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DMGT513 DERIVATIVES & RISK MANAGEMENT Copyright © 2012 Bishnupriya Mishra & Sathya Swaroop Debasish
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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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