Chapter Seven a Derivatives B DERIVATIVES A derivative is a financial instrument whose value depends on underlying, assets. The underlying assets could be prices of traded securities of gold, copper, aluminium and may even cover prices of fruits and flowers. Derivatives have become important in india since 1995, with the amendment of the Securities Contract Regulation Act of 1856, Derivatives such as options and futures are traded actively on many exchanges. Forwate contracts, swaps and different types of options are regularly traded outside exchanges by financial institutions, banks and corporate clients in over-the-counter markets. There is no single marketplace or an organised exchange Organised exchanges began trading in options on securities in 1973, whereas exchange traded debt op! started trading in 1982. On the other hand, fixed income futures began trading in 1975, but equity related futures started trading in 1982. The reasons for debt options being stronger than futures are that share exchanges tend 10 inroduce those instruments that they think will be successful in trading. Inthe equity market, a relatively large proportion ofthe total risk of a security is unsystematic. At the same time, many securities display a high degree of liquidity that can be expected to be maintained for long periods of time. These two factors contributed to the viability of trading equity options on individual securities. This is because, for the contracts to be successful, the underlying instruments have to be traded in large quantities and with some price continuity 50 that the option related transactions need not create more than a minor disturbance in the market. In the debt market, a large proportion of the total risk ofthe security is systematic — in other words, the risk in debt instruments cannot be diversified by investing in a number of securities. Debt instruments are smaller in size in ‘comparison to equity securities, 1, Classification of Derivatives Derivatives can be classified as: Commodities Derivatives: These are derivatives on commodities like sugar, jute, paper, gur and castor seeds. Commodities are traded in different exchanges. For example, futures contract in potatoes are made at Hapur, coffee futures in Coffee futures exchange at Bangalore and pepper futures are made in Kochi. The agricultural commodities, oils and metals futures are offered in Multi-Commodity Exchange of India (MCX), National Multi-Commodity Exchange of India (NMCE) and National Commodi ity and Derivatives Exchange Limited (NCDEX), Financial Derivatives: These derivatives deal in shares, currencies and giltedged securities, Financial derivatives can have transaction ent exchanges in the world. They can be classified as currency derivatives, interest rate derivatives, stock and stock index derivatives, Bombay Stock Exchanwe avd National Stock Exchange trade in index futures, stock index futures, and stock index options and feu Basic Derivatives: Futures and options are basic devatives. They can be distinguished from swaps, and interest rate futures which are called complex derivatives. Complex Derivatives: Interest rate futures and swaps are classified as complex derivatives. Exchange traded Derivatives (ETDs): ETDs are standard contracts traded accordi regulations of a stock exchange. Only members can trade in exchange traded deri Suaranteed against counterparty default. Contracts are settled daily. ETDs are traded in NSE and BSE i Inia, These trades are transacted online. ETDs canbe transacted between one party and ance see tansactions cn move fom one py to another and in a crsscross manner. These tades we eo eee the exchange rules. The value ofthe derivative and changes in the valve are setled day oy pee PY Period through the mark-tormargin method. This reduces the credit risk tothe mininaan’ a OTC Derivatives: These derivatives are regulated by tlutory provisions. Swaps and for foreign exchange are usually OTC derivatives and have a high risk of default, OTC pe a forward contracts. Forward contracts dealing in foreign exchange ae traded as OTC in heave Soret OF ao vaded as OTC in India, OTC detvalves are beween one party and another and fe en pe ing to the rules and Wvatives and they are@ Chapter Seven Investment Management jing to the methodol = between exchange traded and OTF deat as uate move in diferent dit inction bet a “ The distincti the OTC is between one party PF x carried out. AS gi iven above, between OTC at The following figure shows the difference Eu Derivatives: Transactions at OTC and ETD paige | Party ¢——> Party | id cia Party Party dete ueac eae ero |_ >} Pat Party Party Party | 2 Characteristics of Derivatives | The characteristics of derivatives are the following: «Limit of Transactions: Derivatives can have limitless transactions a transacted. «Settlement: Derivatives are settled by squaring or offsetting transactions of the same derivatives and the | cash is settled in the difference between the values of the derivative. + Screen-based Transactions : Derivative contracts are online computerised contracts. There are no physial exchanges of assets. + Transactions in Secondary Market: Derivatives cannot be traded in the new issue market. They a transacted only in the secondary stock market when share in debentures have been already issued in the new issue market + Liquidity: The derivative transactions are liquid in nature and contracts can be formed without any delay. * Hedging Price Risk: A derivative instrument is used for hedging price risk in financial transactions. Cash is paid for settlement for the difference in price and it has to be set i i ttled in fi i on underlying asset and derives its value from it. Se ee 15 no physical assets are transferred a “7 A derivative i Tipe eee ees instrument can be made according to the preference of an investor. !t!§ used fr hedging also for speculation. Through the instrument, return can be enhanced. It does "™ any intrinsic value or physical existence because it represents an underl i + Functions: The main function of derivatives is to hed eee management. It also plays the role of price discovery Participants in Derivatives Market Participants of derivatives market consists of the following: ‘+ Hedgers are those who try to minimise los h ge risk through the application of techniques of '®* of an underlying asset. same time, they protect themselves sgainge os pa the Parties entering into a derivative contract. At and futures and hedge in both financial derivatives se See a a hey deal in They 27 lerivatives. * Speculators participate in futures i : and options. unlimited, but they can take positions and mini They take high risks for potential gains. Their gal” mi i: major players of the derivatives market. * ‘et losses. They trade mainly in futures. They =deans eounane Je to make a profit + Arbitrageurs ent Arbitrage ter into two transactions into two different stock markets. They are abl fit, but they have t© through the difference in price of the analyse the market with speed to eae eat markets. They make a riskless pro! i qm Las ‘The distinction between different types of derivatives has already been explained above. In this section, the financial derivatives are discussed, These are Forwards, Futures, Options and Swaps. 1. Forwards ina forward contract, two parties agree to buy or sell some underlying asset on some future date at & stated price and quantity. The forward contract does not involve any money transaction at the time of signing the deal. Ifa farmer enters into the contract, forward contract safeguards and eliminates the risk of price at @ future date. But iterparty risk the forward market has the problem of lack of centralisation of ti eden trading, difficulty in liquidity and count in the case of one of the parties declaring their insolvency or bankruptcy 7 2. Futures Ina futures contract, both partis are obligated to perform. n the case of futures, neither patty pays 2 Premier Inthe case of futures, the holder of the contract is exposed to the entire spectrum of risk of loss and has the potential Inthe ci retums. The parties to a future contract must perform at the setlement date. They are, however, NOt abligated to perform before the seitlement date. 3. Options In the case of options, only the seller (writer is obligated to perform. In an options contract, the buyer PAY the «ele (waiten a premium. In the case of options, the buyer is abe to limit the downside risk to the option Prem! At ar rtnins the upside potential. The buyers of an options contract can exercise their right any time prior to that expiration date. 4. Swaps All swaps involve exchange ofa series of periodic payments between two parties. Ina swap contract, there /s 20 agreement between two parties to exchange ther respective cash flows through a swap dealer according to some predetermined price formula. A swap transaction usually involves an intermediary who is a large international Fee netukon. The two payment stteams are estimated to have identical present values at the outset when discounted at the respective cost of funds in the relevant markets. ‘the two most widely prevalent types of swaps are intrest rate swaps and cufrency swaps. A third is combination of the two to result in cross-currency interest rate swaps. OF course, a number of variations are po ible under each of these major types of swaps. 5. Types of Transactions Transactions can be spot or ready delivery contracts or they can be future delivery contracts «Spot or Ready Delivery: In such contracts, the payment has 10 be made either in cash or credit. The Frymant may be made with tau physical dalivany ofthe aage-on an Agreement, Credit can be allowed for a few days, but immediate payments are preferred. «Future Delivery Contracts: In a future delivery contract the delivery ofthe asst is made on a future date Fata ere ement forthe date and mode of payment. These future delivery contracts can be either nontransferable or transferable future delivery contracts. « Noctraneferable Future Delivery Contracts: These are also called forward contracts, The agreed contracts have to be performed according to the predetermined terms and conditions of the contract. + Transferable, Future Delivery Contracts: uch contracts are also called futures contract. The rights and Obligations of the parties under this contract can be transfered 10 third panty.og in nature and are an indirect ‘ y speculative in nat 3 = sons or directions come with equity share. 7 ade’ ond ‘strap’. ‘Pat’ is ee Fah sal“ | Options oF ee re in the form of ut “eal “on and has 0 befor a specified ice ¢ of sling in shares, OF eat price, “Calis the ight to uy i920 racing price is called te option pcg specified time a The buyer and seller of options is called ‘wri ea by those who tral de on both sides i | 3 epecified time. The bu .d a call and is generally cont Te eee ee a eemfdle’ is a combination of a put and a c al cone cal. i : Stade’ 3 combine als plus one put ot 0 PUS ATO, prions. The basic reason for dag rate, “ap mea th he um and te ik of iN TS med as leverabe The pen wy speculation and has inners rough a smal vest TRS MAY 200 fora particular period of ie om ays excess amount in premium and in this manner che 0 ak a at er 9 Hier On ys pays excess amour Heed and used nly i they ate rated ANd TY the premium is lost. Opti Options may necessary No he next month. the option isnot wed IPT share price. Option buy price in the next fora oa ature expectation of price change in We AAT sis higher than ther baying rrows that i he exercises options he may also be ata risk, of loss. ie tee os oe ee eH the veier of option can both sell and bay ea One Fane Ipren ch atescaien brave hat share rises and the share “ ste heen nt he Sr pl i re of a particular share. 5 es a od ne wrt able to gat an ational share ofa particular share, > contac Temains neutral and does not rise or fall. The writer of options can ho! and right on them, ' The price of an option in the form of premium generally rises— {@) Ifthe share is held for a longer time as this is a higher risk to the writer; (b) Ifthe rate of fluctuations on the share is higher than premium; fc) When the shares have a very low face value, they usually have a higher premium because even the price is lower in the share market but higher price share receives less premium. Options are usually exercised or ‘struck’ as a cover on the premium paid for an option. It should also cover the cost of transactions; the consideration of tax should also be made before exercising an option. Options are also used for hedging. An investor simultaneously buys 100 shares of a share and ‘puts’ on the share. If share appreciates after twelve months, this loss has gone. The loss on this would be only in the matter of commissions and premiums. Pus are also used for tax planning. Even if the share prices fluctuate, the gains and losses on the assured and long share offset judging. ‘An options agreement is a contract in which the writer of the option grants th purchase from or sell to the writer a designated instrument for a specified price Sana eeene ee vf pe The writer grants this right to the buyer for a certain sum grants the buyer the right to buy some instrument is called a instrument is called a put option. The strike price or the striking price. oh money called the option premium. An option that call option. An option that grants the bu an ryer to se Price at which the buyer can exercise his option is called the exercise price: Options are available on a large variety of un commodities. Options are also traded on share in derlying assets like e i contract or futures style options. nee ‘uity shares, currencies, debt instruments and ‘ures contracts where the underlying asset is a future’ | ial investors wit prices, exchange rates and commodity i es : speculate on the movements of sha‘ Anceving ase for options could be a mca advantage of options is on el the feature of limited loss. The pe modity or a futures contract on a commodity or the futures style reign exchange gives the opti Option buyer the ri Currency). If the opti ci a eee eavocsel oe Piion is exercised, the option seller must seers deliver a ‘An option on spot Price (in terms of anoth fo currency, -ht to Goines EL he option buyer then currency ye the ight 4 esta a longo short pion in a currency the option I exercised, the seller must take the apposite position in ne i Suppose you had. n the a ae an option to buy a December DM contract on Paar once snare the onion when December tutus re tengo os895, Hou can close Ut ur position at Ps s € 2 Profit of $ 0.0095 per DM or, meet futur ements and carry " 1 5 per DM or, meet futures margin requirern | slong position with $ 0.0095 ner DM boeing credited to your margin seeeure: The erin calor automatically Bet 4 hort position in December futures, i futures Style Options: Like futures co getted on isthe price of an option on spot Frthe option, Le., the premium or the pri artis price, which, in turn depends on for example a trader feels that the premi pton. The seller ofthis ‘call option’ is hhyer does not pay the premium to the 4. Types of Options. ‘An option contract is an agreement betw: ‘An option on currency futures gives t res contract at a specified price, If | eierant futures contract. For example, 2 price being tracts, futures style options represent a bet on a price. T ler foreign exchange. The buyer of the option has to pay a price to the ice of the option. In a futures style option, you are betting on the chanes Several factors including the spot exchange rate of the currency involved, ium on a particular option is going to increase. He buys a futures style ‘call betting that the premium will go down, Unlike the option on the spot, the seller. Instead, they both post margins related to the value of the call on spot. ‘ /een two patties representing the option buyer and the option seller. ‘The option seller receives a premium on the price of the option and grants the right to someone else to buy or sell. He is also called the option writer. The option buyer pays a price in the form of premium to the options seller for writing the option. When options are traded in a share exchange, as in the case of futures, once the agreement is reached between two traders, the clearing house (share exchange) interposes itself between the two parties becoming buyer to every seller and seller to every buyer. The clearing house guarantees performance on the part of every seller. There are two types of options. These are Call options and Put options. A call option gives the option buyer the right to purchase currency Y against currency X, at a stated price X/Y, on or before a stated date. For exchange traded options, one contract represents a standard amount of the currency Y. The writer of a call option must deliver the currency if the option buyer chooses to exercise his options. ‘A put option gives the option buyer the right to sell a currency Y against currency X at a specified price on or before a specified date. The writer of a put option must take delivery if the option is exercised, Strike Price is also called exercise price. If the striking price is high, the call option price will be low and the gzin will be limited. The price is specified in the option contract at which the option buyer can purchase the currency (call) or sell the currency (put) Y against X. The date on which the option contract expires is the maturity date. Exchange traded options have standardised maturity dates. Options can be either American or European: An American Option is an option, call or put that can be ®xercised by the buyer on any business day from initiation to maturity. A European option is an option that can be ‘exercised only on maturity date. 2. Features of Options ‘A Premium (Option price, Option value) isthe fee thatthe option buyer must pay the option writer at the time Contract is initiated. If the buyer does not exercise the option, he stands to lose this amount. The intrinsic value of an option is the gain to the holder on immediate exercise of the option. In other words, [or call option, it is defined as Max [( ~ X), 0}, where Sis the current spot rate and X isthe strike rate. If Sis wrestee 2 X, the intrinsic value is positive and if Sis less than X, the intrinsic value will be zero. For a put option. tha intrinsic value is Max [X — 5), 0]. In the case of European options, the concept of intrinsic value is notional “Pons are exercised only on maturity. it wif alte ofan American option, prior to expiration, must be atleast equal to its intinsic value, Normally fol be greater than the intrinsic value, Tis Is because there is some possibilty that the spot price: wit nays vanet in favour of the option holder. The difference between the value of option at any time *t* and ite intrinsic ses called the time value of the option. a as theseBR tase Civ 2, the i to the exercise price. It ‘call option is said to be at-the-money iS = %, Le. the spot price is equal ” Ms i sn i i oe ryt X Coney, a Pu option iathemoney FS < %Inthemng 5 < K and out-olthemoney if S > ¥. Relationshi ion Price: the difference between the ‘omship of Intrinsic Value and Call Option Price: The premium is the d vt value and par eee ‘the call option. With an increase in the share price, the intrinsic value increases by mg premium declines. This can be explained with the help of the Table 7.1. Insinse Vauo (i ©) | Price of Striking, Intrinsic ‘Market price of iu of \ the share price value option option | ao @ (1) -@Q) =3 @ (4) - B) = 6) DMD 40.0 0.00 10.00 10.00 41.00 40.00 1,00 10.50 9.50 55 40.00 15.00 21.00 6.00 6200 40,00 22.00 26.00 4.00 70.00 40.00 30.00 32.00 2.00 3M 40.00 53.00 54.00 1.00 118.00 40.00 78.00 78.50 0.50 3, Option Premium and Share Price Option premium fluctuates as the share price moves above or below the strike price. Generally, option premiums rarely move point to point with the price of the underlying share. This happens only at parity, when the exercise price plus the premium equals the market price of the share. Before attaining parity, premiums tend to increase less than point per point with the share price. One reason for this is that point per point increase in premium would result in sharply reduced leverage for the option buyers Reduced leverage means reduced demand for the option. Also, a higher option premium will bring about increased capital outlay and increased risk, thus reducing demand for the option. if share prices decline, it does not result in a point per point decrease in option premium. Even a steep decline in the share price in a span of few days has only a slight effect on the option’s time value. This term to maturity effect, exists, because the option is a wasting asset. 4, Call Options Profits A call option buyer's profit can be defined as follows: At all points where S < X, the pay-off will be —< At all points where $ > X, the pay-off will S- X -c where, S = Spot price X = Strike price or exercise price © = Call option premium Conversely, the option writer's profit will be as follows: At all points where S < X, the pay-off will be c At all points where 5 > X, the pay-off will be -(S — X - ¢) 5. Put Options Profits A put option buyer's profit can be defined as follows: At all points where S < x, the pay-off will be X - 5 ~ p6 with a strike price of 8 1000/- per sh; in diferent situations is discussed through 1 Atall points where S > X, the pay-off will 4 where, S = Spot price X= Strike price or exercise price P = Put option premium Conversely, the put option writer's profit will as follows: Atall points where S < X, the pay-off will be -~xK ~5— P Atall points where S > X, the payoff willbe p Profit and Pay-offs from Options On the expiration date of the option the profit of Pay-off can be examined for example Mr. A has an option are and option premium of & 200/- per share. The pay-off on the expiration date ferent sit c he following analysis: @ Buying @ Call Option: When an investor is buying a call Option he may or may not exercise his right to buy at the strike price. If he has purchased a call option ands has a premium of & 200/- as stated above and his strike price is of & 1,000/- he will exercise his option when the market price is more than ® 1,000/-if it is less than 5 1 O0GE the nvetior wad be keen to buy the amok Pee price is © 1,200/- the investor ‘scl break evens. gure 2.2, shooa toa the prics mte wenerce ae underlying asset is less than the strike price the call option holder will have a constant lore of tee premium amount that he has paid. {ores I the pric Incasanes und ft tx igher thin toe ake pice bie ed Sai be eclace an ll Hecoma Zero when the price is equal to the suike price plts premium, Tharaere the tnecaiors lose It resticted if he i a call option holder but he can make profits to any extent depending upon the rise in the market price on the maturity date. (i) Selling Call Option: Figure 7.3 shows the risk of unlimited losses that are dependent Position of the call option writer. The call option writer has the on the market price of the underlying asset but his gain will be only % 200/- as long as the price of the asset remains at ® 1,000. His price reduces when the price of the asset increases and is above & 1,000/-. He makes the limited profit of & 200/- only when the asset is lese than the strike price plus premium. Any profit or loss of the call option holder is equal to the loss or profit of the call option writer. In a European option the position shown in Figure 7.2 and Figure 7.5 is possible only on the specified date but an American option the call option holder can exercise the option at any time before the specified date whenever, he has the opportunity to do so depending on the markec conditions. ig Pay-off on Call Option to Option Hole Profit a : Net Payoff on Call (Profit or Loss) Market Price of Underlying Assetnae Investment Management # Chapter Seven [ERIE Paver on cattopton to Option Writer Profit Market Price of ql Underlying Asset -200 | “Net Payoff on Call (Profit or Loss) v Loss iii) Buying a Put Option: Figure 7.4 depicts the position of the put option holder. When the market price sls than € 800). if he exercises his option, he will make a profit. f the price rises, then the option holder shou fell in the market and not exercise his option because he would make losses. Therefore, the option wri has a right to sell at the specified price at the strike price. [EERE 21 on Pur option to Option Holder Profit a 800/- % 1,000 c ________ Market Price of the Asset -200 Net Profit or Loss v LossChapter Seven «« Derivatives oe Payoff on Put Option to Option Writer ii Net Profit or Loss Market Price of the Asset 800 Option Pricing - The Black-Scholes Model The theory of pricing the derivatives dates back to 1973 when Black and Scholes published @ pape cing of Options. This theory is based on certain assumptions. Assumptions i) The share underlying the call option provides no dividends or other distributions during the life. (i) There are no transaction costs involved in buying or selling the option. (ii The risk-free rate of interest is assumed to be constant during the life of the option. (iv) The call option can be exercised only on its expiration date. (v) The movement of the share price is taken to be random. The Black-Scholes Option Pricing Model is based on the concept of riskless hedge, i.e., an investor by buying shares of a share can simultaneously enter into call option on the share, where gains on the share will exactly offset ‘osses on the option and vice versa. Ustinction between Futures and Options Ina futures contract, both parties are obligated to perform. In the case of options, only the seller (writer) is obligated to perform. In an options contract, the buyer pays the seller (writer) a premium. In the case of futures, neither party pays 2 premium, Inthe case of futures, the holder of the contract is exposed to the entire spectrum of risk of loss and has the Potential for all the returns. In the case of options, the buyer is able to limit the downside risk to the option premium "tains the upside potential. The parties to a future contract must perform at the settlement date. They are, however, not obligated to before ions n exercise their ri i Coen y he senlerent date, The buyers of an options contract can exercise their right any time prior to that on thei Oe ‘The Black-Scholes Model is given below: V = P{NG,)} - eS(NG,)} where, V = Current value of the option P = Current price of the underlying share Nid), N(d,) = Areas under a standard normal function 'S = Risk-free rate of interest T = Option period In(P/s) + (R+0.507)T | ofT d, - d,-ofT | a = Standard deviation | mr chr | | | d= = Exponential function This model is very complicated but it is of practical use in finance. It appeals to practitioners because Of the parameters of current share price, exercise price, risk-free interest rate and length of time in years to expiration date | which are observable. These factors help to analyse the hedge position at no risk. DALES Warrants are just like call options and are used to purchase equity shares during a specified period and az | specified time. Warrants are usually long-term options. Warrant prices also fluctuate just like share prices. The valu of a warrant depends on the amount which the investors are willing to pay for it. These are detachable ant | attachable and are usually issued with bonds. Warrants are usually issued for a period above five years and my even be perpetual. Those who hold warrants do not receive any dividends but this does not affect the price a warrant, In India, warrants are not issued. Warrants have the privilege of transfer and it is generally used fx | speculation. The value of a warrant isthe value of call to actual market price of equity shares minus option pict | share depending on the number of times which warrant gives the right to purchase | rh financi ransactions take p Ket index futures. Marker on2! futures. In the financial fue et ie forward or futures market. la there are fo reign currencies, interest rates with the share oe rencies, intere: larket,utures markets are standardised contracts ; Chapter Seven +» Derivatives ere javing HOUSES This reduces risk. acts, involve centralise d . the following values determine the pricin f «Expected rte of return from investing ot aes Risk-free rate of interest inthe asset trading. and settlements are made through «Price of the underlying asset inthe cash mark ret, ex Fores In 1982, the share index futures were ° fu introd / pe market index. It's an obligation the setament al ramets contracts are made on he Tat ‘inch the original contract is struck, and on th lement value depends on the value of share index and the price at sng day ofthe contract and original price ofthe ied times, the difference between the index value at the last dere market index. No physical delivery of share mode The bass ofthe share index futures isthe specified standard and Poor's (S&P) c aha 00 times the Sree cntact is the most popular share index futures. Here, the oblinaion 19 delet iid th vias cont feen share index value atthe close of last trading day of the contract and te eden level at 500 an the as Sucka the setlement dat. For example if he contact struck at the 4 ex sare made Is equal to (@ 510 ~% 500) x ® 500 = Bil a the endo the stlement dae, ep the payment that +e ae ee Financial swaps are a funding technique, which permit a borrower to access one market and then exchange te liability for another type of liability. The global financial markets present borrowers and! investors with a wide vary of financing and investment vehicles in terms of currency and type of coupon fixed or floating Floating rates are tied to an index, which could be the London Inter-bank Borrowing Rate (LIBOR), US Treasury Bill Rate, fc Tis helps investors exchange one type of asset for another for a preferred stream of cash flows. swaps by themselves are not a funding instrument; they are a device to obtain the desired form of financing indirectly. The borrower might otherwise have found this too expensive or even inaccessible. Swaps are used to transform the fixed rate loan into a floating rate loan. Swaps are popular because they work on the concept of comparative advantage, The basic principle is that ye advantage when borrowing in fixed rate markets while others have some companies have a comparat 2 comparative advantage in floating rate markets. This may lead to some companies borrowing in fixed markets ‘when the need is of floating rate loan and vice versa. Types of Swaps ___ All swaps involve exchange involves an intermediary that is a large i have identical present values at the outs The two most widely prevalent types a combination of the two to result in cross-currency Possible under each of these major types of swaps. oa series of periodic payments between two partes. A swap transaction usually res tfonal financial institution. The two payment steams are estimated £0 meen discounted at the respective cost of funds in the relevant markets of swaps are interest rate swaps and currency swaps. A third is interest rate swaps. OF course, a number of variations are 1. Interest Rate Swaps An oP involves an exchange of different payment SAT which are fixed and floating in nny interest rate Swap eed to asa exchange of BorownE! AT Coupon swap. In this, one party, B, agrees e. Such an exchange is refer Fr predetermined fied rate on a notional principal for ‘© pay to the other party, A, cash flows exalt to pay Party B cash flows equal to interest. at a floating rate on ‘number of time, party years, At the same time Pi st Pay cencies ofthe two sets of interest cash flows are the Sesame notional principal fr he or re me, 5 yeas. This ype ofa standard fixed to floating rate swap fe. The life of the swap can range from 2 Y! “bank Offer Rate (LIBOR) is often the floating interest rate in is populry ealled a plain vanilla swap. London IMBz Investment Management & Chapter Sever rate offered by banks on deposits from other bay is the interest : a many ofthe interest rate swaps, BOR ish Tr yeen banks and changes continuously asthe gy Cuceareny mares UBOR f determined Yang OSS I he benchmak othe eg for men | Sorts change Js asthe Pre Lending Rte (LR is uel oe SCT | fing ate stent, LBOR she mos equ used reeencs a ine Unuly, wo norinancial companies donot dre arrange a swap, They des) wt a hacia in such as bank who then stucures the plan vanilla swap in such 2 Way & Os In international markets, they eam about 3 basis points (0.0: cS eee | Swap spreads ae determined by suply and demand. mor paripants inthe wan mats Wao is true, fixed rather floating swap, spreads tend to fall. If the revers | iis unconimon to fd stuation where two companies contact inancal institution a Crate ane ig 2 proposal o make opposite positon inte same saps. Most large franca inuons ae CNA in inh iterate swap. This vos enesing into asap with a counterparty, then hedging he terest ate kung opposite counterparty is found. Interest rate future contracts are resorted to as | erect cee i a loan in one curr Giassacy serps ives sachenging pxincpal and fed re Snetest payments an loan i ency for Principal and fixed rate interest payments on an approximately equivalent loan in anot cy. Suppose that the companies A and B are offered the fixed five year rates of interest in US dollars and Stering, ‘Also suppose that sterling rates are generally higher than the dollar rates. Also, Company A enjoys better ‘creditworthiness than Company B as itis offered better rates on both dollar and sterling, What is important to the trader who structures the swap deal is that difference in the rates offered to the companies on both currencies is not the same. Therefore, though Company A has better deal in both the currency markets, Company B does enjoy a comparatively lower disadvantage in one of the markets. This creates an ideal situation for a currency swap. The deal could be structured such that Company B borrows in the market in which it has a lower disadvantage and Company A in which it has a higher advantage. They swap to achieve the desired currency to the benefit of all concemed. ‘The principal amount must be specified at the outset for each of the currencies. The principal amounts are usually exchanged atthe beginning and the end of the life ofthe swap. They are selected in such a way that they are gual at the exchange rate at the beginning ofthe life ofthe swap. Like interest rate swaps, currency swaps are frequently warehoused by financial institutions that carefully monitor their exposure in various currencies ee thet they can hedge their currency risk. Derivatives have been dieveloped itn forthe imooth flow of investments in the market and to attrac foreign capital Its also expected the constant scams inthe investment market will be reduced, The Heche ne Scam and the Ketan Parekh scam have led t ensuring and bringing back discipline inthe financial mestane through ‘new aspects like eliminating the badla system and bringing about derivatives, ia 8 spread PVA neo The derivatives market in India began to be developed after the year 2000. Equi ive with the submission ofthe L.C. Gupta commitiee report, which recommended derivate ee iete peeeaadure investors. Hedging inthe share makes imporant because it saves the investor from Tonge in lity to the against risk from variations in the prices in the share market. Hedging also helps in bringhigabaa liquidity in the capital market, ut efficiency and Derivatives were introduced in the Indian capital market in phases. Inthe fist phase, ‘Share j ide / ‘Share Index Options ‘Index Share Options, and ‘Index Share Futures’ were adopted fo rae INdex Futures, market, SEB! gave permission for Index futures contracts to be based on the S&P, CNX, NIFTY ats eae ons | 2003, Interest Rate Derivatives were introduced by SEBI. These are Exchange Traded Interest R; pa (IRF). These derivatives were to derive their value from a basket of dated Government Secu ‘ate Futures ities. The the buyers and sellers from the adverse effects of interes rate changes. Its an example ofa Fungo Pe, oe a NE Sig day, exch the i next not and Bair aircad outh 2 Cleating Corporation, The Chapter Seven Derivatives ee ange (BSE). The NSE all lle neg allows trading according to a prescribed set of rations ftamed by NSE Futures and Cxens dealing inthe share exchange have to trade under the norms and fatures, Nifty Options, Individual Share is aio, 2001. National Share Exchange allows trading in Nifty fates and Options in more than 50 shares. The wena son, snare Options. individuals have a choice of Share mnarket. Orders are matched according to 's. The trading system at NSE is called NEAT - F&O. It is an order-driven jer by trading through his termin Mi ae time and quantity of the order. An NSE member can make an active ‘der by another member. line monitor and generate a transaction by finding out a matching ‘At the Mumbai Share Exchange, tradi ive is atures and individual Share Open ing is active in BSE Sensex Futures, BSE Sensex Options, Individual Share The value of a derivative contract for indivi dual and the number of shares in one contract. A ria . Coren on bs market value of the share which en a Raec o saree end he nina chisel oresas ec ee Ea shad bg of 300 units Wi sess ieebetanatiieeratt tract should be & 2,00,000. a ni rivatves have ie distinct feature of being European in nature in Index Option and American in Sas one Bath Futures a Options are available for 1, 2 or 3 months and contracts expire on the last Thursday of every calendar month. A March contract would expire on the last Thursday of March and April contrat! would expire on the last ‘Thursday of April. BSE offers trading even for very short periods like 1 or 2 weeks to allow shorter period maturity and liquidity in the market. Settlement of Contracts: Derivatives contracts have the feature of paying margins. SEBI allows the margins in contracts, Daily settlement margin is also possible by payment in cash on T+1 basis. ‘A Futures Contract is settled through Mark-to-market (MTM) method. This is a method of daly setlement prite ofthe contract atthe end of the day but carrying forward tll the final settlement day of last Thursday of each month. xample: An investor purchases a futures contract in Nifty at 2,000. I Nifty closes at % 1,900 at the end of the day, the investor has made a loss of % 100 x 200 = % 20,000. He has to pay this margin money to the share exchange and his contract can be carried forward the next day. The next day supposing NIFTY increases to € 2,050, the investor has a gain of & 2,050 - © 1950) € 100 x 200 = € 20,000. His cotter. would be carried forward the next day at @ 2,050 and this will continue till the last Thursday of the month which is the final settlement day. It is nat necessary to continue till the last day. The investor can square UP Or even take counter-ransaction on any day and close the contract. ic ji i t. His loss is limited to the premium. Th "An Options Contract is settled by paying the option premium uBFont. A Pi Ke fain or pe has to be settled on a daily basis. Margins are not Tequired to be paid by the option writers and the final aan o loss is settled on the last Thursday of the month — aii is, instrument whose value depends on underlying assets. The + Thischapter discusses derivatives. A derivative a financi i js to mit kof th main purpose of derivatives isto minimise the + Futures area financial contract to eliminate the risk of any negative change in price transactions that takes place through Faaee ane sirar yes market. Ina futures contact, both parties o> obligated to perform. Inthe ease of options, only te seller (writen obligated 0 perform. in an options contrac, the buyer pays the seller (writer) a premium. In the case of futures, neither party pays @ premium, + TheBlackeScholes Model is useful for option valuation and pricing. +