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The early 20th century was a dark period of derivatives trading as bucket
shops were rampant. Bucket shops are small operators in options and
securities that typically lure customers into transactions and then flee with the
money, setting up shop elsewhere.
In 1922 the federal government made its effort to regulate the futures market
with the Grain Futures Act. In 1936 options on futures were banned in the US.
The year 1973 marked the creation of both the Chicago Board Options
Exchange and the publication of perhaps the most famous formula in finance,
the option pricing model of Fischer Black and Myron Scholes.
The 1980s marked the beginning of the era of Swaps and other over-thecounter derivatives.
Englands venerable Barings Bank declared bankruptcy due to speculative
trading in futures contracts by 28 year old clerk in its Singapore office.
While some minor changes occurred in the way in which derivatives were sold,
most firmed simply instituted tighter controls and continued to use derivatives.
DERIVATIVE PRODUCTS:
Forwards: A forward contract is a customized contract between two
entities, where settlement takes place on a specific date in the future at
todays contracted specific price; forward contract is not traded on an
exchange.
Future: A futures contract is an agreement between two parties to buy
or sell a specified quantity and quality of an asset at a certain time in
the future at a certain price. Futures contract are standardized
exchange-traded contracts. Such contracts were originally protection
against price volatility by buyers and sellers of commodities such as
grain, oil and precious metals.
Options: An option is a contract which gives the right, but not the
obligation, to buy or sell the underlying asset at a specific price for a
specified time. Stocks are traded on BSE or Bombay Online Trading
(BOLT) system and options are traded on Derivatives Trading and
Settlement System (DTSS). Calls n Puts are 2 types of options.
USES OF DERIVATIVES:
1. Using these products can help you to reduce the cost of an
underlying asset.
2. Earn money on shares that are lying idle.
3. Benefit from arbitrage (Buying low in one market and selling high
in other market)
4. Protection of securities against price fluctuations.
5. The most important use of these derivatives is the transfer of
market risk from risk-averse investors to those with an appetite for
risk.
6. The objective of firms using derivatives is to reduce the cash flow
volatility and thus to diminish the financial distress costs.
7. Some firms use derivatives not for the purpose of hedging risk but
to speculate about future prices.
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FUTURE TERMINOLOGIES:
Spot Price: The price at which an instrument/asset trades in the spot
market.
Future Price: The price at which the futures contract trade in the
future market.
Contract Cycle: The period over which a contract trades. For
instance, the index futures contracts typically have one month, two
months and three months expiry cycles that expire on the last
Thursday of the month.
Expiry Date: It is the date specified in the futures contract. (Last
Thursday)
Contract Size: The amount of asset that has to be delivered not be
less than one contract. For instance, the contract size of the NSE
future market is 200 Niftiest.
Basis: Basis is defined as the futures price minus spot price. There
will be a different basis for each delivery month for each contract. In a
normal market, basis will be positive. This reflects that futures prices
normally exceed spot prices.
OPTIONS
Consider Indian Oil Company (IOC) imports thousands of
barrels of oil, The Company is expecting increase in the
price of oil. The company can lock the price of oil by
purchasing an option to buy oil at a predetermined future
date at a specified exercise price.
It could acquire 3 month option to buy 3,000 barrels of oil
at an exercise price of $50; IOC will have to pay option
premium to the seller of the option. Assume that this
premium is $0.60/barrel, by incurring a small cost (option
premium); IOC has bought an insurance against increase
in the oil price.
CALL OPTION
An investor buys One American call option on silver at
the strike price of Rs.10000 at a premium of Rs. 500. If
the market price of silver on day of expiry is more than
Rs. 10000, the option will be exercised.
The investor will earn profits once the silver price crosses
Rs. 10000 (Strike price + premium), suppose the price is
Rs. 12000, the option will be exercised and the investor
will buy 1 silver from the seller of the option at 10000 and
sell it in the market at Rs. 12000 making a profit of Rs.
2000. (Spot Price Strike Price (including Premium))
PUT OPTION
An investor buys one American put option on copper at
the strike price of Rs. 10000 at premium of Rs. 500, if the
market price of copper. On the day of expiry is less than
Rs. 10000, the option can be exercised as it s in the
money. The Investors breakeven point is Rs. 9500
(Strike price premium paid) i.e. Investor will earn profits
if the market falls below Rs. 9500.
OPTION TERMINOLOGIES:
Index Options: These options have the index as the underlying. Some
options are European while other is American.
Stock Options: stock options are options on individual stocks. A
contract gives the holder the right to buy or sell shares at the specified
price.
Buyer of an Option: The buyer of an option is the one who by
paying the option premium buys the right not the obligation to
exercise his option on the seller/writer.
Options Premium: Option price is the price that the option buyer
pays to the option seller. It is also referred to as the option premium.
Expiration Date: The date specified in the options contract is known
as the expiration date, the exercise date, and the strike date of the
maturity.
Strike Price: The price specified in the options contract is known as
the strike price or the exercise price.
SWAPS:
Swaps are similar to futures and forwards contracts in providing
hedge against financial risk. A swap is an agreement between two
parties, called counterparties, to trade cash flows over a period of
time. Swaps arrangements are quite flexible and are useful in many
financial situations. The two most popular swaps are currency swaps
and interest rate swaps. These two swaps can be combined when
interest on loans in two currencies are swapped. The interest rate
and currency swap markets enable firms to arbitrage the differences
between capital markets.
CURRENCY SWAPS: Currency swaps involve an exchange of
cash payments in one currency for cash payments in another
currency; most international companies require foreign currency for
making investments in abroad. These firms fin difficulties in
entering new markets and raising capital at convenient terms.
Currency swap is an easy alternative for these companies to
overcome this problem.
Checklist analysis
Assumption analysis -this technique may reveal an
inconsistency of assumptions, or uncover problematic
assumptions.
Diagramming techniques
Cause and effect diagrams
System or process flow charts
Influence diagrams graphical representation of situations,
showing the casual influences or relationships among
variables and outcomes
SWOT analysis
Expert judgment individuals who have experience with
similar project in the not too distant past may use their
judgment through interviews or risk facilitation workshops.
RISK ANALYSIS
TOOLS AND TECHNIQUES FOR QUALITATIVE RISK
ANALYSIS
Quantitative
risk
analysis
&
modeling
techniques-
FUNCTIONS OF ECGC
Provides a range of credit risk insurance covers to exporters
against loss in export of goods and services.
Offers guarantees to banks and financial institutions to
enable exporters to obtain better facilities from them.
Provides Overseas Investment Insurance to Indian
companies investing in joint ventures abroad in the form of
equity or loan.
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ECGC Policies
Special
Schemes
Standard Policy
Specific Policy
Financial
Guarantees to
Banks
For
Giving credit
to exporters
(Transfer Guarantee )
To protect Banks
Issuing L/C,
Confirming L/C,
Insurance Cover,
Line of Credit,
Overseas Investment
Insurance & Exchange
Fluctuation Risk
Insurance
RISK PERCEPTIONS
Industry risk
Business risk
Risk of contract frustration
Risk of physical damage
Credit risk
Country Risk
COMMERCIAL RISK
POLITICAL RISK
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2. Post shipment Export Credit Guarantee: Banks extend postshipment finance to exporters through purchase, negotiation
or discount of export bills or advances against such bills.
The post-shipment credit guarantee provides protection to
banks against non-realization of export proceeds and the
resultant failure of the exporter to repay the advances
availed. However, it is necessary that the exporter concerned
should hold suitable policy of ECGC. The percentage of loss
covered under this guarantee is 75%.
Features of this policy are: Individual Post-Shipment credit Guarantee can also be
obtained for finance granted against L/C bills, even where
an exporter does not hold an ECGC policy, provided that the
exporter makes shipments solely against letters of credit.
This guarantee can also be issued on whole turnover basis
wherein the percentage of cover under shall be 90% for
advances granted to exporters holding ECGC policy.
Advances to non-policyholders are also covered with the
percentage of cover being 65%.
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