INTRODUCTION

1. 2. 3. 4. 5.

DERIVATIVES CALL AND PUT OPTION SWAPS ISDA LIBOR

DERIVATIVES
Definition Derivative is a product whose value is derived from the value of an underlying asset in a contractual manner. The underlying asset can be equity, Forex, commodity or any other asset.

WHEN ,WHERE ,WHY & HOW

WHEN WHERE WHY & HOW

: 1848 : Chicago (USA) : Early forward contracts in the US addressed merchants concerns about ensuring that there were buyers and sellers for commodities. However credit risk remained a serious problem. To deal with this problem, a group of Chicago; businessmen formed the Chicago Board of Trade (CBOT) in 1848. The primary intention of the CBOT was to provide a centralized location known In advance for buyers and sellers to negotiate forward contracts. In 1865, the CBOT went one step further and listed the first exchange traded derivatives Contract in the US; these contracts were called futures contracts.

TYPES OF DERIVATIVES
OTC (Over The Counter)
OTC derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary Out of the total OTC trades 67% are interest rate contracts, 8% are credit default swaps (CDS), 9% are foreign exchange contracts, 2% are commodity contracts, 1% are equity contracts, and 12% are others.

ETD (Exchange-traded derivative contracts)

ETD are those derivatives instruments that are traded via specialized derivatives exchanges or other exchanges. A derivatives exchange is a market where individuals trade standardized contracts that have been defined by the exchange . The world's largest derivatives exchanges (by number of transactions) are the Korea Exchange (which lists KOSPI Index Futures & Options).

DERIVATIVES PRODUCT TYPES

Forwards:

A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at todays pre-agreed price. 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. Options: 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. Swaps: Swaps are private agreement between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts.

OPTIONS
There are basically two types of option Call Option : Call option gives the right to buyer right to buy a certain quantity of the underlying asset, at a specified price on or before a given date in the future, he however has no obligation whatsoever to carry out this right. Put Option : Put option gives the buyer the right to sell a certain quantity of an underlying asset, at a specified price on or before a given date in the future, he however has no obligation whatsoever to carry out this right.

WHEN CAN WE EXERCISE OPTION

These options can be exercised in two styles
European style option :

In European style the call and put option can be exercised only on the expiry of the contract .
American style option :

In American style the call and put option can be exercised at any time until expiry of the contract

SWAPS
Definition: A swap is a derivative in which counterparties exchange certain benefits of one party's financial instrument for those of the other party's financial instrument.

TYPES OF SWAPS
INTEREST RATE SWAPS :

IRS are financial instrument in which two parties agree to exchange interest rate cash flows, based on a specified notional amount from a fixed rate to a floating rate (or vice versa) or from one floating rate to another.Interest rate swaps are commonly used for both hedging and speculating
CREDIT DEFAULT SWAP :

A credit default swap (CDS) is a swap contract in which the buyer of the CDS makes a series of payments to the seller and, in exchange, receives a payoff if a instrument - typically a bond or loan - goes into default (fails to pay).

 CURRENCY SWAP :

A currency swap involves exchanging principal and fixed rate interest payments on a loan in one currency for principal and fixed rate interest payments on an equal loan in another currency. COMMODITY SWAP : A commodity swap is an agreement whereby a floating (or market or spot) price is exchanged for a fixed price over a specified period. The vast majority of commodity swaps involve crude oil. EQUITY SWAP : An equity swap is a special type of total return swap, where the underlying asset is a stock, a basket of stocks, or a stock index.

CDS (credit default swap)

Working of a CDS trade

C
C pays premium on notional To B (10%/month)

(Reference Entity)

This trade comes into effect when c defaults or falls in credit event

B paid C amount of $10,00,000 as loan for 10 yrs

(Protection Buyer) B

(Protection Seller)

B pays premium for protection to A (2%/month)

Effect on market

Negative : CDS trades played a major role in bankruptcy of Lehman Brothers Positive : 1. Citigroup made 24% profit in CDS trades 2. AIG came out of its losses and plans invest aprox. 200 billion in CDS trades

IRS (Interest Rate Swaps)

An interest rate swap is a popular and

highly liquid financial derivative instrument in which two parties agree to exchange interest rate cash flows, based on a specified notional amount from a fixed rate to a floating rate (or vice versa) or from one floating rate to another . Interest rate swaps are commonly used for both hedging and speculating.

TPYES OF IRS
Fixed-for-floating rate swap, same currency Fixed-for-floating rate swap, different currencies Floating-for-floating rate swap, same currency Floating-for-floating rate swap, different currencies Fixed-for-fixed rate swap, different currencies

Structure & Working

Eg: Plain Vanilla swap / Fixed A pays fixed rate to B (A

receives variable rate)

Settlement : Party A pays (LIBOR + 1.50%)+8.65% - (LIBOR+0.70%) =

9.45% net

 ISDA a trade organization of participants in the

market for over-the-counter derivatives (OTC) It was initially created in 1985 It is headquartered in New York It has more than 820 members in 57 countries It Master Agreement

ISDA Master Agreement

The ISDA Master Agreement was first published in

1992, and a second edition was published in 2002. The master agreement is drafted in two main parts 1. First part : the parties enter into master agreement which provides basic terms for all trades between thise parties 2. Second part: the parties will enter into schedules that document each individual class of derivatives trade conducted under that master agreement.

LIBOR (London Interbank Offered Rate)

The LIBOR rate is the average interest rate that leading

banks in London charge when lending to other banks. The LIBOR rates are daily produced at 11 a.m.(london time) LIBOR is calculated and published by Thomson Reuters on behalf of the British Bankers' Association (BBA). The rate LIBOR rate is benchmark rate for financial institution all around the world.