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Module 1-derivative basics

The document discusses derivatives, which are contracts whose prices depend on underlying assets like stocks or commodities, and outlines their historical development in India. It explains various market participants, such as hedgers, speculators, and arbitrageurs, and describes forward contracts and their settlement options. Additionally, it highlights SpiceJet's financial risks and potential hedging strategies to manage these risks.

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subhasisdas2121
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Download as PDF, TXT or read online on Scribd
12 views

Module 1-derivative basics

The document discusses derivatives, which are contracts whose prices depend on underlying assets like stocks or commodities, and outlines their historical development in India. It explains various market participants, such as hedgers, speculators, and arbitrageurs, and describes forward contracts and their settlement options. Additionally, it highlights SpiceJet's financial risks and potential hedging strategies to manage these risks.

Uploaded by

subhasisdas2121
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Company ABC Farmer

31
6M 30th November

Rs. 65/kg
Rs. 78/kg
Buyer

Time Seller

Contract
Underlying
Quantity
asset

Price
 The term ‘Derivative’ stands for a contract whose
price is derived from, or is dependent upon an
underlying asset. The underlying asset could be
a financial asset such as currency, stock and
market index or a physical commodity.

 Some examples are:


 Futures
 Options
 Swap
 Derivatives derive their names from their
respective underlying asset. The underlying assets
could be equities (shares), debt (bonds, T-bills,
and notes), currencies, and even indices of these
various assets, such as the Nifty 50 Index.
 Thus if a derivative’s underlying asset is equity, it is
called equity derivative and so on.
 November 18, 1996- L.C. Gupta Committee was set up to
draft a policy framework for introducing derivatives
 May 11, 1998- L.C. Gupta committee submitted its report
on the policy framework
 June 9, 2000- BSE launched the first Exchange-traded
Index Derivative Contract in India i.e. Futures on the BSE
Sensex
 June 12, 2000- Trading on Nifty futures commenced on
the NSE

Continued…
 June 1, 2001- BSE commenced trading in Index Options
on Sensex
 June 4, 2001- Trading for Nifty options commenced on
the NSE
 July 2, 2001- Trading on Stock options commenced on
the NSE
 July 9, 2001- Stock Options were introduced on 31
stocks in BSE
 November 9, 2001- Single Stock Futures were
launched on NSE.
 August 29, 2008- Currency derivatives trading commences
on the NSE
 October 1, 2008- BSE launched its currency derivatives
segment in dollar-rupee currency futures
 August 31, 2009- Interest rate derivatives trading
commences on the NSE
 February 2010- Launch of Currency Futures on additional
currency pairs
 October 28, 2010- Introduction of European style Stock
Options
 October 29, 2010- Introduction of Currency Options
 Jan 11, 2021- Introduction of Nifty financial services index
 NSE is the largest exchange in India in derivatives,
trading in various derivatives contracts.

 NSE’s equity derivatives segment is called the Futures &


Options Segment or F&O Segment.
 Increased volatility in asset prices in financial
markets
 Increased integration of national financial
markets with the international markets
 Marked improvement in communication facilities
and sharp decline in their costs
 Development of more sophisticated risk
management tools, providing economic agents a
wider choice of risk management strategies
They participate in the derivatives market to lock the
prices at which they will be able to transact in the
future.
Thus, they try to avoid price risk through holding a
position in the derivatives market.
Hedging in futures market can be done through two
positions, viz. short hedge and long hedge.
 Speculators take large,
calculated risks as they
trade based on
anticipated future
price movements. They
hope to make quick,
large gains; but may
not always be
successful.
 Arbitrageurs attempt to
profit from pricing
inefficiencies in the
market by making
simultaneous trades
that offset each other
and capture a risk-free
profit.
 An arbitrageur may also
seek to make profit in
case there is price
discrepancy between
the stock price in the
cash and the derivatives
markets.
 A forward contract or simply a forward is a contract
between two parties to buy or sell an asset at a
certain future date for a certain price that is pre-
decided on the date of the contract.
 The future date is referred to as expiry date and the
pre-decided price is referred to as Forward Price. It
may be noted that Forwards are private contracts
 Forward contracts are traded only in Over the
Counter (OTC) market and not in stock
exchanges. OTC market is a private market
where individuals/institutions can trade
through negotiations on a one to one basis.
When a forward contract expires, two alternate arrangements
are possible to settle the obligation of the parties:

 Physical Settlement  Cash Settlement


 A forward contract can be  Cash settlement does
settled by the physical not involve actual
delivery of the underlying delivery or receipt of
the security. Each party
asset by a short investor to either pays (receives)
the long investor and the cash equal to the net
payment of the agreed loss (profit) arising out
forward price by the buyer of their respective
to the seller on the agreed position in the
settlement date. contract.
 Regardless of whether the contract is for physical
or cash settlement, there exists a potential for
one party to default, i.e. not honor the contract.
It could be either the buyer or the seller. This
results in the other party suffering a loss.
• Fuel Cost Risk: Aviation fuel is one of the largest expenses for
SpiceJet, and fluctuations in fuel prices can significantly impact
their profitability.
• Personnel Cost Risk: The remuneration for pilots and airline
personnel is a major cost, and competitive salaries are necessary to
retain staff due to the global demand for skilled airline personnel.
• Operational Costs: Landing fees, baggage handling, and other
airport-related expenses add to the financial burden.
• Currency Exchange Risk: SpiceJet operates internationally, and
revenue from passengers is received in different currencies, which
exposes the company to currency fluctuations.
• Borrowing Risk: SpiceJet finances its aircraft purchases through
borrowing, which means interest payments and debt management
are significant risks.
• Market Competition: The presence of new airlines increases
competition, which can put pressure on pricing and profitability.
 Fuel Hedging: SpiceJet can use fuel derivatives, such as
futures or options, to lock in fuel prices and protect against
price volatility.
 Currency Hedging: By using currency derivatives like
forwards, futures, or options, SpiceJet can hedge against
adverse currency movements and stabilize their revenue.
 Interest Rate Swaps: To manage borrowing costs, SpiceJet
can use interest rate swaps to convert variable interest rates
to fixed rates, reducing uncertainty in interest payments.
 Options and Futures Contracts: These can be used to hedge
against fluctuations in various costs, such as fuel, airport
fees, or even ticket prices, providing financial stability.
 Credit Default Swaps (CDS): To manage the risk associated
with borrowing, SpiceJet could use CDS to protect itself
against the risk of default on its debt obligations.
 Questions?

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