Published on February 16, 2009
Tell me about DERIVATIVES Volume -1 (Dude, keep it really simple !!) Disclaimers: Do not enter into contracts or agreements based on the information contained in this presentation Taking any action or placing any reliance on the contents of this presentation is strictly prohibited Any views or opinions expressed or stated in this presentation are solely those of the author and do not represent those of the author’s employers either past or present The author accepts NO liability for any damage caused by any information contained in this presentation Disclosing, copying or distributing this information in whole or in part is strictly prohibited Sources are acknowledged
Derivative ? It’s a financial contract that derives value from something else (i.e. the underlying value) Such value can be derived from stocks, bonds, commodities, exchange rates, interest rates etc.
Common derivatives ? Forwards Options Commodities long Call option or Put option forward contract or short forward contract Types Swaps e.g. interest rate swaps, currency swaps, credit default swaps, etc.
Forward contract ? When 2 parties agree to buy or sell an asset at some point specified in the future
Options ? Call option = Owner has the right but not the obligation to buy Put option = Owner has the right but not the obligation to sell When the owner exercises this right the other party (i.e. counterparty) is obligated to perform transaction
Swaps ? Contracts to exchange cash-flows on or before a specified future date based on the underlying value of the instrument The counterparties (i.e. parties to the contract) usually do not exchange the principal amount Cash-flows are computed based on notional principal amounts
Objective of derivatives ? Hedging = mitigate the risk of exposure due to economic loss arising from changes in the underlying value Speculation = to profit from fluctuations in the underlying value
Example 1: exchange of a fixed rate loan to a floating rate loan (same currency) $5M @ 5.25% p.a. $5M @ 5.25% p.a. Party Party payable monthly (fixed) payable monthly (fixed) A A Party A locks in Party A locks in .25% or 25 bp .25% or 25 bp profit. Net movement profit. Net movement in cash-flows. in cash-flows. $5M @ Libor + 25 basis $5M @ Libor + 25 basis Party points (say 5%) payable Party points (say 5%) payable B monthly (floating) B monthly (floating)
Example 2: call option for stocks Party-A buys Party-B sell stocks Party-A is hopeful 1000 stocks at a strike price that the stocks from Party-B of $5 / option for a would gain value in premium of $1 each the future 1 2 3 Party-A has the At a later point Party-A contracts right to buy but in time (usually pre to sell stocks to not the obligation. defined) the stocks Party-C @ $8 each Pays Party-B $1000 are worth $8 each 4 5 6 Party-C pays Party-A exercises Party-A pays Party-A $8000. its right to buy Party-B $5000 Party-A makes stocks from (1000 x $5) a profit of $2000 Party-C (8000-5000-1000) 7 8 9
Example 3: forward contract payoff David owns David knows house worth the bank pays $500K today interest 5% p.a. Susan contracts Susan pays $530K with David to buy at the end of one house for $530K year in one year Susan makes a profit of $20K. Susan sold the house Its unlikely David would have sold in the market @ $550K less than $525K (based on bank interest)
Source / Acknowledgement
Disclaimers Do not enter into contracts or agreements based on the information contained in this presentation Taking any action or placing any reliance on the contents of this presentation is strictly prohibited Any views or opinions expressed or stated in this presentation are solely those of the author and do not represent those of the author’s employers either past or present The author accepts NO liability for any damage caused by any information contained in this presentation Disclosing, copying or distributing this information in whole or in part is strictly prohibited Sources are acknowledged
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