Derivative - types with example

1. Derivative Types with Example Prepared by: Mr. Mohammed Jasir PV Asst. Professor MIIMS, Puthanangadi Contact No: 9605 69 32 66

2. Topics • Derivative • Types with Example

3. Derivatives • Derivatives: derivatives are instruments which include – Security derived from a debt instrument share, loan, risk instrument or contract for differences of any other form of security and , – a contract that derives its value from the price/index of prices of underlying securities. Derivatives (Definition) • A financial instrument whose characteristics and value depend upon the characteristics and value of an underlier, typically a commodity, bond, equity or currency,

4. Derivatives (Definition) • A financial instrument whose characteristics and value depend upon the characteristics and value of an underlier, typically a commodity, bond, equity or currency. • Examples of derivatives include futures and options. • Advanced investors sometimes purchase or sell derivatives to manage the risk associated with the underlying security, to protect against fluctuations in value, or to profit from periods of inactivity or decline. • These techniques can be quite complicated and quite risky.

5. Advantages of Derivative Market • Diversion of speculative instinct form the cash market to the derivatives • Increased hedge for investors in cash market • Reduced risk of holding underlying assets • Lower transactions costs • Enhance price discovery process • Increase liquidity for investors and growth of savings flowing into these markets • It increase the volume of transactions

6. Types of Derivatives Derivatives Financial Derivatives Stock, Bond, Forex Commodity Derivatives Sugar, Cotton, gold, silver

7. Types of Derivatives There are two types of derivatives 1. Financial derivatives – Financial Derivatives the underlying instruments is stock, bond, foreign exchange. 2. Commodity Derivatives – Commodity derivatives the underlying instruments are a commodity which may be sugar, cotton, copper, gold, silver.

8. Types of Financial Derivatives Financial Derivatives Basic Forward Future Options Warrants & Convertibles. Complex. Swap Exotioc

9. Forward contract One party commits to buy Other party commits to sell Specified quantity Pre-determined price Specific date in the future 50 kg Rs. 5000 An agreement

10. Farmer Farmer

11. Forward contract • A forward is a contract in which one party commits to buy and the other party commits to sell a specified quantity of an agreed upon asset for a pre- determined price at a specific date in the future • It is a customised contract, in the sense that the terms of the contract are agreed upon by the individual parties • A bilateral contract • Hence, it is traded OTC • Generally closing with delivery of base asset • Not need any initial payment when signing the contract

12. Contd… • A forward contract is an agreement to buy or sell an asset on a specified date for a specified price • One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date, for a certain specified price

13. Over The Counter(OTC) Trading • In general, the reason for which a stock is traded over-the-counter is usually because the company is small, making it unable to meet exchange listing requirements. • Also known as "unlisted stock", these securities are traded by broker-dealers who negotiate directly with one another over computer networks and by phone. • OTC stocks are generally unlisted stocks which trade on the Over the Counter Bulletin Board (OTCBB)

14. Risks in Forward Contracts • Credit Risk – Does the other party have the means to pay? • Operational Risk – Will the other party make delivery? – Will the other party accept delivery? • Liquidity Risk – Incase either party wants to opt out of the contract, how to find another counter party?

15. Terminology • Long position – Buyer • Short position – seller • Spot price – Price of the asset in the spot market.(market price) • Delivery/forward price – Price of the asset at the delivery date

16. Features - Forward contract • It is a customised contract • A bilateral contract • It is traded OTC (Unlisted Stocks) • Generally closing with delivery of base asset • Not need any initial payment when signing the contract

17. The salient features of forward contracts • They are bilateral contracts and hence, exposed to counterparty risk. • Each contract is customer designed, and hence is unique in terms of contract size, expiration date and the asset type and quality. • The contract price is generally not available in public domain. • On the expiration date, the contract has to be settled by delivery of the asset and If party wishes to reverse the contract

18. Limitations of Forward contract • Lack of centralization of trading • Liquidity and Counterparty risk • Have too much flexibility and generality • Counterparty risk (default by any one party) • Bankruptcy

19. Limitations of Forward contract • Forward markets are afflicted by several problems: – Lack of centralization of trading – Liquidity and Counterparty risk • The basic problem in the first two is that they have too much flexibility and generality • Counterparty risk arises from the possibility of default by any one party to the transaction. • When one of the two sides to the transaction declares bankruptcy, the other suffers

20. Future Contract • A future is a standardised forward contract • It is traded on an organised exchange • Future contract is an agreement between two parties to buy or sell an asset at a certain time in the future, at a certain price • But unlike forward contract, futures contract are standardized and stock exchanged traded • Futures contracts are special types of forward contracts in the sense that the former are standardised exchange-traded contracts • The counter party to a futures is a clearing house on the appropriate futures exchange • Settled by cash or cash equivalents rather than physical assets

21. The standardized items in a futures contract are: • Quantity of the underlying • Quality of the underlying • The date/month of delivery • The units of price quotation and minimum price change • Location of settlement

22. Closing a Futures Position • Most futures contracts are not held till expiry, but closed before that • If held till expiry, they are generally settled by delivery. (2-3%) • By closing a futures contract before expiry, the net difference is settled between traders, without physical delivery of the underlying.

24. Terminology • Contract size (Lots) • Contract cycle (1m,2m,3m) • Expiry date • Strike price • Cost of carry

25. Terminology • Contract size – The amount of the asset that has to be delivered under one contract. All futures are sold in multiples of lots which is decided by the exchange board. – Eg. If the lot size of Tata steel is 500 shares, then one futures contract is necessarily 500 shares. • Contract cycle – The period for which a contract trades. – The futures on the NSE have one (near) month, two (next) months, three (far) months expiry cycles.

26. Terminology • Expiry date – usually last Thursday of every month or previous day if Thursday is public holiday. • Strike price – The agreed price of the deal is called the strike price. • Cost of carry – Difference between strike price and current price.

27. Margins • A margin is an amount of a money that must be deposited with the clearing house by both buyers and sellers in a margin account in order to open a futures contract • Typically only 2 to 10 percent • It ensures performance of the terms of the contract • Its aim is to minimise the risk of default by either counterparty

28. Margins • Initial Margin - Deposit that a trader must make before trading any futures. Usually, 10% of the contract size • Maintenance Margin - When margin reaches a minimum maintenance level, the trader is required to bring the margin back to its initial level. The maintenance margin is generally about 75% of the initial margin • Variation Margin - Additional margin required to bring an account up to the required level • Margin call – If amt in the margin A/C falls below the maintenance level, a margin call is made to fill the gap

29. Marking to Market • This is the practice of periodically adjusting the margin account by adding or subtracting funds based on changes in market value to reflect the investor’s gain or loss • This leads to changes in margin amounts daily • This ensures that there are o defaults by the parties

30. Difference between Forward and Futures Forward Future Trade in OTC Only Ex-changes or through CH Standardised Contract, hence more liquid Customized contract, hence liquid NO Margin payment required Required margin payment Settlement by the end of the period Follows daily settlement Markets are not transparent Markets are transparent No Marked to market daily Marked to market daily No prior delivery Closed prior to delivery No Profits or losses realised daily Profits or losses realised daily

31. What are Options? • An option is the right, but not the obligation to buy or sell something on a specified date at a specified price. • In the securities market, an option is a contract between two parties to buy or sell specified number of shares at a later date for an agreed price.

32. Features of Options • A fixed maturity date on which they expire (Expiry date) • The price option is exercised is called the exercise price or strike price • There are three parties involved 1. The option seller or writer 2. The option buyer 3. The securities broker / Clearing House • The premium is the price paid for the option by the buyer to the seller

33. Types of Option 1 Call Option Put Option 2 European style options American style options

34. Types of Options Options are of two types – call and put • Call option give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a particular date by paying a premium • Put Option: Give the buyer the right, but not obligation to sell a given quantity of the underlying asset at a given price on or before a particular date by paying a premium

35. Types of Options (cont.) The other two types are • European style options can be exercised only on the maturity date of the option, also known as the expiry date. • American style options can be exercised at any time before and on the expiry date.

36. Right to buy 100 Reliance share at price of Rs. 300 / Share after one month. Current price 250 Demo - Call Option Premium Rs. 25/ share Amount to buy Call option = 2500 Suppose after a month, Mkt price is Rs.400, Then the option is exercised. Means the shares are brought. Net gain= 40000 – 30000 – 2500 = 7500 Suppose after a month, Mkt price is Rs.200, Then the option is not exercised. Net Loss = Premium = 2500

37. Right to sell 100 Reliance share at price of Rs. 300 / Share after one month. Current price 250 Demo – Put Option Premium Rs. 25/ share Amount to buy put option = 2500 Suppose after a month, Mkt price is Rs.200, Then the option is exercised. Means the shares are sold. Net gain= 30000 – 20000 – 2500 = 7500 Suppose after a month, Mkt price is Rs.400, Then the option is not exercised. Net Loss = Premium Amt= 2500

38. Options Terminology • Option holder : One who buys option • Option writer : One who sells option • Underlying : Specific security or asset • Option premium : Price paid (Advance) • Strike price : Pre-decided price • Expiration date : Date on which option expires • Exercise date : Option is exercised

39. What are SWAPS? • In a swap, two counter parties agree to enter into a contractual agreement wherein they agree to exchange cash flows at periodic intervals • Most swaps are traded “Over The Counter” • Some are also traded on futures exchange market • Portfolio of Forward Contract

40. Types of Swaps Plain vanilla fixed for floating swaps (Interest rate swaps) Fixed for fixed currency swaps (Currency swaps)

41. What is an Interest Rate Swap? • It is a contractual agreement between two parties to exchange interest payments • A company agrees to pay a pre-determined fixed interest rate on a notional principal for a fixed number of years • In return, it receives interest at a floating rate on the same notional principal for the same period of time • The principal is not exchanged. Hence, it is called a notional amount

42. Floating Interest Rate • LIBOR – London Interbank Offered Rate • It is the average interest rate estimated by leading banks in London • It is the primary benchmark for short term interest rates around the world • Similarly, we have MIBOR i.e. Mumbai Interbank Offered Rate • It is calculated by the NSE as a weighted average of lending rates of a group of banks

44. Company A Company B Bank A Bank B Fixed 7% Variable LIBOUR Fixed 10% Variable LIBOUR+1 Aim 5 Million $ at Variable Aim 5 Million $ at Fixed SWAP Bank 5 M$ 5 M$ 7% 8% 8.5% LIBOR LIBOR LIBOR+1% Notional Amount = $5 Million

45. Using a Swap to Transform a Liability • Firm A has transformed a fixed rate liability into a floater o A is borrowing at LIBOR – 1% o A savings of 1% • Firm B has transformed a floating rate liability into a fixed rate liability o B is borrowing at 9.5% o B saving of 0.5%. • Swaps Bank Profits = 8.5%-8% = 0.5%

46. What is a Currency Swap? • It is a swap that includes exchange of principal and interest rates in one currency for the same in another currency • The principal may be exchanged either at the beginning or at the end of the tenure • If it is exchanged at the end of the life of the swap, the principal value may be very different • It is generally used to hedge against exchange rate fluctuations € to $

47. Direct Currency Swap Example • Firm A is an American company and wants to borrow €40,000 for 3 years. • Firm B is a French company and wants to borrow $60,000 for 3 years. • Suppose the current exchange rate is €1 = $1.50.

48. Firm A Firm B Bank A Bank B € 6% $ 7% Aim €40,000 Aim $60,000 $60,000 €40,000 7% 5% 7% 5% € 5% $ 8%

49. Comparative Advantage • Firm A has a comparative advantage in borrowing Dollars • Firm B has a comparative advantage in borrowing Euros • This comparative advantage helps in reducing borrowing cost and hedging against exchange rate fluctuations

50. Thank You !!!

Derivative - types with example

Derivative - types with example

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