Lecture - 1 Derivatives_Introduction

8/4/2019 Lecture - 1 Derivatives_Introduction

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Introduction to derivatives

By. Prof. Samie A Sayed


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Prof. Samies Bio Qualifications : M.Com (Mumbai University), MBA (Finance ITM EEC in

collaboration with SNHU), BSBA (City University of New York) More than 10 years of corporate experience

Started career as Sales and Design Mechanical Engineer. Started Business studies in New York On return from US, Joined Royal Bank of Scotland (ABN

AMRO) in 2004. Worked across various departments of theoffshoring division of RBS including Credit Analytics, Strategyand Planning, Project Management and the last two years in

Investment Banking. Currently working as Consulting Director Research andStrategy for Delhi based Wealth Management and InvestmentFirm.

Also, worked as a visiting faculty at IMT Ghaziabad. Visiting faculty at ITM ECC.


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The need for derivatives Derivative products initially emerged as hedging

devices against fluctuations in commodity prices,

and commodity-linked derivatives remained the soleform of such products for almost three hundredyears.

After World War II, a global economic orderemerged.

In our global economy, we have market determinedrates. Market determined rates make it hard for

businesses to estimate their future revenues andproduction costs.

Price fluctuations


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The Origins

A Derivative can be defined as a financialinstrument whose value depends the values of an

underlying variable. Derivative exchanges have been existed for a long

time in the US and India.

The Chicago Board of Trade (CBOT) was establishedin 1848 to bring farmers and merchants together.

Initially its main task was to standardize thequantities and qualities of grains that were traded.


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The Origins Within a few years, the first futures type contract was

developed. It was known as a to-arrive contract.

A standard -to-arrive contract is a contract in which thefarmer promises to deliver a stated quantity of grain fora price linked to the price of a future date contract thatexpires in the delivery month.

From the farmer's perspective, such a contract shiftedthe risk of fall in market price before delivery to thebuyer.

From the buyer's perspective, the contract facilitated

hedging or speculation.


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The Origins

A rival exchange to CBOT, Chicago MercantileExchange (CME) was set up in 1898.

Since then, CME has established itself to be theworlds largest exchange for futures and optionstrading with the largest options and futurescontracts open interest (number of contracts

outstanding) of any futures exchange in the world. On 12 July 2007, CBOT merged with CME to form

CME Group, a CME/Chicago Board of TradeCompany.


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Derivatives categories Derivatives fall into three categories : OTC, Exchange Traded,

Cleared Derivatives.

The first is over-the-counter (OTC) derivatives, which are

customized, bilateral agreements that transfer risk from oneparty to the other..

The second category consists of standardized, exchange-traded derivatives, which known generically as listedderivatives or futures. In contrast with OTC derivatives, listed

derivatives are executed over a centralized trading venueknown as an exchange and then booked with a centralcounterparty known as a clearing house.

Finally, the third category is cleared derivatives, which likeOTC derivatives are negotiated bilaterally, but like listedderivatives are booked with a clearing house.


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Differences in categoriesOTC Cleared Exchange-traded

Trades negotiated over-the-counter

Customized contracts

are broken down bytrading desk into tradablerisks and hedged in liquidmarkets

Traded between dealersas principals

Dealer is normally

counterparty to all trades Margin (collateral) often

exchanged but subject tonegotiation betweencounterparties

Trades negotiated over-the-counter

Trades limited to

standardized contracts All trades are booked

with clearinghouse,which is counterparty toall trades

Mandatory marginrequirements

Initial margin Variation margin

Daily settlement (mark tomarket) and margin calls

Trades executed onorganized exchanges

Trades limited to

standardized contracts All trades are booked

with exchangesclearinghouse, which iscounterparty to all trades

Mandatory marginrequirements

Initial margin Variation margin

Daily settlement (mark tomarket) and margin calls

Source : ISDA


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OTC Market size

SIZE DOES MATTER !!

Source : BIS

Data for six month period ending Dec 2010

OTC Derivates Market US$tn

Types of Contracts

Notional Amount

Outstanding

Foreign Exchange 49.181

Interest Rate 449.875

Equity Linked 5.937

Commodity 2.944

Credit Default Swaps 32.693

Unallocated 63.27

Total 603.9

Data for six month period ending June 2010

OTC Derivates Market US$tn

Types of Contracts

Notional Amount

Outstanding

Foreign Exchange 53.1

Interest Rate 451.8

Equity Linked 6.3

Commodity 2.9

Credit Default Swaps 30.3

Unallocated 38.3

Total 582.7

The total notional amount outstanding for OTC Derivative contracts for theyear 2010 was US$600tn which was almost 10 times our world GDP which

is estimated to be around US$60tn.


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OTC Market size

Source : BIS

Foreign Exchange,9.1%

Interest Rate,77.5%

Equity Linked ,1.1%

Commodity , 0.5%

Credit DefaultSwaps, 5.2%

Unallocated, 6.6%Foreign Exchange

8%

Interest Rate75%

Equity Linked1%

Commodity1%

Credit DefaultSwaps

5%

Unallocated10%

Data ending June 2010 Data ending Dec 2010


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Exchange traded marketsFutures Notional Outstanding (US$tn) Notional Outstanding (US$tn)North America 10.72 11.86

Europe 8.05 6.33

Asia and Pacific 2.41 3.17

Other 0.5554 0.9453

Total 21.74 22.32

Options Notional Outstanding (US$tn) Notional Outstanding (US$tn)

North America 23.87 24.35

Europe 26.322 19.21

Asia and Pacific 0.310 0.3848

Other 0.871 1.67

Total 51.4 45.62

Exchange Traded Total 72.29 67.93

Source : BIS

Major trading on exchanges occurs in interest rate derivatives, currencies and equity indices.


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Investment Banks Leading the way

In 2009, a Financial Crisis Inquiry Commission wasset up to probe the role of Investment Banks in the

2008 financial crisis. Wall Streets most profitable bank in 2009,

Goldman Sachs stated during the inquiry that up to35% of its revenues were generated from derivativesbusiness that was approximately US$16bn.

JPMorgan Chase & Co. managed to generate $5billion in profit during the worst year in Wall Streethistory by trading over-the-counter fixed-incomederivatives.


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The origins INDIA Derivatives have had a long presence in India

organized trading in cotton was conducted at CottonTrade Association which was established in 1865.

SEBI took the first towards establishing derivativestrading in India by setting up a committee under Dr.L.C.Gupta in 1996 to establish appropriate regulatoryframework.

This was followed by Prof. J.R.Verma committee which

set up the operational framework in 1998. Securities Contract Regulation Act was amended in

December 1999 to treat derivatives as securities and aregulatory framework was set to govern derivativestrading.


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Derivatives Indian perspective In the Indian context the Securities Contracts

(Regulation) Act, 1956 (SC(R)A) defines "derivative"

to include- A security derived from a debt instrument, share,loan whether secured or unsecured, risk instrumentor contract for differences or any other form ofsecurity or

A contract which derives its value from the prices, orindex of prices, of underlying securities. Derivatives are securities under the SC(R)A and

hence the trading of derivatives is governed by theregulatory framework under the SC(R)A.


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Major players in derivatives

There are three major types of players in thederivatives market:

Hedgers

Arbitragers

Speculators


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Hedgers Hedgers are those who protect themselves from the risk

associated with the increase or decrease in the price ofan asset by using derivatives.

For example, corporates keep a close watch upon theprices discovered in trading of their products and whenthe comfortable price is reflected according to theirwants, the corporate sells futures contracts. In this way,the corporate gets an assured fixed price of his produce.

In general, hedgers use futures for protection againstadverse future price movements in the underlying cashsegment. Hedgers are often businesses, or individuals,who at one point or another deal in the underlying cashmarket. (Example: IT companies hedge their revenues in

US$).


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Speculators Speculators are never interested in actually

owing the underlying asset in the cash market.

They will just buy from one end and sell it to theother in anticipation of future price movements.

They take calculated bets on the futuremovement in the price of an asset.

If the speculators judgment is good, then thespeculator stands to make the make themaximum profit as compared to other traders inthe derivatives market.


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Arbitrageurs Arbitrage involves the simultaneous purchase and sale of

an asset in order to profit from a difference in the price. It is a trade that profits by exploiting price differences of

identical or similar financial instruments, on differentmarkets or in different forms.

Arbitrage exists as a result of market inefficiencies; itprovides a mechanism to ensure prices do not deviatesubstantially from fair value for long periods of time.

Given the advancement in technology it has becomeextremely difficult to profit from mispricing in themarket. Algo trading is the flavour among derivativestraders to monitor fluctuations in similar financialinstruments.


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Factors driving derivatives Over the last three decades, the derivatives market has seen a

phenomenal growth. A large variety of derivative contracts havebeen launched at exchanges across the world.

Some of the factors driving the growth of financial derivatives are: Increased volatility in asset prices in financial markets, Increased integration of national financial markets with the international

markets, Marked improvement in communication facilities and sharp decline in

their costs, Development of more sophisticated risk management tools, providing

economic agents a wider choice of risk management strategies, and Innovations in the derivatives markets, which optimally combine the

risks and returns over a large number of financial assets leading tohigher returns, reduced risk as well as transactions costs as compared toindividual financial assets.


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Derivatives Types Forwards

A derivative instrument, or financial contract, in which twoparties agree to transact a set of financial instruments orphysical commodities for future delivery at a particular price.

FuturesAn exchange traded derivative instrument, or financial contract,

in which two parties agree to transact a set of financialinstruments or physical commodities for future delivery at aparticular price.

Options

An exchange traded contract, sold by one party to another, thatgives the buyer the right, but not the obligation, to buy (call) orsell (put) financial instruments or physical commodities at anagreed-upon price within a certain period or on a specific date.

SwapsA swap is an OTC derivative in which two counterparties agree

to exchange one stream of cash flows against another stream.


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Forwards A forward contract is a non-standardized contract

between two parties to buy or sell an asset at aspecified future time at a price agreed today incontrast to a spot contract, which is an agreement tobuy or sell an asset today.

The party agreeing to buy the underlying asset in thefuture assumes a long position, and the party

agreeing to sell the asset in the future assumes ashort position. The difference between the spot and the forward

price is the forward premium or forward discount,generally considered in the form of a profit, or loss,

by the purchasing party.


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Futures A futures contract is a standardized contract between

two parties to exchange a specified asset of standardizedquantity and quality for a price agreed today (the futures

price or the strike price) but with delivery occurring at aspecified future date.

In many cases, the underlying asset to a futures contractmay not be traditional "commodities" at all that is, forfinancial futures, the underlying asset or item can be

currencies, securities or financial instruments andintangible assets or referenced items such as stockindexes and interest rates.

A futures contract working is very similar to a forwardcontract but there are major differences at an

operational level.


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The Shift
http://en.wikipedia.org/wiki/File:Futures_Trading_Composition.jpg


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Forwards vs. futures Forwards is an OTC contract

Tailor made contracts

Forwards are usually settled onspecified data and not on MTM

The Reserve Bank of India haspermitted limited options, interestrate swaps, currency swaps and other

risk reductions OTC derivativeproducts

Counterparty risk

OTC market has failed to pick up inIndia

Margins may not be needed

Exchange traded contracts

Contracts decided by exchanges

Futures are settled on MTMbasis

SEBI overviews futures exchange tradedcontracts

No counterparty risk

India has the largest single stock futuresmarket in the world

The exchanges take margins from clientsbefore allowing them to take positions

Forwards Futures


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Overview of margins In case of a futures contract, the stock exchange acts as a legal

counterparty to every transaction and if any party fails to pay up,the exchange is legally bound to effect payments to the party whohas made profits.

To ensure that it can meet these commitments, the exchangelevies margins on most players in the Derivatives Segment.

In India, two kinds of margins are applicable Initial Margin

payable at the point of entering into derivative transactions andMark to Market Margins payable on a daily basis thereafter. Boththese margins are calculated using a special software programcalled SPAN.

Typically, margins are charged at a rate of 5-15% based on

volatality of the underlying.


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Options An Option is a contract which gives the right, but not anobligation, to buy or sell the underlying at a stated date and at astated price.

While a buyer of an option pays the premium and buys the right

to exercise his option, the writer of an option is the one whoreceives the option premium and therefore obliged to sell/buythe asset if the buyer exercises it on him.

Options are of two types - Calls and Puts options :

"Calls" give the buyer the right but not the obligation to buy agiven 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 agiven quantity of underlying asset at a given price on or before agiven future date.


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Swaps A Swap is an OTC market contractual agreement

between two parties in which each party agrees toexchange a stream of cash for a stipulated period of timebased upon certain agreed-upon parameters with respect

to price movements in the underlying asset. Interest rate swaps are the most popular swaps in the

world. An interest rate swap is a derivative in which one party

exchanges a stream of interest payments for another

party's stream of cash flows. The stream of cash flows ininterest rate swaps have two interest streams fixedinterest and variable where one party is willing toexchange fixed rate for floating rate and vice versa.


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Landmarks

indiaDerivatives trading on exchanges commenced in India in June 2000.

Single Stock Futures was launched in November 2001.

SEBI permitted trading of derivatives on two stock exchanges in India NSEand BSE

S&P CNX Nifty Index as well as Sensex futures started trading on June 2000.

Trading in Index Options commenced in June 2001

Trading in Individual Stock Options commenced in July 2001


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Conclusion Derivatives market has become an integral part

of our financial markets.

The size of the derivatives market is massive andany structural issues in the derivatives marketcan lead to a systematic collapse of the financialsystem.

As was the case, derivatives played a critical rolein the 2008 financial crisis and the collapse ofLehman Brothers was attributed majorly to theirderivatives trading business.

Lecture - 1 Derivatives_Introduction

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