DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT.pdf - Derivatives and Risk Management DMGT513 DERIVATIVES RISK MANAGEMENT Copyright \u00a9 2012 Bishnupriya Mishra

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Unformatted text preview: Derivatives and Risk Management DMGT513 DERIVATIVES & RISK MANAGEMENT Copyright © 2012 Bishnupriya Mishra & Sathya Swaroop Debasish All rights reserved Produced & Printed by EXCEL BOOKS PRIVATE LIMITED A-45, Naraina, Phase-I, New Delhi-110028 for Lovely Professional University Phagwara SYLLABUS Derivatives & Risk Management Objectives: To provide a basic understanding of financial derivatives as well the application of derivatives, trading mechanism, uses as hedging instruments, risks involved and legal, controlling and regulatory framework. To provide knowledge, understanding of practical investments and corporate financial management strategies (such as hedging or risk mitigation) using various derivatives in a manner which will allow students to apply these concepts and skills in their careers. Sr. No. 1 Content Introduction to derivatives: Definition, types of derivatives, Uses of derivatives, Exchange-traded vs. OTC derivatives, Derivatives in India, Regulation for derivatives trading and SEBI guidelines related to derivatives trade. 2 Introduction to Forwards and Futures: Basic Hedging practices, Forward contracts, Limitations of forward markets, Introduction to futures, Stock Index futures, Commodity Futures and Currency Futures, Distinction between futures and forwards contracts, pay-offs, Cash settlement Vs Physical settlement 3 Pricing of Future Contracts: Pricing Principles, Beta and Optimal Hedge Ratio. 4 Introduction to Options: Option terminology and Types, Index derivatives, European and American calls and puts, Exotic and Asian Options 5 Option Strategies and Pay-offs, Option Pricing and Put-Call parity. 6 Swaps: Meaning, overview, interest rate swaps, currency swaps, credit risk, mechanics of swaps 7 Interest Rate Derivatives & Euro-Dollar Derivatives: T-Bill and T-bond Futures, Euro-Dollar Derivatives, Forward Rate Agreement (FRA), Duration, Convexity 8 Credit Derivatives: Types of Credit Derivatives, Credit Default Swaps, Collateralized Debt Obligations, The Indian Scenario, credit risk mitigation, Weather and Energy Derivatives 9 Risk Management with Derivatives: Hedging Using Greeks (Delta-Gamma Hedging), Hedging with Futures (Strategies of hedging, speculation and arbitrage): Index Options and futures, VaR, Historical Simulations, Risk management structure and policies in India 10 Management of Derivatives Exposure: Introduction, nature of derivatives trading, setting of Risk-vision, reasons for managing derivatives risk and types of risk in derivative trading. Futures and options trading system, Basis of trading CONTENTS Unit 1: Introduction to Derivatives 1 Unit 2: Evolution of Derivatives in India 12 Unit 3: Forward Contracts 25 Unit 4: Future Contracts 37 Unit 5: Pricing of Future Contracts 49 Unit 6: Introduction to Options 60 Unit 7: Option Strategies and Pay-offs 74 Unit 8: Option Pricing 104 Unit 9: Swaps 117 Unit 10: Interest Rate Derivatives and Euro-Dollar Derivatives 133 Unit 11: Credit Derivatives 143 Unit 12: Risk Management with Derivatives I 158 Unit 13: Risk Management with Derivatives II 172 Unit 14: Management of Derivatives Exposure 184 Unit 1: Introduction to Derivatives Unit 1: Introduction to Derivatives Notes CONTENTS Objectives Introduction 1.1 Meaning and Definitions of Derivatives 1.2 Types of Derivatives 1.2.1 Popular Derivative Instruments 1.2.2 Other Types of Financial Derivatives 1.3 Uses of Derivatives 1.4 Exchange Traded vs. OTC Derivatives 1.5 Summary 1.6 Keywords 1.7 Review Questions 1.8 Further Readings Objectives After studying this unit, you will be able to: Define derivatives Identify the types of derivatives Describe the uses of derivatives Compare exchange traded vs OTC derivatives Introduction In recent decades, financial markets have been marked by excessive volatility. As foreign exchange rates, interest rates and commodity prices continue to experience sharp and unexpected movements, it has become increasingly important that corporations exposed to these risks be equipped to manage them effectively. Price fluctuations make it hard for businesses to estimate their future production costs and revenues. Derivative securities provide them a valuable set of tools for managing this risk. Risk management, the managerial process that is used to control such price volatility, has consequently risen to the top of financial agendas. It is here that derivative instruments are of utmost utility. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices. However, by locking-in asset prices, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors. LOVELY PROFESSIONAL UNIVERSITY 1 Derivatives & Risk Management Notes ! Caution The word 'derivatives' originated in mathematics and refers to a variable that has been derived from another variable. For example, a measure of distance in kilometers could be derived from a measure of distance in miles by dividing by 1.61, or similarly a measure of temperature in Celsius could be derived from a measure of temperature in Fahrenheit. In financial sense, a derivative is a financial product which had been derived from a market for another product. 1.1 Meaning and Definitions of Derivatives A derivative security is a financial contract whose value is derived from the value of something else, such as a stock price, a commodity price, an exchange rate, an interest rate, or even an index of prices. Various Definitions of Derivatives 1. Derivatives are financial contracts whose value/price is dependent on the behaviour of the price of one or more basic underlying assets (often simply known as the underlying). These contracts are legally binding agreements, made on the trading screen of stock exchanges, to buy or sell an asset in future. The asset can be a share, index, interest rate, bond, rupee dollar exchange rate, sugar, crude oil, soyabean, cotton, coffee and what you have. 2. Thus, a 'derivative' is a financial instrument, or contract, between two parties that derived its value from some other underlying asset or underlying reference price, interest rate, or index. A derivative by itself does not constitute ownership, instead it is a promise to convey ownership. The Underlying Securities for Derivatives are: (a) Commodities (Castor seed, Grain, Coffee beans, Gur, Pepper, Potatoes) (b) Precious Metals (Gold, Silver) (c) Short-term Debt Securities (Treasury Bills) (d) Interest Rate (e) Common Shares/Stock (f) Stock Index Value (NSE Nifty) In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R)A) defines "derivative" to include: 1. 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; 2. A contract which derives its value from the prices, or index of prices, of underlying securities. Derivatives are securities under the SC(R)A and hence the trading of derivatives is governed by the regulatory framework under the SC(R)A. A very simple example of derivatives is curd, which is derivative of milk. The price of curd depends upon the price of milk which in turn depends upon the demand and supply of milk. 2 LOVELY PROFESSIONAL UNIVERSITY Unit 1: Introduction to Derivatives Notes Notes Derivatives vs Shares The subtle, but crucial, difference is that while shares are assets, derivatives are usually contracts (the major exception to this are warrants and convertible bonds, which are similar to shares in that they are assets). Well, we can define financial assets (e.g. shares, bonds) as: claims on another person or corporation; they will usually be fairly standardized and governed by the property or securities laws in an appropriate country. On the other hand, a contract is merely an agreement between two parties, where the contract details may not be standardized. Possibly because it is thought that investors may be wary of the woolly definition of derivatives, one frequently comes across references to "derivatives securities" or "derivatives products''. These "securities" and "products" sound fairly solid, tangible things. But in many cases there terms are rather inappropriately applied to what are really contracts. Self Assessment Fill in the blanks: 1. Derivatives are ………………. whose value/price is dependent on the behaviour of the price of one or more basic underlying assets. 2. A derivative by itself does not constitute …………..... . 3. A ………… is merely an agreement between two parties. 1.2 Types of Derivatives It is observed that financial derivatives are those assets whose values are determined by the value of some other assets, called as the underlying. Presently, there are bewilderingly complex varieties of derivatives already in existence, and the markets are innovating newer and newer ones continuously. For example, various types of financial derivatives based on their different properties like, plain, simple or straightforward, composite, joint or hybrid, synthetic, leveraged, mildly leveraged, customized or OTC traded, standardized or organized exchange traded, etc., are available in the market. Figure 1.1: Classification of Derivatives Derivatives Financial Commodities Basic Forwards Complex Futures Options Warrants & Convertibles Swaps Exotic (Non – Standard) LOVELY PROFESSIONAL UNIVERSITY 3 Derivatives & Risk Management Notes Due to complexity in nature, it is very difficult to classify the financial derivatives, so in the present context, the basic financial derivatives which are popular in the market have been described in brief. The details of their operations, mechanism and trading, will be discussed in the forthcoming respective units. In simple form, the derivatives can be classified into different categories which are shown in the Figure 1.1 One form of classification of derivative instruments is between commodity derivatives and financial derivatives. The basic difference between these is the nature of the underlying instrument or asset. In a commodity derivatives, the underlying instrument is a commodity which may be wheat, cotton, pepper, sugar, jute, turmeric, corn, soybeans, crude oil, natural gas, gold, silver, copper and so on. In a financial derivative, the underlying instrument may be treasury bills, stocks, bonds, foreign exchange, stock index, gilt-edged securities, cost of living index, etc. It is to be noted that financial derivative is fairly standard and there are no quality issues whereas in commodity derivative, the quality may be the underlying matters. However, the distinction between these two from structure and functioning point of view, both are almost similar in nature. Another way of classifying the financial derivatives is into basic and complex derivatives. In this, forward contracts, futures contracts and option contracts have been included in the basic derivatives whereas swaps and other complex derivatives are taken into complex category because they are built up from either forwards/futures or options contracts, or both. In fact, such derivatives are effectively derivatives of derivatives. 1.2.1 Popular Derivative Instruments The most popularly used derivatives contracts are Forwards, Futures, Options and Swaps, which we shall discuss in detail later. Here we take a brief look at various derivatives contracts that have come to be used. 1. Forwards: A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at today's pre-agreed price. The rupee-dollar exchange rates is a big forward contract market in India with banks, financial institutions, corporate and exporters being the market participants. ! Caution Forward contracts are generally traded on OTC. 4 2. Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts. Unlike forward contracts, the counterparty to a futures contract is the clearing corporation on the appropriate exchange. Futures often are settled in cash or cash equivalents, rather than requiring physical delivery of the underlying asset. Parties to a Futures contract may buy or write options on futures. 3. Options: An option represents the right (but not the obligation) to buy or sell a security or other asset during a given time for a specified price (the "strike price"). Options are of two types - calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date. 4. Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward LOVELY PROFESSIONAL UNIVERSITY Unit 1: Introduction to Derivatives contracts. Swaps generally are traded OTC through swap dealers, which generally consist of large financial institution, or other large brokerage houses. There is a recent trend for swap dealers to mark to market the swap to reduce the risk of counterparty default. The two commonly used swaps are: (a) Notes Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency. Example: Suppose Party A holds a 10-year 10,000 home loan that has a fixed interest rate of 7 %, and Party B holds a 10-year 10,000 home loan that has an adjustable interest rate that will change over the "life" of the mortgage. If Party A and Party B were to exchange interest rate payments on their otherwise identical mortgages, they would have engaged in an interest rate swap. (b) 1.2.2 Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction. Swaps may involve cross-currency payments (U.S. Dollars vs. Mexican Pesos) and crossmarket payments, e.g., U.S. short-term rates vs. U.K. shortterm rates. Other Types of Financial Derivatives 1. Warrants: Options generally have lives of up to one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter. 2. LEAPS: The acronym LEAPS means Long-term Equity Anticipation Securities. These are options having a maturity of up to three years 3. Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average of a basket of assets. Equity index options are a form of basket options. Notes Table 1.1 lists the major developments in financial derivatives. Table 1.1: The Global Derivatives Industry: Chronology of Instruments Year Financial Instruments 1972 Foreign Currency Futures. 1973 Equity futures: Futures on Mortgage-backed bonds. 1974 Equity futures, Equity options 1975 T-bill futures on mortgage backed bonds 1977 T-bond Futures 1979 Over-the-Counter Currency Options 1980 Currency Swaps 1981 Equity Index Futures: Options on T-bond futures; Bank CD Futures, T-note Futures; Euro-dollar Futures: Interest-rate Swaps 1982 Exchange listed Currency Options 1983 Interest-rate Caps and Floor; Options on T-note, Futures; Currency Futures: Equity Contd... Index Futures 1985 Euro Dollar Options; SwapOptions; Futures on US Dollar & Municipal Bond Indices 1987 LOVELY UNIVERSITY Average Options, Commodity Swaps,PROFESSIONAL Bond Futures, Compound Options, OTC Compound Options, OTC Average Options 1989 Three-month Euro-DM Futures Captions ECU ;Interest-rate Futures on Interest rate Swaps 1990 Equity Index Swaps 5 Derivatives & Risk Management Notes 1983 Interest-rate Caps and Floor; Options on T-note, Futures; Currency Futures: Equity Index Futures 1985 Euro Dollar Options; SwapOptions; Futures on US Dollar & Municipal Bond Indices 1987 Average Options, Commodity Swaps, Bond Futures, Compound Options, OTC Compound Options, OTC Average Options 1989 Three-month Euro-DM Futures Captions ECU ;Interest-rate Futures on Interest rate Swaps 1990 Equity Index Swaps 1991 Portfolio Swaps 1992 Differential Swaps 1993 Captions; Exchange listed FLEX Options 1994 Credit Default Options 1995 Credit Derivatives 1996-98 Exotic Derivatives 2003-04 Energy Derivatives, Weather Derivatives Self Assessment Fill in the blanks: 4. In a ……………. derivatives, the underlying instrument is a commodity which may be wheat, cotton, pepper, sugar, jute, turmeric, corn, soybeans, crude oil, natural gas, gold, silver, copper and so on. 5. In a ……………derivative, the underlying instrument may be treasury bills, stocks, bonds, foreign exchange, stock index, gilt-edged securities, cost of living index, etc. 6. A ……….. contract is a customized contract between two entities, where settlement takes place on a specific date in the future at today's pre-agreed price. 7. A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a ……………... . 8. An ……………..represents the right (but not the obligation) to buy or sell a security or other asset during a given time for a specified price. 9. …………… are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. 10. Basket options are options on …………… of underlying assets. 1.3 Uses of Derivatives Futures and options, as all derivatives, have come into existence because nearly every business has its risk. Rates of return are meaningful only in the context of how probable it is to achieve. Researchers usually distinguish between systemic Risk or Market Risk and Idiosyncratic Risk. The former refers to the risks which are common to all such securities, commodities and investments of the same class. Futures and options have arisen from the need to manage the risk arising from movements in markets beyond our control, such as commodities and foreign exchange, which may severely 6 LOVELY PROFESSIONAL UNIVERSITY Unit 1: Introduction to Derivatives impact the revenues and cost of our firm. An oil refiner might find himself paying more for crude oil, or a jewelry manufacturer more for gold. Such movements may adversely affect his or her business, and even threaten its viability. Derivatives, usually in the form of options and futures are, therefore, used as means to protect against key business risks which are beyond one's control. Systemic risks are part and parcel of being in business, and it is for accepting such risks that the market rewards us with a return. We can expect that when a firm's performance varies systematically with those of firms in the industry, (a high positive beta), options and futures may be used to enhance its value by managing such risks. They are, therefore, of use to anyone wishing to reduce or limit the impact with which such risks may have. The need to manage external risk is the primary reason for the existence of futures and options. Now, parties wishing to manage their risks are known as hedgers. The importance of derivatives is primarily for hedging risk exposure as used by hedgers. Notes The derivatives market performs a number of economic functions: 1. Discovery of Prices: Prices in an organized derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. The prices of derivatives converge with the prices of the underlying at the expiration of the derivative contract. Thus derivatives help in discovery of future as well as current prices. 2. Transfer of Risk: The derivatives market helps to transfer risks from those who have them b...
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