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Lecture 1

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krupaoswal36
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© © All Rights Reserved
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Derivatives

CFA Level 1
A derivative is a Financial
Instrument that derives its
value from an underlying asset.
- Equities
- Fixed Income Instruments
- Currencies
- Commodities
- Index
- Alternative Instruments
A Forward is a derivative contract between 2
parties to exchange an asset on a pre-decided
future date at a pre-decided rate.

For example – Rohit & Virat enter into a contract


where Rohit will buy from Virat 10 kgs of gold on
31st October 2024 at Rs. 66,500 per kg.
Remember – Assuming no
transaction costs, a forward
contract is always a zero sum game.
Profit of one party is equal to loss of
the other.
Test Yourself
Rohit and Virat enter into a contract where Rohit will sell 5 kgs of wheat
to Virat on 15th November at Rs. 820 per kg. Let me know in the chat
box the answer in both the scenarios about who is in profit and how
much profit.

If actual price on 15th November is:

a. 845
b. 825
Uses of Forward Contracts

Hedging Speculation

Arbitrage
Hedging
Hedging
• When a party to a derivative transfers their risk to some other party,
it is called hedging.
• Most derivative users across the world use it for this purpose.
• A transaction can either be fully hedged (total market risk transferred)
or partially hedged (partial market risk transferred)
Hedging Example
Mr. Amitabh has purchased goods worth $ 10,000 from a US person
when exchange rate was $1 = Rs. 80. His payment is in 3 months and he
is worried that he might have to pay more if rupee depreciates.

To hedge his risk of dollar depreciating, he enters into a forward


contract today for 3 months to buy $10000 at Rs. 81. This ensures that
irrespective of whatever the price is at expiry, Mr. Amitabh will have to
pay Rs. 81 per dollar and thus he does not have to worry about
currency fluctuation risk at all.
Test Yourself - Hedging
Mrs. Sonia, a cotton farmer is expecting a yield of 3000kgs of cotton
from her farms this year. She normally sells the yield once ready to the
mandi but this year she fears that the prices will be very volatile and
wants to hedge her risk.

How should she proceed?


Speculation
Speculation
It is the opposite of hedging.
Speculation is a situation where you take a position in any asset to
profit from the fluctuation in the price.
Most people feel they will be able to pre-empt the future price
movement of an asset and thus speculate to earn money.
Arbitrage
Arbitrage
• It is Riskless profit.

• It is ideally made when the same asset is trading at different price in


different markets.

• Lets say the price of Infosys on BSE is ₹1,600 and on NSE it is ₹1,590.

Borrow at risk free rate → Buy from NSE → Sell at BSE → Pocket ₹10 profit
→ Repay the borrowing along with interest
Arbitrage

Simultaneous No capital
buying & selling required

Arbitrage trading
improves market
efficiency
Transaction Avenues
• OTC: Over-the-Counter derivative markets involve contracts entered
between derivatives end users and dealers, or financial
intermediaries, such as commercial banks or investment banks. They
can be customized as per the requirements of the parties.

• ETD: An Exchange-Traded Derivative are financial contracts available


on exchanges, such as NSE & BSE. They are standardized contracts.
Margin
• Derivatives can be traded with Leverage (You can take a higher exposure than the money
you have). The amount of money that you pay to take this higher exposure is called Margin.

• No margin on OTC contracts, but ETD contracts requires margin.

• Initial margin is the amount of cash or collateral that must be deposited before a trade may
be made.

• Maintenance margin is the minimum amount of margin that must be maintained in a


futures account. If breached top-up up to Initial Margin. A margin call for equity is different
from this as in a margin call the top-up is only till the maintenance levels.
Mark to Market (M-to-M)
Consider a contract for 10 gram of gold that settles on in 2 days. The initial margin amount is ₹2,000 and the
maintenance margin is ₹1,500. Price of gold today (Day 0) is ₹70,000.

Settlement Change in Seller Margin Buyer Margin Maintenance


Day
Price Price Balance Balance Margin breached?
Day 0 ₹ 70,000 - ₹ 2,000 ₹ 2,000 No
Day 1 ₹ 67,000 -₹ 300 ₹ 2,300 ₹ 1,700 No
Day 2 ₹ 64,000 -₹ 300 ₹ 2,600 ₹ 1,400 Yes

Buyer needs to deposit ₹600 to continue trading, maintaining the initial margin of ₹2,000.
Test Yourself
Consider a futures contract for 50 shares of TCS that is set to settle in 2 days. The initial margin required is
₹40,000, and the maintenance margin is set at ₹30,000. The current market price (CMP) of TCS shares is ₹3,500.

On the next day (Day 1), the settlement price of TCS shares falls to ₹3,350. On Day 2, the settlement price
further decreases to ₹3,100.

Calculate:

The total loss incurred by the end of Day 1&2.


The margin balance at the end of Day 1&2.
The amount that must be paid to replenish the margin to the initial level if required.
Role of Central Clearing House
• A central clearinghouse (CCH) essentially takes the opposite position
to each side of a trade (called novation), guaranteeing the payments
promised under the contract.

• The CCH requires margins from both participants when a trade is


initiated, and additional deposits for accounts that decline in value
(Maintenance Margin), to support its guarantee and minimize
counterparty credit risk.
Central Counterparty & Swap Execution Facility

• After the financial crisis of 2008, regulators instituted a central clearing


mandate requiring that, for many swap trades, a central counterparty (CCP).
• It takes on the counterparty credit risk of both sides of a trade, similar to the role
of a central clearinghouse.
• Example, dealers record their swap trades on a swap execution facility (SEF).
When a dealer makes a swap trade, that information is sent to the SEF and the
CCP replaces the trade with two trades, with the CCP as the counterparty to
both of them.
• The downside of this structure is that counterparty risks are concentrated
rather than distributed among financial intermediaries.
Settlement Types

Deliverable Cash Settled

• Asset is exchanged • Only the gains/losses


on the settlement from the contract are
date exchanged on
• Bullion settlement
• Nifty
Deliverable vs Cash Settled
E.g. You bought a one-month futures contract for Reliance shares at a
price of ₹100. After a month, the price of Reliance shares has risen to
₹120.

Deliverables: You pay ₹100 to seller and get Reliance Share back.

Cash Settle: Instead of receiving the share, you settle the contract in
cash, receiving a profit of ₹20, which is the difference between the
market price at expiration (₹120) and your contract price (₹100).
Price Limits & Circuit Breakers
Price Limits → Exchange-imposed limits on how much each day’s
settlement price can change from the previous day’s settlement price.

Exchange members are prohibited from executing trades at prices


outside these limits.

Circuit breakers → when a futures price reaches a limit price, trading


is suspended for a short period (Cooling off period).

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