Volume -1(Dude, keep it really simple !!)

Disclaimers:Do not enter into contracts or agreements based on the information contained in this presentationTaking any action or placing any reliance on the contents of this presentation is strictly prohibitedAny 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 presentationDisclosing, copying or distributing this information in whole or in part is strictly prohibitedSources are acknowledged

Tell me about DERIVATIVES

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.

OptionsCall option or Put option

Forwards

Types

Commodities long forward contract or short forward contract

Swapse.g. interest rate swaps,

currency swaps, credit default swaps, etc.

Common derivatives ?

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 buyPut option = Owner has the right but not the obligation to sellWhen 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)

PartyA

PartyA

PartyB

PartyB

$5M @ 5.25% p.a. payable monthly (fixed)

$5M @ 5.25% p.a. payable monthly (fixed)

$5M @ Libor + 25 basispoints (say 5%) payable

monthly (floating)

$5M @ Libor + 25 basispoints (say 5%) payable

monthly (floating)

Party A locks in.25% or 25 bp

profit. Net movement in cash-flows.

Party A locks in.25% or 25 bp

profit. Net movement in cash-flows.

Example 2: call option for stocks

Party-A buys1000 stocksfrom Party-B

Party-B sell stocks at a strike price

of $5 / option for apremium of $1 each

Party-A has theright to buy but

not the obligation.Pays Party-B $1000

At a later pointin time (usually predefined) the stocksare worth $8 each

Party-A contractsto sell stocks to

Party-C @ $8 each

Party-C pays Party-A $8000.Party-A makes

a profit of $2000(8000-5000-1000)

Party-A paysParty-B $5000

(1000 x $5)

Party-A exercises its right to buy

stocks fromParty-C

Party-A is hopefulthat the stocks

would gain value in the future

1 2 3

4 5 6

7 8 9

Example 3: forward contract payoff

David ownshouse worth$500K today

David knowsthe bank pays

interest 5% p.a.

Susan contracts with David to buyhouse for $530K

in one year

Susan pays $530Kat the end of one

year

Susan sold the housein the market @ $550K

Susan makes a profit of $20K.Its unlikely David would have sold

less than $525K (based on bank interest)

Source / Acknowledgement

DisclaimersDo not enter into contracts or agreements based on the information contained in this presentationTaking any action or placing any reliance on the contents of this presentation is strictly prohibitedAny 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 presentationDisclosing, copying or distributing this information in whole orin part is strictly prohibitedSources are acknowledged