derivatives forward

8/4/2019 Derivatives Forward

1/19

Derivatives and Risk

Management


2/19

What is Derivative?

A Financial instrument whose value dependson ( or derives from ) the values of other ,more basic ,underlying variables.

e.g. stock option whose value depends uponthe price of the stock.


3/19

OTC Market : Over the Counter market

Ex : An agreement to buy 10 million USD with

Indian Rupees at a predetermined exchangerate in a year.

Exchanges

A )Forward ContractsAn agreement to buy or sell an asset at a certain

future time for a certain price.

Long Position : One of the parties agrees to buythe underlying asset on a certain Specifiedfuture date for a certain specified price .


4/19

Short Position : The other party assumesthe a short position and agrees to sell theasset on the same date for the sameprice.

Forward contracts are extensively used in

india in foreign exchange market.

Ex :An agreement to buy 10 million USDwith Indian Rupees at a predetermined

exchange rate in a year.


5/19

Use of forward contract to hedgeforeign currency risk

Ex : US corporation wanting to buy 1 millionafter six months

BID Offer

Spot 1.6281 1.6285

1-Month Forward 1.6248 1.6253

3- Month Forward 1.6187 1.6192

6- Month Forward 1.6094 1.6100

Quote is number of USD per GBP

1 st row indicates that bank is prepared to buyGBP in the spot market at a rate of $ 1.6281 perGBP and sell sterling in the spot market at $1.6285.


6/19

Payoffs from forward contracts

US corporation wanting to buy 1 millionafter six months

1) If spot rate rose to 1.7000 at the end ofsix months..?

- Profit would be $ 90,000

2) If spot exchange rate fell to 1.5000 at theend of six months ?

- Loss would be $ 110000


7/19

Forward Contract :Pay off profiles : Long

position ( position of the corporation )

K St

K = Delivery Price

St = Spot price of the asset at the maturiyof the contract

Pay off 0


8/19

Forward Contract : Pay off profiles : ShortPosition ( position of the bank)

Pay off

K0 St


9/19

Risk Associated with the forwardcontracts

1) Liquidity Risk

2) Default / Credit risk / Counter party risk


10/19

Futures

An agreement between two parties to buy orsell an asset at a certain time in the future for acertain price.

Unlike forward contracts future contracts aretraded on an exchange.

( Hence futures contracts are essentially

standardised forward contracts , which aretraded on the exchanges and settled through

the clearing agency of the exchanges )


11/19

Options

Why options?

Ex : Mr. X needs to honour an obligation of $

1 million after three months from the givendate.

Option : Its a financial instrument that

gives the holder the right , without anyobligation, to buy or sell an asset by acertain date for a certain price.


12/19

Types of Options :

1) Call option : It gives the holder the right

to buy the underlying asset by a certaindate for a certain price.

2) Put option : It gives the holder the right

to sell the underlying asset by a certaindate for a certain price.

Exercise Price / Strike price : The price

in the contract is known as the exerciseprice or the strike price .


13/19

Expiration date or Maturity : The date inthe contract is known as the expiration

date or maturity date . Its a date onwhich contract ceases to exist .

American Option: options that can beexercised at any point upto the expirationdate.

European option : Options that can beexercised only on the expiration date.


14/19

so what is expiration date and exercise datefor European option if it is exercised?

Option premium : when an option writergives a right to the option buyer he will charge

for that right. So the price that the optionbuyer pays to the option seller for this option /right is called the option premium.


15/19

How options are different from theforwards and futures ?


16/19

FuturesDifference between forwards and futures

1) Operational Mechanism

2) Contract Specifications

3) Counter party risk

4) Liquidation profile

5) Price discovery6) Example


17/19

Futures Contract Month : The month in whichparticular contract expires is called thecontract month.

When do BSE and NSE future contractsexpire?


18/19

Contract Size and Contract Multiplier :

1) For Index Futures

NSE has selected Rs. 100 as the contractmultiplier .

BSE trades in Sensex with a contractmultiplier of Rs. 50

2) For stock futures

Single stock futures trade in terms ofprice and the multilpier is determinedbased on the number of underlyingshares.


19/19

Tick Size : It is the minimum differencebetween two quotes of a similar nature ( two

buy or two sell quotes )Tick size for trading in nifty index futures is0.05 index point or Rs. 5 .

Tick size for single stock futures is 5 paise.

derivatives forward

Documents