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8/4/2019 Derivatives Forward
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Derivatives and Risk
Management
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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.
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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 .
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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.
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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.
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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
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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
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Forward Contract : Pay off profiles : ShortPosition ( position of the bank)
Pay off
K0 St
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Risk Associated with the forwardcontracts
1) Liquidity Risk
2) Default / Credit risk / Counter party risk
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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 )
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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.
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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 .
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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.
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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.
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How options are different from theforwards and futures ?
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FuturesDifference between forwards and futures
1) Operational Mechanism
2) Contract Specifications
3) Counter party risk
4) Liquidation profile
5) Price discovery6) Example
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Futures Contract Month : The month in whichparticular contract expires is called thecontract month.
When do BSE and NSE future contractsexpire?
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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.
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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.