What are Derivatives? Features of Derivatives Importance and Role of Derivatives in Financial Market Speculators and Hedgers

1. Imarticus
Learning
www.imarticus.org
Derivatives:
An Introduction

2. Agenda
In this session, you will learn about:
• What are Derivatives?
• Features of Derivatives
• Importance and Role of Derivatives in
Financial Market
• Speculators and Hedgers

3. The global derivatives market is huge!
Did You Know?
$ 700
TRILLION
GLOBAL FINANCIAL DERIVATIVES
MARKET
SIZE OF WORLD GDP
TOTAL VALUE OF WORLD’S
STOCK AND BOND MARKET
$100 TRILLION
$50 TRILLION

4. Derivatives in the News
So, why are Derivatives so
reviled?

5. Financial Investments: A Risky Business
Risk is a constant companion for all the
participants of the financial markets.
When participants deal with financial
instruments, they face a risk of
Financial Loss owing to fluctuations
in prices.
Derivatives were introduced initially to mitigate this risk or to hedge.
Subsequently, the scope of speculation increased with derivatives.

6. What are Derivatives?
Derivatives are financial contracts whose values
are derived from the values of underlying assets.
Seller Buyer
Rice @ Rs. 120 / kilo
Asset
CONTRACT
Derivatives are financial instruments or an agreement
between two people or parties that has a value determined
by the price of something else (the underlying).

7. Derivatives: Underlying Asset
Underlying Asset Types
Non-financial InstrumentsFinancial Instruments
Equities, Bonds, etc
Commodities, Weather, etc
The underlying of a derivative is an asset, basket of assets, index, or even another
derivative, such that the cash flows of the derivative depend on the value of this
underlying.

8. Speculating and Hedging
Derivatives are used for speculating and hedging the
risks associated with fluctuating prices of assets.
I think the price of
rice will go UP in
the future and I will
make a profit.
I think the price of rice
will go DOWN in the
future and I will make a
loss if I hold on to the
asset.
HEDGE
Derivatives can used to hedge if
market moves exactly opposite to
their expectation
SPECULATE
Derivatives can be used by participants
to speculate and to make a profit if the
market moves as expected by them.
Seller Buyer
Rice @ Rs. 120 / kilo
Asset
CONTRACT

9. Understanding Derivatives
How do you determine the value of the underlying?
UNDERLYING ASSET:
RICE
SPOT PRICE
(CURRENT VALUE) FUTURE MARKET VALUE: ??
Rs. 200
per kilo
Rs. 40
per kilo
Rs. 100
per kilo ?
• If a commodity cost $100, should the price be same if the same commodity
were to be traded today but delivered by the seller after 3 months?
• If the price has to be different from the Spot Price ($100), how should the
price be determined?
• The Price in future will be derived from the Spot Price. This explains the
definition of Derivatives.

10. Understanding Derivatives
UNDERLYING ASSET:
RICE
SPOT PRICE
(CURRENT VALUE)
Rs. 200
per kilo
Rs. 40
per kilo
Rs. 100
per kilo ?
A buyer wants to trade today, agree
on the price but would like to pay at
a later date.
The seller would like to agree and
lock the price but deliver the
commodity at a later date.
In such a scenario, what should the price of the contract?
Since the seller would be incurring additional cost for storing the goods until
delivery and would also be losing on the opportunity of using the consideration,
he will have to be compensated for this by making the buyer pay additional
amount.
PRICE OF THE
CONTRACT: ??

11. Calculating the Price of Derivative Contract
Formula for Financial Derivatives
Futures Price = Spot Price X (1 + i)
n
Where:
i is the rate of interest
n is the period of the contract
How do you calculate the price of a derivatives contract?
Formula for Commodity Derivatives
Forwards Price = Spot Price + Cost of carry
Where cost of carry includes:
Warehousing, transportation
Insurance cost
Interest rate

12. No ownership rights associated with the asset sold.
Features of Derivatives
Depending on the underlying asset on which
the derivative was created, derivatives can
be either:
Commodity
derivatives
Financial
derivatives
Derivative contracts can be
traded:
• On the stock
exchange
• Over-the-counter
(OTC)
The derivative contract is traded, not the underlying asset.
A derivative contract is priced separately from the asset.
Without putting up full cash value.
The derivative contract can be delivery based or cash settled.

13. Purposes & Benefits Of Derivatives
PRICE
DISCOVERY
RISK
MANAGEMENT
IMPROVED
MARKET
EFFICIENCY OF
UNDERLYING
ASSET
REDUCED
MARKET
TRANSACTION
COST
WHY
DERIVATIVES?

14. Value of a Derivatives Contract
The value of a derivatives contract is influenced by several factors:
TIMING OF THE CONTRACT
• Market trends affects the value
of the derivative contracts as in
the Bear or Bull markets.
• As derivatives derives its value,
in a bull market with rising
prices the value is affected or
vice versa.
VALUE OF UNDERLYING
• From the definition of
“Derivatives” the value of the
underlying directly influences
the contract.
OTHER FACTORS
• Other factors like volatility

15. Why Derivatives?
HEDGINGSPECULATION
• Derivatives are used for
speculation/investing.
• Some participants expect the
market to move as per their
expectation and they take this
risk in anticipation of greater
rewards.
• There are participants who
expect market to do a flipside
on them and therefore take a
passive view of derivatives.
• They use derivatives to
mitigate the same risk which
speculators take to make
profits.
I think the price of
rice will go UP in
the future and I will
make a profit.
I think the price of rice
will go DOWN in the
future and I will make a
loss if I hold on to the
asset.

16. Role of Speculators
If the futures price hover around the theoretical price in the futures market,
who will trade in futures market?
Here is where the speculator comes into the picture.
Looking at the prevailing futures price, they might have views, which might
be either bullish or bearish.

17. Role of Speculators
Expecting the spot price to go up.
Technically, it is a view that the spot
market price at the day of the expiry of
contract will be higher than the
agreed/prevailing futures price in the
market.
Expecting the spot price to go
down. Technically, it is a view that
the spot market price at the day of
the expiry of contract will be lower
than the agreed/prevailing futures
price in the market.
Bullish view:
Bearish view:

18. Role of Hedgers
Hedgers enters the market to protect
their investment in the underlying.
They can easily transfer the risk to a
counter party who has an opposite
need or view about the market.
Their main focus is their core business. Their aim is to evade the risk of
loss due to price fluctuation in the market of the underlying.

19. Examples of Hedging
Portfolio Manager: A portfolio manager is worried about the fall in the
market value of a particular security, which he wants to hold for the next
three months. How can he mitigate the risk?
Input cost of construction company: A construction company is
worried about the increasing cost of concrete steel rods. These steel rods are
also traded on the futures market. How can the company eliminate the effect
of price raise in their project?
Exporter of Garments: An exporter of garments to US is expected to
receive 100,000 USD from his vender after three months. However he
worries about the change in the exchange rate at the time when he receives
his payment from his customer. If the domestic currency appreciates, against
USD, he would lose. How can he mitigate the risk?
• Hedgers are averse of risk and want to concentrate on their core business
activity.
• Speculators are ready to take risk based on their judgment in order to earn
from the price movement.
• Hence it is a tool to transfer the risk from the hedgers to the speculator.
Importance of Speculators to the Hedgers:

20. Summary
• Derivatives are financial contracts whose values are derived from the
values of underlying assets.
• Assets can be financial instruments or non-financial instruments.
Accordingly a derivative can be a financial derivative or a commodity
derivative.
• Derivatives can be used by participants to speculate and to make a profit
if the market moves as expected by them.
• Alternatively, derivatives can also be used as a hedging tool to mitigate
risks if market moves exactly opposite to their expectation.
• The derivative contract is traded not the underlying asset.
• The value of a derivatives contract is determined by the timing of the
contract, value of the underlying security or commodity, and volatility in
the market.
• Derivatives are a tool to transfer the risk from the hedger to the
speculator.

21. &
ThankYou
ForYour
Attention