Derivative Markets

Introduction Derivative: A security whose price is dependent upon or derived from one or more underlying assets. Its value is determined by fluctuations in the underlying asset. Stocks, bonds, commodities, currencies and interest rates.

Need for Derivatives Transferring risks. Discovery of future as well as current prices. Increase saving and investments in long run.

History The first organized commodity exchange came into existence in early 1700’s in japan. The first foreign currency future were traded on May 16,1972 on international monetary market. The first call and put options were invented by an American financier Russell Sage in 1872.

Types of Derivatives Forward Futures Option Swap Derivatives

Exchange traded derivatives Over- the- counter derivatives Derivative Markets The derivatives market is the financial market for derivatives. Derivative markets Exchange traded derivatives Over- the- counter derivatives

ETD vs. OTCD Non-regulated markets Bilateral Agreements Settlement and clearing house Standardization Guarantee of completion of operation Non-regulated markets Bilateral Agreements No standard agreement Risk of counter party

Forward Contract Agreement entered today where: One party agrees to buy and other agrees to sell an asset. On a specified future date. At an agreed price. Contract is custom designed. Contract is traded in the over-the-counter market.

Forward Contract Example You will be receiving dollars after 3 months. Present dollar rate Rs 45 per$. Rate after 3 months Rs 38 per $. You will lose Rs 7 per dollar. Therefore you enter into a forward contract to sell dollar at Rs 43. You have locked in the dollar rate at Rs 43 .

Pros & Cons Pros Cons Unregulated market. Lack of liquidity. Easy to understand. Offer a complete hedge. Lack of liquidity. High default risk.

Future Standardized form of forward contract. Contracts are traded in organized exchanges. The future date is called the delivery date or final settlement date. The pre-set price is called the futures price.

Future Contract Example In January purchase 100 shares of IBM stock at $50 a share on April 1. The contract has a price of $5,000. The price of IBM stock rises to $52 a share on March 1. If you sell the contract for 100 shares, you'll fetch a price of $5,200, and make a $200 profit.

Example Cont’d Sell 100 shares of IBM at $50 a share on April 1 for a total price of $5,000. But then the value of IBM stock drops to $48 a share on March 1. Buy the contract back on March 1, then you pay $4,800 for a contract that's worth $5,000. By predicting that the stock price would go down, you've made $200.

Prone & Cons Prone Cons Easy liquidation. No customization of contract Well organized stable market. Little default risk. No customization of contract

To buy or sell something Option Is a right But not an obligation To buy or sell something At a stated date At a stated price Option

Option Cont’d The price at which the asset may be bought or sold is called the exercise price or strike price. The date after which an option is void is called the expiration. There are two types of option: Call option Put option

Option Types Call option Put option Option which gives the holder right to buy an asset but not an obligation to buy. Option which gives the holder right to sell an asset but not an obligation to sell. Call option will be exercise only when the exercise price is lower than the market price. Put option will be exercise only when the exercise price is higher than the market price. The owner makes a profit provided he sells at a higher current price and buys at a lower future price. The owner makes a profit provided he buys at lower current price and sells at a higher future price.

Option Example Example Option premium $20 Current market price $1700 Exercise price $1750 Market price after 3 months Gain/loss Situation 1 $2000 $230 Situation 2 $1730 ($20)

Prone & Cons Prone Cons Flexibility to the buyers as well as to the sellers. They are less risky. It requires a close observation .

Swap Agreements between two parties to exchange sequences of cash flows for a set period of time. Two types of swap: Interest rate swap Currency swap

Interest Rate Swap The interest related cash flows between the parties in the same currency. This involves the exchange of fixed rate and floating rate interest payment. The firm paying the floating rate is the swap seller. The firm paying the fixed rate is the swap buyer.

Currency Swap Agreement to exchange one currency with another ,at a specific rate of exchange.

Prone & Cons Prone Cons Swap is generally cheaper. Swap can be used to hedge risk. Lack of liquidity. It is subject to default risk.

Participants in Derivatives Market Objectives Hedgers They are the players whose objectives is risk reduction. Speculators They are the players who establish position based on their expectations of future price movements. Arbitrageurs They are the players whose objective is to profit from pricing differentials.

Derivatives Market in Pakistan In Pakistan derivative market was developed in 2001. Few banks like SCB, UBL and RBS are allowed by the SBP to deal in derivative transactions. SBP regulates the OTC market for : Foreign currency options. Forward rate agreements. Interest rate swaps.

Cont’d The derivative market of Pakistan is underdeveloped. The main reason is the inconsistent performance of the economy on the whole. Risks and uncertainties are extremely high. Lack of customer knowledge is the most notable issue in the Pakistani Derivative market.

Dark side of Derivatives A hedged position can become unhedg at the worst times. Inflicting substantial losses on those who mistakenly believe they are protected. The use of derivatives can result in large losses because of the use of leverage, or borrowing.

Loss in Derivatives Market American International Group (AIG) lost more than US$18 billion through a subsidiary over the preceding three quarters on credit default swaps. The loss of US$7.2 Billion by Societe General in January 2008 through mis-use of futures contracts. The loss of US$1.2 billion equivalent in equity derivatives in 1995 by Barings Bank.