5th December 2007

Derivatives

Prof.L. Augustin Amaladas

M.com.,AICWA.,PGDFM.,B.Ed.

What do you mean by rest?

Why does BSE index moves
upwards and volatile?

Mortgage market?
 Reasons
• In USA most of the banks engaged in mortgage
market by lending without seeing the client's credit
worthiness. But most of the customers fail to repay
the long term loan. The banks are allowed to recover
such loans by sale of such properties.
• The total funds have to be reinvested in profitable
way. Most of the banks see(BRIC countries)India is
one of the countries where they can get better return
and also india’s inflation is arround 4% and growth
rate is around 9%.
• BRIC-Bracil, Russia, India and China
 Leading Investment and
Commercial banks
• Banc of America Securities LLC
• Citigroup
• Credit Suisse
• Goldman Sachs
• JPMorgan Chase
• Lehman Brothers
• Merrill Lynch
• Morgan Stanley
• UBS
banks in the international markets

• Categories of banks in the international markets:

• 1. commercial banks-JP Morgan Chase
• 2.investment banks-Goldman Sachsas, London
investment bank Morgan Grenfell Bankers Trust
in New York, Crédit Lyonnais Belgium ,Brussels
Moscow-based investment bank
United Financial Group in Russia ,the German
norisbank and Berliner Bank.
• 3.mixed banks-HSBC
Investment And Commercial Banks
Differ?
• Commercial Banks (CB) accept
deposits and make commercial loans
as a financial intermediary.
• CB traditionally could underwrite only
low-risk securities of governments per
the Glass-Steagall Act.
• Many large firms now use the direct
financial markets to finance rather than
bank loans.
 RISK /Uncertain???
• Case-1
• An Indian Garments company has received an
order to supply I,00,000 units of shirts from USA.
The price of $ 500,000 is receivable after six
months. The current exchange rate is
Rs.39.76/$. At the current exchange rate, the
company would get: 39.76 × 500,000 = Rs
1,98,80,000. But the company anticipates
appreciation of Indian rupee over time. Does the
company loose/gain due to appreciation in the
Indian Rupee? How does company minimise the
risk?

Alternative work is rest

 Minimising risk case-1

• The company can lock in the exchange

rate by entering into an advance contract
and forget about any fluctuation in the
exchange rate. Suppose, the six-month
forward exchange rate is Rs39.00/$ The
company can make an agreement at spot
rate at 39.76 in the spot market or at a
lesser price. At the time of receiving dollar,
it will exchange $500,000 at Rs39.76= Rs
1,98,80,000. or agreed price.

Happiness by giving/receiving?
Case 2
•• You
Youhave
haveimported
imported machinery
machinery for for $$100,000
100,000on on 180
180 days
days
credit
credit at
atzero
zerointerest.
interest. The
Thedollar
dollar quotes
quotes at
at Rs
Rs 39.
39. Is
Is
this
thisdeal
dealrisk
riskfree?
free?
•• This
Thisdeal
dealisisnotnotfree
freeofofrisk
riskbecause
becauseafter
after six
six months
months
when
whenyouyoupay pay the
theloan,
loan,ififthe
thedollar
dollar quotes
quotesanything
anything
more
morethan
thanRs39.,
Rs39.,saysayRsRs40,40,you
youwill
willend
endup uppaying
paying
more
more[Rs[Rs11extra
extrafor
for every
every$$1, 1,which
whichisisequivalent
equivalentto toRsRs
100,000
100,000additional
additionalcost].
cost]. OnOnthetheother
other hand,
hand, ifif the
the dollar
dollar
quotes
quotesanything
anythingless lessthan
thanRs Rs39,
39,you
youwill
willstand
standto togain
gain
•• The
Thequestion
questionhere hereisisnot
not whether
whetheryou youstand
standto to gain
gainoror
loose
loose––ititisisthe
the risk
riskyou
you are
aretaking
taking

Happiness by giving not receiving

 Case 03

• You have surplus cash for investment. You

think of investing in Wipro, currently quoting at
Rs 3,500, which you believe will rise to Rs 3,950
in six months. Is this deal risk free?
• This deal is not free of risk because there is no
guarantee that Wipro’s shares would touch Rs
3,950 in six months time.
• The share prices could rise beyond Rs 3,950 or
could also fall below Rs 3,500 – giving you no
return on investment and you could stand to
loose some portion of your investment

Old lady in a seashore!....

How do you protect yourself ?

• Use Derivative instruments.

• What is derivatives?

• See the next example.

Picking up something?...
Example

• You [along with two friends] want to go for the

Aero India January 2008 air show, for which
tickets are sold out. Through one of your close
friends, you obtain a recommendation letter,
which will enable you to buy three tickets. The
price of a ticket is Rs 1,000.
• Which is the commodity that you are suppose to
buy?
• In order to buy the________ what are required
now?
• Money/recommendation letter (instrument) or
both?

People walking in the seashore scared?...

Financial instruments

• The recommendation letter is a derivative

instrument. It gives you a right to buy the ticket
• The underlying asset is the ticket
• The letter does not constitute ownership of the
ticket
• It is indeed a promise to convey ownership
• The value of the letter changes with changes in
the price of the ticket. It derives its value from
the value of the ticket

Children are scared to go near by?...

 Different risk coverage
• Firms are exposed to several risks in the ordinary course
of operations and borrowing funds.
• For some risks, management can obtain protection
from an insurance company(fire,loss of profit,loss of
stock,marine insurance)
• Similarly, there are capital market products available to
protect against certain risks. Such risks include risks
associated with a rise in the price of commodity
purchased as an input, a decline in a commodity
price of a product the firm sells, a rise in the cost of
borrowing funds and an adverse exchange rate
movement. The instruments that can be used to
provide such protection are called derivative instruments
What was see doing? Why?...
Meaning

• Derivative instruments are called so because

they derive their value from whatever the
contract is based on
• “A derivative contract is a financial instrument
whose payoff structure is derived from the value
of the underlying asset”
• These instruments include futures contracts,
forward contracts, options contracts, swap
agreements, and cap and floor agreements

See the next slide…

 Advantages
Advantages

•• The
Thederivative
derivativemarket
markethelps
helpspeople
peoplemeet
meet
diverse
diverseobjectives
objectivessuch
suchas:
as:
––Hedging
Hedging
––Profit
Profitmaking
makingthrough
throughprice
pricechanges
changes
––Profit
Profitmaking
makingthrough
througharbitrage
arbitrage

Guess what does she pick up?

 uses

• Price discovery
– Most price changes are first reflected in the derivative market.
That way derivative market feeds the spot market
– For instance, if the dollars are going down, it means that the
professional investors are expecting dolor price to go down in
the future – this is a good sign for you to buy in the spot market
• Risk transfer
– A derivative market is like an insurance company
– Derivative instruments redistribute the risk amongst market
players
– However, if you want protection against adverse price
movements, you must pay a price, ie the premium

Children are not allowed to go near by…!

 Derivative instruments on
 Stocks (Equity)
 Agri Commodities including grains, coffee beans, pepper,.
 Precious metals like gold and silver.
 Crude oil
 Foreign exchange rate
 Bonds
 Short-term debt securities such as T-bills
 Index
 Interest rate

The old lady looked shabby…

 TYPES OF DERIVATIVES

Futures
Forwards
Option
Floor
cap

Policemen also ask the public to go away from her

 Players in the market

• Banks-Citi Bank
• Deutsche Bank
• Goldman Saches
• JP Morgan Chase
• HSBC
• ICICI

See next slide

 Old
Old lady
lady in
in aa seashore?
seashore?
• She picked up broken glasses from
seashore?
• Picked up stones?
• Does she harm anybody?
What is your answer?
Broken glasses should not
harm the children
Lesson:1 What we perceive may not
be what is real
Lesson-2

Judge not based on outlook /

colour
 Ways of making contract?

• 1. Private contracts- Known as Forwards

• 2. Through Stock - Known as
exchanges Futures, Options
Swap, Floor and
Cap

Threat is an opportunity
How do they settle the contract?

• Daily basis -Known as Marking to market

Present strengths are your threats

How does stock exchange operate?

• It collects amounts from both the parties

of contract known as Initial Margin Money.
• Stock Exchange also collect additional
margin money is known as Variation
Margin.
 Important terms
• LIBOR
• SWAP
• OPTION HODER
• EXERCISE THE CONTRACT
• CURRENCY SWAPS
• INTEREST SWAPS
• PREMIUM STRIKE PRICE
• AMERICAN OPTION SPOT PRICE
• EUROPEAN OPTION EXPIRY OF CONTRACT
• BERMUDA OPTION BASIS RISK
• OPTION HOLDER COUNTER PARTY RISK
• OPTION WRITER
• CALL OPTION
• PUT OPTION
• LONG
• SHORT
 QUESTIONS?

• Thank you for all professors & students of

II B.Com classes of SJCC .

• By Prof.Augustin Amaladas