Understanding Financial Derivatives: Types, Usage, and Risks

1. Financial Engineering By CA. Pradeep Kumar Gupta (CA., CS., B.com)

2. Financial Market • Capital Market (SEBI) • Money Market (RBI)

3. Capital Market • Primary Market (IPO) • Secondary Market (FPO)

4. Secondary Market • Cash Market • Derivative Market

5. Stock Exchanges of India(under SEBI) • BSE (Bombay Stock Exchange) • NSE (National Stock Exchange)

6. Commodity Exchange of India( under Forward Market Commission) • NCDEX (National Commodity & Derivatives Exchange) (Agriculture Products) • (Index-Dhanya) • MCX (Multi Commodity Exchange) (Metals) • 0nly future trading is permitted in Indian commodity exchanges. • (Index Comdex)

7. What is derivatives • The word derivatives originates from mathematics and refers to a variable, which has been derived from another variable. Derivatives are so called because they have no value of an underlying assets. The underlying assets can be equity, commodity, or any other assets.

8. Types of Derivatives • Forward • Future • Option

9. Forward Contract • Forward contract is a agreement to buy or sell an assets at a certain future time for a certain price.

10. Parties of Forward Contract • Buyer-One of the parties to a forward Contract assumes a Buying Position (Long Position) and agrees to buy the underlying assets on a certain specified future date for a certain specified price.

11. Seller-Other parties to contract i.e.the seller assumes a short position and agrees to sale the assets on the same date for the same price. • Example-on a 01/08/2011 ABC Ltd. enters into a forward contract with PQR.Ltd for buying USD 1 crore at Rs.45 per USD on 30/09/2011.

12. Features of the forward contract • Quantity of the Commodity to be delivered • Quality of the commodity to be delivered • Price which the buyer would pay • Counter parties risk involved • Over the counter agreement

13. Future Contract • Future contract is standardized Forward contract .In future trading there is usually a contract which is essentially an agreement between two parties to buy or sell an underlying assets at a certain time in the future at a certain price.

14. Feature of future contract • A future contract usually has a standardized date and month of delivery quantity and price. • Future trading are traded on exchange. • Three series of future contract are always available and have one-month, two month, and three month expiry cycles.

15. Example-on a 3rd August 2011,Arvind enters into a August 2011 Future contract for buying 1000 shares of Wipro Ltd.

16. Comparison of forward and futures contract

17. Index Future • Index future are the future contract which underlying assets is a market index. For a example future contract on “Senesx” and “Nifty” are called index future.

18. Option • Option is a derivatives instrument that gives the holder a right, without any obligation to perform. • Option are basically contracts which give to the buyer a facility which is similar to buy or sell certain asset (underlying) but the buyer of an option has limited risk & unlimited profit.

19. Types of option(Based on Nature of Activity) • Call Option • Put Option

20. Call Option • A call option gives the buyer the right to buy in the underlying assets at the strike price specified in the option. • The profit /loss that the buyer makes on the option depend upon the spot price of the underlying. If upon expiration the spot price exceeds the strike price he makes a profit.if the spot price of the underlying assets is less than the strike price the premium of that option will become zero & maximum loss in this case is the premium he paid for buying the option.

21. Put Option • A put option gives the buyer the right to sell in the underlying assets at the strike price specified in the option. • The profit /loss that the buyer makes on the option depend upon the spot price of the underlying. If upon expiration the spot price below the strike price he makes a profit. if the spot price of the underlying assets is exceeds than the strike price the premium of that option will become zero & maximum loss in this case is the premium he paid for buying the option.

22. Comparison between Call Option & Put Option

23. Types of the Option(Based on the Exercising the Option) • American Option • European Option

24. American Option • Option under which holder can exercise his right at any time before expiry date.

25. European Option • Option under which holder can exercise his right only on the expiry date.

26. Types of Players/Trader • Hedgers • Speculators • Arbitrageurs

27. Example of hedging using forward contract Payment $100000 Received $100000

28. Speculators • Whereas hedgers want to avoid exposure to adverse moment in the price of an assets, speculators wish to take a position in the market. • Either they are betting that the price of the assets will go up or they are betting that it will go down. • Example:-future and option both

29. Arbitrageurs Arbitrageurs are a careful lot who keep constant vigil on the market, across products and locations to identify temporary imperfection and convert such opportunities into risk less profit. In the pure form of arbitraging, the operator: 1-has no investment; and 2-simultaneously buys and sells in different markets and /or different period which ensure risk less profit to him. (example $ in diff. mkt)

30. Types of Order • Market Order-Buy or sell the rate prevailing in the market at the time of placing the order. • Limit Order-Buy/Sell order at specified time limit irrespective of the rate prevailing in the market at the time of placing order. • Stop loss order-Order where the trader wants to restrict his loss by specifying the limit for closing his deal.

31. Market-if-Touched order: These are similar to stop loss order.This will become market order if certain price is reached. Example:sell when Wipro Future reaches Rs.2500. • Spread order-when customer order to buy future in one delivery month and sell in another delivery month, they are termed as spread order.

32. Scale Order-when customer wishes to make a gradual entry or exit from the market rather than execute the trade at just one price.

33. Strike Price/Exercise Price: It is the price at which the contract is entered into. There can be several strike prices at which one can enter into in contract in the option market. • Spot price: The spot price of the underlying asset in the cash market..

34. Types of Margin • Initial Margin • Mark to Market Margin • Maintenance Margin • Additional Margin • Cross Margin

35. Initial Margin • Whenever a client (both buyer & seller) books future contract he is required to deposit a certain % of contract price(Ex-20%) as margin money which is called initial margin.

36. Variation/Mark to market margin • It is paid to/received from the client daily and is calculated on the basis of daily settlement price.

37. Maintenance Margin • Some exchange in the world work on the system of maintenance margin, which is set at a level slightly less than initial margin. The margin is required to be replenished to the level of initial margin, only if the margin level drops below the margin limit.

38. For example if the initial margin is fixed at 100 and maintenance margin is 80 then the broker is permitted to trade till such time limit that the balance in this initial margin account 80 or more. If it drops below 80 say it drops to 70 then a margin of 30(and not 10) is to be paid to replenish the levels of initial margin.

39. Additional Margin • In case of sudden higher than expected volatility ,additional margin may be called by the exchange. This is generally imposed when the exchange fears that the market have become too volatile and may result in some crises, like payment crisis.

40. Cross Margin • This is a method of calculating margin money account balance and this takes into account combined position in future, Option, Cash market etc. Hence the total margin requirement reduces due to cross hedges. It is also not use in India.

41. Comparison of Stock Market and commodity market