Derivatives - Basics of Derivatives contract covered in this ppt
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The document discusses financial derivatives, their history, characteristics, and how they function in the market. It explains the differences between derivatives and shares, the role of underlying assets, and the benefits and risks associated with derivatives trading. Additionally, it outlines the different participants in the derivatives market, including speculators, arbitrageurs, and hedgers.
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Derivatives - Basics of Derivatives contract covered in this ppt
- 1. FINANCIAL DERIVATIVES SUNDAR B. N. ASSISTANT PROFESSOR COORDINATOR OF M.com
- 7. HISTORY OF DERIVATIVES The word derivatives originated in mathematics and refers to a variable that has been derived from another variable. For example, a measure of distance in KM could be derived from a measure of distance in miles by dividing by 1.61, or Similarly a measure of temperature in Celsius could be derived from a measure of temperature in Fahrenheit. In sense, a derivative is a financial product which had been derived from a market for another product. Derivative market can be traced back to the middle ages. They were originally developed meet the needs of farmers and merchants. The Chicago Board of Trade was the first derivatives market established in 1848 to bring farmers and merchants together. In 1874, the Chicago Produce Exchange was established. In 1919, this was renamed the Chicago Merchantile Exchange (CME) and was reorganized for futures trading. In India it is trading on Multicommodity Exchange (MCX), National Commodity and Derivatives Exchange (NCDEX).
- 9. CHARACTERISTICS OF DERIVATIVES It has one or more underlying assets Requires negligible initial investment compared to other types of financial contracts Should provide net settlement I.e., offsetting of initial contract position
- 12. FEATURES OF DERIVATIVES The instrument relates to the future contract and settlement of terms between parties involved, normally called maturity period in case of Forward contract. The parties involved may be obliged to exercise their contracts or offset them (Forwards, Futures) or may have rights (like option buyers). The contracts are fulfilled or transacted through a recognized exchange (Futures contracts) through the clearing house or they may be private bi-lateral contracts (Forwards, Swaps) or OTC contracts (Options) The value of derivatives depends on their underlying
- 13. FUNCTIONS OF DERIVATIVES MARKET Risk management- Stop loss Transfer of risk Price discovery Transitional efficiency - low transaction cost compare to rest like, brokerage, commission, regulatory costs and margin requirements Financial Engineering- as it is new field creating calls, puts, futures and other derivatives
- 14. USES OF DERIVATIVES Derivatives are used by companies and individuals wanting to cover their risks. This is facilitated by a counter party who has the motivation to make profits out of the Premium, or is holding a mirror-image opposite position. Example for derivatives use; An exporter to the US expects to get $50,000 in 3 months from now. She will be happy to have this converted at around Rs. 45 per $. However, there is great uncertainty in the foreign exchange market as to the nature of the possible movement after 3 months. Fortunately for the exporter a bank is willing to enter into a Forwards contract with her for paying Rs. 45 per $ after 3 months on her surrounding $50,000 then. If the exporter enters into this Forward contract, she makes sure that she will be able to get 22,50,000 ($50,000*Rs.45) after 3 months. However if the rates change to her favor say to Rs. 48 per $ she will not be able to make advantage of the favorable movement since she is already committed to the Forward Contract/agreement
- 17. DIFFERENCE BETWEEN SHARES AND DERIVATIVES SHARES DERIVATIVES Shares are assets Share are primary Risks limited within the company and unable to stop Shares are main products Independent Profits are limited or unlimited Equity derives its values on market conditions like demand and supply Dividend income Generally long term ( 1 year ) No expiry Derivatives are usually contracts Derivatives are secondary ( underlying ) Risks are diversified through speculation, Arbitrages and Hedging Derivatives are by-product Dependent Profit will be locked Derivatives derives its value from the movement performance of one or more underlying assets underlying assets Price fluctuations Short term ( maximum 3 months) Last Thursday of any month
- 18. DEFINITION OF UNDERLYING ASSET? The underlying is a fundamental concept in derivatives trading because it allows investors to speculate risk and purchase options to limit the downside risk of future stock price movements. In addition, it represents the component of the agreement that provides value to the contract. For instance, an investor who buys an option contract on a stock has the right to buy or sell the underlying asset (in this case the stock) at the strike price at maturity to realize a profit. Therefore, the UA represents the stock involved in a derivatives contract, which the parties agree to exchange. An UA can be stock, index, commodity or currency, and the price may be directly correlated (call option) or inversely correlated (put option) to the price of the derivative
- 19. HOW IT WORKS (EXAMPLE): For example, options are derivative instruments, meaning that their prices are derived from the price of another security. More specifically, options prices are derived from the price of an underlying stock. For example, let's say you purchase a call option on shares of Intel (INTC) with a strike price of $40 and an expiration date of April 16. This option would give you the right to purchase 100 shares of Intel at a price of $40 on April 16 (the right to do this, of course, will be valuable only if Intel is trading above $40 per share at that point in time). The seller (writer) has the obligation to either buy or sell the underlying asset (depending on what type ofoption he or she sold -- either a call option or a put option) to the buyer at a specified price by a specified date. Meanwhile, the buyer of an options contract has the right, but not the obligation, to complete the transaction by a specified date. When an option expires, if it is not in the buyer's best interest to exercise the option, then he or she is not obligated to do anything. The buyer has purchased the option to carry out a certain transaction in the future -- hence the name.
- 20. UNDERLYING ASSETS Commodities ( Castor seed, Grain, Coffee, Gur, Pepper, Potato's) Precious metals (Gold, Silver) Interest rate Common shares/ stock Stock index value ( NSE, Nifty, Sensex) Currency
- 24. Lifespan- as each day passes and the expiration date approaches, more and more time premium lose and option’s value decreases Sophistication- Potential for huge losses and huge gains, appropriate for only sophisticated investors with a high tolerance of risk Direction and market timing- Investors must accurately predict the direction in which the market or index will move during a set period of time Derivatives are too illiquid Derivatives are linked to Gambling Counter party risk Hidden tail risk- a hedge position can become unhedged at the worst times, inflicting substantial losses on those who mistakenly believe they are protected Risks- Derivatives allow investors to earn large returns from small movements in the underlying assets prices. Investors could lose large amounts if the price of the underlying moves against them significantly. Americal International Group lost > US $ 18 Bn In Jan 2008 Societe Generale Lost > US $ 7.2 Bn Totally in last decade $ 39.5 Bn lost from derivatives
- 25. DERIVATIVES ADVANTAGES AND DISADVANTAGES Derivatives are the most important innovation which has happened in the past few years when it comes to financial markets. It has changed the whole way of operations of stock, commodities and currency market. Given below are some of the advantages and disadvantages of derivatives –
- 26. ADVANTAGES OF DERIVATIVES Since all transactions related to derivatives take place in future it provides individuals with better opportunities because an individual who want to short some stock for long time can do it only in futures or options hence the biggest benefit of this is that it gives numerous options to an investor or trader to execute all sorts of strategies. In derivatives market people can transact huge transactions with small amounts and therefore it gives the benefit of leverage and hence even people who have less amount of money can enter into this market. Intraday traders get the benefit of liquidity as these contracts are very liquid and also the costs such as basis expense, brokerage are less as compared to cash market. It is a great risk management tool and if applied judiciously it can produce good results and benefit its user.
- 27. DISADVANTAGES OF DERIVATIVES Leverage is a double edged sword and therefore if you do not get it right chances are you wound end up losing huge amount of money because these contracts have specific maturities and on that date they get expired unlike cash market where you can hold on to stocks for long period of time. Since its inception many critics have been blaming derivatives for huge fall which keeps happening frequently after the introduction of derivatives and many people say that it increases unnecessary speculation in the market which is not good for the small retail investors who are the backbone of stock market. It is quite complex and various strategies of derivatives can be implemented only by an expert and therefore for a layman it is difficult to use this and therefore it limits its usefulness.
- 32. PARTICIPANTS/ TRADERS IN DERIVATIVES MARKET SPECULATORS When a securities are brought with a sole object of selling them in future at higher price or these are sold now with the intension of buying at a lower price in future are called Speculation transactions. The main objective of such transactions is to take advantage of price differential at different times. For example; Ramu bought 200 shares of Tata Steel Limited at Rs. 235 per share. He does not take and give delivery of shares but settles the transactions by receiving the difference in prices amounting to Rs. 5,000 plus brokerage . Example 2; manu bought 200 shares of ONGC Limited at Rs. 87# per share and sold them at Rs. 69 per share. He settles these transaction by simply paying the difference amounting to Rs. 3,600 plus brokerge. However, nowadays stock exchanges have a system of rolling settlement. Such transactions of purchase and sale made on the same day, as no carry forward is allowed. Speculation; Settlement by paying difference in price without delivery of securities.
- 33. ARBITRAGEURS Arbitrage signifies the existence of a riskless profit. ‘Person actively engaged in seeking out minor price discrepancies are called Arbitrageurs. Arbitrage is simultaneous purchase and sale of equivalent assets at prices which guarantee a fixed profit at the time of the transactions, although the life of the assets and hence the consumption of the profit may be delayed until some future date. Example: Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets (NSE and BSE)
- 34. HEDGER Hedge is a strategy intended to protect an investment or portfolio against loss. It usually involves buying securities that move in the opposite direction than the asset being protected. Hedging is like buying insurance. It is protection against unforeseen events. It is usually involves balance any gains and losses to the underlying assets.