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Introduction To Derivatives
Introduction To Derivatives
Introduction To Derivatives
Derivatives
Introduction: Risk
Management
Risk is inherent in all our day to day activities
and is defined as deviation from expected
It is not possible to eliminate all the risks,
however one can manage the risks
The impact or magnitude of risk is estimated
from the following two factors:
1. The probability of an adverse event
happening
2. In case the even occurs, the magnitude of
loss it can cause
..contd.
From
the
perspective
of
its
management, risk can be viewed in
two ways:
I. Risk of small losses with high
probability:
eg.
Changes
in
commodity prices, exchange rates,
interest rates etc.
II. Risk of large losses with low
probability: strategic in nature like
capital budgeting, capital structure
Derivative Instruments
A derivative (or derivative security) is a
financial instrument whose value
depends upon the value of other, more
basic, underlying variables.
Origin of Derivatives
Indian Commodity
Exchanges
The National Level Multi Commodity Exchanges:
Classification based on
Underlying Asset
Commodities
Currencies
Interest Rates
Equity Shares
Indices
Credit: eg: credit default swaps
Weather
Exchange traded:
Traditionally an open outcry system, but
gradually switching to electronic system
No credit risk due to default because of
standard contracts
Over-the-counter (OTC):
A network of dealers at financial
institutions, corporations and fund
managers
Contracts are non-standard and there is
some credit risk involved
12
Forwards
Futures
Options
Swaps
Functions of Derivatives
Market
Price Discovery
Risk Transfer
14
15
Why do we use
derivatives
Three Purposes
Speculation
Hedging
Arbitrage
16
Traders in derivative
markets
Hedgers:
Hedgers face risk associated with the price of an asset;
they use these instruments to reduce or eliminate that
risk.
These are firms that face a business risk. They wish to get rid
Speculators:
They bet on the future movement in the price of an
asset.
These instruments give them large leverage by putting
small amount of money, they can take large positions
large potential gains / losses.
Arbitragers:
They trade to profit from the disequilibrium or
imperfections in prices in different markets cash and
derivative.
17
Equity Index
7,416
8,460
Individual Equity
6,295
7,062
Interest Rate
3,205
3,491
Agriculture
1,306
991
Energy
724
815
Currency
2,526
3,147
Precious Metal
175
341
644
435
Other
138
230
Total Volume
22,425
24,972
Korea Exchange
3,928
2,822
NYSE Euronext
2,283
NSE
2,200
BM &F Bovespa
1,500
1,296
1,217
1,196
10
1,083
Index
Futures
Stock
Futures
Index
Options
Stock
Options
Total
2009-10
22.3
29.4
45.4
2.9
100
20101-11
14.9
18.8
62.8
3.5
100
2011-12
11.4
13.0
72.5
3.1
100
April Sep
2012
9.2
12.7
73.0
5.1
100