Introduction to Derivatives - International Commodity Management - Lecture Slides, Slides of International Management

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An introduction to Derivatives • Price risks are integral in physical markets • Derivative markets provide an insurance against unfavourable price movements by exchanging or transferring market risks known as hedging • Derivatives also find a use as investments • Derivatives are useful to both producers and consumers • Derivative markets exist globally for all commonly traded commodities • Instruments include futures and forward contracts, options swaps and other derivatives An introduction to Derivatives • Derivatives are a generic term for a variety of financial instruments • Derivatives are contracts and not assets • Derivatives are an investment vehicle whose value is based on the value of the asset • Derivatives can range from company stocks etc to commodities An introduction to Derivatives • Commodity Derivatives and Financial Derivatives contract are the two common derivative contracts • In Commodity derivative contracts the underlying assets are commodities like coffee, gold, silver • In Financial Derivative contracts there are bonds, stocks, foreign exchange etc • The underlying in a financial derivative contract must be identical that is fungible • Diverse types of assets are fungible e.g gold mined in any part of the world or cross listed stocks An introduction to Derivatives • There are four kinds of derivatives that is, forwards, futures, options and swaps • Forward contract is an agreement to buy or sell an asset on a specified date for a specified price • It is traded over- the- counter market and is a customised contract between two parties • Settlement takes place on a specific date in the future at an agreed price An introduction to Derivatives • The salient features are: These are bilateral contracts and exposed to counter party risks • Each contract is custom designed and unique in terms of contract size, expiry date, and the asset type and quality • The contract price is generally not available in public domain • On the expiration date, the contract has to be settled by delivery of the asset • If the party wants to reverse the contract, it has to go back to the same counter party and high prices can be charged Futures contract • A Futures contract is a standardised contract to buy or sell an underlying asset at a certain time in the future at a certain price • It has standardised date and month of delivery, quantity and price • It is normally traded on an exchange and has regulated cash flows to representing change in value • The exchange provides a mechanism that gives a guarantee that the contract will be honoured Futures contract • Futures are exchange traded contracts to sell or buy financial instruments or physical commodities for future deliveries at a price agreed today • Contracts have certain specified features: • Quantity of the underlying asset • Quality of the underlying asset • Date and month of delivery • Units of price quoted • Location of settlement Futures contract • The buyer and seller negotiate the price at which the contract will be bought or sold at the time of negotiating he contract • At exit, the buyer will pay the difference between the prevailing price of the underlying and his purchase price if the price drops • The buyer will receive the difference if the price rises • Most contracts are cash settled • Only 2% contracts are settled by physical deliveries Options • Options give the buyer the right (but without an obligation to buy or sell an underlying asset at a predetermined strike price , on or by the maturity date • Seller is under the obligation to perform the contract that is buy or sell • The underlying asset for an exchange options contract is the corresponding futures contract Options • Option to buy is the right to exercise into a long futures position at the strike price • The strike or exercise price is the price at which an option can be exercised • Option to sell is the right to exercise into a short futures position at a corresponding strike price • Options can also expire worthless • Investors profit will be the difference between the current value of the asset and the strike price • Options have an initial cost – premium which has the same characteristic as insurance premium • Expiry date is the date and time after which the option can not be exercised Options • Call: An option contract that gives the holder the right to buy the underlying security at a specified price for a certain, fixed period of time • Call option: An exchange traded option contract that gives the purchaser the right, but not the obligation, to enter into an underlying futures contract to buy the commodity at a stated strike price any time prior to the options expiration date. The grantor of the call has the obligation, upon exercise, to deliver the long futures Futures Contract • Both the buyer and seller are under an obligation to fulfill the contract • The buyer and seller are subject to unlimited risk of losing • The buyer and seller have unlimited potential to gain • The price depend upon the price of the underlying only Options Contract • The buyer of the option has the right, and not the obligation whereas the seller is under the • obligation to fulfill the contract • The seller is subject to unlimited risk of losing whereas the buyer has a limited potential to loose • The seller has limited potential to gain while the buyer has unlimited potential to gain • The price depends upon the spot price, strike price, time to maturity, implied volatility and risk free interest rate Commodity option • Commodity option is a contract in which the seller agrees to pay the buyer the difference between the commodity’s market price and the agreed strike price if the market price is more favourable than the strike price of the underlying commodity • The option protects against price fluctuations above or below a pre-agreed level Regulatory measures • Futures markets can be misused by speculators and following are regulatory measures: • Limit on open position of an individual operator to prevent overtrading • Limit on price fluctuation(daily/weekly)to prevent abrupt upswing or downswing in prices • Special margin deposits to be collected on outstanding purchases or sales to curb excessive speculative activity through financial restraints • Maximum/minimum prices to be prescribed to prevent future prices from falling below the levels that are not remunerative and from rising above levels that are not warranted by genuine supply and demand factors Swap Contracts • A swap is an agreement to exchange one set of cash flows for another • Forward rate agreement (FRA) is a forward contract carried out over the counter between two parties • FRA’s are frequently used by banks to hedge their interest rate exposure • Commodity swaps involves an exchange of obligations • A variable price is exchanged for a fixed price • It is a widely used hedging instrument for fixing the price of a particular commodity • It protects against price risks by exchanging cash flows • There is no physical delivery of commodities Swap Contracts • Energy swap is a is a commodity swap • User and bank agree to a fixed price for a pre- agreed period • In this period the customer buys energy from the supplier of its choice and pays the market price for this energy • Through a swap, the user can exchange the contract price for a fixed price • Hence there is a certainty of an agreed fixed price even if there are fluctuations in price index Futures trading • Futures trading can be organized in those commodities/ markets which display some special features. The concerned commodity should satisfy certain criteria • The commodity should be homogenous in nature, i.e., the concerned commodity should be capable of being classified into well identifiable varieties and the price of each variety should have some parity with the price of the other varieties • The commodity must be capable of being standardized into identifiable grades Futures trading • Supply and demand for the commodity should be large and there should be a large number of suppliers as well as consumers • Commodity should flow naturally to the market without restraints either of government or of private agencies • There should be some degree of uncertainty either regarding the supply or the consumption or regarding both supply and consumption • The commodity should be capable of storage over a reasonable period of time of, say, a few months or more Futures trading • There are three broad categories of participants in the futures markets, namely, hedgers, speculators and arbitrageurs. • Hedgers are those who have an underlying interest in the specific delivery or ready delivery contracts and are using futures market to insure themselves against adverse price fluctuations Examples could be stockists, exporters, producers, etc. • They require some other market players who are prepared to accept the counter-party position Futures trading • Hence, the speculators who are essentially expert market analysers take on the risk of the hedgers for future profits and thereby provide a useful economic function and are an integral part of the futures market • It would not be wrong to say that in the absence of speculators, the market will not be liquid and may at times collapse Futures trading • Arbitrageurs are those who make simultaneous sale and purchase in two markets so as to take benefit of price imperfections • In the process they help, remove the price imperfections in different markets • For example, the arbitrageurs help in bringing the prices of contracts of different months in a commodity in alignment • They watch the spot and futures market and on spotting mismatch in the prices of the two markets they enter into a buy transaction in one and sell transaction in other market so as get profit in risk free transaction • They take advantage of discrepancy between prices in two markets Forward Contract (Regulation) Act • The Commodity Future Markets are regulated according to the provisions of Forward Contract (Regulation) Act 1952 • The Act broadly divides commodities into 3 categories, i.e. commodities in which forward trading is prohibited, commodities in which forward trading is regulated and residuary commodities • Under Section 17 of the F.C(R) Act, 1952, the Government has powers to notify commodities, forward trading in which is prohibited in whole or part of India • Any forward trading in such commodities in the notified area is illegal and liable to penal action Forward Contract (Regulation) Act • The Act defines three types of contracts i.e. ready delivery contracts, forward contracts and options in goods • Ready delivery contracts are contracts for supply of goods and payment thereof where both the delivery and payment is completed within 11 days from the date of the contract • Such contracts are outside the purview of the Act Forward Contract (Regulation) Act • Forward Contracts, on the other hand, are contracts for supply of goods and payment, where supplies of goods or payment or both take place after 11 days from the date of contract or where delivery of goods is totally dispensed with • The forward contracts are further of two types, viz., specific delivery contracts and 'other than specific delivery contracts' • The specific delivery contracts are those where delivery of goods is mandatory though delivery takes place after a period longer than 11 days • Specific delivery contracts are essentially merchandising contracts entered into by the parties for actual transactions in the commodity and terms of contract may be drawn to meet specific needs of parties as against standardized terms in futures contracts • The specific delivery contracts are again of two sub-types viz., the transferable variety where rights and obligations under the contracts are capable of being transferred and the non-transferable variety where rights and obligations are not transferable Forward Contract (Regulation) Act • Forward contracts other than specific delivery contracts are what are generally known as 'futures contracts' though the Act does not specifically define the futures contracts • Such contracts can be performed either by delivery of goods and payment thereof or by entering into offsetting contracts and payment or receipt of amount based on the difference between the rate of entering into contract and the rate of offsetting contract • Futures contracts are usually standardized contracts where the quantity, quality, date of maturity, place of delivery are all standardized and the parties to the contract only decide on the price and the number of units to be traded • Futures contracts are entered into through the Commodity Exchanges