The document discusses derivatives and how they are used to manage financial risk. It defines derivatives as securities derived from underlying assets like debt, shares, loans, or indices. There are different types of derivatives like forwards, futures, and options. Derivatives allow risk to be transferred from those who don't want it to those who do. They also lead prices to reflect market participants' perceptions of future prices and increase savings and investment over the long run.
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The document discusses derivatives and how they are used to manage financial risk. It defines derivatives as securities derived from underlying assets like debt, shares, loans, or indices. There are different types of derivatives like forwards, futures, and options. Derivatives allow risk to be transferred from those who don't want it to those who do. They also lead prices to reflect market participants' perceptions of future prices and increase savings and investment over the long run.
The document discusses derivatives and how they are used to manage financial risk. It defines derivatives as securities derived from underlying assets like debt, shares, loans, or indices. There are different types of derivatives like forwards, futures, and options. Derivatives allow risk to be transferred from those who don't want it to those who do. They also lead prices to reflect market participants' perceptions of future prices and increase savings and investment over the long run.
Copyright:
Attribution Non-Commercial (BY-NC)
Available Formats
Download as PPT, PDF, TXT or read online from Scribd
The document discusses derivatives and how they are used to manage financial risk. It defines derivatives as securities derived from underlying assets like debt, shares, loans, or indices. There are different types of derivatives like forwards, futures, and options. Derivatives allow risk to be transferred from those who don't want it to those who do. They also lead prices to reflect market participants' perceptions of future prices and increase savings and investment over the long run.
Copyright:
Attribution Non-Commercial (BY-NC)
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Derivatives : Managing
Financial Risk Definition • A security derived from a debt instrument, share, secured/unsecured loan, risk instrument or any other form of security.
• A contract that derives its value from the
prices/index of prices of underlying securities. Variants • Forwards
• Futures
• Options Participants • Hedgers : Face risk with the price associated with an asset.
• Speculators : Wish to bet on future
movements in the price of an asset.
• Arbitrageurs : To take advantage of a
discrepancy between prices in two different markets. Economic Functions of Derivatives • Prices in an organised derivative market reflect the perception of the market participants about the future and lead the prices to a perceived future level. • Helps to transfer risk from those who have them and may not like them to those who have an appetite for them. • Are linked to the underlying cash markets. • Speculative trades shift to a more controlled environment of derivatives market. • It acts as a catalyst for new entrepreneurial activity. • Help increase savings and investment in the long run. Transfer of risk enables market participants to expand their volume of activity. Forward Contract • A agreement to buy or sell an asset on a specified date of a specified price.
• Normally traded outside stock exchanges.
• They are popular in the Over the Counter
(OTC) market. • They are bilateral contract and hence open to counterparty risk. • Each contract is customer designed and hence unique. • The asset is price is not generally available in public domain. • On expiry date the contract has to be settled by delivery of the asset. • If a party wishes to reverse, it has to go compulsorily to the same counterparty. Limitations of FCs • Lack of centralisation of trading.
• Counterparty risk (default of any one party
to the transaction) Futures/Future Contracts • Designed to solve problems that exist in the Forward Markets: • An agreement between two parties to buy or sell an asset at a certain time in the future, at a certain price. • But, unlike forward contracts, future contracts are standardised and stock-exchange traded. • A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. Distinction between Future and Forwards Futures Forwards 1. Traded on an 1. Over the counter in organised stock nature. exchange. 2. Standardised 2. Customised contract contract terms, terms, hence, less hence more liquid. liquid. 3. Requires margin 3. No margin payment. payments. 4. Settlement happens 4. Follows daily in the end of the settlement. period. Options/Options Contracts • Options are fundamentally different from forward ad future contracts. • It gives the holder the right to do something. • The holder need not necessarily exercise this right. • In F & F contracts the two parties have committed themselves to do something. • It costs nothing (except margin payments) to enter into a F & F contract; the purchase of an Option requires an upfront payment. Difference between Futures and Options Futures Options
1. Exchange traded 1. Same as futures
with novation 2. Exchange defines 2. Same as futures the product 3. Strike price is fixed, 3. Price is zero, strike price moves. price moves 4. Price is always 4. Price is zero positive. 5. Linear payoff 5. Non linear payoff 6. Both long and short 6. Only short at risk at risk Pay off for Buyer of Futures: Long Futures • The pay offs for a person who buys a futures contract is similar to the pay off for a person who holds an asset. He has potentially unlimited upside as well as downside. Take the case of a speculator who buys a two month Nifty index futures contract when the Nifty stands ant 1220. The underlying asset in this case is the Nifty portfolio. When the index moves up, the long futures position starts making profits and when index moves down it starts making losses. Pay off for Seller of Futures: Short Futures • The pay off for a person who sells a futures contract is similar to the pa off for a person who shorts an asset. He has potentially unlimited upside as well as downside. Take the case of a speculator who sells a two month Nifty index futures contract when the Nifty stands at 1220. The underlying asset in this case is the Nifty portfolio. When the index moves down, the short future position starts making profits and when the index moves up, it starts making losses. Illustration 1 • On January 15, X bought a January Nifty futures contract that cost him Rs.5,38,000. For this he had to pay an initial margin of Rs.43,040 to his broker. Each Nifty futures contract is for the delivery of 200 Nifties. On January 25, the index closed at 2,720. How much profit/loss did he make? Solution 1 • X bought one futures contract costing Rs.5,38,000. At a market lot of 200, this means he paid Rs.2,690 per Nifty future. On the futures expiration day, the futures price converges to the spot price. If the index closed at 2,720 this must be the futures close price as well. Hence, he would have made profit (Rs.2,720 – Rs.2,690)X200 = Rs.6,000.
