12/6/2007

Brijesh Grover

CCI

Derivatives

What are derivatives?

Derivatives really on a fundamental level are:
merely pieces of paper ; or In modern day view, contracts electronic

To give you a right or an obligation, or a combination of the two to receive or give something in the future.
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Derivatives

Derivative is a product whose value is derived from the value of the underlying asset. Underlying asset can be equity, forex, commodity, or any other asset say an agreement with your neighbour for 2 bags of sugar next week.
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Derivatives
Security Contract (Regulation) Act, 1956 [SC(R)A] defines derivative to include

1. A security derived from a debt instrument, share, loan (secured/unsecured), risk instrument or contract for differences or any other form of security 2. A contract which derives its value from prices, or index of prices, of underlying securities Derivatives thus are securities under the SC(R)A and hence the trading of derivatives is governed by the regulatory framework under SC(R)A
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Uses of Derivatives
1. Hedging
Done by parties who seek to offset their existing risks by entering into a derivatives transaction. Existing risks could be an investment portfolio, price changes in oil for a petroleum mining company or perhaps investments in a foreign country. Speculation is more commonly used by hedge funds or traders who aim to generate profits with only a marginal investment

2. Speculating

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Uses of Derivatives
3. Arbitrage
Arbitragers work at making profits by taking advantage of discrepancy between prices of the same product across different markets. Practitioners working within risk finance or quantitative finance often develop models to price various assets being traded across the markets Upon finding price discrepancies, one can make use of a specific combination of derivatives in order to make a risk less profit.
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Are Derivatives Dangerous?

-"We view them as time bombs both for the parties that deal in

them and the economic system .. In our view ... derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."
- Warren Buffett, the Chairman of Berkshire Hathaway and his critique of the derivatives market. -Are derivatives dangerous? -That's almost like asking if water is dangerous. -Derivatives can be dangerous if used incorrectly - as several large companies and individuals have found out in recent history.
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Are Derivatives Dangerous?

Derivatives contribute to the 'completeness' of the global markets, and without them, loopholes within the financial industry would exist. Even through numerous financial disasters ala Barings, LTCM, Enron and others related to the mismanagement of derivatives It is key to consider that it has not been the use of derivatives as a tool which has led to the downfall of these companies - but rather, the misuse and compromise of such instruments.
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Evolution of Derivatives
Over 2000 years ago, contracts for delivery in the future was commonly used with Greek olive farmers In the 1600s, Tulip derivatives were used by the Dutch and it was more or less only as Louis Bachelier in 1900 formally introduced futures pricing when people began to take derivatives at more than just face value. More systematic derivative products initially emerged as hedging devices against fluctuations in commodity prices. Commodity linked derivatives remained the sole form of such product for almost 3 centuries Emergence of Financial Derivatives in the post-1970 period. These products are extremely popular and account for 2/3 of the total derivatives transactions.
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Growth Driving Factors

Increased volatility in asset prices in Financial Markets Increased integration between International Markets Exponential improvement in communication at exceptionally reduced costs Development of more sophisticated Risk Management tools, providing economic agents a wider choice of Risk Management strategies Innovations in the derivatives markets, which optimally combine the risks and returns over a large number of financial assets leading to higher returns, reduced risk as well as transactions cost as compared to individual financial assets
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Types of Derivatives
Forwards
A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at todays pre-agreed price A future contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures are special types of forward contracts in the sense that futures are standardized exchange-traded contracts.

Futures

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Types of Derivatives
Options Options are of two types:
Calls & Puts
Calls 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 given future date. Puts give the buyer the right but not the obligation to sell a given quantity of the underlying asset, at a given price on or before a given future date.

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Types of Derivatives
Warrants. LEAPS
Longer -dated options are called warrants and are generally traded over-the-counter (OTC) Long-Term Equity Anticipation Securities. These are options having a maturity of up to three years.

Baskets

Swaps

Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average of a basket of assets. Equity index options are a form of basket options.

are private agreements between two parties to exchange cash flows in the future Agreement on formula to be used for exchange of cash-flows is determined in advance
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Types of Derivatives
Swaps
Interest Rate Swaps Currency Swaps

Swaptions are options to buy or sell a swap

that will become operative at the expiry of the options. Swaption is nothing but an option on a forward swap.

Receiver Swaption is an option to receive fixed and pay floating. Payer Swaption is an option to pay fixed and receive floating.

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Economic functions of Derivative market

Derivatives help in discovery of future as well as current prices. The derivatives market helps to transfer risks from those who have them but may not like them in comparison to those who have an appetite for them. Speculative trades shift to a more controlled environment of derivatives market. Act as a catalyst for new entrepreneurial activity.
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OTC Derivatives
Characteristics of OTC Derivatives market:
The management of counter-party (credit) risk is located within individual institutions. No formal limit on individual positions, leverage, or margining. No formal rules of risk and burden sharing No formal rules for ensuring market stability and integrity Lack of regulator, although they are affected indirectly by national legal systems, banking supervision and market surveillance.
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Exchange Traded Derivatives Market

Individuals trade standardized contracts that have been defined by the exchange. (First Futures contract were traded in 1865 in CBOT) (www.cbot) NSEs derivatives market
Commencement of derivative trading with S & P CNX Nifty Index futures on 12/06/2000. Trading in index options commenced on 04/06/2001. Single Stock trading in options started on 02/07/2001 Single Stock trading in futures started on 09/11/2001.

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Derivatives Market-NSE
Three Contracts are available for trading with 1,2,3 month expiry. A new contract is introduced on the next trading day following the expiry of the near month contract. Participants and Functions
Self Clearing Member (SCM) Trading Member Clearing Member (TM-CM) Professional clearing Member (PCM)

Trading Mechanism Turnover

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