Different Asset Classes

Equity Debt Gold & other commodities Real Estate Foreign Exchange & Currency Derivatives

Risk
What

do you mean by Risk ?

risk is defined as the unexpected variability of returns & thus includes both potential worse-thanexpected as well as better-thanexpected returns

Financial

How

do you reduce risk ?

Derivatives

Derivative is a product whose value is derived from the value of the underlying asset. Underlying asset can be equity, commodity, or any other asset. forex,

History of Derivatives
Chicago Board of Trade (1848) is the first recognised Futures Exchange Next 100 years Futures Exchanges were dominated by trading in futures of Agricultural commodities 1970 saw the introduction of futures on Financial instruments (equity, bonds & currency)

Current Status

According to various distinguished sources the amount of outstanding derivatives worldwide as of Dec 2007 crossed USD 1,144 Trillion. credit derivatives: USD 548 trillion;

Listed Over-The-Counter

(OTC) derivatives: face value at USD 596 trillion and included:

Interest Rate Derivatives at about USD 393+ trillion (66%); Credit Default Swaps at about USD 58+ trillion (10%); Foreign Exchange Derivatives at about USD 56+ trillion (9%); Commodity Derivatives at about USD 9 trillion (1.5%);

What would be the relative positioning of USD 1,144 trillion for outstanding derivatives, i.e., what is their scale ???
The entire GDP of the US is about USD 14 trillion. The entire US money supply is also about USD 15 trillion. The GDP of the entire world is USD 50 trillion. USD 1,144 trillion is 22 times the GDP of the whole world. The real estate of the entire world is valued at about USD 75 trillion. The world stock and bond markets are valued at about USD 100 trillion. The population of the whole planet is about 6 billion people. So the derivatives market alone represents about USD 190,000 per person on the planet.

Features:

Purpose:

Defined & limited life Bilateral Agreement

Price Discovery Risk Management / Hedging Making Markets more efficient Lowering Transaction costs

De rivative s are o fte n c ritic ise d as be ing Dange ro us fo r unkno wle dge able inve sto rs & have be e n inappro priate ly linke dto Gambling

Top on the charts

Company
Socit Gnrale Amaranth Adv isors Long Term Capital Management Sumitomo Corporation Orange County Aracruz BAWAG Metallgesellschaft CITIC Pacific Barings Bank

Amount Lost
USD 7.1bn USD 6.7bn USD 5.85bn USD 3.44bn USD 2.38bn USD 2.1bn USD 1.97bn USD 1.96bn USD 1.9bn USD 1.8bn

Source of Loss
European Index Futures Gas Futures Interest Rate and Equity Deriv es ativ Copper Futures Interest Rate Deriv es ativ FX Options Foreign Exchange Trading Oil Futures Foreign Exchange Trading Nikkei Futures

20 20 19 19 19 20 20 19 20 19

TYPESOFDERIVATIVES

Classification of Derivatives

Other examples of underlying exchangeable

Property derivatives Energy derivatives that pay off according to a wide variety of indexed energy prices.

Oil Gas power

Commodities Freight derivatives Inflation derivatives Insurance derivatives Weather derivatives Credit derivatives Economic derivatives

FORWARDCONTRACT
qForwardContractAfo rwardc o ntrac tisasimple de rivative
thatinvolvesanagreementtobuy/sellanassetonacertaindateatan agreedprice.Thisisacontractbetweentwoparties. q

q
Money Security

Buyer

Seller

FEATURES
Delivery&SettlementofaForwardContract DefaultRisk TerminationofaForwardContract

Types of Forward Contract

EQUI TY FORWARDS:

Forward Contracts on Individual Stock Forward Contracts on Stock Portfolios Forward Contracts on Stock Indices

BOND & INTEREST RATE FORWARD CONTRACTS:

Forward Contracts on Individual Bonds & Bond Portfolio Forward Contracts on Interest Rates: Forwards Rate Agreements

Currency Forward Contracts Commodity Forwards

Pricing a Forward Contract

We use the principle of No-arbitrage for pricing a Forward contract. The principle assumes the following Transaction cost is Zero There are no restrictions on short sales or on use of short sales proceeds Borrowing & Lending for unlimited amount at risk free rate

Forward price = price that would not permit risk less arbitrage in frictionless market

Price of a Forward Contract

FP = S0 x (1+Rf)T
FP = Forward price of an asset S0 = Spot price Rf = Risk free rate T = Forward Contract term in years

S0 = FP / (1+Rf)T

Valuation of a Forward Contract

Value of the Long Forward Contract at Zero day

V0 = S0 FP / (1+Rf)T

Value of the Long Forward Contract at any day t

-t) Vt = St FP / (1+Rf)(T

Value of the Long Forward Contract at Expiry

Vt = St FP

Valuation of a Forward Contract

Value of the short Forward Contract at Zero day

V0 = FP / (1+Rf)T S0

Value of the short Forward Contract at any day t

-t) Vt = FP / (1+Rf)(T St

Value of the short Forward Contract at Expiry

Vt = FP St

Equity Forward Contract

FP

(on an equity security)

= (S0 PVD) x (1+Rf)T = [S0 x (1+Rf)T] FVD

FP

(on an equity security)

PVD = Present Value of Expected Dividends FVD = Future Value of Expected Dividends

Value of Equity Forward Contract

For

a long contract
(T -

Vt = [St PVDt] [FP / (1+Rf) t) ]

For

a short contract

-t) Vt = [FP / (1+Rf) (T ] [St PVDt]

Forward contracts on Fixed Income Securities & Rates

Forward price on a coupon paying bond is similar to dividend paying stock

FP(fixed income security) = (S0 PVC) x (1+Rf)T

a long contract
(T -t)

For

Vt = [St PVCt] [FP / (1+Rf)

PVC = Present Value of Expected Coupon payments

Forward Rate Agreements (FRA)

Forward price in a FRA is actually a forward interest rate T day o 3m

FRA 1x4
T day o FRA initiatio n 1m FRA Expiratio n &Lo an Initiatio n

4m Lo an Maturity

Currency Forwards
Consider Thus, However, Hence,

a importer who has to make a USD payment 12 months from now he would have to buy USD exactly 12 months from now he is not sure what the USD/INR rate would be??? he can enter into a Forward contract to buy USD 12 months from now at a pre-determined rate

Calculated as follows: Combination of spot exchange rate and interest rates over a period of time in the future

USD/INR:42.50,USIntrates:2.00%,IndianInterestrates:7.50% BankbuysUSDat BorrowsINR 42.50 42,500,000 PlacesDeposit@ 2.00% GetsUSD1,020,000 Borrowsat7.50%

PaysINR45,687,500

Forwardrate:45,687,500/1,020,000=44.79 Forwardpremium:2.29

FP (1+RFC )T]

(currency forward contract )

= S0 x[(1+RDC )T/

F and S are quoted in domestic currency per unit of foreign currency RDC = Domestic currency interest rate RFC = Foreign currency interest rate

Futures
Similarity to Forwards: Deliverable contracts obligate the long to buy & short to sell a certain quantity of an asset for a certain price on specified future date Cash settlements are settled in cash on expiration date Both futures & forwards are priced to have zero value at the time of initiation

Futures Vs Forwards
CRITERION Buyer-Seller Interaction Contract Terms FUTURES Via Exchange Standardised FORWARDS Direct Tailor made Not Possible Individual Parties Collaterals

Unilateral ReversalsPossible Default risk borne Exchange by Default Controlled Margin Accounts by

Payoff profile of futures contracts

Pro fit Lo ss

PRICING INDEX FUTURES DIVIDEND AMOUNT

GIVEN

EXPECTED

Niftyfuture strade o nNSEaso ne ,two andthre e mo nthc o ntracts. Mo ne ycanbe bo rro we datarate o f10% pe rannum.Whatwillbe the pric e o fane wtwo mo nthfuture sc o ntrac to nNifty? 1.Le tusassume thatABCLtd.willbe de c laringadivide ndo fRs.20pe r share afte r15dayso fpurc hasingthe c o ntrac t. 2.Curre ntvalue o fNiftyis4000andNiftytrade swithamultiplie ro f 100. 3.Sinc e Niftyistrade dinmultiple so f100,value o fthe co ntractis 100*4000= Rs.400,000. 4.IfABCLtd.Hasawe ighto f7% inNifty,itsvalue inNiftyisRs.28,000 i.e .(400,000*0.07). 5.Ifthe marke tpric e o fABCLtd.IsRs.140,the natrade dunito fNifty invo lve s200share so fABCLtd.i.e .(28,000/140).

6.T c alc ulate the future spric e ,we ne e dto re duc e the co sto fcarryto o the exte nt o f divide nd re c e ive d. The amo unt o f divide nd re ce ive d is Rs.4000 i.e . (200*20). The divide nd is re c e ive d 15 days late r and he nc e co mpo unde do nlyfo rthe re mainde ro f45days.T calculate the o future spric e we ne e dto c o mpute the amo unto fdivide ndre c e ive dpe r unito fNifty.He nc e we divide the c o mpo unde ddivide ndfigure by100. 7.Thus,future spric e

Future Margins & MTM

Initial Margin Requirement Maintenance Margin Variation Margin

InitialFuturesprices:Rs.100;InitialMargin:Rs.5; MaintenanceMarginRequirement:Rs.3;NoofContracts:10
Day Beginning Balance (Margin) Funds Deposited Settlement Price Futures Price Gain / Loss Ending Change Balance (Margin)

Calculation of Margin for a Long position

0 1 2 3 4 5 6

0 50 42 10 100 125 120

50 0 0 40 0 0 0

100.00 99.20 96.00 101.00 103.50 103.00 104.00 -0.80 -3.20 5.00 2.50 -0.50 1.00 -8.00 -32.00 50.00 25.00 -5.00 10.00

50.00 42.00 10.00 100.00 125.00 120.00 130.00

Monetary & Non Monetary benefits & costs of holding the Underlying

Recall: FP = S0 x (1+Rf)T Any positive costs associated with holding the asset in a cash & carry arbitrage will increase the no arbitrage Futures price A monetary benefit from holding the asset will decrease the no arbitrage Futures price

FP = S0 x (1+Rf)T + FV (NC)

Net Cost (NC) = Storage cost convenience yield

FP = S0 x (1+Rf)T - FV (NB)
Net benefits (NB) = Convenience Yield storage cost

BACKWARDATION: the futures price For this to occur, benefit to holding or non-monetary.

refers to a situation where is below the spot price. there must be significant the asset, either monetary

CONTANGO: refers to a situation where the futures price is above the spot price

Consider an asset priced at Rs.50. Risk free interest rate is 8% & the futures contract expires in 45 days.

a. Find the appropriate futures price if the underlying

asset has no storage cost, cash flows or convenience yield b. Find the appropriate futures prices if the future value of storage cost on the underlying at the futures expiration equals Rs.2.25 c. Find the appropriate futures price if the future value of positive cash flow on the underlying asset equals Rs.0.75 d. Find the appropriate futures price if the future value of the net overall cost of carry on the underlying asset equals Rs.3.55 e. Using Part D above, illustrate how an arbitrage transaction could be executed if the futures contract is trading at Rs.60

Options
Call Options A call option gives the holder (buyer/ one who is long call), the right to buy specified quantity of the underlying asset at the strike price on or before expiration date.

The

seller (one who is short call) however, has the obligation to sell the underlying asset if the buyer of the call option decides to exercise his option to buy.

 An

investor buys One European call option on Infosys at the strike price of Rs. 2500 at a premium of Rs. 100. If the market price of Infosys on the day of expiry is more than Rs. 2500, the option will be exercised. investor will earn profits once the share price crosses Rs. 2600 (Strike Price + Premium i.e. 2500+100). stock price is Rs. 2800, the option will be exercised and the investor will buy 1 share of Infosys from the seller of the option at Rs 2500 and sell it in the market at Rs 2800 making a profit of Rs. 200 {(Spot price Strike price) - Premium}

The

Suppose

Put Options A Put option gives the holder (buyer/ one who is long Put), the right to sell specified quantity of the underlying asset at the strike price at expiry date.

The

seller of the put option (one who is short Put) however, has the obligation to buy the underlying asset at the strike price if the buyer decides to exercise his option to sell.

 An

investor buys one European Put option on Reliance at the strike price of Rs. 2300/- , at a premium of Rs. 125/-. If the market price of Reliance, on the day of expiry is less than Rs. 2300, the option can be exercised as it is 'in the money'. investor's Break-even point is Rs. 2175/ (Strike Price - premium paid) i.e., investor will earn profits if the market falls below 2175. stock price is Rs. 2160, the buyer of the Put option immediately buys Reliance share in the market @ Rs. 2160/- & exercises his option selling the Reliance share at Rs 2300 to the option writer thus making a net profit of Rs. 15 {(Strike price - Spot Price) Premium paid}

The

Suppose

Position of Call option buyer

Traders

price. Traders obligations- Nil. Premium paid or received - Paid. Margin requirements - No. Risk profile - Limited, to the extent of the premium paid. Profit potential - Unlimited, if prices go up. Breakeven point - Strike price + Premium.

rights- Buy underlying at strike

Position of Call option seller

Traders

rights- Nil. Traders obligations- Sell underlying at strike price. Premium paid or received - Received. Margin requirements - Yes. Risk profile - Unlimited, if prices go up. Profit potential - Limited , to the extent of the premium received. Breakeven point - Strike price + Premium.

Payoff profile of Call options

Position of Put option buyer

Traders

price. Traders obligations- Nil. Premium paid or received - Paid. Margin requirements - No. Risk profile - Limited, to the extent of the premium paid. Profit potential - Unlimited*, if prices go down (BEP = Strike price - Premium). Practically, Put option buyers profit is limited as the price of the asset can not go below zero (Max. profit = Strike price Premium paid)

rights- Sell underlying at strike

Position of Put option seller

Traders rights- Nil. Traders obligations- Buy underlying at strike price. Premium paid or received - Received. Margin requirements - Yes. Risk profile - Unlimited*, if prices go down. Profit potential - Limited, to the extent of the premium received (BEP = Strike price Premium) Practically, Put option sellers risk is limited as the price of the asset can not go below zero (Maximum loss = Strike price Premium received)

Payoff profile of Put options