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i Introduction
i Derivatives
i Types of Derivatives
i Derivative as a Hedging Tool
i Use of derivatives by MNCs (GENERAL MOTORS)
i Exotic Instruments


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i Derivatives transactions takes place in every business

day with unremarkable regularity.
i Global derivatives volume has grown in each of the
last seven years and, is showing the fastest growth
rate to date.
i The growing popularity of derivatives results largely
from several features valued by corporations and
other investors.
i Derivatives can serve to hedge against risks either
inherent in a firm·s portfolio or in the nature of a
business .
i Derivatives offer a way to speculate for higher gains.
i Derivatives also provide a tool for managing cash
flow more effectively and predictably, while
sometimes providing the opportunity for higher
yields.
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i The term "Derivative" indicates that it has no independent value,
i.e. its value is entirely "derived" from the value of the underlying
asset.
i The underlying asset can be securities, commodities, bullion,
currency, live stock or anything else.
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i They do not have value on their own.
i They derive their values from another asset or multiple of assets.
m 

i A security derived from a debt instrument, share, loan, whether
secured or unsecured, risk instrument or contract for differences
or any other form of security;
i A contract which derives its value from the prices, or index of
prices, of underlying securities.
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Derivatives are basically classified into two :
1£   

Over-the-counter (OTC) derivatives are
contracts that are traded directly between two
parties, without going through an exchange or other
intermediary. Products such as swaps, forward rate
agreements and exotic options are almost always
traded in this way.
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i Exchange-traded derivatives are those derivatives
products that are traded via Derivatives exchanges.
Products such as futures and options are traded in
this way.
i The world's largest derivatives exchanges are
Korea Exchange
Eurex (which lists a wide range of European
products such as interest rate & index products).
   
i The price is set at the time the forward contract is
committed to by the bank. The counter-party to the
forward contract is the broker-dealer who takes the
order from the bank.
i Forward contracts are obligations entered into at a point
in time for sale or purchase of a specific type of security
at a future point in time.
  

i Futures Contract means a legally binding agreement

to buy or sell the underlying security on a future date.

i Future contracts are the organized/standardized

contracts in terms of quantity, quality (in case of
commodities), delivery time and place for settlement
on any date in future.
Traditionally futures markets are recognized to meet
the following needs:

i ·
: The futures market helps in

revealing information about the future cash market
prices thereby serving a social purpose by helping
people make better estimates of future prices so that
they can make their investment decisions more
wisely.
i ÷ Futures are traded as a substitute for a
cash market transaction, thereby reducing the risk of
the investor for his positions in the cash market.
 
i Options Contract is a type of Derivatives Contract which gives
the buyer/holder of the contract the right (but not the
obligation) to buy/sell the underlying asset at a predetermined
price within or at end of a specified period.
i The underlying asset could include securities, an index of prices
of securities etc.
 
Option type defines the nature of buyer·s right, which can be
i Right to buy the underlying asset, which is called the call option;
or
i Right to sell the underlying asset, which is called the put option.
è
i In finance a swap is a derivative, where two
counterparties exchange one stream of cash flows
against another stream. These streams are called the
legs of the swap.
i The cash flows are calculated over a notional
principal amount. Swaps are often used to hedge
certain risks, for instance interest rate risk.
i Another use is speculation.



i ? 
  

Interest Rate swaps are the most common type of

swap, also known as a 'plain vanilla' swap. They
typically exchange fixed rate payments against floating
rate payments.The principals are not exchanged, and
are known as the notional principal.
  
 
i A total return swap is a swap, where party A pays the
total return of an asset, and party B makes periodic
interest payments.
i The total return is the capital gain or loss, plus any
interest or dividend payments. Note that if the total
return is negative, then party A receives this amount
from party B.
Y
  
i An equity swap is a special type of total return swap,
where the underlying asset is a stock, a basket of
stocks, or a stock index
  
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i ÷
 Hedgers are those who protect themselves
from the risk associated with the price of an asset by
using derivatives. A person keeps a close watch upon the
prices discovered in trading and when the comfortable
price is reflected according to his wants, he sells futures
contracts.
i  
Speculators wish to bet on the future
movement in the price of an asset. They use derivatives
to get extra leverage. A speculator will buy and sell in
anticipation of future price movements, but has no desire
to actually own the physical commodity.
i m  
: They are in the business to take advantage
of a discrepancy between prices in two different markets
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i Hedging techniques involve using complicated financial instruments
known as derivatives, the two most common of which are options and
futures.
i The best way to understand hedging is to think of it as insurance. When
people decide to hedge, they are insuring themselves against a negative
event. This doesn't prevent a negative event from happening, but if it
does happen and you're properly hedged, the impact of the event is
reduced.

i Let's see how this works with an example. Say you own shares of Indian
Tobacco Company (Ticker: ITC). Although you believe in this company
for the long run, you are a little worried about some short-term losses
in the Tobacco industry. To protect yourself from a fall in ITC you can
buy a put option (a derivative) on the company, which gives you the
right to sell ITC at a specific price (strike price). This strategy is known
as a married put. If your stock price tumbles below the strike price,
these losses will be offset by gains in the put option.
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i Let·s look at using forward rates, futures rates and call

and put options to hedge a long (Account Receivable
or Note Receivable) or short (Account Payable or
Note Payable) position in a currency. First, let·s
assume that we sold merchandise to a British firm for
1 million pounds payable in 6 months.
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i Assume that the forward rate that the bank offers is USD
1.5179 per pound. Then, the amount we will receive will be the
following:
Value of 1 million pound receivable
= 1,000,000 pounds * USD 1.5179 per pound
= USD 1,517,900

i It shows that whether the pound appreciates or depreciates,

we will get an amount of USD 1,517,900
÷  
i An alternative to contracting privately with a bank is to
contract for 1,000,000 pounds with futures contracts. Assuming
that the futures rate of exchange is USD 1.5ü04 per pound, but
will include transactions costs (commissions) of 0.ü , we will
net the following amount when we receive the one million
pounds in six months:
= 1,000,000 pounds * USD 1.5ü04 per pound
= USD 1,5ü0,400 pounds
- USD 3,041 pounds
($1,5ü0,400*.00ü)
= USD 1,517,359
i The market effect is that there will be a slight
increase in supply of pounds in the forward market
(driving the rate down, with less demand in the
futures market (driving the rate up). They should be
the same.
ÔÔ ÷
i This relies upon borrowing and investing funds via the
money markets and using the spot rate to lock-in the
amount we will receive from the receivable.
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i Take the case of an investor who holds the shares of a
company and gets uncomfortable with market movements in
the short run.
i He sees the value of his security falling from Rs.450 to
Rs.390.
i With security futures he can minimize his price risk by
entering into an offsetting stock futures position, in this case,
take on a short futures position. Assume that the spot price
of the security he holds is Rs.390. Two-month futures cost
him Rs.40ü. For this he pays an initial margin.
i If the price of the security falls, he will suffer losses on the
security he holds.
i However, the losses he suffers on the security will be offset
by the profits he makes on his short futures position.
i Suppose the price of his security falls to Rs.350. The fall in the
price of the security will result in a fall in the price of futures.
Futures will now trade at a price lower than the price at
which he entered into a short futures position. Hence his
short futures position will start making profits. The loss of
Rs.40 incurred on the security he holds, will be made up by
the profits made on his short futures position.
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i To protect the value of portfolio from falling below a

particular level, buy the right number of put options with
the right strike price.
i Concern for the value of the stock: buy put options on
that stock.
i Concern for overall portfolio: buy put options on the
index. When the stock price falls your stock will lose value
and the put options bought by you will gain, effectively
ensuring that the total value of your stock plus put does
not fall below a particular level. This level depends on the
strike price


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i General Motors was the world·s largest automaker and since

1931, the world·s sales leader.
i International operations were also growing and international
sales had reached 18 of overall sales.
i The key objectives of GM·s foreign exchange risk management
policy was to reduce :

- Cash flow and earnings volatility,

- Minimize management time and costs dedicated to FX
management
- Align FX management in a manner consistent with how GM
operated its automotive business.
i GM hedged only cash flows (transaction exposures) and
ignored balance sheet exposures (translation
exposures).
i A passive hedging policy of hedging 50 of all significant
foreign exchange exposures arising from receivables
and payables was adopted.
i Forward contracts were used to hedge exposures
arising within six months and options used to hedge
exposures arising within seven to twelve months.
i GM·s competitive exposure to the yen arose because of
competing against Japanese automakers who had large
parts of their cost structure denominated in yen.
i Any fluctuation in the dollar/yen exchange rate affected
the operating profits of Japanese automakers
significantly, since they derived 43 of their revenue
from the US markets. The yen appreciation from 117 to
107 during the first half of ü000 had reduced their
combined global operating profit by nearly $4 billion.
i Depreciation of the yen would lead to reduced costs for
Japanese automakers (since ü0 to 40 content was
sourced from Japan). 15 to 45 of this cost saving
would be passed on to the customer
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i To hedge the competitive exposure to Japanese yen, GM
can try the following strategies:
i Shift some of its production to Japan
i Source some parts from Japan
i An easier approach to manage the competitive exposure to
the Japanese yen would be for GM to increase its yen
borrowings .
i This would serve as a natural hedge to any depreciation in
the yen and would also not require the use of complex
derivatives.
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i Derivatives help in discovery of future as well as current prices.
i The derivatives market helps to transfer risks from those who have
them but may not like them to those who have an appetite for them.

i Derivatives, due to their inherent nature, are linked to the underlying

cash markets. With the introduction of derivatives, the underlying
market witnessed higher trading volumes because of participation by
more players who would not otherwise participate for lack of an
arrangement to transfer risk.

i Speculative trades shift to a more controlled environment of

derivatives market. In the absence of an organized derivatives market,
speculators trade in the underlying cash markets.
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; We have heard of ´vanillaµ options³basic puts and calls.

; Other kinds of options³´exoticsµ³are traded in the
OTC market.
; Although the variety of exotics is limited only by the
imagination of traders, some exotics are more common
than others.
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These are options on an option,

such as a put on a call, or a call on a call. There are
formulae for valuing such options given Black-Scholes
assumptions.
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These give you the right, but not the
obligation to exchange one asset for another. There are
formulae for valuing such options given Black-Scholes
assumptions.
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! 
: Here you only pay
the premium if they wind up the money. These options
can have a negative payoff.
i —  
Cross-currency options are the most common
example. An example is a contract on the Nikkei Index with
the payoff converted to USD. This conversion can occur at
either an exchange rate set when the option is written or the
exchange rate prevailing at expiration.

i 
These are options with payoffs max where the

strike price is in the domestic currency.

i " "
Lookbacks are path dependent options because

the payoff depends on the maximum (or minimum) price
reached by the underlying during the option·s life. Lookback is
more valuable than a vanilla call.
 


i Hedging allows financial professionals to accomplish a

number of risk management objectives, from decreasing
cash flow volatility and offsetting interest rate
fluctuations to minimizing price risk, default risk, and
more.
i Select a hedge that provides the most protection while
incurring the least expense.
i In volatile times, derivatives can be used as an effective
hedging tool. Any gain or loss in the original portfolio, can
be offset by a similar loss or gain in the derivative
product used to hedge a portfolio.
i But if derivatives are used as a speculation tool, it could
be risky