Derivatives

Introduction

Leading Investment and Commercial banks

Banc of America Securities LLC Citigroup Credit Suisse Goldman Sachs JPMorgan Chase Lehman Brothers Merrill Lynch Morgan Stanley UBS

RISK /Uncertain???
Case-1 An Indian Garments company has received an order to supply I,00,000 units of shirts from USA. The price of $ 500,000 is receivable after six months. The current exchange rate is Rs.39.76/$. At the current exchange rate, the company would get: 39.76 500,000 = Rs 1,98,80,000. But the company anticipates appreciation of Indian rupee over time. Does the company loose/gain due to appreciation in the Indian Rupee? How does company minimise the risk?
Answer please

Minimising risk case-1

The company can lock in the exchange rate by entering into an advance contract and forget about any fluctuation in the exchange rate. Suppose, the six-month forward exchange rate is Rs39.00/$ The company can make an agreement at spot rate at 39.76 in the spot market or at a lesser price. At the time of receiving dollar, it will exchange $500,000 at Rs39.76= Rs 1,98,80,000. or agreed price.

Case 2
You have imported machinery for $ 100,000 on 180 days credit at zero interest. The dollar quotes at Rs 39. Is this deal risk free?

CASE 2 CONTINUED
This deal is not free of risk because after six months when you pay the loan, if the dollar quotes anything more than Rs39., say Rs 40, you will end up paying more [Rs 1 extra for every $ 1, which is equivalent to Rs 100,000 additional cost]. On the other hand, if the dollar quotes anything less than Rs 39, you will stand to gain The question here is not whether you stand to gain or loose it is the risk you are taking

Case 03
You have surplus cash for investment. You think of investing in Wipro, currently quoting at Rs 3,500, which you believe will rise to Rs 3,950 in six months. Is this deal risk free?

CASE3 CONTINUED
This deal is not free of risk because there is no guarantee that Wipros shares would touch Rs 3,950 in six months time. The share prices could rise beyond Rs 3,950 or could also fall below Rs 3,500 giving you no return on investment and you could stand to loose some portion of your investment

How do you protect yourself ?

Use Derivative instruments. What is derivatives?

See the next example.

Picking up something?...

Example
You [along with two friends] want to go for the Aero India January 2008 air show, for which tickets are sold out. Through one of your close friends, you obtain a recommendation letter, which will enable you to buy three tickets. The price of a ticket is Rs 1,000. Which is the commodity that you are suppose to buy? In order to buy the________ what are required now? Money/recommendation letter (instrument) or both?
People walking in the seashore scared?...

Financial instruments
The recommendation letter is a derivative instrument. It gives you a right to buy the ticket The underlying asset is the ticket The letter does not constitute ownership of the ticket It is indeed a promise to convey ownership The value of the letter changes with changes in the price of the ticket. It derives its value from the value of the ticket
Children are scared to go near by?...

Different risk coverage

Firms are exposed to several risks in the ordinary course of operations and borrowing funds. For some risks, management can obtain protection from an insurance company(fire,loss of profit,loss of stock,marine insurance) Similarly, there are capital market products available to protect against certain risks. Such risks include risks associated with a rise in the price of commodity purchased as an input, a decline in a commodity price of a product the firm sells, a rise in the cost of borrowing funds and an adverse exchange rate movement. The instruments that can be used to provide such protection are called derivative instruments
What was see doing? Why?...

Meaning
Derivative instruments are called so because they derive their value from whatever the contract is based on A derivative contract is a financial instrument whose payoff structure is derived from the value of the underlying asset These instruments include futures contracts, forward contracts, options contracts, swap agreements, and cap and floor agreements
See the next slide

Advantages
The derivative market helps people meet diverse objectives such as:
Hedging Profit making through price changes Profit making through arbitrage

Guess what does she pick up?

HEDGING
Hedge is an investment position intended to offset potential losses that may be incurred by a companion investment. A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of over-the-counter and derivative products, and futures contracts. Public futures markets were established in the 19th century to allow transparent, standardized, and efficient hedging of agricultural commodity prices; they have since expanded to include futures contracts for hedging the values of energy, precious metals, foreign currency, and interest rate fluctuations.

Example 1 Agricultural commodity price hedging A typical hedger might be a commercial farmer. The market values of wheat and other crops fluctuate constantly as supply and demand for them vary, with occasional large moves in either direction.

Example continued
Based on current prices and forecast levels at harvest time, the farmer might decide that planting wheat is a good idea one season, . Once the farmer plants wheat, he is committed to it for an entire growing season.

Example continued
If the actual price of wheat rises greatly between planting and harvest, the farmer stands to make a lot of unexpected money, But if the actual price drops by harvest time, he could be ruined. If at planting time the farmer sells a number of wheat futures contracts equivalent to his anticipated crop size, he effectively locks in the price of wheat at that time

Example continued
The contract is an agreement to deliver a certain number of bushels of wheat to a specified place on a certain date in the future for a certain fixed price. The farmer has hedged his exposure to wheat prices; he no longer cares whether the current price rises or falls, because he is guaranteed a price by the contract. He no longer needs to worry about being ruined by a low wheat price at harvest time, but he also gives up the chance at making extra money from a high wheat price at harvest times.

Hedging a stock price

A stock trader believes that the stock price of Company A will rise over the next month, due to the company's new and efficient method of producing widgets. He wants to buy Company A shares to profit from their expected price increase. But Company A is part of the highly volatile widget industry. If the trader simply bought the shares based on his belief that the Company A shares were underpriced, the trade would be a speculation.

price..continued
Since the trader is interested in the company, rather than the industry, he wants to hedge out the industry risk by short selling an equal value (number of shares price) of the shares of Company A's direct competitor, Company B.

 The first day the trader's portfolio is: Long 1,000 shares of Company A at $1 each Short 500 shares of Company B at $2 each (Notice that the trader has sold short the same value of shares)

 On the second day, a favorable news story about the widgets industry is published and the value of all widgets stock goes up. Company A, however, because it is a stronger company, increases by 10%, while Company B increases by just 5%: Long 1,000 shares of Company A at $1.10 each: $100 gain Short 500 shares of Company B at $2.10 each: $50 loss (In a short position, the investor loses money when the price goes up.) The trader might regret the hedge on day two, since it reduced the profits on the Company A position.

 But on the third day, an unfavorable news story is published about the health effects of widgets, and all widgets stocks crash: 50% is wiped off the value of the widgets industry in the course of a few hours. Nevertheless, since Company A is the better company, it suffers less than Company B: Value of long position (Company A): Day 1: $1,000 Day 2: $1,100 Day 3: $550 => ($1,000 $550) = $450 loss Value of short position (Company B): Day 1: $1,000 Day 2: $1,050 Day 3: $525 => ($1,000 $525) = $475 profit

uses
Price discovery
Most price changes are first reflected in the derivative market. That way derivative market feeds the spot market For instance, if the dollars are going down, it means that the professional investors are expecting dolor price to go down in the future this is a good sign for you to buy in the spot market

Risk transfer
A derivative market is like an insurance company Derivative instruments redistribute the risk amongst market players However, if you want protection against adverse price movements, you must pay a price, ie the premium

Derivative instruments on
Stocks (Equity)

Agri Commodities including grains, coffee beans, pepper,. Precious metals like gold and silver. Crude oil Foreign exchange rate Bonds Short-term debt securities such as T-bills Index Interest rate

The old lady looked shabby

TYPES OF DERIVATIVES
Futures
Forwards
Option

Floor cap

Players in the market

Banks-Citi Bank Deutsche Bank Goldman Saches JP Morgan Chase HSBC ICICI

Ways of making contract?

1. Private contracts- Known as Forwards 2. Through Stock Known as exchanges Futures, Options Swap, Floor and Cap

How do they settle the contract?

Daily basis -Known as Marking to market

How does stock exchange operate?

It collects amounts from both the parties of contract known as Initial Margin Money. Stock Exchange also collect additional margin money is known as Variation Margin.

Forwards