ftkmc-introduction to derivatives

8/18/2019 FTKMC-Introduction to Derivatives

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Introduction to Derivatives

Chirag Sheth – Executive Director – GoldStoneAdvisors Pvt Ltd

STRICTLY CO!IDETIAL



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#eaning o$ Derivatives

• Derivatives is a %roduct &hose value is derived $ro' the value o$ the underl(ingasset

•)nderl(ing asset can *e e+uit(, $orex, co''odit( or an( other asset

• The derivatives 'ar-et ena*les various entities to lessen price risk , the ris- o$ loss*ecause o$ uncertaint( over the $uture %rice o$ a co''odit( or .nancial asset



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!unctions o$ Derivatives

• Price discover(

•Ris- trans$er

•0igher volu'es

•Controlled s%eculation

•Enhances entre%reneurshi%



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Derivatives 2 Ris-s

Derivative 'ar-ets neither create nor destro( &ealth 3 the( %rovide a 'eans totrans$er ris-4

5ero su' ga'e in that one %art(6s gains are e+ual to another %art(6s losses4

Partici%ants can choose the level o$ ris- the( &ish to ta-e on using derivatives

7ith this e8cient allocation o$ ris-, investors are &illing to su%%l( 'ore $unds to the.nancial 'ar-ets, ena*les .r's to raise ca%ital at reasona*le costs

Derivatives are %o&er$ul instru'ents 3 the( t(%icall( contain a high degree o$leverage, 'eaning that s'all %rice changes can lead to large gains and losses

This high degree o$ leverage 'a-es the' e9ective *ut also :dangerous6 &hen'isused4



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T(%es o$ Derivatives

Forwards

Bilateral

OTC

Futures

Exchange Traded

Standardised

Options

CallPut

Derivatives

Swaps

Interest rate swapForeign currency swap



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T(%es o$ Derivatives

♦ A $or&ard contract is a custo'i=ed agree'ent *et&een t&o %arties to exchange an

asset at certain %eriod in $uture at toda(6s %re agreed %rice

♦ A $utures contract is an agree'ent *et&een t&o %arties to exchange an asset at acertain date at a certain %rice4 !utures contracts are standardi=ed $or&ard contractsthat are traded on an exchange

An o%tions contract gives *u(er the right, *ut not the o*ligation to *u( or sell as%eci.ed underl(ing at a set %rice on or *e$ore a s%eci.ed date

S&a%s are arrange'ents in &hich one %art( trades so'ething &ith another %art(4 The s&a% 'ar-et is ver( large, &ith trillions o$ dollars outstanding



Introduction to !or&ards

A $or&ard contract is a custo'i=ed agree'ent *et&een t&o %arties toexchange an asset at certain %eriod in $uture at toda(6s %re agreed %rice

eg4 On >an ?, "@?/, #r4 agrees to *u( ten tola o$ Gold $ro' #r4 Y on Dec /?,"@?/ at Rs /";@@Btola

#r4 has ta-en a long %osition and #r4 Y short

Other details are negotiated *ilaterall(



!or&ards – Salient $eatures

♦ ilateral contracts

♦ Custo'i=ed agree'ent

♦ Price -no&n onl( to the %arties

♦ Deliver( settled

♦ Reversal co'%ulsor( &ith the sa'e counter %art(



!or&ard 3 Li'itations

♦ Lac- o$ centrali=ation o$ trading

♦ Illi+uidit(

♦ Counter %art( ris-



Introduction to !utures

♦ !utures &ere designed to solve the %ro*le's that existed in the $or&ard 'ar-ets

♦ A $utures contract is an agree'ent *et&een t&o %arties to exchange an asset at acertain date at a certain %rice

♦ !utures contracts are standardi=ed $or&ard contracts that are traded on an

exchange

♦ To $acilitate li+uidit( exchange s%eci.ed standard $eatures $or the contract

uantit( and +ualit( o$ the underl(ing

Date and 'onth o$ deliver(

)nits o$ %rice +uotation and 'in4 %rice change

Location and 'ode o$ settle'ent

♦ !utures can *e o9set %rior to 'aturit(, F o9set %rior to 'aturit(



Distinction *et&een !utures and !or&ards

Futures Forwards

Traded on exchange OTC in nature

Standardi=ed Custo'i=ed

Li+uid Illi+uid

#argins re+uired o 'argins

Dail( settled Ex%ir( settled



Introduction to O%tions

♦ Audi is Launching A

♦ Price is Rs H; La-h

♦ You can *oo- the car *( %a(ing Rs ?,@@,@@@

♦ ( *oo-ing the car, &hat have (ou *ought

♦ 7hen *oo-ing 'atures, can Audi $orce (ou to *u( A

♦ Can (ou $orce Audi to sell A



O%tions Ter'inolog(

♦ Index options: 0ave index as the underl(ing

♦ Stock Options: 0ave stoc- as the underl(ing

♦ Option buyer: u(s the o%tion *( %a(ing %re'iu' and gets the right to exercise o%tions on&riterBseller

♦ Option seller: SellsB&rites the o%tion and receives the %re'iu' and is hence under o*ligationto *u(Bsell asset i$ the *u(er exercises o%tion

♦ Option premium: Price %aid *( the *u(er to seller to ac+uire the right4 Co'%rises o$ IntrinsicJalue and Ti'e Jalue

♦ Strike / Exercise price: Price at &hich the underl(ing 'a( *e %urchased or sold

♦ Expiry date: It6s last Thursda( o$ the 'onth $or o%tions to *e exercisedB traded4 O%tions ceaseto exist a$ter ex%ir(


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Introduction

♦ S&a%s are arrange'ents in &hich one %art( trades so'ething &ith another %art(

♦ The s&a% 'ar-et is ver( large, &ith trillions o$ dollars outstanding in s&a%agree'ents

♦ Currenc( s&a%s

♦ Interest rate s&a%s

♦ Co''odit( 2 other s&a%s 3 e4g4 atural gas %ricing


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S&a%s

♦ In an interest rate s&a%, one .r' %a(s a .xed interest rate on a su' o$ 'one(and receives $ro' so'e other .r' a Koating interest rate on the sa'e su'4

♦ In a $oreign currenc( s&a%, t&o .r's initiall( trade one currenc( $or another4Su*se+uentl(, the t&o .r's exchange interest %a('ents, one *ased on a $oreigninterest rate and the other *ased on a )4S4 interest rate4 !inall(, the t&o .r's re3exchange the t&o currencies4

♦ Co''odit( S&a%s Si'ilar to an interest rate s&a% in that one %art( agrees to%a( a .xed %rice $or a notional +uantit( o$ the co''odit( &hile the other %art(agrees to %a( a Koating %rice or 'ar-et %rice on the %a('ent dateMsN


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Partici%ants in the Derivatives 7orld

♦ 0edgers

♦ S%eculators

♦ Ar*itrageurs

♦

Scal%ersB>o**ers


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0edging

♦ I$ so'eone *ears an econo'ic ris- and uses the $utures 'ar-et to reduce that

ris-, the %erson is a hedger

♦ 0edging is a %rudent *usiness %ractice and a %rudent 'anager has a legal dut( tounderstand and use the $utures 'ar-et hedging 'echanis'


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S%eculation

♦ A %erson or .r' &ho acce%ts the ris- the hedger does not &ant to ta-e is aspeculator

♦ S%eculators *elieve the %otential return out&eighs the ris-

♦ The %ri'ar( %ur%ose o$ derivatives 'ar-ets is not s%eculation4 Rather, the(

%er'it the trans$er o$ ris- *et&een 'ar-et %artici%ants as the( desire


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0edgers and S%eculators

Hedgers Speculators

Ris Trans!er


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Ar*itrage

♦ Ar*itrage is the existence o$ a ris-less %ro.t

♦ Ar*itrage o%%ortunities are +uic-l( ex%loited and eli'inated

♦ Persons activel( engaged in see-ing out 'inor %ricing discre%ancies are called

ar*itrageurs

♦ Ar*itrageurs -ee% %rices in the 'ar-et%lace e8cient4

– An e8cient 'ar-et is one in &hich securities are %riced in accordance &ith their

%erceived level o$ ris- and their %otential return


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)ses o$ Derivatives

♦ Ris- 'anage'ent

♦ Inco'e generation

♦ !inancial engineering



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Ris- #anage'ent

FALLING !I"ES FLA# $A!%E# !ISING !I"ES

E&E"#E' E&E"#E'E&E"#E'

(EA!IS) NE*#!AL (*LLIS)

Increasin+ bearis,ness Increasin+ bullis,ness



Than- You

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