DERIVATIVES

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8th June 06

AGENDA
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INTRODUCTION TYPES OF DERIVATIVES RISK FACTOR SETTLEMENT & DISCLOSURE OF DERIVATIVE TRANSACTION GROWTH & FUTURE

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INTRODUCTION
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UNDERSTANDING DERIVATIVES
Primary objective is to maximize returns and minimize risks. The word originates from mathematics and refers to variable, which has been derived from another variable.

HISTORY
The history of derivatives can be traced to the middle ages. In 1995 the Chicago Board of Trade commenced trading in Derivatives.

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INTRODUCTION
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MEANING A contract between two parties to buy/sell a commodity at a future date at a predefined price. PARTIES TO DERIVATIVE TRANSACTIONS Hedgers Speculators Arbitrageurs
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TYPES OF DERIVATIVES
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FORWARDS-BASED DERIVATIVES OPTIONS

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FORWARDS-BASED DERIVATIVES

Forward Contract Swaps Futures Contracts

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FORWARDS-BASED DERIVATIVES
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FORWARD CONTRACT :
Simplest form of Derivatives. Buy/ Sell a specified quantity of a underlying financial instrument at a specific price on a specified date in future. Traded OVER THE COUNTER.

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FORWARDS-BASED DERIVATIVES
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SWAPS :
Infinitely flexible. Commits the participants to exchange cash flows at specified intervals, which are called payment or settlement dates. Main users are large multinational banks or corporations. Create credit exposures and are individually designed to meet the risk management objectives of the participants.

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FORWARDS-BASED DERIVATIVES

TYPES OF SWAPS

INTEREST RATE

CURRENCY

COMMODITY

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FORWARDS-BASED DERIVATIVES
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FUTURES CONTRACTS :
Standardized form of Forward Contract. Price being the only variable element. Traded through the Recognised Exchanges. Buyer/Seller is under an obligation to buy/sell the underlying on or before the specified date.
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TYPES OF FUTURES
Futures

INTEREST RATE

CURRENCY

STOCK / EQUITY

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OPTIONS :

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Gives the holder, in exchange for a premium, a right (not an obligation) to buy/sell the underlying asset. Can be exercised within a given period of time. Is exercised at a specified price called Strike Price. Two parties to the contract: 1. Buyer 2. Writer Loss to the buyer is to the extent of premium.

OPTIONS

Equity Stock / Index Option

CALL OPTION

PUT OPTION

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RISK FACTOR

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RISK FACTOR

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RISK FACTOR
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Time Constraint Unpredictable MARKET High Loss Exposure Information Sensitive

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SETTLEMENT & DISCLOSURE OF DERIVATIVES TRANSACTION

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FORWARD CONTRACT :
Settled on specified date. Seller Delivers the specified quantity of the underlying asset. Buyers pays the pre determined price. Both the parties are under an obligation to execute the contract.
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SETTLEMENT & DISCLOSURE OF DERIVATIVES TRANSACTION

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FUTURES CONTRACT :
Required to pay an Initial Margin to the Trading/Clearing Member computed as per SPAN. Balance in Margin A/c is disclosed under the head Current Asset. If Bank Guarantee is given, separate disclosure is required. Every Futures Contract is Mark-to-Market at the end of the trading session.
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SETTLEMENT & DISCLOSURE OF DERIVATIVES TRANSACTION

MMM is Debited/Credited to the Initial Margin A/c. Keeping in view prudence as consideration for the preparation of Financial Statement a provision for the anticipated loss in respect of open futures contracts should be made. For this purpose, the net amount paid/received on account of MMM on Open Futures contract on Balance Sheet date should be determined Index/Script wise.
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SETTLEMENT & DISCLOSURE OF DERIVATIVES TRANSACTION

At the expiry of the series, Profit/Loss on final settlement should be calculated as a difference of Final settlement price & contract price. In case of Default, a contract is Closed & the unpaid amount is adjusted against Initial Margin.

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SETTLEMENT & DISCLOSURE OF DERIVATIVES TRANSACTION

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OPTIONS :

Buyer/Holder has to pay premium. Provision by Buyer Excess of premium paid for option over premium prevailing on the Balance Sheet date.

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SETTLEMENT & DISCLOSURE OF DERIVATIVES TRANSACTION

Provision by WriterExcess of premium prevailing on the Balance Sheet date over the premium received for the option.

Settlement - Option If Not Exercised : Premium paid/received will be treated as expenditure/income.

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SETTLEMENT & DISCLOSURE OF DERIVATIVES TRANSACTION

- Option if Exercised: Buyers Books : - Premium considered as expenditure. - Excess of Market Price over Strike Price considered as profit for Call Option.

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GROWTH & FUTURE

77 Million contracts for index and stock futures and options traded on NSE during 04-05. Represents a growth of 35%. Options account for 20% of derivatives trades. NSE chief forecasts derivatives trading to surge by 70% each year for the next few years.

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B u s in e s s G r o w t h in D e r iv a t iv e s s e g m e n t
In d e x F u t u r e s S to c k Fu tu r e s In d e x O p t io n s C a ll Put C a ll S t o c k O p t io n s Put

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STATUTORY WARNING
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It could rip your guts out overnight ... the biggest, most potentially lucrative, and destructive market in the world . We view them as time bombs both for the parties that deal in them and the economic system ... In our view ... derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.

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THANK YOU &

HAPPY INVESTING

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