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A buyer of a derivative gets a right over the asset which after or during a particular period of time might result in her buying or selling the asset. The asset may be a commodity, a stock or a foreign currency. A right is bought either to buy or sell the underlying the asset after or during a specified time. The price at which the transaction is to be carried out is also spelt out in the beginning itself.

Any transaction that results in a right without actually transacting the asset becomes a derivative instrument. A brief picture of the common Derivatives is given below: Futures and Forwards Contracts under this category relate to transactions entered into on a given date to become effective after a specified time frame and subject to payment at rates determined currently but becoming due after that specified time.

Forwards and Futures are entered into by those who wish to be assured of a price after a specified time in line with the current price. With prices fluctuating all the time, it is impossible to predict the price levels after a few months. A Forward or a Futures contract will ensure that the prices are frozen upon at the time of entering into the contract and the time frame for the contract is also firmed up.

The buyer of an option contract gets the right without the obligation to either buy or sell the underlying asset. There is a time frame and a price fixed for the contract.

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For the privilege of going ahead with the contract as per her desire, the option buyer has to pay the seller a premium up front. If, ultimately All the detailed aspects of an Options contract are covered in a later Module. Swaps In a swap transaction the two parties thereto exchange their obligations on predetermined terms. In its simplest version, two companies having different obligations of interest payments with one Company obliged to pay a fixed rate of interest to its bankers and the other Company having to pay a floating rate of interest , enter into a contract whereby they exchange their obligations.

This exchange of their obligations results in one Company getting the fixed interest from the other Company to be used for satisfying its obligation. The principal amount to be reckoned for the purpose of calculating the two interests called the Notional principal , and the benchmark interest rate to be used for the purpose of determining the floating rate are decided at the time of entering into the contract.

Typically, like all Derivatives, this does not directly result in the underlying commodity being traded. Instead, a right or an obligation is established with respect to the underlying commodity.

This type of derivative is also used by manufacturers and exporters who want to ensure a specified amount of commodities to meet their business obligations. The principles involved in these Derivatives are the same as those governing general Options. Sometimes these transactions are entered into for getting compensation for interest rate declines. The notional principal, the benchmark interest rate and the time of reckoning all are decided at the time of entering into the contract.

Interest Rate Derivatives are covered in a later Module. Credit Derivatives Bankers and lenders use Credit Derivatives to safeguard themselves against credit defaults. There are many varieties of these Derivatives involving sometimes the creation of a third body called a Special Purpose Vehicle. Credit Derivatives constitute an area of great development in recent years and many new sophisticated instruments are getting developed by the day.

An introduction to some common Credit Derivatives is given in a later module. This is facilitated by a counter party who has the motivation to make profits out of the premium, or is holding a mirror-image opposite position. Used this way, Derivatives offer an important tool of risk management, without which companies and individuals would have been exposed to the vagaries of price fluctuations.

One of the greatest objections to Derivatives has been that they encourage speculation. In other words, deals on Derivative contracts can be entered into even by those who do not have a risky asset position. It can be entered into by speculators betting on a given price movement or absence of fluctuations.

While this in itself may not seem Many companies have been ruined by over-zealous officials recklessly entering into positions on Derivatives and taking on enormous risk in the hope of gains on favorable price movements. Since Derivatives instruments are complex and involve sophistication in pricing and strategy, it is beyond the non-specialist manager to comprehend the exact risk that the Company is exposed to because of a series of derivative transactions.

In the process the Company concerned is exposed to great risk. Many companies set up their own strategies regarding the extent of risk they needed to be covered and correspondingly they enter into appropriate Derivative transactions for the purpose.

This process results in prevention of unnecessary risk and optimization of profits. She will be happy to have this converted at around Rs.

However there is great uncertainty in the foreign exchange market as to the nature of the possible movement after 3 months. Fortunately for the exporter a bank is willing to enter into a Forward contract with her for paying Rs. If the exporter enters into this Forward contract, she makes sure that she will be able to get Rs. However, if the rates change to her favor say to Rs. A detailed discussion on this aspect and other related topics are covered in a later unit.

There are other The use of Derivatives in the commodity segment has been existent over several years, but these were mostly confined to Futures and Forwards transactions. Options contracts in the stock markets have become very popular in recent years and have given a new facet to share portfolio management. In the foreign exchange market, over-the-counter Forwards have been prevalent for long, but formalized Futures and Options are yet to take shape.

Trading of Interest Rate Derivatives has been formally introduced in the stock exchanges but these are yet to capture the imagination of the common investor. Swap transactions have been reported more on a customized one-to- one basis rather than being taken as formal standardized instruments.

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Credit Derivatives have made an entry but are yet to become very popular. Stock markets find Derivative instruments very useful and portfolio managers find a number of uses from these for protecting and enhancing their stock holdings. The rising volumes of Index-based and individual securities are an indication of their growing popularity. The fact remains, however, that most of the deals are speculative in nature and are not necessarily for risk management.

But this by itself need not be taken as an adverse factor, since in most world markets initial uses of derivative instruments have been basically speculative. Besides, the existence of a large number of speculators enables the genuine risk manager to put through his deals comfortably and volumes will not suffer.

Strict In conventional analysis, trading involves buying and selling an asset. In the Derivatives segment, trading involves not the selling and buying of the asset itself, but a right on the asset. This right does not carry with it any obligation and comes at a price called the premium. There are many types of derivative instruments, the most notable among them being Forwards and Futures, Options and Swaps.

Derivative Markets: An Introduction

Derivatives are useful for managing the risk of an organization. Usually companies develop a strategy for active risk management using Derivatives. The stock-based Derivatives have become very popular in India and result in great trading volumes. In India, Forwards and Futures are in great use in the commodity segment.

It is also common to have Forward contracts in foreign exchange transactions. They are widely used and are quite intuitive in nature. The pricing and payoff follow a pattern that can be easily understood. A Forward or Futures contract enables one to enter into an agreement to buy or sell a specified quantity of the underlying asset after a specified time at a specified price.

In other words, a Forward or Futures contract locks up the rate of the underlying asset and regardless of the actual rate at the time of expiry, the deal has to be executed at the rate agreed upon.

This arrangement enables the parties to the contract to lock up their receipts or payments at convenient levels. However, the disadvantage is that if rates move in the opposite direction to what is feared, it might turn out to be a mistake to have entered into the contract. For instance a commodity trader wishes to sell kgs. He expects the price to be steady at this level even after 3 months when the crop will be ready, but fears that some adverse movements in other sectors might result in a fall in the price.

To safeguard himself he enters into a Forward contract for the quantity at around Rs. The contract in effect means that he is obliged to surrender kgs of the commodity after 3 months in exchange of getting Rs. Now, if as feared, the prices fall However, if the price rises above Rs. If the invoicing were made in the Indian currency, the exporter would not have had any difficulty in estimating her potential receipt after 3 months.

It goes without saying that one of the parties to the contract will stand to gain more in the final analysis, but what it ensures at the time of entering into the contract is that the risk element is eliminated. The importer is apprehensive that the amount to be paid may become more in terms of the Indian rupees because of adverse movements in the foreign exchange market. At the expiry of the period, the importer pays the agreed The amount to be paid in Indian Rupees does not vary with the then prevailing exchange rate.

Even if the exchange rate movement is adverse, the importer is not affected since the amount to be paid in exchange has been firmed up in advance.

However, like the contract for selling foreign currency seen earlier, here again one of the parties would lose opportunity gains in the final analysis depending upon the exchange rates at the time of expiry, but it ensures that the risk is eliminated at the time of entering into the contract.

Futures contracts work in exactly the same way as the Forwards, except that they are better regulated. The quantity of the underlying asset that is to be contracted is in specified lots and the time of expiry is also pre-fixed. For instance if the importer wants to sell Rs. Thus if a standard Futures contract is for say Rs.

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There are other structural differences in Futures as well like the margin requirement, mark-to-market rules and settlement. These are dealt with in detail later in the Module. A commodity farmer expects kgs of a commodity to be ready after harvest in 3 months. The price of the commodity as of now is Rs. The farmer would be happy if the price he obtains is around this level.

However, market economics suggest that the price may take a dip and he may end up getting only say around Rs. In other words, the farmer would be obliged to sell kgs of the commodity after 3 months at a price of Rs. This will be regardless of what the final price of the commodity is to be at the end of 3 months.

If he accepts this offer today, the farmer is able to make sure that he gets Rs. However, he has to continue to worry about obtaining the harvest of kgs In case the harvest is not as successful as anticipated and he ends up having only less than kgs. As far as the trader is concerned he has ensured that he will get a supply of kgs.

This is an example of a short hedge as far as the farmer is concerned and a long hedge as far as the trader is concerned. In a short hedge the individual is concerned about fall in prices and sells the commodity in advance at a pre- determined price.

In a long hedge the individual is concerned about the rise in prices and ensures the price by buying the commodity at the pre- determined price. In either case the quantity is frozen. The short hedge has enabled the farmer to reduce his anxiety about the prices. Now regardless of the actual movement of prices in the market the If the price at the end turns out to be Rs. On the other hand, if the price rises beyond 2.

The Forward would force him to sell at Rs. This is the price he pays for ensuring a minimum amount. He will not be able to participate in upward movement of prices The long hedge has enabled the trader to reduce his anxiety about prices.

Now regardless of the actual movement of prices in the market the trader will have to pay only Rs. On the other hand, if the price falls to say Rs. The Forward would force him to buy at 2. This is the price he pays for ensuring a Forward amount. He will not be able to take the benefit from downward movement of prices. In the following example the possible payoff from a short hedge can be seen. The situation involves selling Forward at Rs. If the price ends up at Rs.

Table I. Price after 3 months Gain in Forwards Total proceeds 95 6. Here again the long hedge has been made at Rs. Price after 3 months Gain in Forwards Total proceeds 97 In Derivatives pricing the universal method is to use continuous compounding. In other words, the final value based on interest for a period of 6 months on an investment of Rs. We get Forward pricing is based on interest rate computation and the principles of arbitrage.

Financial theory has the support of the principle of arbitrage for various postulates. If the prices as per the postulate do not hold good, it would be possible for alert operators to buy one type of instrument and sell Arbitrage ensures that prices reach their equilibrium levels in an ideal market. The theoretical correct price for a Forward contract which has 3 months to go on a spot price of Rs.

If the price is greater than The spot asset will be bought using borrowed funds which will necessitate an interest payment of Rs.

Interest is calculated on a principal of Rs. On the expiry of the period, the operator will sell the asset which he had bought originally in the spot market using borrowed funds at Rs.

He will repay Rs. As more and more operators do this the price will come back to its equilibrium level of Rs.

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If the price is less than Rs. The amount got out of selling the spot asset Rs. On the expiry of the period, the operator will buy the asset based on his Forward contract by paying Rs. He will receive Rs. As more and more operators seize on this risk-free opportunity, the prices will reach back the equilibrium level of Rs. More aspects of the cost of carry principle and the risk-free arbitrage are covered in a later unit.

A Futures contract is standardized in terms of the quantity per contract and the time of expiry. A Forward contract, on the other hand, is customized based on the needs of the two parties to the contract. There will be no default risk in a Futures contract since it is exchange- oriented, whereas the possibility of default exists in Forward contract.

In a Futures contract the buyer and the seller do not directly interact and the exchange is the effective counterparty for each of the dealers 3. A Futures contract will entail a margin for avoidance of default and this amount has to be remitted from time to time to the exchange based on extant regulations. In a Forward contract, there is no standardized margin but this can also be incorporated as a condition to the contract by the parties concerned.

A Futures contract is monitored on a regular basis by the regulating authority and hence entails a mark-to-market margin.

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Thus, if a trader has bought a Forward contract of 3 months for a commodity at Rs. This is because the adverse price movement might result in ultimate default and the mark-to-market enables the contract to be scaled up or down to the current market levels. Mark-to- market margins are generally not insisted upon in a Forward contract. A Futures contract is cash settled. This means that that the final price of the underlying is compared to the rate agreed upon and the difference either paid or received from the parties concerned.

Actual delivery of the underlying is not done. A Forward contract, on the other hand, can be of cash settled or based on physical delivery.

They are in wide use for risk management. A Forward contract facilitates the buying or selling of an underlying asset at a pre-determined price after a specified period. A Futures is similar in operation to Forwards except for structural variations on account of contractual specifications, margins and mark-to market. A long Forward contract obliges the buying of the underlying asset and a short Forward contract obliges the selling of the underlying asset.

Forwards and Futures are used widely in the hedging of price risks. While the practice of hedging enables the avoidance of price risk, traders find that occasionally they lose out on opportunity gains because of price movements which turn out to be more favorable than expected. According to this, the price at the time of its inception has a definite relationship with the spot price and is generally represented by the interest for the period involved. If the price does not conform to this pattern it is possible to enter to arbitrage and make risk-free profits.

That fact that a number of operators will embark upon this arbitrage will result in the prices once again coming to the equilibrium levels. However, he will get his crop only after 2 months. He fears that the prices might fall in the meantime. How can the farmer use Forwards to reduce his risk? Under what circumstances will a trader feel that he would have been better off without the Forward? Is this applicable only to Futures contracts? Hedging is an important requirement for all mangers.

Based on price fluctuations and market behavior, managers will tend to hedge their exposures short or long. We recapitulate the principal factors in respect of hedges below: Hedges using Forwards and Futures can be long or short. A long hedge is one that goes long the Forwards or Futures long means buy. This is entered into by those fearing price rises.

A short hedge is used by those fearing price falls. A short hedge signifies selling of the Forward or Futures. By selling the Forward or Futures they seek to freeze the prices at a level.

Derivative Markets: An Introduction

Hedging is a double-edged sword. While the hedge does offer protection, it would also mean that if the prices do not move in the direction feared, one might lose a chance for bonanza profits. In the same way, if the price is greater than anticipated then the short hedger suffers an opportunity loss. However, in both the cases, the operators would have frozen upon a It is only the opportunity of higher gains that they lose in the process.

Hedging is a part of the strategic process of companies. They generally have a policy as to how much of their exposure to hedge and the price bands at which these should be carried out.

Companies tend to leave a portion of their exposure open. The farmer expects to produce kgs in 3 months might decide to hedge only kgs and leave the remaining kgs unprotected. Hedging with Forwards and Futures result in almost identical coverage. However, a Futures contract might entail the payment of periodic margins and mark-to-market margins, resulting in some differences in cash flow analysis. The cost of carry principle introduced in the earlier unit needs to be modified in respect of Futures contract factor because of margins and deposit money.

There will be little default in a Futures contract whereas a Forward, being a one to one contract might result in defaults. In order to make reasonable profits from the deal the exporter has to acquire this commodity from the domestic market at Rs.

The current price is Rs per unit and the Futures price currently going in the market is Rs. Readers would have noticed that the Futures price does not conform to the cost of carry principle introduced in the previous unit.

The possible reasons for this are discussed in the subsequent Chapters. The exporter will buy Futures at Rs. This was what the exporter had feared. However, since he had the foresight to go in for a Futures contract his interests are protected.

Risk Management of Financial Derivatives

Now he gets delivery of the commodity at Rs. The actual price of Rs. One important difference between Forwards and Futures in respect of final settlement may be noticed in this context.

If the exporter had entered into a Forward contract he would have got actual delivery by paying Rs. But if he had entered into a Futures contract for his hedge he will instead be paid the difference between the prevailing commodity price of Rs.

This means that he collects the difference of Rs. He was in any case prepared to pay Rs. If, however, the price in the spot market ends up at Rs. In such a case the exporter is not able to take advantage of the fall in the prices and still ends up paying Rs.

As we have seen this is the sacrifice he makes for seeking a hedge using Forwards or Futures. To take an example a Company fears that the price of its output will come down.

It expects units of output by the end of next 3 months. The current output price is Rs. The Futures for the output asset are currently going at Rs. Again the reader This will be looked at in detail in the next unit. Similarly, in a short hedge the operator can use Futures by selling the Futures today. As we have seen the Futures will conform more or less to the cost of carry principle. After the specified period of contract he will be able to get the difference between the price at which he sold the Futures, from the commodity exchange and the actual price in the spot market.

If, however, the spot price in the end happens to be higher than the price at which he sold the Futures, he will have to pay the difference to the exchange.

Fearing a decline in prices our Company goes for a short hedge by selling the 3 months Futures at Rs. After 3 months if the final price is say Rs.

The cash settlement from the Futures contract will give the Company Rs. The Company will sell the commodity in the market atRs. Here again the procedural difference between a Forward contract and a Futures contract may be noticed. In the Forward contract the Company would have been able to sell to the counter party the quantity contracted at Rs. In the Futures contract because it is cash settled only the difference between the Futures contracted price and the actual price in the end is handed over to the Company.

The actual buying of the commodity has to be done by the Company through the regular market. Continuing the example if it so happens that the final price were Rs. Although it will still be able to sell the output at Rs.

This is the sacrifice for freezing a price using Forwards or Futures. One such aspect is that Futures are well regulated by stock exchanges. Every person entering into a Futures contract is actually doing so with the stock exchange as the counter party In order to ensure that the parties entering into a Futures contract meet the stringent requirements of payment, stock exchanges insist on margins.

Margins are amounts required to be paid by dealers in respect of their Futures positions. There will be initial margins, some special margins imposed from time to time and mark to market margins. Mark to market margins result in the dealer having to pay margins specially for meeting the adverse movement in underlying positions as a result of changes in spot prices. Some exchanges insist on maintenance margins which mean that the trader is required to pay additional margin when the mark to market position falls below a trigger point.

Margin requirements vary from exchange to exchange and sometimes from time to time. The following illustration shows a typical position and its impact on the trader based on certain assumptions regarding maintenance margin and mark to market margin. In the example the initial margin is Rs. If the initial margin as adjusted by adverse mark to market, falls below the Rs. The table below shows the position: Date Sett. The trader had taken a short position in Futures and has paid an initial margin of Rs.

On 6th Nov the price fell to Rs. The next day the spot price was Rs. As shown under the Equity column the margin now is only Rs. Since the maintenance margin is Rs. This entails a payment of Rs. This procedure goes on till the end of the contract. The last two columns show the effective Equity position and the margin position from time to time. Basis risk has greater application in Futures contracts because here the contracts do not expire at the time when the trader requires.

In a Forward contract it is possible to customize the contract to the appropriate time frame. Basis refers to the difference between the Spot price of the asset and the Futures price of the asset. After 3 months, the spot price becomes 2. Here the basis at the beginning B1 is - 0. At the time when the contract is entered into there is a spot price for the asset and a corresponding Futures price. Normally, the Futures will conform to the cost of carry principle and can be determined fairly accurately.

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Start your free month Start your free month Or buy the eBook for only Content Context Learning outcomes Introduction The financial system in brief Ultimate lenders and borrowers Financial intermediaries Financial instruments Spot financial markets Interest rates The derivative markets Summary Bibliography Derivative markets: