Presentation on

Analysis of Derivatives
&
Other Products

By:
Submitted to: Raghav Sehgal
Ms. Navleen Kaur Pooja Varshney
 DERIVATIVES:
• A derivative is a financial contract whose value is derived from the value of some
other financial asset, such as a stock price, a commodity price, an exchange rate, an
interest rate, or even an index of prices.

• The main role of derivatives is that they reallocate risk among financial market
participants, help to make financial markets more complete.

• Derivatives are agreements that derive their values on the basis of some assets,
called as underlying assets. It is a financial contract with a value linked to the
expected future price movements of the asset it is linked to - such as a share or a
currency.

• Derivative is an agreement between two parties that is contingent on a future

outcome of the underlying. Derivative is a contract whose price is derived from the
price of the underlying asset and which remains distinctly different from and
independent of the underlying asset for all other features.
 Uses of Derivatives:
Derivatives are used by investors to
• provide leverage or gearing, such that a small movement in the underlying
value can cause a large difference in the value of the derivative.
• speculate and to make a profit if the value of the underlying asset moves
the way they expect (e.g., moves in a given direction, stays in or out of a
specified range, reaches a certain level)
• hedge or mitigate risk in the underlying, by entering into a derivative
contract whose value moves in the opposite direction to their underlying
position and cancels part or all of it out
• obtain exposure to underlying where it is not possible to trade in the
underlying (e.g., weather derivatives)
• create optionability where the value of the derivative is linked to a specific
condition or event (e.g., the underlying reaching a specific price level).
 Functions of derivatives:
• Price discovery: First the derivatives and its market increase the competitiveness of the
market as it encourages more number of participants with varying objectives of hedging,
speculation and arbitraging. With broadening of the market, the changes in the price of
the product are watched by those who trade on the slightest of reasons. Active
participation by large number of buyers and sellers ensures fair price. The derivatives
markets therefore facilitate price discovery of assets due to increased participants,
increased volumes, and increased sensitivity of participants to react to smallest of price
changes.

• Facilitate transfer of risk: Hedgers amongst themselves could eliminate risk if two
parties face risk from opposite movement of price. When speculators enter the market,
they discharge an important function and help transfer of risk from those wanting to
eliminate the risk to those wanting to assume the risk.

• Leveraging: Taking position in derivatives involves only fractional outlay of capital

when compared with the position in the underlying asset in the spot markets. Derivatives
as a products and their markets provide various exit routes by letting him enter into a
contract and then permitting him to neutralize the position by booking an opposite
contract at a later date. This magnifies the profit manifold with same resource base. This
also helps build volumes of trade, further helping the price discovery process.
 Classification of derivatives:
There is a wide range of instruments available as derivatives. Each of the
instruments is different in some respect or the other- conceptually, operationally, or
in its uses.

• Futures

• Forwards

• Swaps

• options
 Forwards:
A forward contract is an agreement between two parties to exchange an
asset for cash at a predetermined future date for a price that is specified
today. A forward contract is an agreement for the future delivery of a
specified amount of goods at a predetermined price and date. In finance, a
forward contract or simply a forward is a non-standardized contract
between two parties to buy or sell an asset at a specified future time at a
price agreed today. This is in contrast to a spot contract, which is an
agreement to buy or sell an asset today. It costs nothing to enter a forward
contract. The party agreeing to buy the underlying asset in the future
assumes a long position, and the party agreeing to sell the asset in the
future assumes a short position. The price agreed upon is called the
delivery price, which is equal to the forward price at the time the contract
is entered into.
 Three main problems with
forwards:
• There was a risk of default by the other party, especially if prices were either
extremely high or low by the delivery date, which negated the main value of a
forward contract—price certainty;

• The only way to legally terminate a contract was by mutual agreement, which
would be unlikely when the market price was significantly different from the
delivery price;

• There was no easy way to resell the contract, because it had customized terms that
specifically suited the seller and buyer—hence, forward contracts were highly
illiquid.
 Features:
• Like any contract, a forward contract also involves minimum of two parties, a
buyer and seller of asset. It is an OTC product where all relevant aspects of assets,
quantity, price, and delivery date are fixed on one-to-one basis customized to the
needs of parties involved.
• The price at which the exchange of an asset will be done is negotiated in advance.
By doing so, both buyer and seller attempt to avoid the price risk by locking in a
price today.
• On due date of contract, seller makes the delivery and buyer pays the price. There
is a mutual obligation between the buyer and the seller to perform according to the
requirement. The seller are committed to make delivery on due date, and the buyer
is obligated to pay the consideration.
• The buyer and seller of the contract assume risk, assume as counter-party risk on
each other. The seller may fail to deliver the asset and/or buyer may fail to make
the payment on the agreed date. While entering the forward contract, both the
contracting parties are aware of the possible default by the other party and take
adequate precaution to prevent such default on either side.
• No exchange of money is done at the time of entering the forward contract, though
any of the party can insist on initial deposit adjustable against price and delivery to
mitigate the counter-party risk.
 Futures
Futures: Futures are similar to forward contracts in terms of pricing and its concept, but are
operationally different from forwards in terms of other features. The features of future
contracts are standardized in terms of quality, delivery dates, delivery venues, quality of
product, etc, unlike forward contracts.

A futures contract is a standardized contract between two parties to buy or sell a specified
asset of standardized quantity and quality at a specified future date at a price agreed today
(the futures price). The contracts are traded on a futures exchange. Futures contracts are not
"direct" securities like stocks, bonds, rights or warrants. They are still securities, however,
though they are a type of derivative contract. The party agreeing to buy the underlying asset
in the future assumes a long position, and the party agreeing to sell the asset in the future
assumes a short position.
The price is determined by the instantaneous equilibrium between the forces of supply and
demand among competing buy and sell orders on the exchange at the time of the purchase or
sale of the contract.
A futures contract gives the holder the obligation to make or take delivery under the terms of
the contract, whereas an option grants the buyer the right, but not the obligation, to establish a
position previously held by the seller of the option.
 Specifications of a Futures Contract

The futures contract itself specifies exactly what is being bought and sold, and the manner in
which the transaction takes place. A futures contract defines:

•The standard, fixed quantity of the commodity being traded

•The quality grade of the commodity (this is not relevant for all commodities; national
currencies, for example, do not have varying degrees of quality)
•Rules for price adjustments for commodities delivered that are either above or below the
specified quality grade
•The minimum price fluctuations for the contract
•The day on which the actual commodity is to be delivered, and the manner in which the
buyer will take possession of the commodity, if not offset before expiration of the futures
contract.
•The unit pricing of the commodity
•The hours and days during which the contract will be available for trade at the exchange.
Advantages of Futures Contracts
•If price moves are favorable, the producer realizes the greatest return with this marketing
alternative.
•No premium charge is associated with futures market contracts.

Disadvantages of Future Contracts

•Subject to margin calls
•Unable to take advantage of favorable price moves
•Net price is subject to Basis change
•Futures contracts are similar to Options. Both represent actions that occur in future. But
Options are contract on the underlying futures contract where as futures are either to
accept or deliver the actual physical commodity. To make a decision between using a
futures contract or an options contract, producers need to evaluate both alternatives.
 
 Forward Contract vs Futures Contract
Forward Contract Futures Contract

Structure: Customized to customers need. Usually no initial payment required. Standardized. Initial margin payment required.

Opposite contract with same or different counterparty. Counterparty risk

Method of pre-termination: Opposite contract on the exchange.
remains while terminating with different counterparty.

Risk: High counterparty risk Low counterparty risk

Market regulation: Not regulated Government regulated market

A futures contract is a standardized contract, traded on a futures exchange, to buy

A forward contract is an agreement between two parties to buy or sell an
What is it?: or sell a certain underlying instrument at a certain date in the future, at a specified
asset (which can be of any kind) at a pre-agreed future point in time.
price.

Institutional guarantee: The contracting parties Clearing House

Depending on the transaction and the requirements of the contracting

Contract size: Standardized
parties.

Expiry date: Depending on the transaction Standardized

Transaction method: Negotiated directly by the buyer and seller Quoted and traded on the Exchange

None. It is very difficult to undo the operation; profits and losses are cash Both parties must deposit an initial guarantee (margin). The value of the
Guarantees:
settled at expiry. operation is marked to market rates with daily settlement of profits and losses.
 Options
Options are contracts for delivery in future like forwards and futures except that one of two
parties involved holds an option whether to enforce the contract or not, while the other party
is obligated to perform at the option of the first party. an option is a financial instruments
that gives its owner the right, but not the obligation, to engage in some specific transaction
on an asset. Options are derivative instruments, as their fair price derives from the value of
the other asset, called the underlying. The underlying is commonly a stock, a bond, or a
futures contract, though many other types of options exist, and options can in principle be
created for any type of valuable asset.

An option to buy something is called a call; an option to sell is called a put. The price
specified at which the underlying may be traded is called the strike price. The process of
activating an option and thereby trading the underlying at the agreed-upon price is referred to
as exercising it it. Most options have an expiration date. If the option is not exercised by the
expiration date, it becomes void and worthless. Option contracts give trade hedgers and
investors a more flexible alternative to futures as a means of trading on the Exchange. When
buying an options contract, the purchaser (taker) is not entering into a firm obligation. They
are simply buying a choice of action. This choice allows the genuine trade hedger the
opportunity of locking in a fixed price while maintaining the ability to abandon the option in
order to take advantage of favorable price movements. This would be forfeited with a
straight futures hedge.
Advantages
•Leverage. Options allow you to employ considerable leverage. This is an advantage to disciplined traders who know how to use leverage.
•Risk/reward ratio. Some strategies, like buying options, allows you to have unlimited upside with limited downside.
•Unique Strategies. Options allow you to create unique strategies to take advantage of different characteristics of the market - like volatility
and time decay.
•Low capital requirements. Options allow you to take a position with very low capital requirements. Someone can do a lot in the options
market with $1,000 but not so much with $1,000 in the stock market.

Disadvantages
•Lower liquidity. Many individual stock options don't have much volume at all. The fact that each optionable stock will have options trading
at different strike prices and expirations means that the particular option you are trading will be very low volume unless it is one of the most
popular stocks or stock indexes. This lower liquidity won't matter much to a small trader that is trading just 10 contracts though.
•Higher spreads. Options tend to have higher spreads because of the lack of liquidity. This means it will cost you more in indirect costs
when doing an option trade because you will be giving up the spread when you trade.
•Higher commissions. Options trades will cost you more in commission per dollar invested. These commissions may be even higher for
spreads where you have to pay commissions for both sides of the spread.
•Complicated. Options are very complicated to beginners. Most beginners, and even some advanced investors, think they understand them
when they don't.
•Time Decay. When buying options you lose the time value of the options as you hold them. There are no exceptions to this rule.
•Less information. Options can be a pain when it is harder to get quotes or other standard analytical information like the implied volatility.
•Options not available for all stocks. Although options are available on a good number of stocks, this still limits the number of possibilities
available to you.
 
 Swaps
Swaps are agreements between two parties to exchange a set of cash flows according to a predetermined method.
In the case of a swap involving two bonds, the benefits in question can be the periodic interest (or coupon) payments
associated with the bonds. Specifically, the two counterparties agree to exchange one stream of cash flows against
another stream. These streams are called the legs of the swap. The swap agreement defines the dates when the cash
flows are to be paid and the way they are calculated. Usually at the time when the contract is initiated at least one of
these series of cash flows is determined by a random or uncertain variable such as an interest rate, foreign exchange rate,
equity price or commodity price.
The cash flows are calculated over a notional principal amount, which is usually not exchanged between counterparties.
Consequently, swaps can be used to in cash or collateral.
Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on changes in the expected direction
of underlying prices.

Interset rate swap:

A swap is a derivative in which one party exchanges a stream of interest payments for another party's stream of cash
flows. Interest rate swaps can be used by hedgers to manage their fixed or floating assets and liabilities. They can also
be used by speculators to replicate unfunded bond exposures to profit from changes in interest rates. Interest rate swaps
are very popular and highly liquid instruments.
Currency swap:
A currency swap is an agreement between two parties to exchange the principal loan amount and interest applicable on
it in one currency with the principal and interest payments on an equal loan in another currency. These contracts are
valid for a specific period, which could range up to ten years, and are typically used to exchange fixed-rate interest
payments for floating-rate payments on dates specified by the two parties.
Since the exchange of payment takes place in two different currencies, the prevailing spot rate is used to calculate the
payment amount. This financial instrument is used to hedge interest rate risks.
Derivatives can further be grouped according to the markets they are dealt within. The
derivatives can be of two types, namely:
Over-the-counter (OTC) products, or
Exchange traded products.
 
When two mutually consenting parties enter into a contract with matching needs that are
known to each other, such contracts are called over-the-counter products. These contracts
are specific to the parties involved and are not traded in the market. These contracts are
customized to the requirements of the counter parties and are normally settled by delivery of
underlying asset, though there is a possibility of existing the obligations by entering into
subsequent contract opposite to the first one.
 
Other kind of derivatives, namely the exchange traded products, are traded on the
organized exchanges where the buyer and seller need not to know each other, the exchange
being the counter-party for both buyer and seller. They are standard products whose
specifications are designed by the exchange authorities taking into consideration the
characteristics of the underlying asset.
 
 Numericals

Suppose the market rates are as follows:

UDS/CHF spot : 1.6450, 6 month forward: 1.6580
Euro$ 6 month interest rate: 4.5% p.a.
EuroCHF 6 month interest rate: 6.5% p.a.
Its easy to see that the forward discount on CHF is
[(1.6580-1.6450)/1.6450]*100*2 = 1.58%,
Which is less than 2% as required by the covered interest parity condition. Forward CHF is overvalued relative to spot
CHF

Cases according to above situation:

Q1) A Swiss firm needs $ 1 million right now to settle an import bill. It can acquire this in the spot market at a cost of
CHF 1.6450 million. Alternatively, it can take a 6 month $ 1 million loan in the Eurodollar market to settle the import
bill and set aside enough CHF on deposit to buy the dollar loan principal and interest 6 moths forward. It has to replay

$1000000[1+(0.045/2)] = $1.0225 million

To acquire this in the forward market it will need
CHF (1.0225*1.6850) million = CHF 1.695305 million
To have this amount ready 6 months later it must deposit now
CHF (1.695305/1.0325) million = CHF 1,641,941.90

It saves little over 3000 CHF following the indirect route and avoiding the spot market altogether.
Q2) A US firm needs CHF 1 million 6 months from now to pay off a maturing payable. How should it go about
acquiring it? It can directly buy it in the forward market or indirectly acquire via spot and money markets – borrow
dollars, convert spot to CHF and deposit CHF in the Euromarket. Intitutively, we can guess the answer. It should use
the spot marlet route since forward CHF is relatively overvalued and it is buying CHF. We can confirm this by
comparing the costs. For a forward purchase it will need:

$(1000000/1.6580) = $ 603136.31, 6 months hence.

Via the indirect route, to have CHF 1 million 6 months hence, it must deposit
CHF (1000000/1.0325) = CHF 968525 now,
To acquire this in the spot market, it will need to borrow:
$(968523/1.6450) = $ 588767.78 now,
The repayment of this loan will require
$(588767.78*1.0225) = $ 602015.06, 6 months hence.

Thus, the US firm will save little over a thoudand dollars avoiding the forward contract.
Thank You