A) Introduction to Derivatives (1)

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Derivatives

Introduction


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Leading Investment andCommercial banks

Banc of America Securities LLC

Citigroup

Credit Suisse

Goldman Sachs JPMorgan Chase

Lehman Brothers

Merrill Lynch Morgan Stanley

UBS
http://en.wikipedia.org/wiki/Banc_of_America_Securities_LLChttp://en.wikipedia.org/wiki/Citigrouphttp://en.wikipedia.org/wiki/Credit_Suissehttp://en.wikipedia.org/wiki/Goldman_Sachshttp://en.wikipedia.org/wiki/JPMorgan_Chasehttp://en.wikipedia.org/wiki/Lehman_Brothershttp://en.wikipedia.org/wiki/Merrill_Lynchhttp://en.wikipedia.org/wiki/Morgan_Stanleyhttp://en.wikipedia.org/wiki/UBS_AGhttp://en.wikipedia.org/wiki/UBS_AGhttp://en.wikipedia.org/wiki/Morgan_Stanleyhttp://en.wikipedia.org/wiki/Merrill_Lynchhttp://en.wikipedia.org/wiki/Lehman_Brothershttp://en.wikipedia.org/wiki/JPMorgan_Chasehttp://en.wikipedia.org/wiki/Goldman_Sachshttp://en.wikipedia.org/wiki/Credit_Suissehttp://en.wikipedia.org/wiki/Citigrouphttp://en.wikipedia.org/wiki/Banc_of_America_Securities_LLC


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RISK /Uncertain???

Case-1 An Indian Garments company has received an

order to supply I,00,000 units of shirts from USA.The price of $ 500,000 is receivable after six

months. The current exchange rate isRs.39.76/$. At the current exchange rate, thecompany would get: 39.76 500,000 = Rs1,98,80,000. But the company anticipatesappreciation of Indian rupee over time. Does thecompany loose/gain due to appreciation in theIndian Rupee? How does company minimise therisk?

Answer please


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Minimising risk case-1

The company can lock in the exchangerate by entering into an advance contractand forget about any fluctuation in theexchange rate. Suppose, the six-monthforward exchange rate is Rs39.00/$ Thecompany can make an agreement at spotrate at 39.76 in the spot market or at alesser price. At the time of receiving dollar,it will exchange $500,000 at Rs39.76= Rs1,98,80,000. or agreed price.


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Case 2

You have imported machinery for $ 100,000 on 180 dayscredit at zero interest. The dollar quotes at Rs 39. Isthis deal risk free?


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CASE 2 CONTINUED

This deal is not free of risk because after sixmonths when you pay the loan, if the dollarquotes anything more than Rs39., say Rs 40,you will end up paying more [Rs 1 extra forevery $ 1, which is equivalent to Rs 100,000additional cost]. On the other hand, if the dollarquotes anything less than Rs 39, you will standto gain

The question here is not whether you stand togain or loose it is the riskyou are taking


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Case 03

You have surplus cash for investment. Youthink of investing in Wipro, currently quoting atRs 3,500, which you believe will rise to Rs 3,950in six months. Is this deal risk free?


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CASE3 CONTINUED

This deal is not free of risk because thereis no guarantee that Wipros shares wouldtouch Rs 3,950 in six months time.

The share prices could rise beyond Rs3,950 or could also fall below Rs 3,500giving you no return on investment andyou could stand to loose some portion ofyour investment


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How do you protect yourself ?

Use Derivative instruments.

What is derivatives?

See the next example.

Picking up something?...


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Example

You [along with two friends] want to go for theAero India January 2008 air show, for whichtickets are sold out. Through one of your closefriends, you obtain a recommendation letter,

which will enable you to buy three tickets. Theprice of a ticket is Rs 1,000. Which is the commodity that you are suppose to

buy?

In order to buy the________ what are requirednow? Money/recommendation letter (instrument) or

both?

People walking in the seashore scared?...


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Financial instruments

The recommendation letter is a derivativeinstrument. It gives you a right to buy the ticket

The underlying asset is the ticket

The letter does not constitute ownership of theticket

It is indeed a promise to convey ownership

The value of the letter changes with changes inthe price of the ticket. It derives its value fromthe value of the ticket

Children are scared to go near by?...


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Different risk coverage

Firms are exposed to several risks in the ordinary courseof operations and borrowing funds.

For some risks, management can obtain protectionfrom an insurance company(fire,loss of profit,loss of

stock,marine insurance) Similarly, there are capital market products available to

protect against certain risks. Such risks include risksassociated with a rise in the price of commoditypurchased as an input, a decline in a commodity

price of a product the firm sells, a rise in the cost ofborrowing funds and an adverse exchange ratemovement. The instruments that can be used toprovide such protection are called derivative instruments

What was see doing? Why?...


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Meaning

Derivative instruments are called so becausethey derive their value from whatever thecontract is based on

A derivative contract is a financial instrumentwhose payoff structure is derived from the value

of the underlying asset

These instruments include futures contracts,forward contracts, options contracts, swapagreements, and cap and floor agreements

See the next slide


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Advantages

The derivative market helps people meetdiverse objectives such as:

Hedging

Profit making through price changes

Profit making through arbitrage

Guess what does she pick up?


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HEDGING

Hedge is an investment position intended to offset potential lossesthat may be incurred by a companion investment.

A hedge can be constructed from many types of financialinstruments, including stocks, exchange-traded funds, insurance,forward contracts, swaps, options, many types of over-the-counterand derivative products, and futures contracts.

Public futures markets were established in the 19th century to allowtransparent, standardized, and efficient hedging of agriculturalcommodity prices; they have since expanded to include futurescontracts for hedging the values of energy, precious metals, foreigncurrency, and interest rate fluctuations.


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xamp e gr cu ura commo y pr cehedging

A typical hedger might be a commercialfarmer.

The market values of wheat and othercrops fluctuate constantly as supply anddemand for them vary, with occasionallarge moves in either direction.


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Example continued

Based on current prices and forecastlevels at harvest time, the farmer mightdecide that planting wheat is a good idea

one season,

. Once the farmer plants wheat, he iscommitted to it for an entire growing

season.


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Example continued

If the actual price of wheat rises greatly betweenplanting and harvest, the farmer stands to makea lot of unexpected money,

But if the actual price drops by harvest time, hecould be ruined.

If at planting time the farmer sells a number ofwheat futures contracts equivalent to hisanticipated crop size, he effectively locks in theprice of wheat at that time


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Example continued

The contract is an agreement to deliver a certain numberof bushels of wheat to a specified place on a certain datein the future for a certain fixed price.

The farmer has hedged his exposure to wheat prices; heno longer cares whether the current price rises or falls,because he is guaranteed a price by the contract.

He no longer needs to worry about being ruined by a lowwheat price at harvest time,

but he also gives up the chance at making extra moneyfrom a high wheat price at harvest times.


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Hedging a stock price

A stock trader believes that the stock price ofCompany A will rise over the next month, due tothe company's new and efficient method of

producing widgets. He wants to buy Company Ashares to profit from their expected priceincrease. But Company A is part of the highlyvolatile widget industry. If the trader simply

bought the shares based on his belief that theCompany A shares were underpriced, the trade

would be a speculation.

i ti d


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price..continued

Since the trader is interested in thecompany, rather than the industry, hewants to hedge out the industry risk by

short selling an equal value (number ofshares price) of the shares of Company

A's direct competitor, Company B.


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The first day the trader's portfolio is:

Long 1,000 shares of Company A at $1each

Short 500 shares of Company B at $2each

(Notice that the trader has sold short thesame value of shares)


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On the second day, a favorable news story about thewidgets industry is published and the value of all widgetsstock goes up. Company A, however, because it is astronger company, increases by 10%, while Company B

increases by just 5%: Long 1,000 shares of Company A at $1.10 each: $100

gain

Short 500 shares of Company B at $2.10 each: $50 loss

(In a short position, the investor loses money when theprice goes up.)

The trader might regret the hedge on day two, since itreduced the profits on the Company A position.


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But on the third day, an unfavorable news story is published aboutthe health effects of widgets, and all widgets stocks crash: 50% iswiped off the value of the widgets industry in the course of a fewhours. Nevertheless, since Company A is the better company, itsuffers less than Company B:

Value of long position (Company A):

Day 1: $1,000

Day 2: $1,100

Day 3: $550 => ($1,000 $550) = $450 loss

Value of short position (Company B): Day 1: $1,000

Day 2: $1,050

Day 3: $525 => ($1,000 $525) = $475 profit


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uses

Price discovery Most price changes are first reflected in the derivative market.

That way derivative market feeds the spot market

For instance, if the dollars are going down, it means that theprofessional investors are expecting dolor price to go down in

the future this is a good sign for you to buy in the spot market

Risk transfer A derivative market is like an insurance company

Derivative instruments redistribute the risk amongst marketplayers

However, if you want protection against adverse pricemovements, you must pay a price, ie the premium


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Derivative instruments on

Stocks (Equity)

Agri Commodities including grains, coffee beans, pepper,.

Precious metals like gold and silver.

Crude oilForeign exchange rate

Bonds

Short-term debt securities such as T-bills

Index

Interest rate

The old lady looked shabby


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TYPES OF DERIVATIVES

Futures

Forwards

Option

Floor

cap


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Players in the market

Banks-Citi Bank

Deutsche Bank

Goldman Saches JP Morgan Chase

HSBC

ICICI


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Ways of making contract?

1. Private contracts- Known as Forwards

2. Through Stock - Known asexchanges Futures, Options

Swap, Floor andCap


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How do they settle the contract?

Daily basis -Known as Marking to market


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How does stock exchange operate?

It collects amounts from both the partiesof contract known as Initial Margin Money.

Stock Exchange also collect additionalmargin money is known as VariationMargin.


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Forwards

Documents

A) Introduction to Derivatives (1)