Description

Why do we need derivative in the world of finance

Derivative Market at a glance

Content  Very Basic of Finance  What is Derivative  Why do we need derivative in the world of finance  Derivative Market at a glance  Types of Derivative  OTC Vs Exchange Traded  Option and Future (F&O)  Derivative Market in India  Beginning  Regulatory Framework  Present Day  Financial Engineering – Building block  Career Opportunity 2

Very Basic of Finance  Finance is the study of risk.  How to measure it  How to reduce it  How to allocate it  All finance problems ultimately boil down to three main questions:  What are the cash flows, and when do they occur?  Who gets the cash flows?  What is the appropriate discount rate for those cash flows?  The difficulty, of course, is that normally none of those questions have an easy answer. 3

Very Basic of Finance  We can generally classify risk as being diversifiable or non-diversifiable:  Diversifiable – risk that is specific to a specific investment – i.e. the risk that a single company’s stock may go down (i.e. Enron). This is frequently called idiosyncratic risk.  Non-diversifiable – risk that is common to all investing in general and that cannot be reduced – i.e. the risk that the entire stock market (or bond market, or real estate market) will crash. This is frequently called systematic risk.  The market “pays” you for bearing non-diversifiable risk only – not for bearing diversifiable risk.  In general the more non-diversifiable risk that you bear, the greater the expected return to your investment(s).  Many investors fail to properly diversify, and as a result bear more risk than they have to in order to earn a given level of expected return. 4

Very Basic of Finance  In this sense, we can view the field of finance as being about two issues:  The elimination of diversifiable risk in portfolios;  The allocation of systematic (non-diversifiable) risk to those members of society that are most willing to bear it.  Indeed, it is really this second function – the allocation of systematic risk – that drives rates of return.  The expected rate of return is the “price” that the market pays investors for bearing systematic risk.  So it is important to have a tool that would help us managing ‘Risk’ 5

What is Derivative 6

What is Derivative  A derivative (or derivative security) is a financial instrument whose value depends upon the value of other, more basic, underlying variables. 7

An Example  Disney wanted to open a theme park in Tokyo, but did not want to have the shareholders bear the risk of an earthquake destroying the park.  They financed the park through the issuance of earthquake bonds.  If an earthquake of at least 7.5 hit within 10 km of the park, the bonds did not have to be repaid, and there was a sliding scale for smaller quakes and for larger ones that were located further away from the park  Normally this could have been handled in the insurance (and re- insurance) markets, but there would have been transaction costs involved. By placing the risk directly upon the bondholders Disney was able to avoid those transactions costs.  Although the risk of earthquake is not diversifiable to the park, it could be to Disney shareholders, so this does beg the question of why buy the insurance at all.  This was not a “free” insurance. Disney paid LIBOR+310 on the bond. If the earthquake provision was not it there, they would have paid a lower rate. 8

Why do we need Derivative  Because they somehow allow investors to better control the level of risk that they bear.  They can help eliminate idiosyncratic risk.  They can decrease or increase the level of systematic risk. 9

Why do we need Derivative  Typically we use derivative for  Hedging – To protect our investment in an adverse market condition  Arbitrage – Exploiting the mispricing. In other words it is termed as ‘A Free Lunch’  Speculation – Taking Directional Bet 10

Types of Derivatives 11 Derivative Over The Counter (OTC) Swap a. Interest Rate b. Credit Default c. Currency Forward Rate Agreement (FRA) a. Currency b. Commodity Exchange Traded (Flow Derivative) Equity Futures and Option a. Index b. Stock Interest Rate a. Future b. Option Forward (FRA) / SWAP Future Option

Size of Derivative Market* 12 *Source: BIS

Position in Derivative – Long / Short  Positions – In general if you are buying an asset – be it a physical stock or bond, or the right to determine whether or not you will acquire the asset in the future (such as through an option or futures contract) you are said to be “LONG” the instrument.  If you are giving up the asset, or giving up the right to determine whether or not you will own the asset in the future, you are said to be “SHORT” the instrument.  In the stock and bond markets, if you “short” an asset, it means that you borrow it, sell the asset, and then later buy it back.  In derivatives markets you generally do not have to borrow the instrument – you can simply take a position that will require you to give up the asset or determination of ownership of the asset.  Usually in derivatives markets the “short” is just the negative of the “long” position 13

Introduction and Market Convetion 14

Forward Contracts A forward contract is an agreement between two parties to buy or sell an asset at a certain future time for a certain future price.  Forward contracts are normally not exchange traded (Over The Counter).  The party that agrees to buy the asset in the future is said to have the long position.  The party that agrees to sell the asset in the future is said to have the short position.  The specified future date for the exchange is known as the delivery (maturity) date.  The specified price for the sale is known as the delivery price  As time progresses the delivery price doesn’t change, but the current spot (market) rate does. Thus, the contract gains (or loses) value over time 15

Forward Contract — A simple example 16

After 6 Months…. Scenario 1 Scenario 2  Ajay approaches Sujay to take the delivery of the CAR.  Sujay tells him car is not ready.  Would take 6 more months.  Did any party breach the contract?  YES, Sujay breached the contract by not delivering the car.  Is there any remedy available to Ajay?  Almost None.  During the waiting period of six months, the favorite color of Ajay changes.  Ajay is not keen to take delivery of the car.  Ajay does not go to take the delivery of car.  Did any party breach the contract?  YES, Ajay breached the contract by not taking delivery of the car.  Is there any remedy available to Sujay?  Almost None. 17

Forward Rate Agreement  Problem  You are an exporter and your firm will have € 1,000,000 in 3 months’ time for a 6-month period. You think that interest rates may fall. You want to protect the return you will get and you are looking at ways of doing this.  Solution  To fix today an interest rate for the future cash investments  The firm negotiates the following FRA (it sells the FRA).  Notional (M). € 1000000  Reference rate. 6-month Libor (London Interbank Offer Rate)  FRA contract Rate. 4%  de. in 3 months  dt. in 9 months  Duration (N) = (dt – de). 6 months  dt. maturity date of underlying FRA contract  de. settlement date of FRA contract 18

Forward Rate Agreement  19

Forward Rate Agreement   20

FRA Market Quotation Notation Effective Date from now Termination Date from now Reference Rate 1 x 4 1 month 4 months 4-1 = 3 months LIBOR 1 x 7 1 month 7 months 7-1 = 6 months LIBOR 3 x 6 3 months 6 months 6-3 = 3 months LIBOR 3 x 9 3 months 9 months 9-3 = 6 months LIBOR 6 x 12 6 months 12 months 12-6 = 6 months LIBOR 12 x 18 12 months 18 months 18-12 = 6 months LIBOR 21 How to interpret a quote for FRA? [US$ 3×9 — 3.25/3.50%p.a ] — means deposit interest starting 3 months from now for 6 month is 3.25% and borrowing interest rate starting 3 months from now for 6 month is 3.50%. Entering a payer FRA means paying the fixed rate (3.50% p.a.) and receiving a floating 6-month rate, while entering a receiver FRA means paying the same floating rate and receiving a fixed rate (3.25% p.a.).

Forward Contract – in a Nut shell Pros and Cons Forward – a quick Snap  Pros 1. Flexible  Cons 1. Lack of liquidity: hard to find a counter-party and thin or non-existent secondary market 2. Subject to default risk— requires information to screen good from bad risk 3. Adverse selection and moral hazard problems.  Customizable contracts  Not Available for trading on exchanges  Traded on OTC (Over the Counter) market  Highly illiquid and High Default Risk  Forwards are executed by the banks with the underlying being Interest Rates, Currencies Etc.  The Counter party to the banks are the companies who require the currency to execute Impex. 22

The next generation FRA 23

Future Contracts  A futures contract is similar to a forward contract in that it is an agreement between two parties to buy (long) or sell (Short)an asset at a certain time for a certain price.  Futures, however, are usually exchange traded and, to facilitate trading, are usually standardized contracts.  The long and short party usually do not deal with each other directly or even know each other for that matter.  The exchange acts as a clearinghouse.  As far as the two sides are concerned they are entering into contracts with the exchange.  In fact, the exchange guarantees performance of the contract regardless of whether the other party fails.  Note however, that the basic payoffs are the same as for a forward contract. 24

Future Contracts – Features and Benefits  Financial Futures Contracts Specify  Type of security to be traded  Delivery Location  Amount to be Delivered  Date  Price  Success of Financial Future Contract (FFC)  FFC are more liquid: standardized contracts that can be traded  Delivery of range of securities reduces the chance of corner.  Mark to market daily: avoids default risk  Don’t have to deliver: cash netting of positions 25

Pricing Principal of Future  26

Pricing Principal of Future — Example  Let’s assume Nifty spot is at 7560  Risk free rate is 8.50%  Nifty Dividend Yield is 1.50%  Expiry Date: 31st July 2014  τ = 0.09 years  Then theoretical Nifty Future price should be  F = 7560 * exp<( 8.50% — 1.50%)*0.09> = 7607.99  However, in reality Future price may be lesser than the prevailing spot.  If F > S => Positive Cost of Carry => ‘Future is at premium to Spot’  If F < S => Negative Cost of Carry => ‘Future is at discount to spot’  In real world, especially in equity market, future price hardly follow Cost of Carry Model as the sentiment of the underlying plays a vital role. 27

Future Contracts  Delivery?  If the position remains open until the delivery date, then shorts must deliver and longs must accept delivery of underlying asset.  But before the delivery date, positions can be closed by taking the opposite position.  Profit or Loss—note that when the price of the futures contract rises, investors with a long position gain, and short positions loose. 28

A typical Future Contract Contract Specification – Nifty Instruments FUTIDX Underlying Nifty Expiry Date DD-MMM-YYYY Trading Cycle 3 month trading cycle — the near month (one), the next month (two) and the far month (three) Expiry Day Last Thursday of the expiry month. If the last Thursday is a trading holiday, then the expiry day is the previous trading day. Permitted Lot Size Underlying Specific. For Nifty it is 50 Price Steps Rs.0.05 Exposure Underlying Value x Lot Size Margin Exposure x Underlying specific margin (in %) Settlement Cash 29

Application of Future Contracts  Hedging  Rock Solid has a stock portfolio worth $100 million, which tracks closely with the S&P 500 (i.e. portfolio beta = 1). The portfolio manager fears that a decline is coming and wants to completely hedge the value of the portfolio over the next one year.  Assume that current market price of 1 S&P 500 Future contract of expiry June 2015 is 1930.30  For each S&P500 Future ‘SHORT’ position, we get exposure of  US $ 250 X 1930.30 = US $ 482,575  Hence in order to hedge the portfolio, we need to sell  [100 x1,000,000]/482, 575 = 207.22 number of contracts or  207 number of contracts (rounded –off)  In case the portfolio beta is, say, 1.1 then we would have needed to short  [100 x 1,000,000 x 1.1]/482, 575 = 227.94 number of contracts or  228 number of contracts (rounded – off) 30

Application of Future Contracts Spot: S&P  10%, index falls from 1930.30 to 1737.20 $10m loss on portfolio Futures: profit of 207 x 250 x(1930.30-1737.20) = $9,989,302 You shorted the S&P index, so you sold 207 contracts at $250×1930.30 for each But you can close your position by buying at $250×1737.20 per contract Net Profit / Loss: Loss of US $ 10, 697.50 31

Application of Future Contracts  32

How to calculate Portfolio Beta  Please see below the table for arriving at portfolio beta 33 Price Beta Qty Value Wt Wt.Average Beta LT 1,666.00 0.90 500 833,000.00 30% 0.27 TATAMOTORS 432.40 1.25 1000 432,400.00 16% 0.20 SBIN 2,642.00 1.15 500 1,321,000.00 48% 0.55 INFY 3,225.45 0.60 50 161,272.50 6% 0.04 Portfolio Value 2,747,672.50 100% Beta 1.06 Portfolio Value to be hedged 2,906,113.50

Margin in Future Market  While Future contract is exchange traded, both buyer and seller are required to keep certain amount with exchange when they take positions in the underlying Future.  Margin is required to cover the default risk by either parties.  For each underlying margin is computed as  Value at Risk + Extreme Loss rate (in %) Or  Sigma = The volatility of the underlying asset Which ever is higher.  Example: SBIN (State Bank of India)  Lot Size = 125  Margin = 12.73% (VaR. 7.73% + Extreme Loss Rate: 5.00%)  Current Spot Price = 2642.00  Required Margin = 2642 x 125 x 12.73% = Rs. 42,040.82 34

Mark to Market in Future All Future position (be it long or short) are mark to market (MTM)  Based on the closing price of the underlying (last 30 mins weighted average cost) MTM amount is arrived and that amount is adjusted from margin (specifically initial margin)  Below is the example of MTM computation for TATAMOTORS LONG FUTURE @ 432.40  Lot Size: 1000 Initial Margin: 12.50% Maintenance Margin: 12.00%* 35 Day Opening Balance ( Total Margin Deposit) Funds Deposited Settlement Price Contract Value Gain / Loss Closing Balance 1 105,938 450 450,000 17,600 123,538 2 123,538 440 440,000 -10,000 113,538 3 113,538 415 415,000 -25,000 88,538 4 88,538 395 395,000 -20,000 68,538 5 68,538 360 360,000 -35,000 33,538 6 33,538 19,431 355 355,000 -5,000 47,969 *Maintenance Margin is levied by Broker

Derivatives in India – A Chronicle  Jan’94- Cross Currency Options  Mid’95- 3rd Currency Hedging  Mid’96- Structured Cross Currency Options  Aug’96- FCY Interest rate Derivatives  Apr’97- Rupee Swaps  Sep’98- Commodity hedging  May’99- Gold hedges and Commodity derivatives  July’99- Interest Rate Derivatives in INR  June’2000 – Equity Index Future – Exchange Traded  June’2001 – Equity Index Option – Exchange Traded  July’2001 – Equity Stock Futures – Exchange Traded  November’2001 – Equity Stock Option (American Style) – Exchange Traded  November’2010 – Equity Stock Option (European Style) – Exchange Traded 36

Regulatory Landscape — India  All OTC derivative regulation is governed by RBI  The Fixed Income Money Market and Derivatives Association of India (FIMMDA), an association of Scheduled Commercial Banks, Public Financial Institutions, Primary Dealers and Insurance Companies, is a voluntary market body for the bond, money and derivatives markets.  All Exchange Traded Derivatives are governed by SEBI  SEBI (Securities and Exchange Board of India) is an autonomous body was enacted on April 12, 1992 in accordance with the provisions of the Securities and Exchange Board of India Act, 1992.  The Preamble of the Securities and Exchange Board of India describes the basic functions of the Securities and Exchange Board of India as . to protect the interests of investors in securities and to promote the development of, and to regulate the securities market and for matters connected therewith or incidental thereto 37