Study Notes on Financial Derivatives

FINANCIAL DERIVATIVES

Chapter-1: Introduction to Financial Derivatives

  • Overview: Introduction to the concept of financial derivatives.

Risk Management

  • Definition: Risk management is defined as the process of planning, organizing, directing, and controlling the resources and activities of an organization to minimize the adverse effects of potential losses at the least possible cost.

Risk vs. Uncertainty

  • Definitions:
      - Uncertainty: Refers to a state of mind characterized by doubt based on a lack of knowledge about what will or will not happen in the future.
      - Risk: An adverse deviation from a desired or expected outcome. Essentially, risk arises from uncertainty.

Types of Risks

1. On the basis of Objectivity

  - Objective Risk: The relative variation of actual loss from the expected loss.
  - Subjective Risk: The degree of uncertainty perceived by an individual, which varies from person to person.

2. On the basis of Insurability

  - Pure Risks: Risks where loss is the only possible outcome and no potential gain exists. Also known as insurable or non-speculative risks.
    - Types:
      - Personal risk
      - Property risk
      - Liability risk
  - Speculative Risks: Risks where the possibility of either financial gain or loss exists, which cannot be insured (e.g., investing in shares, betting on horses).

3. Other Types of Risks

  - Liquidity Risk: The risk of loss due to lack of marketability of an investment. Typically faced by OTC products.
  - Counterparty Risk: The risk of loss arising from the default of either party in a contractual agreement.
  - Interest Rate Risk: The risk of loss due to changes in interest rates affecting bonds, debentures, or loans.
  - Exchange Rate Risk: The risk associated with changes in the value of a currency.
  - Country Risk: The risk arising from changes in government policies of other countries, often referred to as political risk.
  - Default Risk: The risk of loss faced by lenders due to non-payment of interest or principal by borrowers; also known as credit risk.
  - Financial Risk: The risk associated with the use of debt in capital structure; also known as financial leverage.
  - Basis Risk: Also known as spread risk, associated with imperfect hedging and the lack of correlation between two investments. Can be divided into types:
    - Price basis risk
    - Calendar basis risk
    - Location basis risk

Risk Management Process

  1. Risk Identification: Identify both major and minor loss exposures and analyze pure and business risks.
  2. Risk Measurement and Evaluation: Analyze loss exposures to ascertain two components:
       - Frequency: The expected number of losses during a defined period.
       - Severity: The size of losses expected.
  3. Risk Control: Involves avoiding losses before they occur or reducing the severity of losses after they occur.
  4. Risk Financing: Develop a financing plan that meets risk management objectives, with two key methods being risk retention and risk transfer.

Factors Determining Retention Level

  1. Size of Business Firm: Larger firms tend to retain more risk due to larger cash flows—retention is directly proportional to the size of the firm.
  2. Availability of Investment Opportunities: Firms with many investment opportunities are likely to transfer more risk, showing an inverse relationship to retention levels.
  3. Correlation of Profit: Firms with negatively correlated profits to cash flows will tend to retain more risk due to lower standard deviation of cash flows.
  4. Financial Leverage: Firms with high leverage are more likely to transfer risk; this indicates an inverse relationship with retention.
  5. Diversification: Firms that are diversified are more prone to retain risks compared to less diversified firms; this demonstrates a direct relationship.

Risk Hedging

  • Hedging Instruments: Financial derivatives are used to transfer risk.
  • Insurance: A contractual agreement that transfers risk from an insured to an insurer in exchange for premium payments.
Insurance Contracts
  • Definition: Insurance is a contract where the insurer agrees to compensate the insured for specified losses in exchange for payment of a premium.
  • Benefits of Insurance:
      - Allows firms to manage significant claims without affecting regular business operations, thereby avoiding financial distress.
      - Helps firms evade costly external funding needs.
      - Premium payments are tax-deductible, reducing tax liabilities.

Financial Derivatives

  • Definition: A contract whose payoff structure is determined by the value of an underlying asset, which can include stocks, indices, currencies, or commodities.
Factors Driving the Growth of Financial Derivatives
  1. Increased volatility in asset prices.
  2. Integration of domestic financial markets with international markets.
  3. Advanced information technology and communication facilities.
  4. Innovative and sophisticated risk management tools.
  5. Cost-effectiveness of risk management tools.

Origin of Derivatives

  • Significant events:
      - FRAs and IR swaps originated in 1999.
      - SEBI granted permission to NSE and BSE for trading on May 25, 2000, following recommendations from the L.C. Gupta committee.
      - Trading in index futures commenced in June 2000, with subsequent expansions into stocks, commodities, and options by 2001 and currency futures by NSE in 2004.
      - Weekly options launched by BSE in 2004.

Types of Financial Derivatives

1. Financial Derivatives
  • Equity Derivatives:
      - Equity Forwards
      - Equity Futures
      - Index Futures
      - Equity Swaps
2. Commodity Derivatives
  • Commodity Forwards
  • Commodity Futures
3. Debt Derivatives
  • Interest Rate Derivatives:
      - Interest Rate Forwards
      - Interest Rate Futures
      - Interest Rate Swaps
4. Currency Derivatives
  • Forex Derivatives:
      - Currency Forwards
      - Currency Futures
      - Currency Swaps
5. Types of Trading
  • OTC Traded Derivatives
  • Exchange Traded Derivatives

Objectives of Financial Derivatives

  1. Reduce funding costs for borrowers through interest rate forwards, futures, swaps, and currency swaps.
  2. Enhance yields on assets using commodity and equity derivatives.
  3. Modify payment structures of assets to align with investors' market views.
  4. Provide protection against unforeseen price changes, thus allowing for effective hedging.

Advantages of Financial Derivatives

  1. Facilitate risk transfer from conservative individuals to aggressive takers.
  2. Aid in price discovery for both futures and current prices of underlying assets.
  3. Boost market trading volume through increased participation of risk-averse traders.
  4. Promote long-term savings and investment growth.

Financial Derivative Exchanges

  • National Level:
      - Stock Exchanges: BSE & NSE
  • Regional Level:
      - Historically 21 regional exchanges, but now non-functional.
  • National Level Commodity Exchanges:
      - MCX, NCDEX, NMCEIL, ICEX, ADCX, UCX
  • Current Operational Regional Level Commodity Exchanges:
      - Six operational exchanges.

Participants in the Derivative Market

1. Hedgers
  • Traders aiming to eliminate losses from price fluctuations due to existing exposures.
2. Speculators
  • Traders seeking profit from price movements.
3. Arbitragers
  • Individuals who exploit price differentials across markets to gain riskless profits.
      - Types of Arbitrage:
        - Arbitrage over Space: Taking advantage of pricing differences in different markets.
        - Arbitrage over Time: Exploiting price differences that exist over time.

Functions of the Derivative Market

1. Price Discovery
  • Informed individuals participate in the market to leverage better information for price advantage.
2. Risk Transfer
  • Derivative instruments allow risk to be transferred from risk-averse participants (hedgers) to risk-takers (speculators and arbitragers).
3. Market Completion
  • A complete market has derivatives that provide coverage against all potential adverse outcomes.
4. Financing Function
  • Participants only deposit a fraction (5-10%) of the contract value instead of the full volume.
5. Liquidity
  • The market allows for larger trading volumes compared to spot markets, enhancing overall liquidity.
6. Price Stabilization
  • The derivative market mitigates extreme price fluctuations, thus stabilizing prices.