Introduction to Derivatives 2003

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Introductionto

Derivatives


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M eaning of DerivativeThe term Derivative stands for a contract whose price is derived

from or is dependent upon an underlying asset.

A derivative is a financial instrument whose value depends on (or derives from) the values of other, more basic underlying

variables.

Derivatives generally involve an agreement between two partiesor counterparties to exchange a standard quantity of an asset or

cash flow at a predetermined price and a specified date in future.As the value of underlying security to be exchanged changes, thevalue of the derivative security changes.

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M eaning of Derivative (contd)V ery often the variables underlying derivatives are the prices

of traded assets.The underlying asset could be a financial asset such ascurrency, stock and market index, an interest bearing security(bond, T-bills, notes) or a physical commodity.

Derivative contracts are traded on electricity, weather,temperature, insurance and even volatility.Derivatives derive their names from their respectiveunderlying asset.

For example, a stock option is derivative whose value isdependent on the price of a stock.If a derivatives underlying asset is equity, it is called equityderivative and so on.

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Securities Contract Regulation Act, (1956)

(i) a security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differencesor any other form of security;

(ii) a contract which derives its value from the prices, or index of prices, of underlying securities.

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Typ es of Derivative Contracts

Forward ContractsFutures Contracts

O ptions Swaps

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O ver-the-counter ( O T C)v/s

Exchange traded Derivatives

Derivatives that trade on an exchange arecalled exchange traded derivatives, whereas

privately negotiated derivative contracts are

called O TC contracts.

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Derivatives Markets

Exchange traded Traditionally exchanges have used the open-outcry system , but increasingly they are switching to electronic trading.

Contracts are standard there is virtually no credit risk.

O ver-the-counter ( O T C) A computer-and telephone-linked network of dealers at

financial institutions, corporations, and fund managers. Contracts can be non-standard and there is some small

amount of credit risk or default risk. The O TC contracts are generally not regulated by a

regulatory authority and the exchanges self-regulatoryorganization

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Fo rward C on tracts

A forward contract is an agreement to buy or sell anasset at a certain time/period/date in the future for acertain price (the delivery/forward price).

One of the parties to the contract assumes a longposition and agrees to bu y the underlying asset on acertain specified future date for a certain specified

price.The other party assumes a short position and agreesto sell the asset on the same date for the same price.

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Fo rward C on tracts

It is traded only in the O TC marketIt can be contrasted with a spot contract which is anagreement to buy or sell immediately

Each contract is custom designed, and hence is uniquein terms of contract size, delivery date and the assettype and quality.

The contract price is generally not available in publicdomain.

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Settleme n t of Fo rward C on tracts Physical S ettlement and Cash S ettlement

P hysical SettlementA forward contract can be settled by the physicaldelivery of the underlying asset by a short investor (i.e.the seller) to the long investor (i.e. the buyer) and the

payment of the agreed forward price by the buyer to theseller on the agreed settlement date.

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Settleme n t of Fo rward C on tracts

Illustration: P hysical SettlementConsider two parties (A and B) enter into a forwardcontract on 1 August, 2009. A agrees to deliver 1000stocks of Unitech to B, at a price of Rs.100 per share, on29 th August, 2009.

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Settleme n t of Fo rward C on tractsIllustration: P hysical Settlement

In case of physical settlement, on 29th August, 2009(expiry date), A has to actually deliver 1000 Unitechshares to B and B has to pay the price (1000 * Rs. 100 =Rs. 10,000) to A.

In case A does not have 1000 shares to deliver on 29th

August, 2009, he has to purchase it from the spot marketand then deliver the stocks to B .

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Settleme n t of Fo rward C on tractsIllustration: P hysical Settlement

P rofit and Loss for each part yO n the expiry date the profit/loss for each party dependson the settlement price and the closing price in the spotmarket on 29th August, 2009.Depending on the closing price, three different scenariosof profit/loss are possible for each party.

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Illustration: P hysical SettlementScenario I: Closing spot price on 29 August, 2009 ( SP )is greater than the Forward price (F P ).

(SP> FP )Assume that the spot price of Unitech on the settlement date 29August, 2009 is Rs. 105.

Since the short investor has sold Unitech at Rs. 100 in the Forwardmarket on 1 August, 2009, he should buy 1000 Unitech shares atRs. 105 from the market and deliver them to the long investor.Therefore the person who has a short position makes a loss of

(100 105) X 1000 =Rs. 5000.If the long investor sells the shares in the spot marketimmediately after receiving them, he would make an equivalentprofit of (105 100) X 1000 = Rs. 5000.

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Illustration: P hysical SettlementScenario II: Closing spot price on 29 August, 2009 ( SP )is less than the Forward price (F P ).

(SP< FP )Assume that the spot price of Unitech on the settlement date 29August, 2009 is Rs. 95.

Since the short investor has sold Unitech at Rs. 100 in the Forwardmarket on 1 August, 2009, he should buy 1000 Unitech shares atRs. 95 from the market and deliver them to the long investor.Therefore the person who has a short position makes a profit of

(100 95) X 1000 =Rs. 5000.If the long investor sells the shares in the spot marketimmediately after receiving them, he would make an equivalentloss of (105 100) X 1000 = Rs. 5000.

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Illustration: P hysical SettlementScenario III: Closing spot price on 29 August, 2009(SP ) is equal to the Forward price (F P ).

(SP =FP )The spot price of Unitech on the settlement date 29 August, 2009is Rs.100.The short seller will buy the stock from the market at Rs. 100 andgive it to the long investor.As the settlement price is same as the Forward price, neither partywill gain or lose anything.

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Settleme n t of Fo rward C on tractsP hysical Settlement

H uge Transaction Costs

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Settleme n t of Fo rward C on tractsCash Settlement

Cash settlement does not involve actual delivery or receipt of the security. E ach party either pays (receives)cash equal to the net loss (profit) arising out of their respective position in the contract.

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Illustration: Cash SettlementScenario I: Closing spot price on 29 August, 2009 ( SP )is greater than the Forward price (F P ).

(SP> FP )The spot price of Unitech on the settlement date 29 August,

2009 is Rs. 105.In this case, we have seen the short party is at loss

The party with the short position will be at loss and haveto pay an amount equivalent to the net lossto the party

at the long position.In our example, A will simply pay Rs. 5000 to B on theexpiry date (105 100) X 1000 = Rs. 5000.

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Illustration: Cash SettlementScenario II: Closing spot price on 29 August, 2009 ( SP )is less than the Forward price (F P ).

(SP< FP )The spot price of Unitech on the settlement date 29 August,

2009 is Rs. 95.In this case, we have seen the long party is at loss

The long party will be at a loss and have to pay anamount equivalent to the net loss to the short party.

In our example, B will have to pay Rs. 5000 to A on theexpiry date (105 100) X 1000 = Rs. 5000.

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Illustration: Cash SettlementScenario III: Closing spot price on 29 August, 2009(SP ) is equal to the Forward price (F P ).

(SP =FP )The spot price of Unitech on the settlement date 29 August, 2009is Rs.100.There is no need for any party to pay anything to the other party.

P hysical Settlement v/s Cash SettlementThe profit and loss position in case of physical settlement and cash

settlement is the same except for the transaction costs which isinvolved in the physical settlement.

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Exam ple: Forward contract to hedge foreign currenc y risk

S uppose that on August 16, 2001, the treasurer of U S corporationKnows that the corporation will pay 1million in six-months onFebruary 16, 2002 and wants to hedge against the exchange ratemovements. Using the quotes given in Table the treasurer can

agree to buy 1million six months forward at an exchange rate of 1.4359 U S$ per 1.The corporation has agreed that on February 16, 2002, it will buy1million from the bank for U S$ 1.4359 million ( $14,35,900).

The bank has agreed that on February 16, 2002, it will sell1million from the bank for U S$ 1.4359 ( $ 14,35,900).

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Fo reig n Excha n ge Qu o tes fo r

GBPon

Aug 16, 2001 (No.

of

US$ per GBP)Bid Offer

Spot 1.4452 1.4456

1-m onth forward 1.4435 1.4440



12-m onth forward 1.4262 1.4268

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Introduction to Derivatives 2003

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