1. MBA & MBA – Banking and Finance (Term-IV) Course : Security Analysis and Portfolio Management Unit III: Financial Derivatives

2. FINANCIAL DERIVATIVES Fluctuations in the prices of financial assets expose the dealers in such assets to risk. The dealers would like to hedge the risk involved in their financial transactions. Financial derivatives have evolved as instruments for hedging the risk involved in buying, holding and selling various kinds of financial assets. Basically, they are financial instruments for the management of risk arising from the uncertainty prevailing in financial markets regarding asset prices. 2

3. FINANCIAL DERIVATIVES Financial Derivatives are those assets whose value is derived from the value of underlying assets Underlying assets may be equity, commodity, or currency Derivatives have no independent value Derivatives are promise to convey ownership Derivatives may be exchange traded or privately negotiated over the counter 3

4. Types of Derivatives Forwards Futures Options 4

5. FORWARD CONTRACTS A forward contract is customised contract between two entities where settlement takes place on a specific date in the future at today’s pre agreed price Two parties irrevocably agree to settle a trade at a future date, for a stated price and quantity No money changes hands 5

6. Futures Contracts FUTURES A future contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. These are special types of forward contracts in the sense that the former are standardised exchange- traded contracts. Traded over an Exchange Standardized Forward Contract Contract to buy or sell a specified asset at a specified price on a specific date 6

7. LIMITATATIONS OF FORWARD CONTRACTS Private Bilateral agreement, Involves Counter Party Risk Cannot take Reverse Position, Lack of Liquidity Lack of Standardization These limitations can be overcome by use of Future Contracts 7

8. COMPARISON OF FORWARDS AND FUTURES 8

9. OPTIONS CONTRACTS Options may be defined as a contract, between two parties whereby one party obtains the right, but not the obligation, to buy or sell a particular asset, at a specified price, on or before a specified date Give the buyer the right but not the obligation to buy/sell a specified underlying asset At a set price On or before a specified period One who receives the right is the Option buyer/holder One who is obliged to perform the contract is the Option seller/writer 9

10. COMPARISON OF FUTURES AND OPTIONS 10

11. Types of Options Call Option Put Option 11

12. Call Option A Call Option gives 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. 12

13. PUT OPTION Put Option gives 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. 13

14. Comparison of Call & Put Option Buyer / Holder (privileged person) Seller/ Writer (Bearing risk) Call OptionRight to buy an asset Obligation to Sell Put OptionRight to SellObligation to Buy 14

15. Styles of Options European Style : They can be exercised on specified future date only. ( Last Thursday of expiry month in India ) American Style : They can be exercised on or before a specified future date.( They are difficult to administer but more beneficial to the buyer. 15

16. Terminology to be used for Options Pricing Spot Price : The current price of the stock Exercise Price/Striking Price: The fixed price at which the option holder can by and / or sell the underlying asset. Exercise Date : When option is exercised Expiry Date : Last Date when option can be exercised Option Premium :It is the price the buyer pays the writer for an option contract. 16

17. Advantages Of Options Leverage Unlimited Profit Potential Fixed Risk 17

18. Example A stock’s prevailing market price is Rs.250 (S 0 ). A call option contract having exercise price (E) of 260 and 3 months maturity is available at an option premium of Rs.3(c). Interpretation Out of pocket cost right now is Rs.3 If market price 3 months hence S 1 = 270 Exercise the call option Net pay off = (270 - 260 – 3 ) = 7 (gain) 18

19. If S 1 = 250 Do not exercise the call option No benefit / No loss Net payoff = 3 (loss) Net loss will remain max 3 irrespective of S 1 If S 1 = 290 Net pay off = (290 - 260 – 3 ) = 27 (gain) There is potential for unlimited gain 19

20. Diagrammatic Representation 20 Break even point Loss Gain Area Stock Price 263 260

21. If S 1 > E Exercise Call Option If S 1 < E Do not exercise call option A call option will be exercised if S 1 > E or S 1 = E Net payoff = S 1 - E -c 21

22. Option Pricing FACTORS AFFECTING OPTION PRICE Stock price (on expiration date): The value of call option, other things being constant, increases with the stock price. Strike/ Exercise price: Other things being constant, the higher the exercise price, lower would be the value of a call option. Time to Expiration: Other things being constant, longer the time to expiration date the more valuable the call option. The holder gets more time for exercising the option Variability of the stock price: Other things being constant, the higher the variability of the stock price, the greater the likelihood that the stock price will exceed the exercise price. Risk Free Rate of Interest: The higher the interest rate, the greater the benefit will be from delayed payment and vice-versa. So, the value of a call option is positively related to the interest rate. Dividends: The call option price is lower at the ex-dividend date compared to the pre-dividend date. 22