Financial Derivatives

Dr Roshna Varghese
Asst Prof, RCBS Email: roshna@rajagiri.edu; roshnavarghese@gmail.com Mob : 98474743625

Evaluation Criteria
Mid Trimester Exam End Trimester Exam Assignment Projects/Presentations Class Participation Attendance TOTAL : 20 marks : 40 marks : 10 marks : 15 marks : 10 Marks : 5 marks : 100 marks

References
John C. Hull. (2007). Options, Futures and other Derivatives, 6th ed. New Delhi : Prentice Hall of India

Robert A. Strong. (2006). Derivatives : An Introduction, Thomson South Western S.S.S. Kumar ( 2007). Financial Derivatives, New Delhi : Prentice Hall of India

Outline of the lectures

Module 1
Introduction to Derivatives

Module 2
Options

Module 3
Futures

Module 4
Currency, commodity, interest rate derivative

Module 5
Swaps, credit derivatives, real options

Investment
Investment is a commitment of funds made in the expectation of some positive rate of return.

Investment and Savings

Savings lead to investment Savings, if Income > expenditure Investment
Savings expectation of return

Characteristics of investment
Return Risk Marketability Safety

Investment : Assets
Tangible Assets
Land, machinery, work of art (dealt in product market)

Intangible Assets : legal claims

E.g. Financial Assets - Equity shares, bonds (dealt in financial Market)

Investment Avenues
Corporate Securities
Equity shares Preference shares Debentures/Bonds GDRs/ADRs

Derivatives Govt and semi govt Securities Money market instruments Mutual fund schemes Deposits in banks and non banking companies Post office Savings/Life insurance policies Provident fund schemes Real assets Real estate, precious objects

Securities
Definition of Security Securities include shares, bonds, debentures or other marketable securities like securities of incorporated companies or other body corporate or government.

Securities Contract Regulation Act 1956

Securities Market Financial Market - Chart

Securities Market
Money Market
Debt instruments having a maturity of less than one year are dealt in money market. T- bill market, Ready forward contracts (Repo) market, Call money market, Commercial Paper market

Capital Market
Securities with maturities of more than one year are bought and sold in the capital market. Equity Market; Debt Market ; Derivatives market Primary or Secondary market

Derivatives

Derivatives
Instruments that derive value from underlying assets. Changes in price of the underlying asset affect the price of the derivative security.

Derivatives Underlying assets

Commodities
including grain, coffee .. Precious metal like gold and silver

Securities
stock, Bonds and other debt instruments

Foreign Exchange rate Interest rate Index of prices Weather,.

Types of Derivatives
Options Futures Complex Derivatives
Swaps Credit Derivatives

Derivatives permitted in India

Derivatives

Equity

Debt

Forex

Commoditi es

Index futures & Options Single stock options & futures

Interest rate futures & forwards Interest rate swaps

Currency futures Currency options

Forwards
Cross currency swaps

Forwards Futures

S.S.S. Kumar ( 2007). Financial Derivatives, New Delhi : Prentice Hall of India, p.4

What are futures and options?

A contract to make or take delivery of a product in the future, at a price set in the present In formalized futures and options trading on exchanges, standardized agreements specify price, quantity, and month of delivery Started in agriculture, but have expanded to a wide range of products

Derivatives - History
Not a modern invention
First option transaction by Greek Philosopher Thales from Miletus (624 BC 546 BC) Futures markets evolved from commodity markets Agriculture futures
Money lenders used to compel their borrowers to sell their forthcoming crop at a price agreed upon at the time of taking loan

S.S.S. Kumar ( 2007). Financial Derivatives, New Delhi : Prentice Hall of India, pp.2-3

Derivatives - History
Establishment of Chicago Board of Trade (CBoT) in 1848 New York Mercantile Exchange (NYMEX) in 1877 London Metal Exchange (LME), Chicago Metal Exchange (CME) in 1898 Trading in financial derivatives foreign currency started in Chicago Metal Exchange in 1972 Publication of Black Scholes Option pricing model in 1973

Derivatives in India
In India
First organised futures market in 1875 in Bombay
Bombay Cotton Trade Association Ltd

After independence, in 1969, prohibited derivatives trading Reintroduction in 2000

Trading in index futures began on BSE and NSE

2001 : Trading in options on index and stocks on BSE and NSE 2002 Trading on single stock futures 2003 Interest rate futures, commodity futures 2008 Currency futures

What led to the development of Derivatives Market?

Economic pursuits became very risky Breakthrough in option pricing

Where do derivatives trade

BSE NSE NCDEX ( National Commodity and Derivative Exchange)

MCX (Multi Commodity Exchange)

Uses of Derivatives
Risk Management
Risk Transfer Hedging

Income Generation Financial Engineering

Participants in Derivative Market

Hedging (Hedger) Speculation (Speculator) Arbitrage (Arbitrageur)

What many critics of equity derivatives fail to realise is that the markets for these instruments have become so large not because of slick sales campaigns but because they are providing economic value to their users. By enabling pension funds and other institutional investors to hedge and adjust positions quickly and inexpensively, these instruments have come to play an important role in portfolio management. Alan Greenspan Congressional Testimony, May 19, 1988