Derivatives and Risk Management

What is Derivative? A Financial instrument whose value depends on ( or derives from ) the values of other , more basic ,underlying variables. e.g. stock option whose value depends upon the price of the stock.

OTC Market : Over the Counter market Ex : An agreement to buy 10 million USD with Indian Rupees at a predetermined exchange rate in a year. Exchanges

A )Forward Contracts
An agreement to buy or sell an asset at a certain future time for a certain price. Long Position : One of the parties agrees to buy the underlying asset on a certain Specified future date for a certain specified price .

Short Position : The other party assumes the a short position and agrees to sell the asset on the same date for the same price. Forward contracts are extensively used in india in foreign exchange market. Ex :An agreement to buy 10 million USD with Indian Rupees at a predetermined exchange rate in a year.

Use of forward contract to hedge foreign currency risk

Ex : US corporation wanting to buy 1 million BID Offer after six months
Spot
1-Month Forward 3- Month Forward 6- Month Forward

1.6281
1.6248 1.6187 1.6094

1.6285
1.6253 1.6192 1.6100

Quote is number of USD per GBP

1 st row indicates that bank is prepared to buy GBP in the spot market at a rate of $ 1.6281 per GBP and sell sterling in the spot market at $ 1.6285.

Payoffs from forward contracts

US corporation wanting to buy 1 million after six months 1) If spot rate rose to 1.7000 at the end of six months..? - Profit would be $ 90,000 2) If spot exchange rate fell to 1.5000 at the end of six months ? - Loss would be $ 110000

Forward Contract :Pay off profiles : Long

position ( position of the corporation

Pay off 0

St

K = Delivery Price
St = Spot price of the asset at the maturiy of the contract

Forward Contract : Pay off profiles : Short Position ( position of the bank)

Pay off 0 K St

Risk Associated with the forward contracts

1)

Liquidity Risk

2) Default / Credit risk / Counter party risk

Futures
An agreement between two parties to buy or

sell an asset at a certain time in the future for a certain price. Unlike forward contracts future contracts are traded on an exchange. ( Hence futures contracts are essentially standardised forward contracts , which are traded on the exchanges and settled through the clearing agency of the exchanges )

Options
Why options? Ex : Mr. X needs to honour an obligation of $ 1 million after three months from the given date. Option : Its a financial instrument that gives the holder the right , without any obligation, to buy or sell an asset by a certain date for a certain price.

Types
1)

2)

of Options : Call option : It gives the holder the right to buy the underlying asset by a certain date for a certain price. Put option : It gives the holder the right to sell the underlying asset by a certain date for a certain price. Exercise Price / Strike price : The price in the contract is known as the exercise price or the strike price .

Expiration date or Maturity : The date in the contract is known as the expiration date or maturity date . Its a date on which contract ceases to exist .

American Option: options that can be exercised at any point upto the expiration date. European option : Options that can be exercised only on the expiration date.

so what is expiration date and exercise date for European option if it is exercised?

Option premium : when an option writer gives a right to the option buyer he will charge for that right. So the price that the option buyer pays to the option seller for this option / right is called the option premium.

How options are different from the forwards and futures ?

Futures
Difference

1)
2) 3) 4) 5)

6)

between forwards and futures Operational Mechanism Contract Specifications Counter party risk Liquidation profile Price discovery Example

Futures
Contract Month : The month in which particular contract expires is called the contract month.

When do BSE and NSE future contracts expire?

Contract Size and Contract Multiplier : 1) For Index Futures NSE has selected Rs. 100 as the contract multiplier . BSE trades in Sensex with a contract multiplier of Rs. 50 2) For stock futures Single stock futures trade in terms of price and the multilpier is determined based on the number of underlying shares.

Tick Size : It is the minimum difference between two quotes of a similar nature ( two buy or two sell quotes ) Tick size for trading in nifty index futures is 0.05 index point or Rs. 5 .

Tick size for single stock futures is 5 paise.