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Derivatives, Futures and Options (3)

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    Risk

    A probability or threat of damage,

    liability, loss, or any other negativeoccurrence that is caused by external orinternal vulnerabilities, and that may be

    avoided through preemptive action.

    Financial Risk is defined as the chancethat an investment's actual return willbe different than expected. This includes

    the possibility of losing some or all ofthe original investment.

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    Types of Risk

    FUNDAMENTAL TYPE OF RISK

    Systematic Risk- It influences a large number of assets.This type of risk is both unpredictable and impossible tocompletely avoid.

    Unsystematic Risk- This kind of risk affects a verysmall number of assets. An example is news that affects

    a specific stock such as a sudden strike by employees.

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    Types of Risk

    Foreign-Exchange Risk- When investing in foreign countriesyou must consider the fact that currency exchange ratescan change the price of the asset as well. Foreign-exchange risk applies to all financial instruments that are

    in a currency other than your domestic currency.

    Interest Rate Risk- Interest rate risk is the risk that aninvestment's value will change as a result of a change ininterest rates. This risk affects the value of bonds more

    directly than stocks.

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    Types of Risk

    Political Risk- Political risk represents the financial risk that acountry's government will suddenly change its policies. This is amajor reason why developing countries lack foreign investment.

    Market Risk- Also referred to as volatility, market risk is the day-to-day fluctuations in a stock's price. Market risk applies mainlyto stocks and options. As a whole, stocks tend to perform wellduring a bull market and poorly during a bear market - volatilityis not so much a cause but an effect of certain market forces.Volatility is a measure of risk because it refers to the behavior, or

    "temperament", of your investment rather than the reason forthis behavior.

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    Risk Reward Return

    The risk-return tradeoff is the balance an investor must decide on

    between the desire for the lowest possible risk for the highest possible

    returns.

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    Derivatives

    Derivative is an instrument that

    does not have a value of its own,

    rather it derives its value/price

    on the basis of some other

    instrument, hence the name

    Derivative.

    In derivatives transactions, one

    partys loss is always another

    partys gain

    The main purpose of derivatives is

    to transfer risk from one person

    or firm to another, that is, to

    provide insurance

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    Usage of Derivatives

    To hedge risks

    To speculate (take a view on the future direction of the market)

    To lock in an arbitrage profit

    To change the nature of a liability

    To change the nature of an investment without incurring the

    costs of selling one portfolio and buying another

    Derivatives improve overall performance of the economy

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    Derivatives

    Derivatives exchange is a market whereindividuals trade standardized contracts that havebeen defined by the exchange

    The Chicago Board of Trade, established in 1948 isthe oldest exchange to trade derivatives

    It brought farmers and merchants together andstandardized the qualities and quantities of the

    grains traded Chicago Mercantile Exchange was established in

    1919 in order to trade futures

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    Major kind of Derivatives

    1. Forwards and futures

    2. Options

    3. Swaps

    These derivatives are traded on following markets

    Over the counter

    Exchange traded markets

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    Kinds of Derivatives

    Forwards and Futures

    A forward, or a forward contract, is:

    An agreement between a buyer and a seller to

    exchange a commodity or a financial instrument for a

    pre specified amount of cash on a prearranged future

    date

    Example: interest rate forwards

    Forwards are highly customized, and are much less

    common than the futures

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    Example of Futures

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    Features of Forward contract

    >Forward contracts are bilateral contracts and are are exposed tocounter party risk

    > Each contract is custom design and is unique in terms of contract size,expiration date, asset type and quality

    > The specified price in forward contract is referred to as delivery price.The forward price of particular forward contract at a particular time is

    the delivery price that would apply if the contract would have entered at

    that time. Both price are equal at the time the contract is entered into.

    However, as the time passes the forward price changes while delivery

    price remains same>The forward contract has to be settled by delivery of the asset onexpiration date

    > If the party wishes to reverse the contract, then it has to deal with thesame counter party

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    Forward contract Payoff

    So in a long forward contract, you have a positive payoff only if the Spot Price (S) > Contract

    Price (K) since in a long forward contract you have an obligation to buy. Hence, if S>K, then you

    can buy it at lower cost and sell it into the market at a higher price and earn profits. In a short

    forward contract, if S

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    Features of Futures

    >All futures contract have standardized specification i.e. quantity ofasset, quality of asset, date and month of delivery, unit of price quotation,

    location of settlement.

    >Clearing house acts as intermediary or middlemen in futures. It gives

    guarantee for the performance of the parties to each transaction. It is thecountry party for every contract

    >At the close of trading day, each contract is marked to market.Settlement price is established to calculate profit or loss of each member

    >When a person enters into a futures contract, he is required to depositfunds with broker called as margin. The basic objective of margin accountis to act as collateral security in order to minimize the risk of failure by

    either party in the futures contract

    >Most of the futures contract are settled in cash

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    Futures contract

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    Hedging and Speculating with

    Futures

    Agents hedge against adverse events in the market using futures

    market

    E.g. manager wishes to insure the firm against the rise in interest rates and

    the resulting decline in the rise in interest rates and the resulting decline in the

    value of bonds the firm holds value of bonds the firm holdsCan sell a futures contract and lock in a price

    Producers and users of commodities use futures extensively to hedge

    their risks extensively to hedge their risks

    Farmers, oil drillers (producers) sell futures contracts for Farmers, oil drillers

    (producers) sell futures contracts for their commodities and insure themselvesagainst price their commodities and insure themselves against price declines

    Food processing companies, oil refineries (users) buy Food processing

    companies, oil refineries (users) buy futures contracts to insure themselves

    against price futures contracts to insure themselves against price increase

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    Hedging and Speculating with

    Futures

    Speculators try to use futures to make a profit by betting on price

    movements: profit by betting on price movements:

    Sellers of futures bet on price decreases

    Buyers of futures bet on price increasesFutures are popular because they are cheap

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    Arbitrage and Futures Prices

    On the delivery date, the price of the futures contract must equalthe price of the asset the contract the seller is obligated to deliver

    If this were not true, it would be possible to earn instantaneous risk

    free profit

    If bond price were below the futures price, buy a bond, sell the

    contract, deliver the bond, and earn the profit

    Practice of simultaneously buying and selling financial instruments

    to benefit from temporary price difference is called arbitrage

    Existence of arbitrageurs ensures that at delivery date, the futures

    price equals the market price of the bond

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    Option Contracts

    Optionis a contract entered between two parties whereby one party obtainsthe right and not the obligation, to buy or sell a particular asset, at a specified

    price on or before the specified date

    The person who acquires the right is known as option buyer or option holder

    and the person is called option seller or option writer

    The seller of the option for giving such option to the buyer charges an amountknown as option premium

    TWO TYPES OF OPTION

    Call options

    Gives the holder an option to buy an asset at the specified price and time

    Put options

    Gives the holder an option to sell an asset at the specified price and time

    The specified price in such contract is called Exercise price or strike price

    the specified date is called expiration date or maturity date

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    Option Contracts

    American OptionIt can be exercised at any time before the expiration date

    European Option

    It can be exercised only on the expiration date

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    Option Contracts

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    Swap Contracts

    A swap is an agreement between two counter partiesto exchange cash flows in the future.

    Under the swap agreement, various terms like thedates when the cash flows are to be paid, the

    currency in which to be paid and the mode of

    payment are determined and finalized by the parties.

    Usually the calculation of cash flows involves thefuture values of one or more market variables.

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    Warrants and Convertibles

    Warrants

    Warrant is just like an option contract where the holder hasthe right to buy shares of a specified company at a certainprice during the given time period.

    If the holder exercised the right, it increases the number of

    shares of the issuing company, and thus, dilutes the equitiesof its shareholders.

    Warrants are usually issued as sweeteners attached tosenior securities like bonds and debentures so that they aresuccessful in their equity issues in terms of volume and price.

    Warrants are highly speculative and leverage instruments,

    so trading in them must be done cautiously.

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    Warrants and Convertibles

    ConvertiblesThese are hybrid securities which combine the basic attributesof fixed interest and variable return securities. Most popularamong these are convertible bonds, convertible debentures

    and convertible preference shares. These are also called equityderivative securities.

    They can be fully or partially converted into the equity sharesof the issuing company at the predetermined specified termswith regards to the conversion period, conversion ratio and

    conversion price.These terms may be different from company to company, asper nature of the instrument and particular equity issue of thecompany.

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    Features of Forward Contracts

    1. It is an agreement between the two counterparties in which one is buyer and

    other is seller. All the terms are mutually agreed upon by the counterparties at the

    time of the formation of the forward contract.

    2. It specifies a quantity and type of the asset (commodity or security) to be sold

    and purchased.

    3. It specifies the future date at which the delivery and payment are to be made.

    4. It specifies a price at which the payment is to be made by the seller to the buyer.

    The price is determined presently to be paid in future.

    5. It obligates the seller to deliver the asset and also obligates the buyer to buy the

    asset.

    6. No money changes hands until the delivery date reaches, except for a small

    service fee, if there is.


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