Derivatives Instrument

1.
2.
3.
4.
5.

Bhargav
Mukesh
Rucha
Heena
Ketan

What is a Derivative?

The term derivative refers to a broad class of

financial instrument which mainly include option
and future.

These instrument derive their value from the price

and other related variables of the underlying assets.

A simple example of derivative is butter which is

derivative of milk. The price of butter depends upon
price of milk. Which in turn depends upon the
demand and supply of milk.

Definition of derivatives

In finance a derivative is a contract that derive its

value from performance of an underlying entity.

To derive something from something else.

Derivatives are those financial instrument that

derive their value from the other assets.

For Example
The price of gold to be delivered after two months
will depend among so many things. On the present
and expected price of this commodity
3

Players in Derivatives Market

There are 3 types of traders in the Derivatives Market :

HEDGER

A hedger is someone who faces risk associated with price movement of an

asset and who uses derivatives as means of reducing risk.

They provide economic balance to the market.

SPECULATOR

A trader who enters the futures market for pursuit of profits, accepting risk in
the endeavor.

They provide liquidity and depth to the market.

ARBITRAGEUR

A person who simultaneously enters into transactions in two or more

markets to take advantage of the discrepancies between prices in these
markets.

Arbitrage involves making profits from relative mispricing.

Arbitrageurs also help to make markets liquid, ensure accurate

and uniform pricing, and enhance price stability

They help in bringing about price uniformity and discovery.

Classification of
derivatives

Broadly it can be classified in two categories:

1. Commodities
2. Financial

. In

case of commodity derivatives underlying

assets like wheat, gold, silver, etc.

. Whereas

in Financial underlying assets are

stock, currencies, bonds and other int. Rate
bearing securities

Classification of
Derivatives

Various types of derivative

contracts

Forward contract

Future contract

Option contract

Swap contract

Forward contract

A customized contract between two parties to buy or sell an

asset at a specified price on a future date.

A forward contract can be used for hedging.

Forward contract can be customized to any commodity,

amount and delivery date.

Its useful when futures do not exist for commodities and

financials being considered
9

Over-the-counter

Over-the-counter (OTC) or off-exchange

trading is to trade financial instruments such
as stocks, bonds, commodities or derivatives
directly between two parties without going
through an exchange or other intermediary.

10

Forward Contract Example

Farmer

I agree to sell
500kgs wheat
at Rs.40/kg
after 3
months.

Bread
Maker

3 months
Later

Farmer

500kgs
wheat
Rs.20,00
0

Bread
Maker

11

Terminology

Long position - Buyer

Short position - seller

Spot price Price of the asset in the spot

market.(market price)

Delivery/forward price Price of the asset at

the delivery date.

12

Future contract

A futures contract is similar to the forward

contract but is more liquid because it is traded
in an organized exchange.

Future contract are standardized.

Future contract transaction method is Quoted

and traded on the Exchange

13

Example

I have bought 1 lot (250 shares) of Reliance 26th July

Future @ Rs 700.

If the actual price of Reliance is Rs 800 on the

settlement day (26th July), I will buys 250 shares at
the contracted price of Rs 700. so I get 100 more per
share is my profit.

if the price falls to 650 he loses Rs 50 per share as I

have to buy at Rs 700.
14

Difference Between Forward &

Future

FUTURE

FORWARD

They trade on exchanges

Trade in OTC markets

Are standardized

Are Customized

Identity of Counterparties is
irrelevant

Identity is relevant

Marked to market( M to M)

No Marked to market

Less Costly

More Costly
15

Option

Options are of two types

1. Call Option
2. Put Option

3.

Call Option
The owner of a Call Option has the right to purchase the
underlying good at a specific price, and this right lasts
until a specific date.

2. Put Option
The owner of a Put Option has the right to sell the
underlying good at a specific price, and this right lasts
until a specific date.

16

Call Option Example

CALL OPTION
Premium =
Rs.25/share
Amt to buy Call
option = Rs.2500

Current Price =
Rs.250
Right to buy 100
Reliance shares at a
price of Rs.300 per
share after 3 months.

Suppose after a month,

Market price is Rs.400,
then the option is
exercised i.e. the shares
are bought.
Net gain = 40,00030,0002500 = Rs.7500

Strike
Price
Expir
y
date

Suppose after a month,

market price is Rs.200,
then the option is not
exercised.
Net Loss = Premium amt
= Rs.2500
17

Put Option Example

PUT OPTION
Current Price =
Rs.250

Premium =
Rs.25/share
Amt to buy Call
option = Rs.2500

Right to sell 100

Reliance shares at a
price of Rs.300 per
share after 3 months.

Suppose after a month,

Market price is Rs.200,
then the option is
exercised i.e. the shares
are sold.
Net gain = 30,000-20,0002500 = Rs.7500

Strike Price
Expiry
date

Suppose after a month,

market price is Rs.300,
then the option is not
exercised.
Net Loss = Premium amt
= Rs.2500
18

Option Characteristics

Options are created only by buying and selling.

Therefore, for every owner of an option, there

is a seller.

Options on futures

Futures option contract as its underlying good.

The structure is similar something physical

option owner has the right to exercise and the

seller has the duty to perform on exercise.

19

Cont
The call owner receives a long position in the
underlying futures
The call owner also receives a payment that equals
the settlement price minus the exercise price of the
futures option.

20

Options Terminology

Moneyless: Concept that refers to the potential profit or loss from

the exercise of the option. An option maybe in the money, out of
the money, or at the money.

Call Option

Put Option

In the money

Spot price > strike

price

Spot price < strike

price

At the money

Spot price = strike

price

Spot price = strike

price

Out of the
money

Spot price < strike

price

Spot price > strike

price

21

Swaps

In a swap, two counter parties agree to enter into a

contractual agreement wherein they agree to
exchange cash flows at periodic intervals.

Most swaps are traded Over The Counter.

Some are also traded on futures exchange market.

22

Cont..

Two Way of Swaps

1. Interest

rate swaps:
. These involve swapping only the interest related
cash flows between the parties in the same currency.
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

23

Interest Rate Swap Example

8%

A is fixed Rate
gaining interest

Mr .B

SWAPS BANK

Mr A

8.5%

B is floating rate
gaining interest

24

Direct Currency Swap Example

Dolour
Firm B

Miss A
Rupees
Miss A is Importing
some product then
she need a dolour so
she swap rupees with
dolour

Mr B is coming to
India he need
rupees so he swap
rupees with dolour
to miss A

25

Comparative Advantage

Firm A has a comparative advantage in borrowing Dollars.

Firm B has a comparative advantage in borrowing Euros.

This comparative advantage helps in reducing borrowing cost and

hedging against exchange rate fluctuations.

26

The Case of Southwest Airlines

Abstract

In order to stay in business, a passenger airline has to consistently

generate profits. Profits come only from paying passengers, hence
all stratagems must be customer oriented.

In a scenario where there are many airlines competing with each

other, one way of attracting passengers is to keep the cost of
flying low, while providing value for money.

On the other hand, expenses must tightly controlled to reach and

stay at the lowest possible.

Certain expenses are unavoidable; however, one variable that can

be kept low through decisive planning and foresight is the cost of
fuel, which, at best, can be called volatile.
27

Objective

To understand that how the airline company

using the derivative instruments for
reducing there cost.

28

Southwest Airlines

INTRODUCTION
Southwest was formed in 1971. Southwest Airlines, is
the third largest airline in the world as well as in America
in terms of passenger aircraft among all of the world's
commercial airlines.

It operates more than 540 Boeing 737 aircraft today

between 67 cities in the U.S.A. Today, Southwest
operates approximately 3,300 flights daily.

Southwests business model is the best low cost

model yielding considerable profit, while providing
value for money.

29

Case background

On June 12, 2001,Southwest Airlines is concerned

about the cost of fuel for Southwest.

High jet fuel prices in the past 18 months have

caused havoc in the airline industry. They knows that
since deregulation in the industry in 1978, airline
profitability and survival depends on controlling costs.

After labor cost, jet fuel is the second largest

operating expense. If airlines can control the cost of
fuel, they can more accurately estimate budgets and
forecast earnings.
Jet fuel prices are largely unpredictable.

30

jet fuel spot prices (Gulf Coast) have been on an overall upward trend
since reaching a low at $0.28 per gallon on December 21, 1998.
On September 11, 2000, the Gulf Coast jet fuel spot price was $1.01 per
gallon increase of 255 % in the spot price since the low in 1998.

31

Southwests average fuel cost per gallon in 2000 was

$0.7869, which was the highest annual average fuel
cost per gallon experienced by the company since 1984.

Although they thought the price of jet fuel would

decrease over the next year, they cannot be sure
energy prices are hard to predict. Any political
instability in the Middle East could cause energy prices
to rise dramatically without much warning.

Southwests jet fuel usage to be approximately 1,100

million gallons for next year.

Airlines use derivative instruments based on crude

oil, heating oil, or jet fuel to hedge their fuel cost
risk.
32

Following the Fuel Cost per Gallon for the past 7 years.

33

Questions
Which kind of player the Southwest Airlines
should be?
For what kind of product they can make a
strategy?
Which kind of contract they should do?
Does basis risk exist for Southwest Airlines in
their strategy?

34

Thank you for your attention crew !

35