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DERIVATIVES AND RISKMANAGEMENT
Submitted By,
Ambar R. Kumar Nagpal- 32
Abhinav Nair- 33
Nitin V. Shukla- 47
Samarth R. Singh- 49
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Flow Of Presentation
Derivatives?Forwards
Futures
Options
Swap
Derivatives: Risk Management Tool
Risk Management by Exchange
New developments
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A Derivative is a contract whose value isderived from the value of its underlying.
Underlying product can be a commodity,currency, equity, interest rate, foreignexchange rate, electricity, etc.
Derivatives are risk management tools.
hat are Derivatives?
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Why Total Risk Matters?
Unsystematic Risk is unique risk and is diversifiable,whereas Systematic risk is market risk and notdiversifiable
Unsystematic risk are not priced in the financial marketand has no bearing on the required rate of return
Systematic risk is priced, and hence has an influence onthe required rate of return
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FORWARDS
It is an agreement to buy or sell an asset ata certain future time for a certain price.
It can be contrasted from a spot contractwhich is an agreement to buy or sell anasset today.
Traded in OTC
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Long Position- Agree to buy
Short Position- Agree to sell
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EXAMPLE OF FORWARD
Bid OfferSpot-1 month forward-3 month forward-6 month forward
.2 0558
.2 0547
.2 0526
.2 0483
.2 0562
.2 0552
.2 0531
.2 0489
&Spot Forward quotes for the/ ( )USD GBP Sterling exchange rate
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PAYOFFS FROM FORWARDCONTRACT
The payoff from the contract is the traderstotal gain or loss from the contract.
The payoff from a long position in a forward
contract on one unit of an asset is ST K
The payoff from a short position in a forwardcontract on one unit of an asset is
K ST
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In the last example, if K=2.0489 & if a corporation
has a long contract. When ST =2.1000, the payoff is $0.0511 per 1
When ST = 1.9000, the payoff is $-0.1489 per
1
Bid OfferSpot
-1 month forward-3 month forward-6 month forward
.2 0558
.2 0547.2 0526
.2 0483
.2 0562
.2 0552.2 0531
.2 0489
PAYOFF FROM LONG
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PAYOFF FROM LONGPOSITION
K ST
Payoff
0
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PAYOFF FROM SHORTPOSITION
Payoff
K ST0
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FUTURE CONTRACTS
It is an agreement between two parties tobuy or sell an asset at a certain time in thefuture for a certain price
Unlike forward contracts, future contractsare traded on an exchange
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EXAMPLE OF FUTURESCONTRACT
When the market is bullish
Take a long position
When Reliance Futures is at Rs. 480 Market rises and Reliance Futures goes to Rs. 500 Sell Reliance Futures Profit is = Rs 20/-
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When the market is bearish Take a short position
When Reliance Future is at 480 Sell Reliance Futures
Market falls and Reliance Futures goes to 460/- Buy Reliance Futures
Profit = Rs.20/-
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FUTURE PRODUCTS IN INDIA
Equity Index FuturesSingle Stock FuturesInterest Rate FuturesCommodity FuturesCurrency Futures
DIFFERENCE BETWEEN FORWARDS &
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Parameters Forwards Futures
ContractSpecifications
Customized Contract asper the needs of theparties involves
Standardized as per thespecifications laid down bythe exchange
Counter
Party Risk
There is a risk of
counterparty default
The clearing corporation is
the counterparty. Nocounterparty riskLiquidity Less Liquid Highly Liquid due to theparticipation of multiplepartiesDelivery
dateUsually one specifieddelivery date
Range of delivery date
Transparency
Opaque instruments ascontract specificationsare not reported in themedia
Highly transparent. Priceinformation isdisseminated almostinstantaneously.Settlement Settlement takes place
on the date of maturity ofthe contract
Settlement takes place
daily due to mark tomarket rovisions
DIFFERENCE BETWEEN FORWARDS &FUTURES
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Option Contracts
Options are deferred delivery contracts thatgive the buyers the right, but not the obligation, tobuy or sell a specified underlying at a set price on
or before a specified date.
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TYPES OF OPTIONS
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Option Terminology
Call OptionOption to buy
Put OptionOption to sell
Option Buyerhas the right but not the obligationOption Writer/Seller
has the obligation but not the right
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Option Terminology
Option PremiumPrice paid by the buyer to acquire the right
Strike Price OR Exercise PricePrice at which the underlying may be purchased or
soldExpiration DateLast date for exercising the option
Exercise DateDate on which the option is actually exercised
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Types of Options
American Optioncan be exercised any time on or before the
expiration date
European Option
can be exercised only on the expiration date
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In the Money Option : Positive cashflow to holder
At the Money Option : Zero Cashflow to holder
Out of the Money Option: Negative Cash flow to holderOption Premium:
Intrinsic Value :Call : Max [0,Spot Price- Strike Price]Put : Max [o, Strike Price- Spot Pice]
Time Value of an option
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Settlement Type
Derivatives Contracts are settled in cash - final settlement results in flow of cash from one party to another.
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Example of a Call Option
Bought a Reliance March 500 Call option bypaying a premium of Rs 10/-.
Spot Price (Rs.) Profit / Loss (Rs.)
490 -10
500 -10
510 0520 10
530 20
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Example of a Put Option
Bought a Reliance March 500 Put option bypaying a premium of Rs 10/-
Spot Price (Rs.) Profit / Loss (Rs.)
470 20
480 10
490 0
500 -10
510 -10
S ik P i I l f
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Strike Price Intervals forOptions
Sr. No. Price of the Strike Price Underlying (Rs.) Interval
(Rs.)1. Less than or equal to Rs. 50 Rs. 22. > Rs. 50 to < Rs. 250 Rs. 53. > Rs. 250 to < Rs. 500 Rs. 10
4. > Rs. 500 to < Rs. 1000 Rs. 205. > Rs. 1000 to < Rs. 2500 Rs. 306. > Rs. 2500 Rs. 50
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CALL OPTION (BUY)
TYPE STRIKE PREMIUM BREAKEVEN
BUY CALL 110 -20 130 (110 + 20)
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PUT OPTION (BUY)
TYPE STRIKE PREMIUM BREAKEVEN
BUY PUT 110 -20 90 (110 - 20)
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CALL OPTION (SELL)
TYPE STRIKE PREMIUM BREAKEVEN
SELL CALL 110 20 130 (110 + 20)
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PUT OPTION (SELL)
TYPE STRIKE PREMIUM BREAKEVEN
SELL PUT 110 20 90 (110 - 20)
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SWAPS
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SwapsMeaning:
An Agreement between two parties toexchange one set of cash flows for another
Major two types of Swaps
Interest Rate Swaps
Currency Swaps
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Features Interest Rate Swaps
Effectively translates a floating rate borrowing into afixed rate borrowing and vice versa
No exchange of principal repayment obligation
Translate an asset
Life 2 years to 15 years
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Plain Vanilla Interest Rate Swap
Meaning:
Company agrees to pay cash flows equal
to interest at a predetermined fixed rateon a notional principal for a number ofyears. In return, if receives interest at afloating rate on the same notional
principal for the same period of time
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Example
Consider a hypothetical 3 year swap initiatedon March 1, 2004, between Microsoft andIntel. We suppose Microsoft agrees to pay toIntel an interest rate 5% per annum on anotional principal of $100 million, and inreturn Intel agrees to pay Microsoft the 6month LIBOR rate on the same notionalprincipal.
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Date Libor Floating
Cash Flow(in million)
Fixed Cash
Flow (inmillion)
Net Cash
Flow ( inmillion)Mar 1,2004
4.2
Sept 1,2004
4.8 +2.10 -2.5 -0.4
Mar 1,
2005
5.3 +2.40 -2.5 -0.1
Sept1,2005
5.5 +2.65 -2.5 +0.15
Mar 1,20065.6 +2.75 -2.5 +0.25
Sept
1,2006
5.9 +2.8 -2.5 +0.30
Mar 1,20076.4 +2.95 -2.5 +0.45
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Transaction
Intel Microsoft. %5 2+ . %LIBOR 0 8
%5
LIBOR
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Payoffs
Microsoft Pays LIBOR + 0.8% to
outside lenders
Receives LIBOR underthe terms of Swaps Pays 5% under the
terms of Swaps Effectively net cash
outflow of 5.8%
Intel Pays 5.2% to its outside
lenders
Pays LIBOR under theterms of Swaps Receives 5% under the
terms of Swaps Effectively net cash
outflow of LIBOR+0.2%
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Uses
SpeculationReducing funding costs
Hedging interest rate exposure
Risk management
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Company A Company BFinancial Institution
Role of Intermediary
. %5 2 . %4 985
Libor
. %5 015
Libor
+Libor. %0 8
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Currency Swaps
Meaning:
A currency swap is a contract which commits twocounter parties to an exchange, over an agreedperiod, two streams of payments in differentcurrencies, each calculated using a different interestrate, and an exchange, at the end of the period, ofthe corresponding principal amounts, at an exchange
rate agreed at the start of the contract.
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Features Currency Swaps
An exchange of cash flows in twodifferent currencies
Exchange of principal amount at the
beginning or at the end of the contract
Calculated using different interest rates
The agreed exchange rate need not be
related to the market
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Example
USD AUD
General Motors 5.0% 12.6%
Qantas Airways 7.0% 13.0%
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Transaction
o
o
USD 5.0% USD 6.3%
AUD 11.9%
GeneralMotors
QantasAirwaysFinancial Institution
%USD 5
USD AUD
General Motors 5.0% 12.6%
Qantas Airways 7.0% 13.0%
%AUD 13
%AUD 13
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Payoffs
General MotorsPays 5% in USD to the
outside lender
Pays 11.9% AUD underswap agreement
Receives 5% USD underswap agreement
Effectively net cash outflowof AUD 11.9% (12.6%)
Qantas AirwaysPays 13% AUD to the
outside lender
Pays 6.3% USD under theswap agreement
Receives 13% AUD underthe swap agreement
Effectively net cash outflow
of USD 6.3% (7%)
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Uses
Switching loan from one currency to anothercurrency
Tap Foreign Capital Markets for Low Cost
Financing
Lower Financing Costs for Foreign Subsidiaries
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Comparison of Interest Rate Swaps and CurrencySwaps
Interest Rate SwapsAn exchange of
payment in singlecurrency
No exchange of
principal amountsince it is notional
Currency Swaps
An exchange ofpayment in twocurrencies
An exchange ofprincipal amount
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Derivatives: RiskDerivatives: RiskManagement ToolManagement Tool
M k t P ti i t i
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Market Participants inDerivatives
Hedgers
Speculators
Arbitrageurs
Hedgers: Forward
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Hedgers: ForwardContracts
Hedgers using forward contracts to safeguardfrom currency risk
Example:Import Co. has to pay 10 million on 3rd Sept,
2010 i.e. after 3 monthsPayment to British supplier
Type of payment Bid Offer
Spot 1.6281 1.6285
1-month forward 1.6248 1.6253
3- month forward 1.6187 1.6192
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Hedgers: Options
1000 Microsoft shares: MayCurrent Price $28/ share
Expectation of fall in the next 2 months
Buy 10 July put options, Strike Price: $27.50
Cost of Buying: $1000, considering eachcontract is $1
Guarantee that stock will be bought at $27.50
Net Returns, if
Share price goes down Exercising the option $26500
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Speculators: Options
Money in hand: $2000Speculation: Amazon.com going , Current
Price: $20
2-month Call option, Strike Price: $22.50
$ 2 0 0 0
O p tio n 1B u y 1 0 0 sh ares for $ 2 0 0 0S u p p ose th e p rice g o es u p to $ 2 7
: * =P ro fit 1 0 0 $ 7 $ 7 0 0
O p tio n 2 ,B u y 2 0 callo p tio n con tra cts fo r $ 2 0 0 0 a ssu m i
,N o w p rice g o e s u p b y $ 2 7 : * . =P ro fit 2 0 0 0 $ 4 5 $ 9 0 0 0 =N e t Pro fit $ 7 0 0 0
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Risk Management:Exchange Regulations
Levels of Risk
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Levels of RiskManagement
Liquid Net worth of a member
Security Deposit (Collateral)
Margining
Position Limits
Liquid Networth of a Member
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Liquid Networth of a Memberof the Derivatives Segment
Clearing Member - Rs. 300 lacsTrading Member - Rs. 25 lacs
Limited Trading Member Rs. 25 lacs
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Minimum Security Deposit
By a Clearing Member - Rs. 50 lacs - To be deposited with the Exchange.
By a Trading Member / Limited TradingMember - Rs. 7.5 lacs
- To be deposited with the Clearing
Member
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Margins
Initial Margin
Mark to Market Margin
Exposure Margin (Capital Adequacy)
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Initial Margin
It is to be collected upfront
Calculated on a portfolio basis
At client level
On trade executed basisBased on VAR
Calculated using SPAN (Standard PortfolioAnalysis of Risk)
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Mark to Market Margin
Charged for Futures Contract i.e. - Index Futures
and Stock Futures
No M-T-M in case of Options
Collected in Cash on T + 1 basis
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New Developments in theDerivatives Segment
Introduction of Weekly Options in Stocksand Index.
Introduction of F & O on BSE-Tec
kIndexIntroduction of additional stocks for F &
O trading.
Marketing of Derivatives to FIIs
Currency Options: Permission granted bySEBI
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THANK YOU