DERIVATIVES AND RISK

MANAGEMENT
Submitted By,
Ambar R. Kumar Nagpal- 32
Abhinav Nair- 33
Nitin V. Shukla- 47
Samarth R. Singh- 49
Flow Of Presentation
Derivatives?
Forwards
Futures
Options
Swap
Derivatives: Risk Management Tool
Risk Management by Exchange
New developments
What are Derivatives?


A Derivative is a contract whose value is

derived from the value of its underlying.


Underlying product can be a commodity,

currency, equity, interest rate, foreign
exchange rate, electricity, etc.


Derivatives are risk management tools.


 Classification of Risks

 A business firm is exposed to wide array of risks, which

are classified in to the following types
1.Technological risks
2.Economic risks
3.Financial risks
4.Performance risks
5.Legal risks
 Why Total Risk Matters?

 Unsystematic Risk is unique risk and is diversifiable,

whereas Systematic risk is market risk and not
diversifiable

 Unsystematic risk are not priced in the financial market
and has no bearing on the required rate of return

 Systematic risk is priced, and hence has an influence on
the required rate of return
FORWARDS
Ø It is an agreement to buy or sell an asset at
a certain future time for a certain price.


Ø It can be contrasted from a spot contract

which is an agreement to buy or sell an
asset today.


Ø Traded in OTC

Ø Long Position- Agree to buy


Ø Short Position- Agree to sell

EXAMPLE OF FORWARD
Spot & Forward quotes for the
USD/GBP(Sterling) exchange rate

Bid Offer
Spot 2.0558 2.0562
1-month forward 2.0547 2.0552
3-month forward 2.0526 2.0531
6-month forward 2.0483 2.0489
 PAYOFFS FROM FORWARD
CONTRACT
Ø The payoff from the contract is the trader’s
total gain or loss from the contract.
Ø The payoff from a long position in a forward
contract on one unit of an asset is
 ST – K
Ø The payoff from a short position in a forward
contract on one unit of an asset is
 K – ST

Ø In the last example, if K=2.0489 & if a corporation
has a long contract.
 When ST =2.1000, the payoff is $0.0511 per £1
 When ST = 1.9000, the payoff is $-0.1489 per
£1


Bid Offer
Spot 2.0558 2.0562
1-month forward 2.0547 2.0552
3-month forward 2.0526 2.0531
6-month forward 2.0483 2.0489
PAYOFF FROM LONG
POSITION
Payoff

0
K ST
PAYOFF FROM SHORT
POSITION
Payoff

0
K ST
FUTURE CONTRACTS
Ø It is an agreement between two parties to
buy or sell an asset at a certain time in the
future for a certain price


Ø Unlike forward contracts, future contracts

are traded on an exchange

 EXAMPLE OF FUTURES
CONTRACT
 When the market is bullish


 Take a long position

– When Reliance Futures is at Rs. 480
– Market rises and Reliance Futures goes to Rs. 500
– Sell Reliance Futures
– Profit is = Rs 20/-

 When the market is bearish
 Take a short position
– When Reliance Future is at 480
 Sell Reliance Futures
– Market falls and Reliance Futures goes to 460/-
 Buy Reliance Futures
– Profit = Rs.20/-
FUTURE PRODUCTS IN INDIA
Ø Equity Index Futures
Ø Single Stock Futures
Ø Interest Rate Futures
Ø Commodity Futures
Ø Currency Futures
DIFFERENCE BETWEEN FORWARDS &
FUTURES
Parameters Forwards Futures

Contract Customized Contract as Standardized as per the

Specificatio per the needs of the specifications laid down by
ns parties involves the exchange
Counter There is a risk of The clearing corporation is
Party Risk counterparty default the counterparty. No
Liquidity Less Liquid counterparty
Highly Liquid risk
due to the
participation of multiple
Delivery Usually one specified parties of delivery date
Range
date delivery date
Transparen Opaque instruments as Highly transparent. Price
cy contract specifications information is
are not reported in the disseminated almost
Settlement Settlement
media takes place Settlement takes place
instantaneously.
on the date of maturity of daily due to mark to
the contract market provisions
 Option Contracts


 Options are deferred delivery contracts that

give the buyers the right, but not the obligation, to
buy or sell a specified underlying at a set price on
or before a specified date.

TYPES OF OPTIONS
 Option Terminology
Call Option
Option to buy
Put Option
Option to sell
Option Buyer
has the right but not the obligation
Option Writer/Seller
has the obligation but not the right

 Option Terminology
Option Premium
Price paid by the buyer to acquire the right
Strike Price OR Exercise Price
Price at which the underlying may be purchased or
sold
Expiration Date
Last date for exercising the option
Exercise Date
Date on which the option is actually exercised

 Types of Options
American Option
can be exercised any time on or before the
expiration date
European Option
can be exercised only on the expiration date



 In the Money Option : Positive cashflow to holder
 At the Money Option : Zero Cashflow to holder
 Out of the Money Option: Negative Cash flow to holder
Option Premium:


 Intrinsic Value :
Call : Max [0,Spot Price- Strike Price]
Put : Max [o, Strike Price- Spot Pice]
 Time Value of an option

 Settlement Type

 Derivatives Contracts are settled in cash
 - final settlement results in flow
 of cash from one party to another.
 Example of a Call Option
Bought a Reliance March 500 Call option by
paying a premium of Rs 10/-.

Spot Price (Rs.) Profit / Loss (Rs.)

490 -10
500 -10
510 0
520 10
530 20
 Example of a Put Option

Bought a Reliance March 500 Put option by

paying a premium of Rs 10/-
Spot Price (Rs.) Profit / Loss (Rs.)
470 20
480 10
490 0
500 -10
510 -10
 Strike Price Intervals for
Options

Sr. No. Price of the Strike Price
 Underlying (Rs.) Interval
(Rs.)
1. Less than or equal to Rs. 50 Rs. 2
2. > Rs. 50 to < Rs. 250 Rs. 5
3. > Rs. 250 to < Rs. 500 Rs. 10
4. > Rs. 500 to < Rs. 1000 Rs. 20
5. > Rs. 1000 to < Rs. 2500 Rs. 30
6. > Rs. 2500 Rs. 50
CALL OPTION (BUY)

TYPE STRIKE PREMIUM BREAKEVEN

BUY CALL 110 -20 130 (110 + 20)
PUT OPTION (BUY)

TYPE STRIKE PREMIUM BREAKEVEN

BUY PUT 110 -20 90 (110 - 20)
CALL OPTION (SELL)

TYPE STRIKE PREMIUM BREAKEVEN

SELL CALL 110 20 130 (110 + 20)
PUT OPTION (SELL)

TYPE STRIKE PREMIUM BREAKEVEN

SELL PUT 110 20 90 (110 - 20)
SWAPS
 Swaps
Meaning:


An Agreement between two parties to



exchange one set of cash flows for another


Major two types of Swaps
Interest Rate Swaps
Currency Swaps

 Features – Interest Rate Swaps
Effectively translates a floating rate borrowing into a
fixed rate borrowing and vice versa

No exchange of principal repayment obligation


Translate an asset


Life – 2 years to 15 years






Plain Vanilla Interest Rate Swap
 Meaning:


 Company agrees to pay cash flows equal

to interest at a predetermined fixed rate
on a notional principal for a number of
years. In return, if receives interest at a
floating rate on the same notional
principal for the same period of time

Example
Consider a hypothetical 3 year swap initiated
on March 1, 2004, between Microsoft and
Intel. We suppose Microsoft agrees to pay to
Intel an interest rate 5% per annum on a
notional principal of $100 million, and in
return Intel agrees to pay Microsoft the 6
month LIBOR rate on the same notional
principal.
Date Libor Floating Fixed Cash Net Cash
Cash Flow Flow (in Flow ( in
Mar 1, 4.2 (in million) million) million)
2004
Sept 1, 4.8 +2.10 -2.5 -0.4
2004
Mar 1, 5.3 +2.40 -2.5 -0.1
2005
Sept 5.5 +2.65 -2.5 +0.15
1,2005
Mar 1,20065.6 +2.75 -2.5 +0.25
Sept 5.9 +2.8 -2.5 +0.30
1,2006
Mar 1,20076.4 +2.95 -2.5 +0.45
 Transaction

5 %
5.2%
Intel Microsoft
LIBOR + 0.8%
LIBOR
 Payoffs

Microsoft
 Intel


 Pays LIBOR + 0.8% to  Pays 5.2% to its outside

outside lenders lenders
 Receives LIBOR under  Pays LIBOR under the
the terms of Swaps terms of Swaps
 Pays 5% under the  Receives 5% under the
terms of Swaps terms of Swaps
 Effectively net cash  Effectively net cash
outflow of 5.8% outflow of LIBOR
+0.2%
 Uses
Speculation
Reducing funding costs
Hedging interest rate exposure
Risk management

 Role of Intermediary

5.2 % 4.985% 5.015 % Libor +

Company A Company B 0.8%
Financial Institution

Libor Libor
 Currency Swaps
Meaning:


A currency swap is a contract which commits two



counter parties to an exchange, over an agreed

period, two streams of payments in different
currencies, each calculated using a different interest
rate, and an exchange, at the end of the period, of
the corresponding principal amounts, at an exchange
rate agreed at the start of the contract.
 Features – Currency Swaps
An exchange of cash flows in two
different currencies

Exchange of principal amount at the
beginning or at the end of the contract

Calculated using different interest rates

The agreed exchange rate need not be
related to the market
 Example

USD AUD

General Motors 5.0% 12.6%

Qantas Airways 7.0% 13.0%

 Transaction
o
o


 USD 5.0% USD 6.3%

AUD 13 %


USD 5% General Qantas

Motors  Financial InstitutionAUD
AUD 11.9% 13 % Airways


USD AUD
General Motors 5.0% 12.6%
Qantas Airways 7.0% 13.0%
 Payoffs

General Motors  Qantas Airways

 Pays 5% in USD to the  Pays 13% AUD to the
outside lender outside lender


 Pays 11.9% AUD under  Pays 6.3% USD under the
swap agreement swap agreement


 Receives 5% USD under
 Receives 13% AUD under
swap agreement
 the swap agreement
 Effectively net cash outflow 
of AUD 11.9% (12.6%)  Effectively net cash outflow
of USD 6.3% (7%)
 Uses
Switching loan from one currency to another
currency

Tap Foreign Capital Markets for Low Cost
Financing

Lower Financing Costs for Foreign Subsidiaries


Comparison of Interest Rate Swaps and Currency
Swaps

 Interest Rate Swaps  Currency Swaps

An exchange of An exchange of
payment in single payment in two
currency currencies


No exchange of
An exchange of
principal amount
since it is notional principal amount
 
Derivatives: Risk
Management Tool
Market Participants in
Derivatives

Hedgers
Speculators
Arbitrageurs
Hedgers: Forward
Contracts
 Hedgers using forward contracts to safeguard
from currency risk
Example:

Import Co. has to pay 10 million on 3rd Sept,

2010 i.e. after 3 months
 Payment to British supplier


Type of payment Bid Offer

Spot 1.6281 1.6285

1-month forward 1.6248 1.6253

3- month forward 1.6187 1.6192

 Hedgers: Options
1000 Microsoft shares: May
Current Price $28/ share
Expectation of fall in the next 2 months
Buy 10 July put options, Strike Price: $27.50
Cost of Buying: $1000, considering each
contract is $1
Guarantee that stock will be bought at $27.50
Net Returns, if
 Share price goes down
 Exercising the option
 $26500
 Speculators: Options
Money in hand: $2000
Speculation: Amazon.com going , Current
Price: $20
2-month Call option, Strike Price: $22.50

$2000

O p tio n 2
B u y 2 0 ca llo p tio n co n tra cts fo r $ 2 0 0 0 , a ssu m in
O p tio n 1
B u y 1 0 0 sh areN oswfo, rp ri
$ ce
2 0 0g0o e s u p b y $ 2 7
S u p p o se th eProp rifi
cet: g2o0e0s0 *u$p4to
.5 =
$ 2$79 0 0 0
Pro fit: 1 0 0 * $N7 =
e t$Pro
7 0 fi
0 t= $ 7 0 0 0
 Risk Management:
Exchange Regulations
Levels of Risk
Management

Liquid Net worth of a member

Security Deposit (Collateral)


Margining


Position Limits

 Liquid Networth of a Member
of the Derivatives Segment

Clearing Member - Rs. 300 lacs

Trading Member - Rs. 25 lacs
Limited Trading Member Rs. 25 lacs
Minimum Security Deposit
By a Clearing Member
 - Rs. 50 lacs
 - To be deposited with the Exchange.


By a Trading Member / Limited Trading

Member - Rs. 7.5 lacs
 - To be deposited with the Clearing
 Member
Margins
 Initial Margin

 Mark to Market Margin

 Exposure Margin (Capital Adequacy)


 Initial Margin
It is to be collected upfront
Calculated on a portfolio basis
At client level
On trade executed basis
Based on VAR
Calculated using SPAN (Standard Portfolio
Analysis of Risk)


Mark to Market Margin
Charged for Futures Contract i.e. - Index Futures

and Stock Futures

No M-T-M in case of Options

Collected in Cash on T + 1 basis

New Developments in the
Derivatives Segment
Introduction of Weekly Options in Stocks
and Index.
Introduction of F & O on BSE-Teck Index
Introduction of additional stocks for F &
O trading.
Marketing of Derivatives to FIIs
Currency Options: Permission granted by
SEBI



THANK YOU