M.Com IV Semester: Financial Derivatives and Risk Management

Financial Derivatives and Risk Management

Financial Derivatives

• Payoffs are linked to underlying assets or securities, such as interest rates, currencies, or commodities.
• Include futures, options, forwards, and swaps.

Futures

• Traded on exchanges, such as NCDEX, NMCE, and MCX.
• Mark-to-market settlement system used.
• Open interest refers to the total number of outstanding contracts.

Options

• Give the buyer the right, but not the obligation, to buy or sell an underlying asset.
• Types: call, put, American, European, and Bermudan options.
• OPTION STRATEGIES:
  • Selling one put option at a low strike price and buying a put option at a high strike price is a put bear spread.
  • A calendar spread is formed by using options on the same asset with the same strike price but different expiration dates.

Forwards

• Customized contracts between two parties.
• Not traded on exchanges.
• Settlement occurs on the expiration date.

Swaps

• Agreement to exchange cash flows between two parties.
• Types: currency swaps, interest rate swaps, and commodity swaps.
• SWAP FEATURES:
  • Callable swap: seller has the chance to terminate the swap at any time before maturity.
  • Putable swap: buyer has the chance to terminate the swap at any time before maturity.

Risk Management

• Hedging: reduces risk by taking a position in a futures or options contract to offset potential losses or gains in an underlying asset.
• Types of risk: market risk, liquidity risk, credit risk, and operational risk.
• Value-at-Risk (VaR): estimates the potential loss of a portfolio over a specific time horizon with a given probability.

Option Pricing Models

• Binomial Option Pricing Model: developed by John Cox, Stephen Ross, and Mark Rubinstein.
• Black-Scholes Model: used to estimate the value of options.

Swap Agreements

• Notional principle: the underlying amount in a swap contract.
• LIBOR: London Interbank Offered Rate, used as a reference rate in swap agreements.

Hedging and Speculation

• Hedgers: reduce risk by taking a position in a futures or options contract to offset potential losses or gains in an underlying asset.
• Speculators: take positions in futures or options contracts in anticipation of profit from price movements.
• Arbitrageurs: take advantage of price differences between two markets to earn a risk-free profit.### Types of Swaps
• An accreting swap is a type of swap where one stream of future interest payments is exchanged for another based on a specified principal amount.
• Interest rate swaps are a type of swap where one party exchanges a series of fixed-rate interest payments for a series of floating-rate interest payments.

Futures vs. Forwards

• Futures differ from forwards because they are marked to market daily.
• Futures are used to hedge portfolios, individual securities, and in both financial and foreign exchange markets.

Standardized Futures Contracts

• Standardized futures contracts exist for stock indexes, gold, and Treasury bonds.
• Common stocks are an exception, where standardized futures contracts do not exist.

Roles in Futures Markets

• A pit trader is a type of trader who executes trades on the floor of an exchange.
• A local is a trader who trades for their own account.
• A floor broker is a trader who executes trades for others.
• A futures commission merchant is similar to a stock broker, as they act as an intermediary between buyers and sellers.

Risk Management

• Using futures contracts to transfer price risk is called hedging.
• Hedging involves reducing or eliminating risk by taking a position in a futures contract that is opposite to a current position.