Derivatives

Prof Mahesh Kumar

Amity Business School
[email protected]
‘It is the difference of opinion that make
horse races.’
Mark Twain
Introduction
 An easy way to think of derivatives is as a “side
bet” on interest rates, exchange rates,
commodity prices, and practically ANYTHING
that you can think of say an agreement with
your neighbor for 2 bags of sugar next week.
 Derivatives really on fundamental levels are :
 Merely pieces of paper or
 In modern day view, electronic contracts.
 Derivatives give you a right or an obligation or
combination of the two to receive or give
something in future.
Why Derivatives?

 No need to raise capital. They are highly

leveraged products.
 Buy or sell to protect against adverse changes
in external factors.
Definition
Derivatives are financial instruments whose
value is ‘derived’ from the value of the
underlying asset. The underlying asset can be
securities, commodities, bullion, currency,
interest rates, WPI (inflation based derivatives)
or anything else.
Derivatives defined as per Securities Contract
Regulation Act (SCRA)

A derivative includes:
a) A security derived from a debt instrument,
share, loan-whether secured or unsecured,
risk instrument or contract for differences or
any other form of security.
b) A contract which derives its value from the
prices, or index of prices, of underlying
securities.
Examples of Derivative
1. Interest Rate Future Contracts
2. Options on futures
3. Mortgage Based Securities
4. Interest rate caps and floors
5. Swap Options
6. Commodity linked bonds
7. Zero Coupon Treasury Strips
Types of Derivative Market
There are two distinct markets:
1. Over The Counter Derivative Market:
Market
Contracts that are traded directly between two
eligible parties, with or without the use of an
intermediary and without going through an
exchange.
2. Exchange Traded Derivative Market:
Market
Derivative products that are traded on
exchange.
What is Foreign Exchange Exposure?
Exposure means that a firm or individual will
be affected if there is a change in exchange
rates.
Types of Foreign Exchange Exposure
There are three types foreign exchange exposures:
1. Translation Risk: This risk results from uncertainty in
exchange rates at which the value of foreign currency
assets or liabilities is converted or translated into
domestic currency for inclusion in financial statements.
2. Transaction Risk: This risk results from uncertainty in
exchange rates when the assets are actually sold or
liabilities repaid i.e. when transaction occurs.
3. Operating/Economic Risk: The economic risk results
from the effect that exchange rates have on export
prices and quantities and hence on future corporate
income. It also results from the effect of exchange rates
on the prices and quantities sold of imported goods.
Conceptual Comparison of Transaction, Operating
and Accounting Foreign Exchange Exposure
Moment in time when exchange rate changes

Translation exposure Operating exposure

Changes in reported owners’ equity Change in expected future cash flows
in consolidated financial statements arising from an unexpected change in
caused by a change in exchange rates exchange rates

Transaction exposure
Impact of settling outstanding obligations entered into before change
in exchange rates but to be settled after change in exchange rates
Time
Types of Foreign Exchange Exposure
 Existing assets and liabilities face translation
risk only with regard to amounts appearing in
accounts, they face transaction risk only when
gains and losses are realized.
 The risk faced by exporters vis-a-vis their
future income has been called economic risk
and results from economic exposure.
 Economic risk depends on the principle of
purchasing power parity while transaction or
translation risk depends on this and on the
Principle of International Fischer Effect.
Types of Foreign Exchange Exposure
 Hedging can be done in forward/future market
and helps in avoiding transaction and
translation exposure-but not economic
exposure.
 When translation or transaction risk is avoided
using the forward market, we say that the
company is hedged or covered.
 When currencies are bought and sold and
there is no matching revenue, import payment
and so on the activity is called speculation.
Uses of Derivatives
Hedging
 Done by parties who seek to offset their risks
by entering into derivative transaction.
 Existing risks can be an investment portfolio,
price changes in oil for petroleum mining
company or investment in a foreign country.
Uses of Derivatives
Speculating
 Speculation is more commonly used by traders
or hedge funds who aim to generate profits
with only a marginal investment.
Uses of Derivatives
Arbitrage
 Arbitragers work at making profits by taking
advantage of discrepancy between prices of the
same products across different markets.
 Upon finding price discrepancies, one can make
use of a specific combination of derivatives in
order to make a risk less profit.
Types of Derivatives
The main types of derivatives are:
a) Futures
b) Forward
c) Options
d) Swaps
Forward Contract
 Forward Contract is contract to buy or sell an
asset at a specified future date.
 They are also known as OTC derivatives since
they are traded (and privately negotiated)
directly between two parties without going
through an exchange or an intermediary.
 They are largely subject to counterparty risk as
the validity of a contract depends on the
counterparty’s solvency and ability to honour
its obligations.
Forward Contracts
The agreement to pay for and pick up, “Something”
at a pre-determined date and or time, for a pre-
determined price. Usually traded off of the trading
floor between two firms.
Terms

 Taking Delivery: Physical reception of item.

 Deliverable Instrument: The item to be
delivered
 Making Delivery: Turning over the item.
 Forwards are not options, they are
obligations and should be considered as a
“cash transaction.”
 A Modest Example

An agreement on Monday to buy a book, from a bookstore on

Friday for $1000.00.
On Friday, you return to the bookstore and take delivery of the
book and pay the $1000.00.
The contract is actually the agreement.
Future Contract
 Future contract is a legally binding agreement
to buy or sell the underlying security on future
date.
 Future contracts are standardized contracts in
terms of quantity, quality (in case of
commodities), delivery time and place for
settlement on any date in future.
 The contract expires on a pre specified date
which is known as a expiry date of the contract.
 On expiry, future can be settled by delivery of
underlying asset or cash.
Futures
 Similar to forwards in length of time. However,
profits and losses are recognized at the close of
business daily, “Mark-to-market.”
 Transactions go through a clearing house to
reduce default risk.
 90% of all futures contracts are delivered to
someone other than the original buyer.
 Futures Example
On Monday we enter into a futures contract to buy our
book on Friday. We are required to place a deposit for the
book of 50% ($500.00). We are told that if the book
appreciates in value we may be required to increase the
deposit. If the book depreciates in value, we may take
back some of the money.
Wednesday the book goes to $1500.00. We must
deposit another $250.00.
 On Thursday the book drops to $750.00. We can
collect $125.00.
 On Friday the book value is $800.00, therefore we owe
$425.00 on the remaining balance.
 Options Contract
 Options contract gives the buyer/holder of the contract
the right to buy/sell the underlying asset at a
predetermined price within or at the end of a specified
period.
 An OPTION is the right, not the obligation to buy or sell
an underlying instrument.
 An option to buy is called call option and option to sell is
called put option.
option
 If an option is exercisable on or before the expiry date it
is called American option and one that is exercisable
only on expiry date is called European option.
 The price at which the option is to be exercised is called
strike price or exercise price.
 Options
Options come in many flavors. To name a few:
collar, cylinder, fence, mini-max, zero-cost tunnel
and straddle. These are all newer forms of options.
The most common options discussed are put and
call.
Option Terms
• Put: the right to sell @ a certain price
• Call: the right to buy @ a certain price
• Long: to purchase the option
• Short: to sell or write the option
• Bullish: feel the value will increase
• Bearish: feel the value will decrease
• Strike/Exercise Price: Price the option can be
bought or sold.
 Calls

Long a call. Person buys the right (a contract) to

buy an asset at a certain price. They feel that the
price in the future will exceed the strike price. This
is a bullish position.

Short a Call. Person sells the right (a contract) to

someone that allows them to buy a asset at a
certain price. The writer feels that the asset will
devalue over the time period of the contract. This
person is bearish on that asset.
 PUTS

Long a Put. Buy the right to sell an asset at a pre-

determined price. You feel that the asset will devalue
over the time of the contract. Therefore you can sell
the asset at a higher price than is the current market
value. This is a bearish position.

Short a Put. Sell the right to someone else. This will

allow them to sell the asset at a specific price. They
feel the price will go down and you do not. This is a
bullish position.
SWAPS

New in the market, late 70’s early 80’s

Two Types: Interest Rate & Currency
Swaps
 Swaps are the contracts where the two parties
agree to exchange cash flows.
 Two types of swaps
a) Interest rate swap
b) Currency swap
 OTC derivative product
 Counterparty risk involved
Use of Swap
 To smooth out interest rate payments in a
cyclic environment.
 To secure and level out future interest
payments.
 To secure foreign currency for loans when you
are a visitor in that country and it would be too
difficult to secure credit or the cost is
prohibitive.
Derivative Securities

 Mortgage Backed Securities: Fanny Mae,

Freddie Mac
 Structured Notes: Sally Mae
Explanation

Freddie Mac & Fanny Mae: Both are derivative

instruments used to pool Home Mortgage loans.
This creates a secondary market which allows banks
to sell the loans, therefore reducing their risk. It
also reduces default risk for the holder. These are
also known as pass through instruments.
 Cont’d Explanation

Sally Mae: Same principal as the previous example

except they use student loans. All of these also help
to keep interest rates for the underlying asset low by
keeping default risk down.
Exchange Traded V/s OTC Derivatives
Market
Exchange Traded OTC
1. Standardized contracts. 1. Tailor made contracts.
2. Legally binding. 2. No legal binding.
3. Specialized derivatives 3. No intermediary. Contract
exchange act as between two parties.
intermediary. 4. Counterparty risk
4. No counterparty risk. involved.
5. No margin involved.
5. Better risk management
as margin is paid for
trading. 6. Swaps, forward rate and
6. Future contracts are exotic options are traded.
traded.
Uses of Derivatives
 Hedging: Most important use of derivative is to
transfer risk by taking opposite position in the
underlying asset. e.g. a rice farmer & a rice miller
would enter into contract to exchange cash for rice
in the future. Both parties have hedged their
future risk, for rice farmer the uncertainty of price
for the rice mill owner the availability of rice.
 Speculation and arbitrage: In financial market the
value of speculative trade is far higher than the
value of true hedge trade. There are times when
derivative traders may also look for arbitrage
opportunities between different derivatives on
identical or closely related underlying securities.
 Derivative Market in India
In India, derivative products have been introduced in
phased manner. Chronologically they are enumerated as
follows:
1. Index Futures Contract in June 2000.
2. Index Options and stock Options introduced in June 2000 &
July 2001 followed by Stock Futures in Nov 2001.
3. Sectoral indices were permitted for derivatives trading in
2002.
4. Interest rate futures introduced in 2003.
5. Mini Derivative (F&O) contract on Index (Sensex & Nifty)
introduced in 2007.
6. In 2008, SEBI permitted longer tenure index options
contracts & Currency Derivatives. They also introduced the
concept of bond index and volatility index.
Structure of Derivative Market in India
 Derivative trading in India can take place either
at a separate and independent Derivative
Exchange or on a separate segment of an
existing Stock Exchange.
 Derivative Exchange/ Segment function as a
Self Regulatory Organization (SRO) & SEBI acts
as the oversight regulator.
Membership Types in the Derivative
Exchange
The various membership types in the
derivative exchange are:
a) Trading Member (TM): A TM is a member of
the derivative exchange and can trade on his
behalf as well as on behalf of his clients.
b) Clearing Member (CM):
(CM) These members are
permitted to settle their own trades as well as
the trades of other non-clearing members who
have agreed to settle trade through them.
c) Self Clearing Members (SCM): A SCM are
those clearing members who can clear and
settle their own trades only.
 Eligibility for Membership of the Currency
Derivative Exchange in India
 The trading member is subject to a balance sheet
net worth requirement of Rs. 1.00 crore while the
clearing member is subject to a balance sheet net
worth requirement of Rs. 10.00 crores. The
clearing member is subject to a liquid net worth
requirement of Rs.50 lakhs.
 The members are required to pass the certification
program approved by SEBI. Further every TM is
required to appoint at least two approved users
who have passed the certification program. Only
approved users are permitted to operate the
derivative trading terminal.
Margins in Derivative Market
 In Exchange traded derivative products,
members are required to keep with the clearing
house margin ranging from 2.5% to 10% of
the contracts o/s in their names, in form of
cash , T-bills or LCs. The margin that is
required to be deposited at the time of entering
into the contract is the initial margin.
margin Another
level of margin, although less than initial
margin is also prescribed which is also known
as the maintenance margin.
margin The margin money
will be adjusted with the change in the current
values of the futures.
 Marking to Market
 The value of each o/s contract is determined
everyday by reference to the closing quotation and
any excess or shortage is adjusted in the margin
account of the concerned member. The process of
revaluing the contract based on the ruling price for
futures is known as marking to market. With this
clearing house ensure the continued liquidity of the
members and minimizes for itself the counterparty
risk.
 Lot Size of Contract
 Lot size is standardized size of transaction and
refers to number of underlying securities in one
contract .
 The lot size is determined keeping in mind the
minimum contract size requirement at the time of
introduction of derivative contract on a particular
underlying and represent the value of one future.
 Example at LIFFE (London International Financial
Futures Exchange) the contract in sterling can be
only in multiples of GBP 62500 and in Euro in
multiples of Euro 100000.
Risk Management in Derivatives Market
Following risk management measures have been
specified by SEBI to protect the rights of investors in
derivatives markets.
1. Investor's money has to be kept separate at all levels
and is permitted to be used only against the liability of
the investor and is not available to the trading
member or clearing member or even any other
investor.
2. The Trading Member is required to provide every
investor with a risk disclosure document which will
disclose the risks associated with the derivatives
trading so that investors can take a conscious decision
to trade in derivatives.
Risk Management in Derivatives Market
3. The Exchanges are required to set up arbitration and
investor grievances redressal mechanism operative
from all the four areas / regions of the country
4. Investor would get the contract note duly time
stamped for receipt of the order and execution of the
order. The order will be executed with the identity of
the client and without client ID order will not be
accepted by the system. The investor could also
demand the trade confirmation slip with his ID in
support of the contract note. This will protect him
from the risk of price favour, if any, extended by the
Member.
Risk Management in Derivatives Market
5. In the derivative markets all money paid by the
Investor towards margins on all open positions is
kept in trust with the Clearing House/Clearing
corporation and in the event of default of the
Trading or Clearing Member the amounts paid by
the client towards margins are segregated and
not utilized towards the default of the member.
However, in the event of a default of a member,
losses suffered by the Investor, if any, on settled/
closed out position are compensated from the
Investor Protection Fund, as per the rules, bye-
laws and regulations of the derivative segment of
the exchanges.  
 Controversy
Over the past few years, derivatives have been
inviting targets for criticism. They have become
demonized-the ‘D’ word- the Junk Bonds of New
Millennium.
a) The use of derivatives can result in large losses
due to the use of leverage. Derivatives allow
investors to earn large returns from small
movements in the underlying asset's price.
However, investors could lose large amounts if the
price of the underlying moves against them
significantly.
b) Derivatives (especially forwards & swaps) expose
investors to counter-party risk .
 Controversy
c) Derivatives pose unsuitably high amounts of risk
for small or inexperienced investors. Because
derivatives offer the possibility of large rewards,
they offer an attraction even to individual
investors. However, speculation in derivatives
often assumes a great deal of risk, requiring
commensurate experience and market knowledge,
especially for the small investor, a reason why
some financial planners advise against the use of
these instruments. Derivatives are complex
instruments devised as a form of insurance, to
transfer risk among parties based on their
willingness to assume additional risk, or hedge
against it.
 Controversy
d) Derivatives typically have a large notional value. As
such, there is the danger that their use could result in
losses that the investor would be unable to compensate
for. The possibility that this could lead to a chain
reaction ensuing in an economic crisis, has been
pointed out by legendary investor Warren Buffett in
Berkshire Hathaway's annual report. Buffet stated that
he regarded them as 'financial
weapons of mass destruction'. The problem with
derivatives is that they control an increasingly larger
notional amount of assets and this may lead to
distortions in the real capital and equities markets.
Investors begin to look at the derivatives markets to
make a decision to buy or sell securities and so what
was originally meant to be a market to transfer risk
now becomes a leading indicator.
 Controversy
e) Derivatives massively leverage the debt in an
economy, making it even more difficult for the
underlying real economy to service its debt
obligations and curtailing real economic activity,
which can cause a recession or even depression.
Derivatives get a ‘Bad Name’
 Most Financial Scandals of the last decade in the
US and UK were linked to derivatives, some
combination of excessive speculation and fraud:
1. Barings Bank
2. Enron
3. Lehman Brothers
4. Merrill Lynch
Reasons for Fraud
 Leveraging makes possible fantastic gain, but
also horrible losses
 Gambler’s ‘Last Desperate Hope’ (Adverse
Selection)
 Complexity of Derivatives make fraud harder to
identify
The Moral Hazard of Insurance

 If you had a car that is less damaged by any

given car crash – would that make you drive
faster?
Any Questions?
Seriously, Any Questions?