" ' ( , Edited by: Dr. Rupesh Roshan Singh DERIVATIVES & RISK MANAGEMENT Edited By Dr. Rupesh Roshan Singh Printed by EXCEL BOOKS PRIVATE LIMITED A-45, Naraina, Phase-I, New Delhi-110028 for Lovely Professional University Phagwara SYLLABUS Derivatives & Risk Management Objectives: To provide a basic understanding of financial derivatives as well the application of derivatives, trading mechanism, uses as hedging instruments, risks involved and legal, controlling and regulatory framework. To provide knowledge, understanding of practical investments and corporate financial management strategies (such as hedging or risk mitigation) using various derivatives in a manner which will allow students to apply these concepts and skills in their careers. Sr. No. Description 1. Introduction to derivatives: Definition, types of derivatives, Uses of derivatives, Exchange-traded vs. OTC derivatives, Derivatives in India, Regulation for derivatives trading and SEBI guidelines related to derivatives trade. 2. Introduction to Forwards and Futures: BasicHedging practices, Forward contracts, Limitations of forward markets, Introduction to futures, Stock Index futures, Commodity Futures and Currency Futures, Distinction between futures and forwards contracts, pay-offs, Cash settlement vs Physical settlement, Pricing Principles, Beta and Optimal Hedge Ratio. 3. Introduction to Options: Option terminology and Types, Index derivatives, European and American calls and puts, Exotic and Asian Options, Stretagies and Pay-offs, Option Pricing and Put-Call parity. 4. Swaps: Meaning, overview, interest rate swaps, currency swaps, credit risk, mechanics of swaps. 5. Interest Rate Derivatives & Euro-Dollar Derivatives: T-Bill and T-bond Futures, Euro-Dollar Derivatives, Forward Rate Agreement (FRA), Duration, Convexity. 6. Credit Derivatives: Types of Credit Derivatives, Credit Default Swaps, Collateralized Debt Obligations, The Indian Scenario, credit risk mitigation, Weather and Energy Derivatives. 7. Risk Management with Derivatives: Hedging Using Greeks (Delta-Gamma Hedging), Hedging with Futures (Strategies of hedging, speculation and arbitrage): Index Options and futures, VaR, Historical Simulations, Risk management structure and policies in India. 8. Management of Derivatives Exposure: Introduction, nature of derivatives trading, setting of Risk-vision, reasons for managing derivatives risk and types of risk in derivative trading. Futures and options trading system, Basis of trading. CONTENT Unit 1: Introduction to Derivatives 1 Rupesh Roshan Singh, Lovely Professional University Unit 2: Evolution of Derivatives in India 12 Rupesh Roshan Singh, Lovely Professional University Unit 3: Forward Contracts 25 Rupesh Roshan Singh, Lovely Professional University Unit 4: Future Contracts 37 Rupesh Roshan Singh, Lovely Professional University Unit 5: Pricing of Future Contracts 49 Rupesh Roshan Singh, Lovely Professional University Unit 6: Introduction to Options 60 Mahesh Kumar Sarva, Lovely Professional University Unit 7: Option Strategies and Pay-offs 74 Mahesh Kumar Sarva, Lovely Professional University Unit 8: Option Pricing 104 Mahesh Kumar Sarva, Lovely Professional University Unit 9: Swaps 117 Mahesh Kumar Sarva, Lovely Professional University Unit 10: Interest Rate Derivatives and Euro-Dollar Derivatives 133 Mahesh Kumar Sarva, Lovely Professional University Unit 11: Credit Derivatives 143 Dilfraz Singh, Lovely Professional University Unit 12: Risk Management with Derivatives I 158 Dilfraz Singh, Lovely Professional University Unit 13: Risk Management with Derivatives II 172 Dilfraz Singh, Lovely Professional University Unit 14: Management of Derivatives Exposure 184 Dilfraz Singh, Lovely Professional University Rupesh Roshan Singh, Lovely Professional University Unit 1: Introduction to Derivatives Unit 1: Introduction to Derivatives Notes CONTENTS Objectives Introduction 1.1 Meaning and Definitions of Derivatives 1.2 Types of Derivatives 1.2.1 Popular Derivative Instruments 1.2.2 Other Types of Financial Derivatives 1.3 Uses of Derivatives 1.4 Exchange Traded vs. OTC Derivatives 1.5 Summary 1.6 Keywords 1.7 Review Questions 1.8 Further Readings Objectives After studying this unit, you will be able to: Define derivatives Identify the types of derivatives Describe the uses of derivatives Compare exchange traded vs OTC derivatives Introduction In recent decades, financial markets have been marked by excessive volatility. As foreign exchange rates, interest rates and commodity prices continue to experience sharp and unexpected movements, it has become increasingly important that corporations exposed to these risks be equipped to manage them effectively. 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. Risk management, the managerial process that is used to control such price volatility, has consequently risen to the top of financial agendas. It is here that derivative instruments are of utmost utility. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices. However, by locking-in asset prices, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors. LOVELY PROFESSIONAL UNIVERSITY 1 Derivatives & Risk Management Notes ! Caution The word 'derivatives' originated in mathematics and refers to a variable that has been derived from another variable. For example, a measure of distance in kilometers could be derived from a measure of distance in miles by dividing by 1.61, or similarly a measure of temperature in Celsius could be derived from a measure of temperature in Fahrenheit. In financial sense, a derivative is a financial product which had been derived from a market for another product. 1.1 Meaning and Definitions of Derivatives A derivative security is a financial contract whose value is derived from the value of something else, such as a stock price, a commodity price, an exchange rate, an interest rate, or even an index of prices. Various Definitions of Derivatives 1. Derivatives are financial contracts whose value/price is dependent on the behaviour of the price of one or more basic underlying assets (often simply known as the underlying). These contracts are legally binding agreements, made on the trading screen of stock exchanges, to buy or sell an asset in future. The asset can be a share, index, interest rate, bond, rupee dollar exchange rate, sugar, crude oil, soyabean, cotton, coffee and what you have. 2. Thus, a 'derivative' is a financial instrument, or contract, between two parties that derived its value from some other underlying asset or underlying reference price, interest rate, or index. A derivative by itself does not constitute ownership, instead it is a promise to convey ownership. The Underlying Securities for Derivatives are: (a) Commodities (Castor seed, Grain, Coffee beans, Gur, Pepper, Potatoes) (b) Precious Metals (Gold, Silver) (c) Short-term Debt Securities (Treasury Bills) (d) Interest Rate (e) Common Shares/Stock (f) Stock Index Value (NSE Nifty) In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R)A) defines "derivative" to include: 1. 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; 2. A contract which derives its value from the prices, or index of prices, of underlying securities. Derivatives are securities under the SC(R)A and hence the trading of derivatives is governed by the regulatory framework under the SC(R)A. A very simple example of derivatives is curd, which is derivative of milk. The price of curd depends upon the price of milk which in turn depends upon the demand and supply of milk. 2 LOVELY PROFESSIONAL UNIVERSITY Unit 1: Introduction to Derivatives Notes Notes Derivatives vs Shares The subtle, but crucial, difference is that while shares are assets, derivatives are usually contracts (the major exception to this are warrants and convertible bonds, which are similar to shares in that they are assets). Well, we can define financial assets (e.g. shares, bonds) as: claims on another person or corporation; they will usually be fairly standardized and governed by the property or securities laws in an appropriate country. On the other hand, a contract is merely an agreement between two parties, where the contract details may not be standardized. Possibly because it is thought that investors may be wary of the woolly definition of derivatives, one frequently comes across references to "derivatives securities" or "derivatives products''. These "securities" and "products" sound fairly solid, tangible things. But in many cases there terms are rather inappropriately applied to what are really contracts. Self Assessment Fill in the blanks: 1. Derivatives are ………………. whose value/price is dependent on the behaviour of the price of one or more basic underlying assets. 2. A derivative by itself does not constitute …………..... 3. A ………… is merely an agreement between two parties. 1.2 Types of Derivatives It is observed that financial derivatives are those assets whose values are determined by the value of some other assets, called as the underlying. Presently, there are bewilderingly complex varieties of derivatives already in existence, and the markets are innovating newer and newer ones continuously. For