AJ INSTITUTE OF MANAGEMENT,

MANGALORE

AUGUST 30, 2011

Financial Derivatives-Theory and Concepts-B.V.Raghunandan, SVS College, Bantwal

Financial Derivatives: Meaning

” a financial asset that derives its value from an underlying security”-used extensively for risk management attributed to holding and trading in securities

Instruments of Financial Derivatives

Stock Derivative

Index Derivative

Interest Derivative

Foreign Currency Derivative

Types of Dealings in a Stock Exchange

Dealings in Cash Market

Dealings in Futures & Options Market

Cash Market Rolling Settlement

T+2 Settlement

Trading Day

Pay-In Day

Pay-Out Day

Futures & Options Market

Meant for Risk Management Arising Out of Dealings in Cash Market

Exchange Traded

Big Investors and Institutions Take Positions

For Protecting the Value of Holding

Providing for the Risks Arising Out of Trading

Futures: Characteristics

Standardised Features

Counter-Party is the Clearing House

Margin Requirement

Time Spread

Three Contracts for Settlement

Futures: Trading Mechanism

Trading Strategies

Uses:

-Hedging

-Speculation

-Arbitrage

Types of Futures: Stock Future and Index Future

Hedging A transaction in the cash market

is accompanied by a contra transaction in the futures market

Buyer in cash market protects against subsequent fall in the price through sale in the futures market

A seller in the cash market protects against subsequent increase through buying in the futures market

Objective is to maintain asset purchased at the latest value

Buyer in the Cash Market

Buys 1000 shares of L&T in cash market @ Rs.1,500

He can protect against fall in price upto three months

If he chooses protection for one month, he sells 1000 shares of L&T in September future. (Protection for two months, sell October future-for three months, sell November future)

Settlement of September future on the last Thursday of September i.e 29-09-2011

Around 27th, the price in the cash market is Rs.1400. He buys 1000 shares in the cash market and settles the September future sale at Rs. 1,500, making a profit of Rs. 100

Position of the Buyer on September 29th

Value of original purchase = Rs 1, 40,000

Cost of original purchase = Rs.1,50,000

Sale of September Future = Rs. 1, 50,000

Purchase to settle = Rs. 1, 40,000

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Value of Holding on September 29 th = 1, 40,000

Cash at Bank (Profit) = 10,000

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1,50,000

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Where the Price goes up to Rs. 1, 600

At any time before 29th September, Price of L&T goes upto Rs.1600

Cost of His original Purchase= 1500 x 100 = 1, 50,000

Value of the original Purchase=1,600 x 100 = 1,60,000

Sale of September Future = 1, 50,000

Purchase for Sept Future = 1, 60, 000

Loss on the Future Sale = 10,000

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Value of Holding on 29th = 1, 60,000

(-) Loss on September Future = (10,000)

Net Value in Hand = 1,50,000

Speculation

Original purchase will not be there in the cash market

A bull buys the September future

A bear sells the September future

Profit made the bull when the price goes up or loss is incurred when the price comes down

Profit made by bear when the price comes down and vice versa

Arbitrage

Buying in low priced market and selling in high-priced market

Between one stock exchange to another

Between cash market and futures market

Between future of one month and other months

Between future market and a call market

Option

A contract to buy or sell without an obligation

European Option and American Option

Call Option and Put Option

Uses of Options:

-Hedging

-Speculation

-Arbitrage

Advantages of Option

No Big Investment

No Margin as in Futures

No Obligation

No Marked-to-Market

More Gain than Risk

Premium paid alone is the Disadvantage

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