors for the following:
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Provide leverage (or gearing), such that a small movement in the underlying value can cause a large difference in the value of the derivative Speculate and make a profit if the value of the underlying asset moves the way they expect (e.g., moves in a given direction, stays in or out of a specified range, reaches a certain level) Hedge risk in the underlying, by entering into a derivative contract whose value moves in the opposite direction to their underlying position and cancels part or all of it out Obtain exposure to the underlying where it is not possible to trade in the underlying (e.g., weather derivatives) Create option ability where the value of the derivative is linked to a specific condition or event (e.g. the underlying reaching a specific price level)

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The Derivative World

Exchange Traded OTC Structured Embedded

Futures Options

Forwards Options Swaps

Bonds plus Warrants & Options

Interest Rate Currency Equity Commodity

Securitization

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Categorization / Types of Derivatives

Derivatives are usually broadly categorized by the: Relationship between the underlying and the derivative (e.g., forward, option, swap) type of underlying (e.g., equity derivatives, foreign exchange derivatives, interest rate derivatives, commodity derivatives or credit derivatives) market in which they trade (e.g., exchange-traded or over-the-counter) pay-off profile (Some derivatives have non-linear payoff diagrams due to embedded optionality) There is no definitive rule for distinguishing one from the other, so the distinction is mostly a matter of custom.

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Derivative Market
Two types of Derivative Market namely;

Exchange-Traded Derivatives Over-the-Counter(OTC) Market

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Exchange-Traded Derivatives

Exchange traded derivatives contract (ETD) are those derivatives instruments that are traded via specialized Derivatives exchange or other exchanges. A derivatives exchange is a market where individuals trade standardized contracts that have been standardized by the exchange. It could increase the liquidity of the derivatives. The world's largest derivatives exchanges (by number of transactions) are the Korea Exchange. There is a very visible and transparent market price for the derivatives.

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Over-the-Counter Market

Over-the-counter (OTC) or off-exchange trading is to trade financial instruments such as stocks, bonds, commodities or derivatives directly between two parties without going through an exchange or other intermediary.

The contract between the two parties are privately negotiated. The contract can be tailor-made to the two parties liking. Over-the-counter markets are uncontrolled, unregulated and have very few laws. Its more like a freefall.

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Exchange-Traded v/s Over-the-counter contracts

In India, two exchanges offer derivatives trading: the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). OTC derivative trading are considered as illegal in Indian Law.
Over-the-Counter Private transaction Credit risk Wide range of structures and contract size Many currencies Any maturity They are Unregulated Exchange-Traded Public price quote Limited credit risk due to clearing house Standard contracts and size Major currencies Standard expiration dates They are Regulated

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What is Financial Derivatives

The financial derivative is an asset whose value is derived from the value of some other asset(s) or derivatives, known as underlying asset(s). Example:
An orange juice can be considered as a derivative of the oranges since its price can be derived from that of oranges. An financial contract on selling 100 barrels of crude oil at $70/barrel in three months. (Forward or futures contract)

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Basic Financial Derivatives

Basic Financial Derivatives

Forward Contract

Future Contract

Options

Swaps

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1. Forward Contract

A 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.

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Contd.

A forward contract is a contractual agreement made directly between two parties, says A and B, Party A (Long the forward contract/Long position) (Buyer of the forward contract): He agrees to buy the underlying asset at certain future time (maturity date) for an agreed contractual price (forward price) (delivery price). Party B (Short the forward contract/Short position) (Seller of the forward contract): He agrees to sell the underlying asset at maturity date for the forward price.

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Contd.

The underlying asset of the forward contact can be commodities such as live cattle, oil and gold; or financial assets like bonds, currencies, stock indices and even derivatives.

Forward contract is traded in the OTC market.

The terminal payoff of a financial contract is defined as the payoff of the contract at its maturity date.

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Example: Forward Contract

I agree to sell 500kgs wheat at Rs.40/kg after 3 months.
3 months Later

Farmer

Bread Maker

500kgs wheat

Farmer
Rs.20,000

Bread Maker

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Salient Features of Forward Contract

They are bilateral contracts and hence, exposed to counterparty risk. Each contract is customer 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. In case, the party wishes to reverse the contract, it has to compulsorily go to the same counter party, which being in a monopoly situation can command the price it wants.

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Limitations of Forward Contract

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Forward markets are afflicted by several problems: Lack of centralization of trading, Liquidity and Counterparty risk. The basic problem in the first two is that they have too much flexibility and generality. Counterparty risk arises from the possibility of default by any one party to the transaction. When one of the two sides to the transaction declares bankruptcy, the other suffers

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2. Future Contract

Future 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 contract, futures contract are standardized and stock exchanged traded.

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Contd.
The standardized items in a futures contract are: 1. Quantity of the underlying, 2. Quality of the underlying, 3. The date/month of delivery, 4. The units of price quotation and minimum price change and 5. Location of settlement.

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Salient Features of Future Contract

Futures markets are designed to solve the problems of trading, liquidity and counterparty risk. Basically, futures markets resemble the forward market Three distinct features of the futures markets are: - standardized contracts - centralized trading - Settlement through clearing houses to avoid counterparty risk.

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Distinction between Futures and Forward

Future Contract Forward Contract

Operational Mechanism

Traded on an organized stock exchange

Over the Counter (OTC) in nature

Nature of the Standardized contract Customized contract terms, hence, less Flexibility terms, hence, more liquid. liquid Margins Settlement Credit Risk Delivery Price Regulation Requires margin payments No margin payment Follows daily settlement Assumed by the exchange The delivery price is the spot price They are regulated Settlement happens at the end of the period Credit risk depends upon counter party The delivery price is the forward price Not Regulated

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Pay off for Futures

A pay off is the likely profit/loss that would accrue to a market participant with change in the price of the underlying asset. Futures contracts have linear pay off. Linear pay off: losses as well as profits for both the buyer and the seller of futures are unlimited

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Pay off for Buyer of Futures: (Long Future)

The pay offs for a person who buys a futures contract is similar to the pay off for a person who holds an asset. He has a potentially unlimited upside as well as downside.

e.g. Take the case of a speculator who sells a two month Nifty index futures contact when the Nifty stands at 1220. the underlying asset in this case is the nifty portfolio. When the index moves down the short futures position starts making profits and when the index moves up it starts making losses.

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3. Options

An option is the right, but not the obligation to buy or sell something on a specified date at a specified price. In the securities market, an option is a contract between two parties to buy or sell specified number of shares at a later date for an agreed price.

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Contd.
There are three parties involved in the option trading, the option seller, buyer and the broker.
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The option seller or writer is a person who grants someone else the option to buy or sell. He receives premium on its price. The option buyer pays a price to the option writer to induce him to write the option. The securities broker acts as an agent to find the option buyer and the seller, and receives a commission or fee for it.

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Option Classifications

Call Option : an option which gives a right to buy the underlying asset at a strike price.

Put Option : an option which gives a right to sell the underlying asset at strike price.

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Call Option Buying

A Call option buyer basically is bullish about the underlying stock.

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Call Option Example

CALL OPTION
Premium = Rs.25/share Amt to buy Call option = Rs.2500
Current Price = Rs.250

Right to buy 100 Reliance shares at a price of Rs.300 per share after 3 months.

Strike Price

Expiry date

Suppose after a month, Market price is Rs.400, then the option is exercised i.e. the shares are bought. Net gain = 40,000-30,0002500 = Rs.7500

Suppose after a month, market price is Rs.200, then the option is not exercised. Net Loss = Premium amt = Rs.2500

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Put Option buying

A buyer of put option is bearish on underlying stock.

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Put Option Example

Premium = Rs.25/share Amt to buy Put option = Rs.2500

PUT OPTION
Right to sell 100 Reliance shares at a price of Rs.300 per share after 3 months.

Current Price = Rs.250

Strike Price

Expiry date

Suppose after a month, Market price is Rs.200, then the option is exercised i.e. the shares are sold. Net gain = 30,00020,000-2500 = Rs.7500

Suppose after a month, market price is Rs.300, then the option is not exercised. Net Loss = Premium amt = Rs.2500

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Option Classifications contd.

Both the Call and Put option buyers are buying the rights, that is they are transferring their risks to the sellers of the option. For this transfer of risk to the sellers, buyers have to compensate by paying Option Premium. Option premium is also known as Price of the option, Cost or Value of the option.

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Option Classifications contd.

The other two types are European style options and American style options. European style options can be exercised only on the maturity date of the option, also known as the expiry date.

American style options can be exercised at any time before and on the expiry date.

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Difference between Futures and Options

FUTURES OPTIONS Futures Contract is an agreement to buy or In options the buyer enjoys the right and sell specified quantity of the underlying not the obligation, to buy or sell the assets at a price agreed upon by the buyer underlying asset. and seller, on or before a specified time. Both the buyer and seller are obliged to buy/sell the underlying asset. Unlimited upside and downside for both Limited downside (to the extent of buyer and seller premium paid) for buyer and unlimited upside. For seller (writer) of the option, profits are limited whereas losses can be unlimited. Futures contracts prices are affected Prices of options are however, affected by mainly by the prices of the underlying (a) prices of the underlying asset, b) time asset. remaining for expiry of the contact and c) volatility of the underlying asset.

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4. Swaps

Swaps are contracts to exchange cash (flows) on or before a specified future date based on the underlying value of currencies/exchange rates, bonds/interest rates, commodities, stocks or other assets.

More complex derivatives can be created by combining the elements of these basic types. For example, the holder of a swaption has the right, but not the obligation, to enter into a swap on or before a specified future date.

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Commonly used Swaps

The two commonly used swaps are :

Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency. Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction.

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Traders in Derivative Market

Hedgers: They are the players whose objective is risk reduction. Speculators: They are the players who establish positions based on their expectations of future price movements.

Arbitrageurs: They are the players whose objective is to profit from pricing differentials/mispricing.

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A) Hedgers
The hedgers can use the derivatives to reduce their risk on the unfavorable movement of market variables such as exchange rates and commodity prices.

Example
Suppose ABC Airline Co. knows that it will have to buy on 31 Dec 2011 (date T) 1 million tons of fuel. To hedge against the possible increase in fuel price between today and T, they could

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Hedgers contd..

long forward contracts with maturity T:

They can lock the fuel price at T with the delivery price (K) of the forward contracts at zero cost today.

long European call option with strike K and maturity T:

If the fuel price at T is higher than K, they can exercise the option to buy the fuel at K. Otherwise, they can buy the fuel from the market at a price lower than K and without exercising the option. In this case, they has to pay the option premium (> 0) today.

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Hedgers contd..
In summary, forward contracts are designed to neutralize the risk by fixing price. By contrast, option contracts offer a way for investors to protect themselves against adverse price movements in the future while still allowing them to benefit from favorable price movements. Unlike forwards, options involve the payment of an upfront fee.

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B) Speculators

The speculator wishes gain profit from taking the market movement. Either they are betting that the price of the asset will go up or go down.

The financial derivatives allow them to create the speculative position in a much lower cost than by actually trading the underlying asset. This is called leverage.

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Speculators contd.

Example Todays price of HSBC: $70 per share Option price of a 1-month European call option on 1 share of HSBC with strike price $70: $0.5 Initial investment cost: $1,400 To bet on the price of HSBC will risk above $70 one month later. Strategy 1: Holding stock: 20 shares Strategy 2: Holding option: 2,800 option contracts

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Speculators contd.
At the end of 1 month: Stock price = $71 Strategy 1: Profit from holding stock = (7170)20=$20. Strategy 2: Profit from holding options = (7170)2800 1400 =$1,400 (70 times of Strategy 1)

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Speculators contd.
At the end of 1 month: Stock price = $69 Strategy 1: Loss from holding stock = (7069)20=$20. Strategy 2: Loss from holding options =$1,400 (70 times of Strategy 1)

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C) Arbitrageurs

An arbitrage is a deal that produces risk-free profit by exploiting a mispricing in the market. An arbitrageur can purchase an asset cheaply in one location and simultaneously sell it in another at a higher price. The arbitrage opportunities cannot last for long. More complicated arbitrage trading strategies can be created from financial derivatives.

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Arbitrageurs contd.

Example Suppose that China Mobile is traded in China and Hong Kong markets, its price in China and Hong Kong are RMB$120 and HK$130 respectively. We further suppose that the specifications of the share of China Mobile are identical in both markets and the exchange rate (HK/RMB) is 1.1. In China market: stock price = RMB$1201.1=HK$132. In Hong Kong market: stock price = HK$130.

An arbitrageurs could simultaneously buy 100 shares of China Mobile in Hong Kong and sell in China to obtain risk-free profit of 100(132 130) = HK$200. (assume no transaction cost)

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Factors Contributing to the Growth of Derivatives

Increased volatility.
Exchange rates became floating Active control of interest rates Commodity prices

Increased integration with the international markets.

Development of more sophisticated risk management tools.

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Factors Contributing to the Growth of Derivatives

Globalization
Revenues in different currencies Operating Costs in different currencies Liabilities in different currencies

Technological advances
Level of computerization Modeling abilities

Regulatory changes Changes in transactions costs

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Advantages of Derivative Market

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Diversion of speculative instinct form the cash market to the derivatives. Increased hedge for investors in cash market. Reduced risk of holding underlying assets. Lower transactions costs. Enhance price discovery process. Increase liquidity for investors and growth of savings flowing into these markets. It increase the volume of transactions.

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Disadvantages of Derivative Market

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Credit Risk/Large notional Value Crimes Interest rate Leverage of economys Debt

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The Dark Side of Derivatives

Six examples will be used to illustrate some of the perils, especially ethical perils, in use of financial derivatives: Equity Funding Corporation of America (1973) Baring Bank (1994) Orange County, California (1994) Long Term Capital Management (1998) Enron (2001) Global Crossing (2002) Each of them represented an effort to use financial derivatives to produce inflated returns. Two cases were proven to be frauds. Two appear to have been innocent of fraud. Two are still to be seen. Each was a major financial catastrophe, affecting not only those directly involved but the world at large.

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Criticism of Derivatives

Speculation Comparison to gambling : Derivatives are often seen as legalized gambling. This is an unfair criticism since derivatives have the benefit of making financial markets work better and provide a means for people to manage risk, whereas it is difficult to argue that gambling improves society as a whole. Sophistication - potential for huge gains and huge losses, appropriate for only sophisticated investors with a high tolerance for risk.

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Criticism of Derivatives contd..

Lifespan - as each day passes and the expiration date approaches, more and more "time" premium lose and the option's value decreases. Direction and market timing - investors must accurately predict the direction in which the market or index will move during a set period of time. A mistake here almost guarantees a substantial investment loss. Costs - The bid/ask spreads of more common derivatives such as options can be daunting. Inappropriate use

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What are myths behind derivatives?

Derivatives increase speculation and do not serve any economic purpose Indian Market is not ready for derivative trading Disasters prove that derivatives are very risky and highly leveraged instruments. Derivatives are complex and exotic instruments that Indian investors will find difficulty in understanding Is the existing capital market safer than Derivatives?

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History of Derivatives

Chicago Board of Trade (CBOT) for derivatives trading, became functional in 1848 and by 1865 futures contract in commodities started trading. In United Kingdom the Call and Put Option trading were introduced in the London Stock Exchange in 1920. In 1972 the Chicago Mercantile Exchange allowed currency futures, followed by equity options in 1973. Year 1975 saw introduction to Interest Rate futures on the CBOT. Currency Swaps were introduced in 1981 and in 1982 Index futures, Interest Rate swaps and Currency Options were started. In 1983, Index Options and Options on futures were started.

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Worldwide derivatives market

The derivatives market is mostly made up of derivatives based on:

Interest rates: ( ~65% of the market). Currencies: (~25%). Options and swaps on foreign exchange. Equity: (~5-10%). Index futures, Index swaps, etc. Commodities: (~0-5%).

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Derivatives in India

In India, derivatives markets have been functioning since the nineteenth century with organized trading in cotton through the establishment of the Cotton Trade Association in 1875. Derivatives, as exchange traded financial instruments were introduced in India in June 2000. (Nifty 50 index futures contract) First to be traded were futures contract on Index. After this came, options on individual securities and index Futures contract on individual stocks were launched in November,2001 In 1999, the Securities Contracts (Regulation) Act of 1956, or SC(R)A, was amended so that derivatives could be declared as securities. The Act considers derivatives on equities to be legal and valid, but only if they are traded on exchanges.

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Derivatives in India contd..

Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2000 on the recommendation of L. C Gupta committee. Securities and Exchange Board of India (SEBI) permitted the derivative segments of two stock exchanges, NSE and BSE, and their clearing house/corporation to commence trading and settlement in approved derivatives contracts. Trading in index options commenced in June 2001, options on individual securities in July 2001 and Futures on individual stocks in November 2001.

Milestones in the development of Indian Derivative Market

December 14, 1995 November 18, 1996 May 11, 1998 July 7, 1999

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May 25, 2000 June 12, 2000 June 4, 2001 July 2, 2001 November 9, 2001 August 29, 2008 August 31, 2009 February 2010 October 28, 2010 October 29, 2010

NSE asked SEBI for permission to trade index futures. L.C. Gupta Committee set up to draft a policy framework for introducing derivatives L.C. Gupta committee submits its report on the policy framework RBI gave permission for OTC forward rate agreements (FRAs) and interest rate swaps. SEBI allows exchanges to trade in index futures Trading on Nifty futures commences on the NSE Trading for Nifty options commences on the NSE Trading on Stock options commences on the NSE Trading on Stock futures commences on the NSE Currency derivatives trading commences on the NSE Interest rate derivatives trading commences on the NSE Launch of Currency Futures on additional currency pairs Introduction of European style Stock Options Introduction of Currency Options

FUTURES AND OPTIONS TRADING IN INDIA

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Products on NSE

Index futures and options on 6 indices:

S&P CNX Nifty S&P Nifty Junior CNX IT CNX 100 Bank Nifty Nifty Midcap 50

Futures and Options on individual securities (189 securities) Interest Rate Derivatives

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Futures and Options on index

S&P CNX Nifty is a well diversified 50 stock index. CNX Nifty Junior is an index based on 50 stocks. CNX 100 is an index based on 100 stocks. CNX Bank Index is an index comprised of the 12 most liquid and large capitalized Indian Banking stocks. CNX IT Index is an index based on 20 stocks of the IT sector.

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Futures and Options on Individual Securities

The futures and options contracts are available on 189 securities stipulated by the Securities & Exchange Board of India (SEBI). As per SEBI guidelines the stock shall be chosen from amongst the top 500 stocks in terms of average daily market capitalization and average daily traded value in the previous six months on a rolling basis.

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Trading Cycle

3 month trading cycle - the near month (one), the next month (two) and the far month (three) Expiry day- Last Thursday of the expiry month. If the last Thursday is a trading holiday, then the expiry day is the previous trading day. On expiry of the near month contract, new contracts are introduced on the trading day following the expiry of the near month contract. The new contracts are introduced for three month duration.

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Options contracts

The options contracts on index European style and cash settled.

are

Option contracts on individual securities are American style and cash settled.

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Future of Derivatives Market in India

Future of Indian derivatives market is bright because: SEBI allowed stock exchanges to offer incentives to brokers for generating volumes in illiquid securities in equity derivatives segment. The Bombay Stock Exchange (BSE) has added 135 stocks to its futures and options segment from August 2011 In only 11 years Indian moves to fifth largest derivatives exchange in the world India has the highest no. of listed companies on exchanges as compared to the other exchanges of the world.

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