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1、Introduction to Financial Derivatives,Introduction to Financial Derivatives,Agenda Introduction to Derivatives Types of Derivatives FRAs Futures Options Swaps Exotics Trading, Clearing and Settlement,2,2,Factors Driving growth of Derivatives,Increased volatility in asset prices in financial markets.

2、 Increased integration of national financial markets with the international financial markets. Marked improvement in communication facilities and sharp decline in their costs. Development of more sophisticated tools, providing economic agents a wider range of risk management strategies. Innovations

3、in the derivatives markets, which optimally combine the risks and returns over a large number of financial assets leading to : higher returns, reduced risk The number of option contracts, multiplied by The contract multiplier The contract multiplier (also called contract size) is different for most

4、classes of options and is determined by each exchange In the US, the contract size for options on shares is 100 If you buy 10 HDFC option contracts, it means that you have the right to buy 1,000 HDFC shares at expiration if the price is right (10 x 100).,35,Who Trades Options,Two broad categories of

5、 players exist in the option markets: risk seekers and risk avoiders A risk seeker, is a speculator A risk avoider, is a hedger,36,Buyer On a public stock exchange (also known as ETOs (Exchange Traded Options) Implicitly agreed between two parties (also known as OTCs (Over The Counter options).,38,O

6、ptions vs. Stocks,Similarities Listed Options are securities, just likestocks Options trade like stocks, with buyersmaking bids and sellers making offers Options are actively traded in a listed market, just like stocks They can be bought and sold just like any other security,Differences Options deri

7、ve their value from something else, the underlying security Options have expiration dates, while stocksdo not There is not a fixed number of options, asthere are with stock shares available Stockowners have a share of the company,with voting and dividend right. Options convey no such rights,39,Optio

8、ns Terminology,Call Option: It gives the holder the right but not the obligation to buy an asset by a certain date for a certain price. Put Option: It gives the holder the right but not the obligation to sell an asset by a certain date for a certain price. Option Premium: The price at which the opti

9、on buyer pays to the option seller. Strike price - amount buyer pays for the asset Exercise - act of paying strike price to receive the asset Expiration - when option must be exercised, or become worthless American Option: The options that can be exercised at any time up to the expiration date. Euro

10、pean style - only exercise on x-date Bermudan style - during specified periods,40,Options Terminology,In the Money Option: It is an option that would lead to a positive cash flow to the holder if it were exercised immediately. A call option on the index is said to be in the money when the current in

11、dex stands at a level higher than the strike price (i.e. Spot pricestrike price). In the case of put, the put is ITM if the index is below the strike price. At the money Option: It is an option that would lead to zero cash flow if it were exercise immediately. An option is at the money when the curr

12、ent index equals the strike price.,41,41,Options Terminology,Out of the money Option: It is an option that would lead to a negative Cash flow if it were exercised immediately. A call option on the index is out of the money when the current index stands at a level, which is less than the strike price

13、 (i.e. spot pricestrike price). In the case of put, the put is OTM if the index is above the strike price.,42,42,Your Strategy,In Bull Markets Buy Calls, Protective Puts In Bear Markets Buy Puts,43,Why Trade Options,Option trading provides many advantages over other investment vehicles Leverage Limi

14、ted risk Insurance Profiting in bear markets Each way betting Market going nowhere,44,An Example,An investor buys a Put on HDFC stock with a strike price of 1000 (the future exchange price) and an exercise date of May 1, 2010, and pays a premium of 50 for this put option. The current price is 1200 A

15、ssume price on May 1 is 900 you will exercise the option and end up with a profit of 50,45,Straddles,Rs. 4300 Buy Call a swap has zero value at the beginning. One party tends to pay a fixed rate while the other pays on the movement of the underlying asset. However, a swap can be structured so that b

16、oth parties pay each other on the movement of an underlying asset. Parties make payments to each other on a settlement date. Parties may decide to agree to just exchange the difference that is due to each other. This is called netting. Final payment is made on the termination date. Usually traded in

17、 the over-the-counter market. This means they are subject to credit risk.,53,Types of Swaps,Interest Rate swaps: It is an agreement between 2 parties to exchange interest obligations or receipts in the same currency on an agreed amount of notional principal for an agreed period of time. Main charact

18、eristics: It effectively translates a floating rate borrowing into a fixed rate borrowing and vice versa. The net interest differential is paid or received, as the case may be. There is no exchange of principal repayment obligations It is structured as a separate contract distinct from the underlyin

19、g loan agreement It is applicable to new as well as existing borrowings,54,54,Typical Uses of an Interest Rate Swap,Converting a liability from fixed rate to floating rate floating rate to fixed rate,Converting an investment from fixed rate to floating rate floating rate to fixed rate,55,Types of Sw

20、aps,Currency Swap: It is an agreement between 2 parties to exchange payments or receipts in one currency for payments or receipts in another. Currency swaps involve: An exchange of principal amounts today An exchange of interest payments during the currency of the loans A re-exchange of principal am

21、ounts at the time of maturity,56,56,SWAP - Process,Currency swap is a contract to exchange cash flow streams from some fixed income obligations (- swapping payments from a fixed-rate loan for payments from a floating rate loan). In a currency swap, the cash flows are in different currencies, so they

22、 cant net. Instead, full principal and interest payments are exchanged. At the origination of a swap agreement, the counterparties exchange notional principals in the two currencies. During the life of the swap, each party pays interest (in the currency of the principal received) to the other. At ma

23、turity, each makes a final exchange (at the same spot rate) of the initial principal amounts, thereby reversing the initial exchange. Generally, each party in the agreement has a comparative advantage over the other with respect to fixed or floating rates for a certain currency.,57,Why Swaps Work,Pe

24、ople have opposite positions Spread differentials in markets Market access More difficult for small firms to borrow in European markets v. US markets Cheap to eliminate risk,58,EXOTICS,59,Exotics Introduction,An exotic is a derivative which has features making it more complex than commonly traded pr

25、oducts (vanilla options). These products are usually traded over-the-counter (OTC) Exotics as opposed to vanilla refers to the fact that the payoff is not standard, as is the case for a regular call option.,60,Exotics Characteristics,An exotic product could have one or more of the following features

26、: The payoff at maturity depends not just on the value of the underlying index at maturity, but at its value at several times during the contracts life: could be an Asian option depending on some average, a lookback option depending on the maximum or minimum, a barrier option which ceases to exist i

27、f a certain level is reached or not reached by the underlying, a digital option) It could depend on more than one index (as in basket options) There could be callability and putability rights.,61,Exotics - Types,Chooser Option Allows the buyer to determine the characteristics of an option during a p

28、re-determined set time span. Look Back Option Affords the buyer the luxury of “looking back” during the life of the option and choose the price level that would generate the most gain. Asian Option Payoff is not determined by the underlying price at maturity but by the average underlying price over

29、some pre-set period of time. Basket Option Option whose underlying asset is a basket of commodities, securities, or currencies,62,Exotics - Types,Binary Option Payoff is either some fixed amount of some asset or nothing at all. The options are binary in nature because there are only two possible out

30、comes. They are also called all-or-nothing options or digital options. Barrier Option Option to exercise depends on the underlying crossing or reaching a given barrier level. In options start their lives worthless and only become active in the event a predetermined knock-in barrier price is breached

31、. Out options start their lives active and become null and void in the event a certain knock-out barrier price is breached. Bermudan Option Option exercisable only on predetermined dates. Neither American nor American.,63,Trading, Clearing & Settlement Systems for Exchange Traded Derivatives,64,64,F

32、eatures of Exchange Traded Derivatives,Centralization of Trading No counter party risk Standardization of contracts Liquidity Mark to Market (MTM) margining system Squared off in cash on expiration. Three series trade at any point in time. Contract expires on last Thursday of the month.,65,Benefits

33、offered by a fully automated trading platform over its open-outcry counterpart,Transparency Speed of execution Reduced market impact No issues of unmatched trades Straight through processing (STP),66,66,Clearing and Settlement systems,All derivatives market contracts are fixed periods contracts, hav

34、ing maturity dates. Theses contracts get traded on the exchange till their maturity date. Entities in a derivatives market clearing and settlement system would be: Exchange(s) Trading Members(TM) Clearing Members(CM) Trading - clearing member Custodial clearing member Professional clearing member,67

35、,67,Clearing and Settlement systems,Clients Interfaces Monitoring and surveillance system Margining system Collateral system Depositories Corporate action system Clearing banks Currency,68,68,Clearing is the process of determining obligations (cash and delivery) resulting from the buying/selling of

36、a derivatives contract Generally understood as Central Counterparty clearing Most exchange-traded contracts are by default subject to CCP clearing,Clearing and risk management for derivatives markets - Concept,69,Clearing process,Clearing mechanism essentially involves working out open position or o

37、bligation of members. The end of day position before making any adjustments for exercise or expiry are called pre-adjusted position. The clearing system validates the excises against available long position and money-ness of the option contracts. In case the exercising member doesnt have sufficient

38、long position as mentioned in the exercise request or the option contracts is not in-the-money, the exercise request is rejected.,70,70,Clearing process,All validated exercises are summed and the total exercised position in terms of marketable lots is determined. These exercised positions are assign

39、ed to members having open short position at the end of the day. All open sale positions at clients level at the end of the day are considered for the purpose of assignment. Assignment is usually done on a random basis. After determination of the exercised and assigned quantities against the members, the position are recomputed. The positions now held in the system are called post-adjuste

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