DERIVATIVES

PRESENTED BY SHEENA SINGH 29 ADITI MERCHANT 33 MITHILA PAI 38 RAINA SHAH 44 POOJA VAIDYA 54 PRADNYA WADIA 57
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INDEX
1. Risk ........................................................................................................................................................ 3 1.1 Types of risk ........................................................................................................................................ 3 2. 3. Exposure................................................................................................................................................ 4 Hedging process .................................................................................................................................... 5 3.1 Internal methods................................................................................................................................. 5 3.2 External methods ................................................................................................................................ 6 3.3 Rise of Derivatives ............................................................................................................................... 7 3.4 History of Derivatives Markets in India............................................................................................... 7 4. 5. Participants in Derivatives Market ........................................................................................................ 9 Classification of Derivatives ................................................................................................................ 10

1. Risk
A risk can be defined as an unanticipated event with adverse financial consequences by way of loss or reduced earnings. Risk represents uncertainty or unpredictability of the future. From the financial perspective risk may generate profit or loss depending on the way in which it is managed. Risk can thus be described as the variability of the potential outcome. Risk management is traditionally seen as a process design to avoid or eliminate risk. 1.1 Types of risk Transaction Risk The exchange rate risk associated with the time delay between entering into a contract and settling it. The greater the time differential between the entrance and settlement of the contract, the greater the transaction risk, because there is more time for the two exchange rates to fluctuate. Transaction risk creates difficulties for individuals and corporations dealing in different currencies, as exchange rates can fluctuate significantly over a short period of time. This volatility is usually reduced, or hedged, by entering into currency swaps and other similar securities. Translation Risk The exchange rate risk associated with companies that deal in foreign currencies or list foreign assets on their balance sheets. The greater the proportion of asset, liability and equity classes denominated in a foreign currency, the greater the translation risk. This poses a serious threat for companies conducting business in foreign markets. Exchange rates usually change between quarterly financial statements, causing significant variances between the reported figures. Companies attempt to minimize these transaction risks by purchasing currency swaps or hedging through futures contracts.

Economic Risk Economic risk can be defined as business risk arising out of changes in the economic environment. For example, a change in the domestic exchange rate may provide an advantage to a competitor which may adversely affect the capacity of the enterprise to compete effectively. Economic risk cannot be anticipated nor can it be quantified and hence cannot be hedged through the use of external derivates. Being a business risk, it is accepted as the risk of being in business. MNCs generally have alternate business strategies framed for dealing with business risks.
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2. Exposure
Exposure can be described as the gross volume of the transaction which is subject to risk and on which loss can be incurred. 'Transaction Exposure' The risk, faced by companies involved in international trade, those currency exchange rates will change after the companies have already entered into financial obligations. Such exposure to fluctuating exchange rates can lead to major losses for firms. Often, when a company identifies such exposure to changing exchange rates, it will choose to implement a hedging strategy, using forward rates to lock in an exchange rate and thus eliminate the exposure to the risk. 'Translation Exposure' The risk that a company's equities, assets, liabilities or income will change in value as a result of exchange rate changes. This occurs when a firm denominates a portion of its equities, assets, liabilities or income in a foreign currency. Also known as "accounting exposure. Accountants use various methods to insulate firms from these types of risks, such as consolidation techniques for the firm's financial statements and the use of the most effective cost accounting evaluation procedures. In many cases, this exposure will be recorded in the financial statements as an exchange rate gain (or loss).

'Economic Exposure' It is an exposure to fluctuating exchange rates, which affects a company's earnings, cash flows and foreign investments. The extent to which a company is affected by economic exposure depends on the specific characteristics of the company and its industry. Most large companies attempt to minimize the risk of fluctuating exchange rates by hedging with positions in the forex market. Companies that do a lot of business in many countries, such as import/export companies, are at particular risk for economic exposure.

3. Hedging process
3.1 Internal methods Exposure Netting Offsetting exposures in one currency with exposures in the same or another currency, when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure. A multinational firm should not consider deals in isolation, but should focus on hedging the firm as a portfolio of currency positions. As an example, consider a U.S.-based multinational with Korean won receivables and Japanese yen payables. Since the won and the yen tend to move in similar directions against the U.S. dollar, the firm can just wait until these accounts come due and just buy yen with won. Even if its not a perfect hedge, it may be too expensive or impractical to hedge each currency separately. Denomination in local currency The exchange risk can be completely avoided if the transaction is denominated in local currency. In such a case the exchange risk will be borne by the opposite party to the transaction. In international trade, the invoicing of transactions is decided between the parties based on the acceptability of the currency and negotiating capacity of the parties. Invoicing of the transaction in either the currency of the importer or the exporter shifts the exchange risk onto the other party. Sometimes, to make things equitable, the invoice value is split i.e. half the transaction is denominated in the importers currency and the balance in the currency of the exporter. Such a process merely distributes the risk between the contracting parties but does not hedge the risk. Foreign Currency accounts Foreign Currency Account (FCA) is a transactional account denominated in a currency other than the home currency and can be maintained by a bank in the home country (onshore) or a bank in another country (offshore). Foreign currency accounts are generally not covered by national deposit insurance schemes. However, such accounts are covered in the United States, within the usual limits, as long the financial institution is insured and the deposits are available for withdrawal inside the U.S.

A foreign exchange hedge (FOREX hedge) is a method used by companies to eliminate or hedge foreign exchange risk resulting from transactions in foreign currencies (see Foreign exchange derivative). This is done using either the cash flow or the fair value method. The accounting rules for this are addressed by both the International
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Financial Reporting Standards (IFRS) and by the US Generally Accepted Accounting Principles Leads and Lags The alteration of normal payment or receipts in a foreign exchange transaction because of an expected change in exchange rates are called leads and lags. An expected increase in exchange rates is likely to speed up payments, while an expected decrease in exchange rates will probably slow them down. Accelerating the transaction is known as "leads", while slowing it down is known as "lags". Leads will result when firms or individuals making payments expect an increase in the foreign-exchange rate, while lags arise when the exchange rate is expected to fall. Leads and lags are used in an attempt to improve profit

3.2 External methods External transactions or instruments undertaken or used with the specific intention of hedging risks arising out of internal business operations represent external hedging. Such products are called Derivatives. The commonly used foreign currency derivatives are as follows:1. Foreign Currency Forward Contracts. 2. Foreign Currency Swaps. 3. Foreign Currency Futures Contracts. 4. Foreign Currency Options Contracts. Definition of Financial Derivatives Section 2(ac) of Securities Contract Regulation Act (SCRA) 1956 defines Derivative as: a) 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; b) A contract which derives its value from the prices, or index of prices, of underlying securities. Underlying Asset in a Derivatives Contract As defined above, the value of a derivative instrument depends upon the underlying asset. The underlying asset may assume many forms: i. Commodities including grain, coffee beans, orange juice; ii. Precious metals like gold and silver; iii. Foreign exchange rates or currencies; iv. Bonds of different types, including medium to long term negotiable debt securities issued by governments, companies, etc. v. Shares and share warrants of companies traded on recognized stock exchanges and Stock Index vi. Short term securities such as T-bills; and
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vii. Over- the Counter (OTC) money market products such as loans or deposits. 3.3 Rise of Derivatives The global economic order that emerged after World War II was a system where many less developed countries administered prices and centrally allocated resources. Even the developed economies operated under the Bretton Woods system of fixed exchange rates. The system of fixed prices came under stress from the 1970s onwards. High inflation and unemployment rates made interest rates more volatile. The Bretton Woods system was dismantled in 1971, freeing exchange rates to fluctuate. Less developed countries like India began opening up their economies and allowing prices to vary with market conditions. 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. This article describes the evolution of Indian derivatives markets, the popular derivatives instruments, and the main users of derivatives in India. I conclude by assessing the outlook for Indian derivatives markets in the near and medium term.

3.4 History of Derivatives Markets in India Derivatives markets in India have been in existence in one form or the other for a long time. In the area of commodities, the Bombay Cotton Trade Association started futures trading way back in 1875. In 1952, the Government of India banned cash settlement and options trading. Derivatives trading shifted to informal forwards markets. In recent years, government policy has shifted in favour of an increased role of market-based pricing and less suspicious derivatives trading. The first step towards introduction of financial derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995. It provided for withdrawal of prohibition on options in securities. The last decade, beginning the year 2000, saw lifting of ban on futures trading in many commodities. Around the same period, national electronic commodity exchanges were also set up. Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2001 on the recommendation of L. C Gupta committee. Securities and Exchange Board of India (SEBI) permitted the derivative segments of two stock exchanges, NSE3 and BSE4, and their clearing house/corporation to commence trading and settlement in approved derivatives contracts. Initially, SEBI approved trading in index futures contracts based on various stock market indices such as, S&P CNX, Nifty and Sensex. Subsequently, index-based trading was permitted in options as well as individual securities. The trading in BSE Sensex options commenced on June 4, 2001 and the trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001. The derivatives trading on NSE commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in index
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options commenced on June 4, 2001 and trading in options on individual securities commenced on July 2, 2001. Single stock futures were launched on November 9,2001. The index futures and options contract on NSE are based on S&P CNX. In June 2003, NSE introduced Interest Rate Futures which were subsequently banned due to pricing issue. Table 1 gives chronology of introduction of derivatives in India.

4. Participants in Derivatives Market

1. Hedgers: They use derivatives markets to reduce or eliminate the risk associated with price of an asset. Majority of the participants in derivatives market belongs to this category.

2. Speculators: They transact futures and options contracts to get extra leverage in betting on future movements in the price of an asset. They can increase both the potential gains and potential losses by usage of derivatives in a speculative venture.

3. Arbitrageurs: Their behaviour is guided by the desire to take advantage of a discrepancy between prices of more or less the same assets or competing assets in different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit.

5. Classification of Derivatives

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1. Forward Contract A forward contract is an agreement between two parties to buy or sell an asset at a specified point of time in the future. In case of a forward contract the price which is paid/ received by the parties is decided at the time of entering into contract. It is the simplest form of derivative contract mostly entered by individuals in day to days life. Forward contract is a cash market transaction in which delivery of the instrument is deferred until the contract has been made. Although the delivery is made in the future, the price is determined on the initial trade date. One of the parties to a forward contract assumes a long position (buyer) and agrees to buy the underlying asset at a certain future date for a certain price. The other party to the contract known as seller assumes a short position and agrees to sell the asset on the same date for the same price. The specified price is referred to as the delivery price. The contract terms like delivery price and quantity are mutually agreed upon by the parties to the contract. No margins are generally payable by any of the parties to the other. Forwards contracts are traded overthe- counter and are not dealt with on an exchange unlike futures contract. Lack of liquidity and counter party default risks are the main drawbacks of a forward contract. For example, consider a US based company buying textile from an exporter from England worth 1 million payment due in 90 days. The Importer is short of Pounds- it owes pounds for future delivery. Suppose the spot (cash market) price of pound is US $ 1.71 and importer fears that in next 90 days, pounds might rise against the dollar, thereby raising the dollar cost of the textiles. The importer can guard against this risk by immediately negotiating a 90 days forward contract with City Bank at a forward rate of say, 1= $1.72. According to the forward contract, in 90 days the City Bank will give the US Importer I million (which it will use to pay for textile order), and importer will give the bank $ 1.72 million (1million $1.72) which is the dollar cost of I million at the forward rate of $ 1.72. 2. Futures Contract Futures is a standardized forward contact to buy (long) or sell (short) the underlying asset at a specified price at a specified future date through a specified exchange. Futures contracts are traded on exchanges that work as a buyer or seller for the counterparty. Exchange sets the standardized terms in term of Quality, quantity, Price quotation, Date and Delivery place (in case of commodity).The features of a futures contract may be specified as follows: These are traded on an organized exchange like IMM, LIFFE, NSE, BSE, CBOT etc. These involve standardized contract terms viz. the underlying asset, the time of maturity and the manner of maturity etc. These are associated with a clearing house to ensure smooth functioning of the market. There are margin requirements and daily settlement to act as further safeguard.
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These provide for supervision and monitoring of contract by a regulatory authority. Almost ninety percent future contracts are settled via cash settlement instead of actual delivery of underlying asset. Futures contracts being traded on organized exchanges impart liquidity to the transaction. The Clearing house, being the counter party to both sides of a transaction, provides a mechanism that guarantees the honoring of the contract and ensuring very low level of default (Hirani, 2007). Following are the important types of financial futures contract:i Stock Future or equity futures, ii Stock Index futures, iii Currency futures, and iv Interest Rate bearing securities like Bonds, T- Bill Futures.

EXAMPLE
SELL $ 100

1 year BUY $ 110

A guarantee deposit of $5 is made for entering into future contract. Now after 1 year if dollar price increases say $145 in the open market then we will receive a profit of $30. This can be calculated as follows (P+1 - $110 - $5) i.e ($145 - $110 - $5) However if the price of the dollar decreases in the open market say $80 then loss would be $35 which is calculated as follows: (P+1 - $110 - $5) i.e ($80 - $110 - $5) In such a case we can let the contract lapse thus minimizing our losses and having a fixed and minimal loss of $5 and buy the dollars from the open market at $80.

3. Options Contract In case of futures contact, both parties are under obligation to perform their respective obligations out of a contract. But an options contract, as the name suggests, is in some sense, an optional contract. An option is the right, but not the obligation, to buy or sell something at a stated date at a stated price. A call option gives one the right to buy; a put option gives one the right to sell. Options are the standardized financial contract that allows the buyer (holder) of the option, i.e. the right at the cost of option premium, not the obligation, to buy (call options) or sell (put options) a specified asset at a set price on or before a specified date through exchanges.

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Options contracts are of two types: call options and put options. Apart from this, options can also be classified as OTC (Over the Counter) options and exchange traded options. In case of exchange traded options contract, contracts are standardized and traded on recognized exchanges, whereas OTC options are customized contracts traded privately between the parties. A call options gives the holder (buyer/one who is long call), the right to buy specified quantity of the underlying asset at the strike price on or before expiration date. The seller (one who is short call) however, has the obligation to sell the underlying asset if the buyer of the call option decides to exercise his option to buy. In case of currencies option call option on one currency is simultaneously a put option on the other currency. An option which a holder enjoys could be:1.) Exercise his right anytime during the life of the option. These is known as American Option 2.) Holder exercise on the expiration date or maturity date. These is known as European Option

Example i) Call option (right to sell):

1 year SELL $ 100 BUY $ 110

If holder goes for call option he has make a guarantee deposit of $5 for entering into the contract. Now after 1 year if dollar price increases say $145 in the open market then we will receive a profit of $30. This can be calculated as follows: (P+1 - $110 - $5) i.e. ($145 - $110 - $5) However if the price of the dollar decreases in the open market say $80 then loss would be $35 which is calculated as follows: (P+1 - $110 - $5) i.e. ($80 - $110 - $5) In such a case we can let the contract lapse thus minimizing our losses and having a fixed and minimal loss of $5 and buy the dollars from the open market at $80.

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ii)

Put option (right to sell):

1 year BUY $ 100 SELL $ 110

If holder goes for put option he has make a guarantee deposit of $5 for entering into the contract. Now after 1 year if dollar price increases say $145 in the open market then we will receive a loss of $40. This can be calculated as follows: ( $110 - P+1 - $5) i.e ($110 - $145 - $5) In such a case we can let the contract lapse thus minimizing our losses and having a fixed and minimal loss of $5 and sell the dollars in the open market at $145. However if the price of the dollar decreases in the open market say $80 then profit would be $25 which is calculated as follows: ($110 - P+1 - $5) i.e ($110 - $80 - $5)

4. Swaps Contract A swap can be defined as a barter or exchange. It is a contract whereby parties agree to exchange obligations that each of them have under their respective underlying contracts or we can say, a swap is an agreement between two or more parties to exchange stream of cash flows over a period of time in the future. The parties that agree to the swap are known as counter parties. The two commonly used swaps are: i) Interest rate swaps: which entail swapping only the interest related cash flows between the parties in the same currency, and 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 the cash flows in the opposite direction.

ii)

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Example An exporter and importer enter into contract for transaction worth $ 1 lakh and whose maturity date is 10th Dec. If on 6th Sept an exporter requires $1 lakh he can receive the amount from Bank A against his export documents. If the rate on 6 th Sept is 1$= Rs.46.65 but Bank A provides it at a premium of 0.15 which makes 1$= Rs.46.80 (46.65 + 0.15). During this time Bank A requires to cover the transaction risk. On 30 th Nov Bank A sells the $ 1lakh to Bank B at a discount of $ 0.12 till 10th Dec which makes 1$ = Rs. 46.77 (46.65 + 0.12). Thus net loss is Rs. 0.03 per dollar (46.80 46.77). Bank A undertakes a swap with Bank C and receives $1 lakh on 30th Nov till 10th Dec which it sells to Bank B on the same date. The interest rate received from Bank B and given to Bank C will cover the loss of Rs.0.03 per dollar. On 10 th Dec Bank B will return the money which Bank A will use to repay Bank C. The importer will credit the Nostro account with $ 1 lakh on the same date thus completing the merchant transaction.

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