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asp (derivatives)
A farmer prays for rain in his dried out paddy
field in the drought affected area
A farmer examines rice in a paddy field
near a farm house
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FINANCIAL
DERIVATIVE
S
Introduction:
Risk is a characteristic feature of all
commodity and capital markets. Over
time, variations in the prices of
agricultural and non-agricultural
commodities occur as a result of
interaction of demand and supply
forces.
The last two decades have witnessed
a many-fold increase in the volume of
international trade and business due
to the ever growing wave of
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As a result, financial markets have
experienced rapid variations in
interest and exchange rates, stock
market prices thus exposing the
corporate world to a state of growing
financial risk.
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What are Derivatives?
T-Bill
Crude Oil
Precious Metals
History
The Derivatives markets can be traced
back to the middle Ages. They
originally developed to meet the needs
of farmers and merchants.
The Chicago Board of Trade (CBOT)
was the first derivatives market
established in 1848 to bring farmers
and merchants together. Initially, its
main task was to standardize the
quantities and qualities of the grains
that were traded. Within a few years,
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Speculators soon became interested
in the contract and found trading the
contract to be an attractive
alternative to trading the gain itself.
The Chicago Board of Trade now
offers futures contracts on many
different underlying assets, including
corn, oats, soybeans, soybean oil,
wheat, silver, treasury bonds, and
treasury notes.
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The Chicago Mercantile Exchange:
In 1874, the Chicago Produced
Exchange was established. This
provided a market for butter, eggs,
poultry, and other perishable
agricultural products. In 1898, the
butter and egg dealers withdrew from
this exchange to form the Chicago
Butter and Egg Board.
In 1919, this was renamed the
Chicago Mercantile Exchange (CME)
and was reorganized for futures
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Since then, the exchange has
provided a futures market for many
commodities including pork bellies
(mutton/chicken) (1961), live cattle
(1964) live hogs (pig) (1966) and
feeder cattle (1971). In 1982, it
introduced a futures contract, and a
Eurodollar futures contract on the
S&P 500 Stock Index.
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The International Monetary Market
(IMM) was formed as a division of the
Chicago Mercantile Exchange in 1972
for futures trading in foreign currencies.
The currency traded on the IMM now
include the British Pound, the Canadian
futures Dollar, the Japanese Yen, the
(Swiss Franc, the German mark)
European Euro and the Australian dollar.
The IMM also trades a gold futures
contract, a treasury bill futures contract,
and a Eurodollar futures contract.
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DERIVATIVES - INDIA
Derivatives have a fairly long history in India too. The
first organized futures market came up in 1875 with
the establishment of BOMBAY COTTON TRADE
ASSOCIATION LTD.
Subsequently, many futures exchanges, predominantly
commodity-based futures sprang up (bounced), like.,
YEAR DETAILS
1875 BOMBAY COTTON TRADE ASSOCIATION LTD
1893 BOMBAY COTTON EXCHANGE LTD
1900 GUJARATI VYAPARI MANDALI
1919 CALCUTTA HESSIAN EXCHANGE LTD
Most of them did not last till the second world war in
1939.
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After the country attained independence,
derivative markets came through a full circle
from prohibition of all sorts of derivatives
trades to their recent reintroduction.
YEAR DETAILS
Securities Laws (Amendment) Act, 1999 permits legal frame
1999
work for derivatives trading in India.
2000 Trading in index futures began on BSE and NSE
Trading in options on index and stocks commenced trading
2001
on BSE and NSE
2002 Trading on single stock futures began on BSE and NSE
Introduction of interest rate futures on NSE, Introduction
Rupee of options, Futures trading-is permitted on almost all
2003 commodities but options on commodities still prohibited
and commencement of NCDEX and MCX commodity
exchange.
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Other Exchanges:
Many other exchanges throughout the
world now trade futures contracts.
Prominent among them are
Chicago Rice and Cotton Exchange (CRCE,
the)
New York Futures Exchange (NYFE),
London International Financial Futures
Exchange (LIFFE),
Toronto Futures Exchange (TFE),
Singapore International Monetary
Exchange (SIMEX) and
National Commodity and Derivative
The Indian financial market woke up
to this new generation of financial
instruments and the Indian
Derivatives Market odyssey in
modern times commenced with the
FOREX derivatives in 1997 has also
seen the introduction of many
derivatives on different underlyings.
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The following factors have been driving the
growth of financial derivatives:
1.Increased volatility in asset prices in
financial
markets,
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Protects investor securities
against
Protects investor securities against
fluctuations in prices. The derivative
market offers products that allow
investor to hedge themselves against
a fall in the price of shares that they
possess. It also offers products that
protects the investor from a rise in the
price of shares that he/she plan to
purchase. This is called hedging.
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Risk Averse Investor
Arisk averse investoris
aninvestorwho prefers lower returns
with knownrisksrather than higher
returns with unknownrisks. In other
words, among
variousinvestmentsgiving the same
return with different level ofrisks, this
investoralways prefers the alternative
with least interest.
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Transfer of risk:
The most important use of these
derivatives is the transfer of market risk
from risk-averse investors to those with an
appetite for risk.
Risk-averse investors use derivatives to
enhance safety, while risk-loving investors
like speculators conduct risky, contrarian
trades to improve profits.
This way, the risk is transferred. There are
a wide variety of products available and
strategies that can be constructed, which
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USES OF DERIVATIVES
1. Derivatives help in discovery of future as well as
current prices:
. Corporations use Derivatives: Corporate are risk averse.
They do not like risk and uncertainties in their financial
planning. Financial uncertainties expose them to unexpected
losses and thereby reduce the value of their
investments.Companies use currency forwards and other
derivatives to hedge their exports, imports and other foreign
exchange exposure.
.They use commodity derivatives to hedge raw material
consumption and inventories as well as their output prices and
inventories.
.Example: An electrical goods manufacturer might use copper
futures to hedge the cost of copper which is a major raw
material for it.
.A gold mining company might use gold futures to hedge the
selling price of its output. Companies also use interest rate
derivatives
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2. Mutual funds and investment institutions
use Derivatives
Many individuals do
speculate on asset prices.
Individual who manage their
own investment portfolios
might also use derivatives for
the same reason as
investment institutions
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Economic benefits of
derivatives
Reduces risk
Enhance liquidity of the underlying asset
Lower transaction costs
Enhances the price discovery process.
Portfolio Management
Provides signals of market movements
Facilitates financial markets integration
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Misuses of Derivatives
1. Speculative and Gambling Motives: One
of the most important arguments against the
derivatives is that they promote speculative
activities in the market.
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2. Increase in Risk:
The derivatives are supposed to be efficient
tool of risk management in the market. But
this is one sided argument.
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4. Price Stability: the derivatives that their
major contribution is towards price stability
and price discovery in the market whereas
some others have doubt about this. Rather
they argue that derivatives have caused wild
fluctuations in the asset prices and moreover,
they have widened the range of such
fluctuations in the prices.
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UNIT 1: Introduction to Derivatives
Development and Growth of Derivative
Markets, Types of Derivatives,
Uses of Derivatives, Fundamental linkages
between spot & Derivative Markets, The Role
of Derivatives Market, Uses & Misuses of
derivatives.
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TYPES OF MARKETS
SPOT
MARKET
DERIVATI
VE
MARKET
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DERIVATIVES
(in general)
OTC ETD
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OTC and Exchange Traded
Derivatives.
1. OTC
Over-the-counter (OTC) or off-exchange trading is to trade
financial instruments such as stocks, bonds, commodities or
derivatives directly between two parties without going
through
an exchange or other intermediary.
The contract between the two parties are privately
negotiated.
FORWAR
FUTURES OPTIONS SWAPS
DS
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What is a Forward?
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.
3 months
Later
500kgs Bread
Farmer wheat
Maker
Rs.20,00
0
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Risks in Forward
Contracts
Credit Risk Does the other party have the
means to pay?
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Terminology
Long position - Buyer
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What are Futures?
A future is a standardized forward contract.
Standardizations-
- quantity of underlying
- quality of underlying(not required in financial
futures)
- delivery dates and procedure
- price quotes
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Futures Contract
Example
A
Long Market
Rs.10 Price/Spot
Price
Day1
B C
Rs.10
Short
Rs.10
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Futures Contract
Example
A
Long
Market
Price/Spot
Price
Rs.10
Short
Profit
Rs.12 Day1
Rs.2 Rs.10
Day2
B C Rs.12
Short L
Rs.10 Rs.12
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Futures Contract
Example
A
Market
Price/Spot
Price
Long
Rs.10
Short Day1
Profit
Rs.12 Rs.10
Rs.2 Day2
Rs.12
B C Day3
Rs.14
Short Long
Rs.10
Long Rs.12
Short
Loss
Rs.14 Rs.14
Profit
Rs.4
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Futures Contract
Example
L
A Market
Price/Spot
Price
S
Rs.10
Rs.12
Profit Day1
Rs.2 Rs.10
Day2
B C
Rs.12
Day3
S L Rs.14
L
Rs.10 S
Rs.12
Loss
Rs.14 Profit
Rs.14
Rs.4
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Types of Futures
Contracts
Stock Futures Trading
(dealing with shares)
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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.
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FUTURE PRICE
Amount required 2,400 X 269.80 = 6,47
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MARGIN MONEY
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Initial Margin (IM)-
Deposit that a trader must
make before trading any
futures. Usually, 10% of
the contract size.
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Advantages of derivatives
over Equity Trading
The financial derivative instruments futures and
options have the following advantages.
derivatives can be uses as convenient substitute
for other investments, leaving risks and rewards
unchanged.
Derivatives can be used to hedge the risk and can
help manage the risks inherent in a business.
Derivatives can used speculatively to increase risk
and reward through leverage (control).
Derivatives are also the basis for modern financial
engineering.
Forward v/s Futures Contract
FORWARD FUTURES
Traded on organized
Over the Counter Products
Exchanges
Customized Contract Standardized Contract
No Involvement of
Clearing House Guarantee
Clearing House
No Margins Margins are Must
Less Liquidity High Liquidity
Regulated by agencies like
Self Regulated
SEBI etc.
Counter Party Risk No Counterparty Risk
Settled by actual delivery Cash Settled
Settled on the Maturity Daily Settlement
Profits or losses realized Profits or losses realized daily
on the Maturity
What are Options?
Contracts that give the holder the option
to buy/sell specified quantity of the
underlying assets at a particular price on
or before a specified time period.
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TYPES OF
OPTIONS
European American
Style Style
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Types of Options (cont.)
Broadly the OPTIONS are two types,
they are European style options and
American style options.
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.
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Options Terminology
Underlying: Specific security or asset.
Option premium: Price paid.
Strike price: Pre-decided price.
Expire date: Date on which option expires.
Exercise date: Option is exercised.
Open interest: Total numbers of option
contracts that have not yet been expired.
Option holder: One who buys option.
Option writer: One who sells option.
Put-call ratio: The ratio of puts to the calls
traded in the market.
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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 options give the seller 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 receiving a
premium.
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Call Option Example
CALL
Right to buy
OPTION Current Price =
Premium =
Rs.25/share 100 Reliance Rs.250
shares at a
Strike
Amt to buy price of Rs.300
Price
Call option = per share after Expiry
Rs.2500 3 months. date
Suppose after a month,
Market price is Rs.400, Suppose after a month,
then the option is market price is Rs.200, then
exercised i.e. the shares the option is not exercised.
are bought. Net Loss = Premium amt =
Gross gain = 40,000- Rs.2500
30,000
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Call Option Example
CALL
Right to buy
OPTION Current Price =
Premium =
Rs.0.95/share 2,400 ITC Rs.278
shares at a
Strike
Amt to buy price of Rs.295
Price
Call option = per share after Expiry
Rs.2280 1 month. date
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Open Interest
Definition:Open interest is the total number of
outstanding contracts that are held by market participants
at the end of each day. Open interest measures the total
level of activity into the futures market.
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Increasing open interest means that new
money is flowing into the marketplace. The
result will be that the present trend (up, down
or sideways) will continue. Declining open
interest means that the market is liquidating
and implies that the prevailing price trend is
coming to an end. Therefore, open interest
provides a lead indication of an impending
change of trend.
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Put Option Example
PUT OPTION
Premium = Right to sell Current Price =
Rs.25/share 100 Reliance Rs.250
shares at a
Amt to receive on Strike
price of Rs.300
put option = Price
Rs.2500 per share after
Expiry
3 months.
date
Suppose after a
month, Market price Suppose after a month,
is Rs.200, then the market price is Rs.300, then
option is exercised the option is not exercised.
i.e. the shares are Net Loss = Premium amt =
sold. Rs.2500
Net gain = 30,000-
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Options Terminology
(cont.)
Moneyness: Concept that refers to the
potential profit or loss from the exercise of
the option. An option maybe in the money,
out of the money, or at the money.
In the money Spot Price > Strike price Spot price < strike price
At the money Spot Price = Strike price Spot Price = Strike price
Out of the Spot price < strike price Spot price > strike price
money
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For Call Option
In- the Money Option : A option is said to
be In- the money, when the underlying stock
price is greater than the strike price. (S>k).
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For Put Option
In- the Money Option : A option is said to
be In- the money, when the underlying stock
price is less than the strike price. (S<k).
At-the Money: A option is said to be At- the
money, when the underlying stock price is
equal to the Strike price. (S=k).
Out-of Money:- A option is said to be Out-
of money, when the underlying stock price is
greater than the strike price. (S>k).
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.
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Types of Swaps
There are 2 main types of swaps:
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What is an Interest Rate
Swap?
A company agrees to pay a pre-determined
fixed interest rate on a notional principal
for a fixed number of years.
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Interest Rate Swap Example
LIB LIBOR
SWAPS
Co.A
OR
BANK Co.B
Aim - 8 8.5% Aim -
VARIABLE % FIXED
5m 7 5m LIBOR
+ 1%
% Notional
Amount = 5
Bank million Bank
Fixed
A Fixed
B
7% 10%
Variable Variable LIBOR
LIBOR + 1%
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Using a Swap to Transform a
Liability
Firm A has transformed a fixed rate liability
into a floater.
A is borrowing at LIBOR 1%
A savings of 1% (8% - 7%)
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Direct Currency Swap
Example
Firm A is an American company and wants to
borrow 40,000 for 3 years.
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Direct Currency Swap Example
Firm 7 Firm
%
A B
Aim -
(American)
Aim - EURO 5% (French)
DOLLAR
$60t
h
7% 40 5%
th
Bank A Bank B
6% 5%
$ $
7%
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Comparative Advantage
Firm A has a comparative advantage in
borrowing Dollars.
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The participants in a derivatives market are of
three types.
Participants in
Derivatives
Speculato Arbitrage
Hedgers
rs urs
Traders in Derivatives Market
There are 3 types of traders in the
Derivatives Market :
HEDGER
A hedger is someone who faces risk
associated with price movement of an
asset and who uses derivatives as
means of reducing risk. They provide
economic balance to the market.
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SPECULATOR:
A trader who enters the
futures market for pursuit of
profits, accepting risk in the
speculation. They provide
liquidity and depth to the
market.
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A speculator is a person who is willing to take a risk by
taking futures position with the expectation to earn
profits. Speculator aims to profit from price
fluctuations.
The speculator forecasts the future economic
conditions and decides which position (long or short)
to be taken that will yield a profit if the forecast is
realized.
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This expected profit is associated with risk
because the silver price after one month may
decrease to Rs 2800 per 100 grams, and may
lose Rs 100 per 100 grams.
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POSITIONA
L TRADERS
SPECULAT
ORS
DAY
TRADERS
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FUNDAMENT
AL ANALYST
POSITIONAL TECHNICAL
TRADERS ANALYST
LOCAL
SPECULATO
RS
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Position Speculator uses
fundamental analysis of economic
conditions of the market and is known
as fundamental analyst.
Technical Analyst whereas the one
who predicts futures prices on the
basis of past movements in the prices
of the asset is known as technical
analyst.
Local Speculator A speculator who
owns a seat on a particular exchange
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SCALPERS
LOCAL
PIT
SPECULAT
TRADERS
ORS
FLOOR
TRADERS
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Scalpers usually try to make profits from holding
positions for short period of time. They bridge the
gap between outside orders by filling orders that
come into the brokers in return for slight price
concessions.
Pit Traders like scalpers take bigger positions and
hold them longer. They usually do not move quickly
by changing positions overnights. They most likely
use outside news
Floor Traders usually consider inter commodity
price relationship. They are full members and often
watch outside news carefully and can hold positions
both short and long. Day traders speculate only
about price movements during one trading day.
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Day Traders speculate only about
price movements during one trading
day.
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ARBITRAGEUR:
A person who simultaneously enters into transactions
in two or more markets to take advantage of the
discrepancies between prices in these markets.
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Reasons to use derivatives
Derivative markets have attained an
overwhelming popularity for a variety of
reasons...
Hedging: Interest rate volatility
Stock price volatility
Exchage rate volatility
Commodity prices volatility
VOLATILITY
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2. Commodity or Product Input
Hedge:
Companies that depend heavily on raw-material
inputs or commodities are sensitive, sometimes
significantly, to the price change of the inputs.
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It is important to note that the derivative
markets do not necessarily make the India or
world economy any larger or wealthier. The
basic wealth, expected returns, and risks of
the economy would be about the same
without these markets. Derivatives simply
create lower cost opportunities for investors to
align their risks at more satisfactory levels.
This may not necessarily make them
wealthier, but to the extent that it makes
them more satisfied with their positions, it
serves a valuable purpose.
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Myths & Realities about
Derivatives
In less than three decades of their coming in
to vogue, derivatives markets have become
the most important market in the world. Today
Derivatives have become the part and parcel
of the day-to-day life for ordinary people in
major parts of the world. While, this is true for
many countries, there are still apprehension
(fear/uneasiness) about the introduction of
derivatives.
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BY
USING FUTURES
Business outcomes are surprising and have
risk and uncertainty elements. To avoid the
risk arising out of price fluctuations in future,
various strategies are devised keeping in view
the timing and pricing dimensions of the
instruments.
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In broader sense, a hedging is an act of
protecting one from future losses due to some
reason. In a future market, the use of future
contracts/instrument in such a way that risk is
either avoided or minimized is called hedging.
The anticipated future losses may occur due
to fluctuations in the price, foreign exchange
or interest rate.
This concept considers that hedging activity is
based on price risk.
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Hedging Types
There are two categories of:
Short
Hedging Hedge
types Long
Hedge
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Short Hedge
Having a short position (selling a futures) in
futures is known as a short hedge. It happens
when an investor plans to buy or produce a
cash commodity sells futures to hedge the
cash position.
It is appropriate when hedger owns an asset
and expects to sell in future on a particular
date.
Generally, Selling some asset without having
the same is known as short-selling. Which
means having a net sold position, or a
commitment to deliver.
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For example suppose a US exporter expects
to receive Euros in three months. He will gain
if the euro increases in value relative to the
US dollar and will sustain loss if the euro
decreases in value relative to US dollar.
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Supposing an oil producer made a contract on
10 Oct, 2006 to sell 1 million barrel crude oil
on a market price as on 10 Jan 2007.
The oil producer supposing that spot price on
10 Oct, 2006 is $ 50 per barrel and Jan crude
future price on NYMEX is $ 48.50 per barrel.
The company can hedge its position by short
selling October futures.
If the oil borrower closed his position on 10
Jan 2007 the effect of the strategy should be
to lock in a price close to $ 48.50 per barrel.
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Suppose the spot price on 10 Jan 2007 be $
47.50 per barrel. The company realizes the
gain/profit:
$ 48.50 $ 47.50 = $ 1.00 per barrel
Total profit = $ 1.00 X 1 million
$ 1 million in total from the short future
position.
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Long hedge
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The objective of a long hedge is to
protect the company against a price
increase in the underlying asset prior
to buy the same either in spot or
future market.
A net bought position is actually
holding an asset which is known as
inventory hedge.
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Cross Hedging
A cross hedge is a hedge where
characteristics of futures and spot prices do
not match perfectly which is known as
mismatch, may occur due to following reasons:
The quantity to be hedged may not be equal
to the quantity of futures contract.
Features of assets to be hedged are different
from the future contract asset.
Same futures period (maturity) on a particular
asset is not available.
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Ex:1:- Suppose a wire manufacturer requires
copper in the month of June but in exchange
the copper futures trade in long delivery in Jan,
March, July, Sept. in this case hedging horizon
does not match with the futures delivery date.
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Basis:
The difference between the spot
price and future price is known as
basis.
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