Derivatives Lecture Notes

derivatives okay so generally before starting any topic I try to discuss about the why of it okay uh in your CFA syllabus where does derivatives F in where does derivatives fit in h so okay what are the subjects in your CFA so this derivatives Equity alternative investment fixed income what are this asset classes right so derivatives is one of the asset classes okay that is one thing uh from exam perspective what is the weightage of the subject 5 to 8% the least weightage that uh if any topic is there it is derivatives okay derivatives and portfolio management and uh AI okay these three topics have least weightage however I think I have told in the past also the weightage concept is purely from uh assigning the number of questions okay uh if it is having 5 to 8% weightage means 5 to 8% questions will be from derivatives okay however before the scenario was different if I had ignored derivatives it was okay or if I had ignored AI it was okay even if I did not prepare AI it was okay but now you have to score 70% in derivatives also 60% or more in derivatives also in AI also in all the topics in ethics to score 80% or more okay so um weightage wise this only proportion of questions otherwise all the topics are important okay all the topics are important uh FSA what is the weightage 15 to 20 15 to 20 is only ethics 13 to 17 okay FSA is 13 to 17% how many modules are there in FSA 12 how many modules are there in derivatives 10 now that 10 is actually three okay in the syllabus that you had before actually two only okay like 2022 syllabus if you see not 23 that two only has been split into nine or 10 okay nine if I'm not wrong how many modules you have 10 okay 10 right effectively I see I look at it as two modules only okay two readings and FSA was 12 readings before also now also 12 readings so for 12 readings I'm getting how much marks roughly around 17% of the marks or 15% of the marks for two readings how much marks I'm getting so which is more beneficial okay okay wrong wrong wrong analysis wrong example with less effort you are getting four marks right so that I will complete derivatives first I'm not telling don't study FSA you have to study you don't have choice this is important but the smaller weightage topics I will try to finish quickly or the readings which are less I will complete picker okay so this is one aspect from exam perspective this is important what is the relevance of this practically why are we studying this subject right why it is included why it is an asset class okay that is also important okay practically speaking it has lot of significance okay uh be it in terms of markets okay it is not only for the purpose of trading okay it is for the purpose of edging okay it is mainly used more used for edging okay and the speculation is also there okay for speculation purpose also this is in terms of your participation in Market without participation how do I use it don't want to invest right then where is the use for derivatives okay from employment perspective from employment and jobs perspective right the entire IB operations right lot of roles relate to derivative even though you don't have to have in-depth understanding of derivatives but lot of roles thousands of roles in Chennai in Bangalore in India you have in operations okay and then IB Finance okay Investment Banking Finance in lot of this is like you can say little higher level than this from a technical standpoint okay better job here also lot of roles are there this is apart from your trading and those things from jobs perspective how do I use why derivatives are relevant in fact more openings are there in this compared to equity okay compared to lot of people think Equity Equity Equity yes for investing for investment for participation equity is more uh important or more it has more number of opportunities but from a job's perspective derivatives has a much more broader scope from that perspective it becomes important so then so practically why it is important is this reason okay so if I prepare properly tomorrow where it will come and use where it will come and hit me then I go for interview point one okay Step One is exam step two is interview step three is on the job role right I have to have the understanding for example my own case I don't have any participation experience I have not traded a single trade in derivative on myself on my behalf neither on others behalf I've done but my entire experience is from my job on derivatives right so likewise the Practical applicability can be either through jobs which is like much more uh uh possible and if you are going to trade then participation okay so this is the Practical aspect of it okay as to how derivatives are important and how derivatives are relevant clear okay fine now let us look at the topic what are derivatives yes Rohan it's a kind of agreement between two parties and it's a financial instrument examples include f h options H SPS H derived from an original contract or a security contract derived from a security or an index contract derived from a security ah yes sir okay yes good any other response deres value from an yes anything else purely based on an underlying ass prices in future I come yes contract for future contract for a future date very good any the response it has an expired date H yes I got the definition already if I combine all these options all these points h see my effort is less I'll ask you guys only yes any other point what is the derivative also not to predict the future also [Music] in whe the price going up or down and it also used to the demands and other than the investment market and how it example example if you are saying that the job right so while analing the present hisory data I can able to no no but how is derivative useful how is a derivative applicable in that so able to determine one seconder of the company how it's performing and how is growth going up or down due to that and based on that I will I predict the future performance compy correct but that is forecasting yeah what is derivatives here you're telling it helps in forecasting yeah okay fine yes online someone was participating it helps it it is used as an hedg okay question what is derivative basically okay yes so all the answers are correct okay meaning is it derives its value from an underlying okay the underlying could be an asset it could be anything okay the underlying could be anything underlying could be an asset asset means it could be your Equity your Commodities right so basically Equity Commodities okay uh bonds fixed income securities okay it could be interest rates okay gold silver all these things defa swaps yes come again credit default swaps CDs okay credit default swaps okay swaps H then it can be on it can be on whether derivatives we have whether it is going to rain today or not you have derivative on that indexes sir the stock index index also on entire index you have derivative right you have a derivative linked to an index's performance okay so derivative can derive its value from this is only a indicative list not an exhaustive list okay there can be many more like this okay derivatives is not cryptocurrency okay cryptocurrency is shooting in the air okay without knowing what it is this is purely for the purpose of the whole purpose of derivatives was to hedge okay the exposure hedge the risk that was the purpose why derivatives were used for mainly how old are derivatives L were basically introduced in the 200 fin the insurance against open your material read the first par or first page IND deres I think new material it will not be there changed REM actually you can lot of things anyways so derivatives have been there in the financial markets right from 1980s 1970s 1980s okay uh but it is not only from the financial markets it has been there in existence for thousands of years okay Cal stock trade agriculture deres have been there okay today also informally it is being done once the crop is produced right wherever the market is uh unorganized Market okay where it is not part of a chain where government is involved in case of unorganized sector in agriculture once the crop is ready once the produce is ready or even before the produce is ready they will agree with the traders to sell at some rate okay and for example I will agree and I will have a token or a piece of paper where I've told that okay I've agreed to sell this to this person for XY Z price okay and when the crop is ready when the produce is ready I will deliver it or the other option is instead of delivering it I will sell this price this token to someone else right because the other person has let's say you are the other person you are also having one one pair of token I have one token and the other pair of the token is with you which says that you have the right to receive the delivery of this produce okay at X price okay let's say tomato today for example you have a piece of paper which says you can take two trucks of tomatoes at 20 rupees a kg okay you have this piece of paper this was agreed 6 months back 3 months back now this piece of paper is valued at much more higher rate right because there is very high demand the prices in the market actual Market are totally different if this piece of paper can be given to another person he can also take the delivery then that becomes a derivative if the agreement says that only tanig nadan and Kamal Kish can trade only I can sell and only he can buy then this is not transferable right in that case it may not be called as derivative so derivatives have been there for thousands of years okay in the trade in the financial markets right from 80s 90s it has started into being then it exploded in 90s and early 2000s then after 2008 it came down okay because of the crisis but it is being used as hedging mechanism and also for trade purpose before 2008 before 2009 before 2010 there was regulation was there it was not enforced much okay it was not enforced much after 2008 2009 2010 the uh enforcement came in okay you have this um uh act socks okay you can go and check what is socks act in the US okay it was there before also but started getting applied much more stringently in 20191 then one more example you can read as to what is the risk of derivatives okay what is the problem with derivatives one more example you can read is about okay this was this fellow was employed in UBS okay he was a Trader there and he was involved in a scandal which cost this bank around $2 billion at that time 12 years back okay he traded on derivatives okay he traded on derivatives and uh uh the loss because of on the back of those trades okay ballooned okay it went uncontrolled and finally it it went beyond the point it got exploded then it came to know it came out in the news okay and it so happened that this company this Bank UBS had to uh incur a loss of $2 billion okay now he was playing on the back of all this derivative positions uh like this lot of examples this is this is close to my heart because when I was in the peak of my work this was happening okay parall I was doing the same thing I was not doing scandals but I was working on the same thing and something similar is happening okay so this becomes and I think this was a very big thing at that point in time I don't think anything bigger than this happened after that okay in last 10 years other kind of scandals are there but involving derivatives and accounting frauds okay this was one like biggest Scandal one of the biggest scandles you can say in the fin markets in last 10 15 years okay so this is something you can go and read okay very interesting this fellow was jailed and he's already out from jail now he's in his hometown and uh you can read his part of story then he became a hero in Africa actually okay he became a hero in Africa why because he was talking about what are the ill or bad things about the financial markets in the Western World right this is always there right the Western world and the other part of the things so he was talking about the other stuff also which is also interesting you can go and read about this okay so the point is derivatives were used for or the main purpose is to cover the exposure okay to cover the exposure to cover the risk that is the main objective okay now how this exposure or risk is covered let us look at one example yes definitely of derivatives is that's all it deres its value from an underline underline could be anything right it could be Equity it could be asset it could be anything okay it could be currency also FX okay Forex also so looking at this Forex we will look at one very simple example I generally regularly use this example only okay let's say I am an importer I'm a Trader of this projector Epson projector okay and let's say I import it from Singapore it is not manufactured in India I import it from Singapore okay I imported from Singapore and sell locally here in India okay let's say each project of cost okay 6,000 sdd what is sdd Singapore dollars okay roughly what is the uh rate of one Singapore dollar roughly 60 now it is 60 okay so roughly rate is 60 so 60,000 Rupees import price okay um I have placed orders for 100 numbers what is my total bill huh in as well as in SD what is the total bill total bill today is 100k sdd right 100,000 SVD and value is 3 lakh rupees okay this is the bill today now I'm not paying it today the vendor is giving me time right two months three months time I'm getting it okay so I'll pay after 3 months let's say I'll pay on October okay in October I'll pay or let us say on 30th September I'll pay on 13th September okay how much I have to pay 60 lakh rupees I pay 60 lakh rupees or should I pay 100,000 sjd 100,000 sjd my invoice will be in inv will mention 100,000 SD it will not mention 60 lakh rupees but in my books of accounts the liability is at what value today 60 lakhs okay so on 30th September payment date okay when I paying right this is INR 60 per sdd this day will the price be same of the Singapore dollar it can be more or less let's say it is 62 Min 62 per SD right so what will be how much will I be paying I'll be paying 100K SD which will translate to how much 62 lakh rupees that means what I will do on that day I will buy 100 K sdd okay for 62 for INR 62 per sdd each SD right so my total outflow my total outflow is 62 lakh rupees okay keep writing okay this examples your books has your your material is also having this examples but little complicated okay they made actually the syllabus they made little complicated right you don't have easy examples you have little difficult examples but once you understand the topic then you can work out those examples so my total outflow is 62 L rupees now my liability was how much 60 L rupees but how much I'm paying 62 lakh now this two lakhs is what loss so I will debit my pnl right now this loss is because of what this is because of change in FX rates my vendor he is not concerned he is telling me you pay me $100,000 Singapore dollars that's all he's not concerned about you are incurring 62 lakh rupees or 58 lakh rupees but as a dealer or as a business have lost 2 lakh rupees two lakhs on a bill off 60 lakhs 3% impact on my GP margin right 3.33% on GP margin correct because I'm purchasing and selling this my selling price will not change because FX rate changed right 3% impact on GP margin that means my GP margin directly will go up or come down by 3% it will translate to 10% on my net profit margin which is a big money on a bill of 60 lakh rupees you're incurring a loss of 2 lakh rupees it's a big money the margin will be 10% on this trade not more than that right so as a business as a finance manager as a CFO I cannot afford to lose this 2 lakh rupees like this right so what is happening this 60 lakhs is an open exposure in my books this 100,000 Singapore dollar in my balance sheet in my balance sheet when I'm having this liability trade payables right even though I will mention 60 lakh rupees in notes I have to say or it is there that the exposure that I have is 100k SVD and this is open exposure we call it as naked exposure open exposure why open exposure because this 100K SD can translate to any amount it can become 60 lakhs it can become 70 lakhs it can become 50 lakhs it can remain 60 lakhs but this is an open exposure that means this is a risk this risk needs to be addressed covered right so this risk is coming because of what because of currency right so because you have a currency where you have an open exposure whose value can s in any which ways right then you are supposed to cover it if you have an option if you have a uh if you have an option in place if you have a way out you should cover it now the question is for that matter everything in balance sheet is open everything in balance sheet value can change for example yesterday we were talking about inventories right I have inventory right inventory value can change then am I covering that also assets I have other assets we were talking about PP right are we covering those also in a way yes your insurance if you take insurance you're cover that right inventory also insurance is there insurance is there protection from damage protection from test protection from fire and all those things but not protection from change in value that risk you have to take right there is no there is no cover for decrease in the value of the inventory because of Market forces you don't have an option that is a risk you're doing business that risk you have to take this is also risk only you can say this is also business risk we are doing import export the currency value can change yes this is a risk but as a finance manager as a CFO my responsibility is risk management risk management is my responsibility risk management which risk management Financial Risk Management is my responsibility right then I have to see whether I can cover it or not right so one way is is it only through derivatives you can cover it no there are a lot of other options also right because we are in the context of derivatives we will see how derivatives can be used to cover this so it is not only through derivatives I can hedge this hedge means what hedge means protection Edge means cover edging edging is a process means in local language or in lman term we can say it is a cover it is a production like your umbrella okay so it is not only through derivatives we can do all the things there are other ways also to do it but how we can do through derivatives is what we are going to see so now what I will do here huh huh so we will see now how I can use derivatives to cover this okay clear did we understand the this is very simple uh a normal day-to-day business activity business transaction how a business is facing risk okay without and there is absolutely zero control over these things by a business business right these are macroeconomic factors okay now what do we do okay so derivatives how we will see how derivatives can be used to address this this is one example uh similar example you can talk about trading in equity stocks right I'm taking a position on Equity I'm buying the shares which company got listed recently IDE huh IDE idea for I do not know I'm asking you what was the rate so 635 was initial rate ah listing rate listing price 15% 15% gain 15% is not th000 40% is th000 50% 60% is th000 15 15 means it would have got listed for 750 rupees or something so let's say Okay I I purchased it at 635 rupees okay then I had a fear whether this price will go come down or not so then I'm using a derivative to cover this exposure okay so let us see how we can use derivatives what are different types of derivatives anyone has any doubts so far okay the first derivatives set of derivatives are forwards and we have to understand derivatives is not only for stock market this we have to keep in mind okay derivatives are there for entire all the businesses use derivatives all bigger businesses use derivatives okay in one form or another forwards the first thing is a forward contract okay so you have different types of derivatives within that forward is one type of derivative what is a forward contract think agreement between buyer and a seller to yes what is the forward contract an agreement between a buyer and a seller to buy at a I mean to take delivery of the Securities or any contract hey hold on hold on hold on man agreement between buyer and a seller H to buy or or take delivery at a certain price uh within a certain period with an expiry date with an expiry date or something with the date attached at a certain date yes sir right right is this what you wanted to convey yes sir good the response your example you no no we will see I'll come to that point I'll clarify yes any other response what is a forward contract H okay something similar at a predetermined price okay at predetermined dat okay anything else no intermed no intermediaries involved happens in an unorganized manner unorganized means [Music] what OTC okay cont ciz your contract okay h coming out is difficult okay now oblation toct but not obligation toy toy and there an obligation for the seller to ex execute the but there nobl for that is options okay now we'll come to the features but what is forwards features of the forwards will come characteristics what are forward contracts that in future whatever happens this price and the profit and loss be equal example the profit is 100 for other zero some game okay so sir the forward is basically is entered today for a future date to exchange the commod underlying asset at a price at a fixed price so Ed today to exchange the goods or the asset on the future dates so to mitigate the risk and to speculate so this this a basic idea of the forward contracts this is okay okay welcome I'll give one more example all what is being discussed is correct let us take the discussion little further telling it is an agreement between buyer and seller to take delivery at certain price at a certain date okay now let's say I'm a Trader okay I am or okay in this case itself let us talk about thison itself so this case what are we did is it an agreement between buyer and seller right delivery will happen after certain date right at a certain price yes then is this a forward contract forget about this risk exposure and all this first transaction this as of today whatever have happened this delivery will come after 1 month 2 months or 10 days 15 days but this transaction is it a derivative is it a forward contract depends that this is the what depends I told everything where is the question of right to right of backing it is not a forward contract why because you only don't know agreement between and to take deliver been delivered at earlier itself sir the projectors have been delivered earlier itself no projector can be delivered after 1 month also today I I given the order so then it is a forward contract then it is a forward contract this is a forward contract but without expiry dates and also expiry date delivery payment date is given is this forward contract no deres undering can be anything can be anything months perod three months is credit period one month is delivery delivery can happen later also right ah what Financial Market you and I can enter a forward contract now yes or no then is this a forward contract who told derivatives is only for edging now forget edging and all what did you tell me agreement between buyer and seller right at a predetermined price at a predetermined date no intermediary right no happens in an unorganized on unorganized meaning was a different meaning not who told I'm I enter into trades uh to make money speculation to cover my risk so is this what is the difference between this definition which you guys told and uh this definitions which you guys told and this transaction the transaction was like 100 that person will say irrespective of what the exchange rate will be on 30th you pay 6 was fixed likeed price no no price is predetermine 100,000 Singapore dollars th000 Singapore dollars no forward contract also agreement is between buyer and seller to buy and sell now if I'm entering into at whatever be the cost or whatever be the condition if I have agreed to deliver to you I will have to deliver to you no purpose there is no defined purpose of D I can use derivative for anything you cannot main difference is the forward premium sir one second one second one second huh cover not necessary is what I'm telling derivatives that is why I'm telling it is was used for Hing purpose but it is not only used foring purpose it is used for speculation purpose also I can take a derivative position to make money simply assume risk and make money not for the only for the purpose of covering the risk yes sir uh the main difference with between that example and we have discussing is the the factor of forward premium there is no any additional consideration we are going to pay to the seller for that what projector we are buying so it's just th000 that 100,000 SG Singapore dollar only we're going to pay with or without the currency fluctuation so the forward premium is the basic thing which we should we will pay for fixing the prices in future date that is the main difference between this uh discussion and the example no see forward premium is basically from a pricing perspective yes sir okay premium is what small it is not going to be 65 rupees 66 rupees yes sir okay that is more from a pricing perspective but per say the contract we are talking about two transactions one is 9th July and the other one is which we have discussed here what is the difference no here also in this case also I can make the payment after 3 months after two months after four months that is my agreement with the uh with the vendor right delivery can happen at a different time at an agreed date what you said at agreed date at agreed price it can be tomorrow also right not necessarily 6 months then where that the other party is not concerned right in case of forward also other part is not concerned he's what he's telling you have agreed to buy I have agreed to sell we have to both both of us have to honor our commitments come what may tomorrow price changes whatever change happens you have to buy and I have to sell no if deliverable forward huh sir forward contracts can be cancelled off can we can back it off but this is honored commitment we should honor it anyway right forward contract you canot you cannot back off how can you back off you're bound by a legal agreement yes sir right Bound by legal agreement if I don't want that cushion of that edging the currency or what I'm committed I can I can cancel it off I can pay the charges I can come right this is between also here also I can cancel the order no I can cancel the order right Amazon 7 Days return back policy I can cancel the order I can talk to vendor what will happen I'll go to Singapore one day and come back go meet him convince him pay some damages and come back what one one trip cost what 20 30,000 rupes not a big deal no if I want to cancel the order I'll go and seek apologies I'll write a letter I'll take some sweets from here over that fellow will get convinced okay good good discussion lot of your points they're close enough very simple here the liability to pay is now this is a normal business transaction I am liable to pay from now order has been given my liability I am showing the liability in my books even though you have agreed to pay after two months three months four months I'm liable to pay now and is liable to dispatch now 7 Days 10 days whatever is a great period here liability to pay will happen when on the expired on the uh fixed date future date there is no liability assumed today here you have already bought delivery is pending payment is pending in this kind of transactions payment could have happened before also right payment could have happened on this day itself on 9th July also payment can happen payment can happen after three months also similarly delivery could have happened on 9th July delivery can happen after 3 months also after two months also that doesn't matter but here delivery will also happen on the certain date and obligation to pay will also happen on certain date same date yes correct are we getting it the minute difference is this here you are agreeing to do the transaction at a future date here you have already done the transaction and you have agreed the outcome of the transaction what is the outcome of the transaction payment and delivery delivery could have happened before payment could have happened before or both will happen in the future or one can happen at a different time one can happen at another time here the transaction itself will take place at a future date not today I'm only agreeing to transact at a future date and you have to do the transaction on the future date if you are agreeing to buy you have to buy you're agreeing to sell you s so this is a normal business transaction this is a derivative contract okay what is a forward contract I will take from this only agreement it is a contract or agreement okay between two parties to buy or sell the underline write like this only don't write in a sentence write like this okay it is a contract or agreement between two parties these two parties could be you and me it could be you and a bank it could be you and a company it could be you and a shop it could be you and anyone or it could be one shop and another shop could be one business and another business it could be one company and another company it could be one financial institution and another financial institution generally it is between a firm a company and a financial institution okay to buy yourself the underlying okay at future date okay or a fixed price okay so very important understand this is not a book definition this is a practical definition okay it is a contract okay what is the implication of it is a contract that means you are legally bound whether tomorrow that fellow is not honoring his commitment that a different thing but he's legally bound you can take him to the court okay this we have to understand because what happens many times people say forwards and Futures in forwards I can back off in Futures I cannot back off in forward also I cannot back off I can I can take you to the court very simple okay contract or agreement it is between two individual parties okay it is between two individual parties individual means not individual it is between one company and another or individual and individual like that okay what is the purpose to buy or sell I can either buy or I can sell and the other party will be selling or buying okay the opposite what the underline there has to be some underline underline can be currency it can be an asset commodity Equity Bond anything okay then at a future date for a future price okay nothing is paid today you don't pay anything today except for transaction charges which is very very minimal can be uh what 50 basis points 20 basis points what is 50 100 basis points means what huh 1% is 100 basis points okay it can be 1% half a perc some transaction charges apart from that you don't pay anything on the contract payment will happen only at a future date okay nothing is paid today and these are customized Transaction what is customized transaction I can enter into a derivative okay to buy let's say here we talked about, 100,000 Singapore dollars it could be 95,000 Singapore dollars it could be $11,000 Singapore dollars okay the delivery date could be um uh 9th sorry 7th October 2023 right it could be 36 Days it could be 45 days it could be 34 days it could be 97 days right customize the way I want the way both of us can want we can customize to suit our requirements okay what is a very good example of a forward contract H Farmers something relating to you guys how many dollars 1,500 22 or 90 $22 so let's say I want to register after 3 months right all of you can go today to a bank and take a forward contract all those who have not registered $1,522 I have to pay right today let's say dollar is how much 803 83 okay 83 let's say you expect you have studied CFA you have done some analysis you expect the price to go to 86 right so what is the difference in terms of INR 4,500 rupees you can save you can buy the CFA calculator right lot of people don't buy the calculator 4,000 rupees 4,000 rupees he already committed one and half lakh rupees 4,000 that fellow will not buy the calculator okay telling it is costly costly C okay so nothing is paid today it is customized transaction this is the meaning of a forward contract okay and because it is a customized transaction because it is between two individual parties okay let us understand the implication so that means this is legally bound to obl both the parties okay because it is between two individual parties there is a counterparty or credit risk there is always a risk that the other person may not oblig okay there is a risk that other person may default okay this is the implication of these things there is a counterparty or credit risk okay nothing is paid today okay so tell me if that be the case what is the value of this forward contract which I entered now let's say I've entered okay three rupees I'm going to the bank okay and I'm telling that okay I want a forward contract okay I want this so many dollars on 9th October okay bank will say 84 rupees let's say okay and he says okay I'm fine for it okay I will go for this contract then you'll say okay the total value of this transaction is 15228 84 okay into let's say 5% okay pay 640 rupees roughly I do not know the charges okay point he'll say Okay pay 640 rupees sign this and this is the paper you come on 9th October I'll give you the dollars I'll credit to your account or payment will be done okay so this is a transaction charges now you have the slip with you what is the value of that slip now so if you give that slip to me will I pay you $522 charges you can ignore small number small huh expiry amount which is how much that is the value of the slip so if you lose the slip what is your loss are you you are you okay how much are you paying today so if you lose this paper what is your loss 639 your loss is not 127,000 and if you if I have to buy this slip from you how much should I pay which I can I can go to the bank and buy myself right why should I buy it from you so the value of this clip is zero so value of the forward contract at the beginning for that matter value of any derivative at the beginning is zero okay this is important we will be discussing about valuation probably in the next class or the subsequent class very very important to understand why value is zero today value today is zero because you're not paying anything today you not paid anything today right there is no value attached to it today correct okay now 9th October okay let's say I'm I'm at 9th September at that day how much you have agreed for8 84 okay on 9th September the spot Market if you go and buy dollars now on 9th September let's say that is 85 rupees okay then what is the value of the slip on 9th September one month before this9 hey ignore 639 okay don't get confused can ignore 639 the correct the value of this slip okay on 9th September when in the spot Market dollar price is 85 rupees hm okay on 9th September will the slip have any value will the value change so today I told no value on 9th September will the value change what did we say so under L value is changing or not changing it has changed right okay now what is happening now let's say the slip is there okay the slip is giving me a right to buy the dollars at what price 84 one month H okay today what is the price 85 so obviously it has got a value because if today it is 85 you expecting it to increase inrease further already one rupee gain is there from 84 to 85 and one month H you may expect it to increase further that means you are getting a right to buy something at 84 okay which is available in the Market at 85 so obviously that you have this premium right so this is like okay in your language very simple your Amazon vouchers if you have Amazon voucher the price is little lesser right you you get some code and all those things if you enter that code discount same thing right so at this time on 9th September the value of the slip is how much 1,522 how 10522 1,522 into 84 minus 10522 into 85 which is 1,522 clear are we getting this now let's say on 15th September this becomes 87 on 25th September this becomes 8 2 tell me like this this is the value of the slip on this day tell me what is the value of the slip on this day and on this day h how much 522 into 3 and here minus 1522 into two you got a loss here okay so basically this is what we call it as deriving the value from underline the value will keep changing immediately after today in fact immediately after this point so let's say if I've entered into the contract now right and if it is a dynamic Market the the prices will keep changing every second then after one hour the price will be different right after to at the end of today the price will be different so at the end of today there will be a value to the contract but at the beginning of the cont cont which is now there is no value getting it okay so this is your forward contract understood okay now come to absent um example so here we have an open exposure so here tell me what do we do to cover this exposure take forward how do we how do we take forward huh h no no you will not you cannot buy it if you okay good point if you buy it at spot Market how much you have to pay so you have to pay 60 lakhs F to fix the price you'll not buy at a spot rate the forward rate so you'll buy 100,000 Singapore 60 not 60 Rupees at the forward Price Right forward price can be 62 rupees 63 rupees it can be anything okay you will agree with the bank or with the financial institution to buy so many dollars at a future date you'll enter into a forward contract okay so let's say you are entering into a forward contract enter into forward contract okay to buy 100K sdd at let's say 61 at INR 61 for sdd one 39 23 okay now tell me tell me the steps okay tell me what will happen to my business on 30th September what all transaction I will do on 30th September how much to the expor and to the from the financial insti where taken the for contract I 61 that's all right so what will happen on 30th September you will pay Bank okay 61s this is per as for the forward contract right so you'll pay minus 61 lakhs okay receive from Bank 100K SD a SG vendor what sdd your net outflow is 61 lakhs your liability was 60 lakhs but your outflow is 61 lakhs your loss is one lakh so by this process your loss is limited right your loss has has been C correct right to some extent it has been arrested okay now this is a normal way in which the transaction will happen for a deliverable but generally what will happen is this is normal transaction generally what will happen or what happens is I will LAX is my is the rate okay you'll also see what is the spot rate on that day right the spot rate on uh 30th September okay 30th September is what 62 INR 62 per SD this is the spot rate what will happen is you need to know about Apple is's website okay I will what will happen is instead of taking the delivery all right we'll settle the difference okay with the bank okay what is the difference one lakh right so I'll pay the bank the difference between spot and future or the forward price between spot and the forward price which is how much 62 minus 61 your spot price is 62 and your um agreed forward price is 61 so one lak you will pay and if it is a gain you will receive from the bank okay minus one lakh you will pay boom you will pay you'll pay with the counterparty with whom you entered into the forward contract okay then I sdd from the spot Market hold on will this be minus one lakh or plus one lakh why plus one lakh because so what I've told is Ive told that from you I will buy it at 61 but in the market it is available 6 2 right so if you have to give me you have to give me at1 61 right so that means I have one rupee gain so that one rupee gain is this okay buy Singapore dollar from the spot Market which is at what 62 right so the outflow that I'm doing isus 62 lakhs and receive 100K SGD and pay s vender 100K SGD from the market receive from the spot Market 100K SGD and pay the SG vendor Singapore vendor 100K so net net your outflow is minus 61 lakhs okay this is for ndf non deliverable forwards this is for deliverable forwards non deliverable means you settle the difference generally you settle the differential amount here how forward can be used as a hedging mechanism okay as a as a tool to cover your open exposure and it is not as I said it is not only the forward contract or it is not only a derivative which can help you to cover the risk there are different ways okay in which you can cover the risk one of the ways is to use a derivative and within derivatives one of the ways is to use forwards you can also use similarly futures or options also for this clear with this did you understand forward contract how do we execute this in in an agricultural CR do we do we the same mechanism no no see what will happen is understand how does iture agriculture also see here my view is the the dollar rate will go up but if my view is dollar rate will not go up it will come down I'll keep Qui I'll not do anything right so similarly in the other Market which you're talking about agricultural Market if I'm confident that my crops will fetch a higher price I will not do anything right and if my crops are not going to if I'm concerned the prices may come down I may enter into a forward contract option no that is a different discussion to where where now here also what will happen lot of companies in finance they'll have a policy that you cannot time the market by default you have to take forward contract by default you have to take a future contract by default you have to cover the risk right you cannot opine telling that my face the price dollar price will come down so let us not go and hedge are you getting it because as a CFO my role is not to make money from currency movements my role is to help the business to make money from the underlying business right my role is to cover the risk any open Financial Risk is there I should cover it so a lot of companies have this default policy the moment you give the order the moment you do some trade business trade if it is coming up with an open exposure immediately go and cover it in fact Banks itself will give this facility right where you are taking your term loans or your loans wherever you're doing transaction with bank right Bank itself will give the option to immediately take a forward cover okay and especially if it is an import transaction import transaction will be supported by this LC's letter of credits and all those things right so for that for LC I have to go to the bank bank will Bank will know that okay if you're coming for LC that means it's an import transaction right then bank will say that okay you have to take forward right this finance manager who is not that very well qualified he'll ask okay what is forward cover and bank will explain give some PP we'll tell okay you bring your management we'll do a meeting in a conference room they'll present a PP they'll say this is forward cover this is hedge this is absent projector okay and then they'll say take forward cover and they will charge premium initially then our finance manager fellow will understand what it is then he will realize then no premium at all normal prices okay clear can we proceed further huh super very good uh question okay I will take this when we discuss swaps or okay very simple you have come to buy dollars from me Singapore dollars he will come to sell dollars from me dollars with me right uh I don't think so this generation is going to bank branches how many of you have visited Branch recently bank branch H very rare if you have noticed if that branch has an fx desk where they buy and sell this foreign currencies they will say the board there will be a board electronic board it will be displayed okay we by us83 we sell 87 we buy GBP 98 we sell 105 this where you makeone huh basically so if he comes to buy I will buy from him at 98 GBP and when you come to sell 105 so it is a Marketplace for the bank so putting a forward contract to my C for CF and all don't take forward contract and all whatever is a fees go and pay contct my for 84 rupees sir so on that same date while paying that date so I'm paying 84 rupees after that process they will pay that one rup for me which one rupe yeah no no cont3 cont entering the contract contct so on the payment date I'm paying 84 they repay me that one you'll pay how much 83 you're entering the contract at what rate 84 84 so pay 84 so now 83 no at what rate you ENT 848 let's say you have entered at 84 on the matur the dollar go up for8 on that day dollar can go to any value you have to pay 84 okay 84 and they'll give you the dollars okay now that operationally how they will give whether they'll give you the currency or will they'll credit to your bank account okay what happens in like the small transaction they'll give the currency okay they will take one kyc okay and uh they will also not the currency they will credit an equivalent amount to your bank account they'll ask for what purpose do you need to use this currency you'll say no I have a friend to whom I have to remit this money in us or for this payment I have to do then say okay give the bank details we will make the payment they'll not give you dollars dollars banks will not give dollars dollars you'll get from the this money exchange fellow okay and larger businesses bigger businesses or businesses when they open the current accounts I will open a dollar account I will open a Singapore currency account I will open a US dollar account I will open a GBP account if my transactions are like in different currencies sitting in China sitting in India with these Banks we'll open a foreign currency account with permission from the RBI they'll ask me why do you want so then I have to get trade licenses permissions and all that will get covered in different regulations FEA and all we have okay yes any doubts okay fine now let us look Ates okay people online following anyone has any doubt clear so what is Futures Contract okay so then I will say wa same as forward can I write like this so Futures Contract okay first I'll go to the definition later tell me what is Futures Contract more standard huh exchange traded okay correct h mark to Market settlement H zero counterpart standardized traes okay then have to pay margins okay regulated regulated how exch the exchange okay cont cont that you can do in forwards also 7 if the view is the prices are going to come down and if the other part is agreeing yes can do it initi that margin Mar basically customized uh standardized settlement dates then spot price iMed you have to make immediate payment that whatever rate Futures is available you can buy very simple at the end of the day margins in forward example don't but in fut the price supposed to assume margin requirement settlement is not there okay all right yes so it is agreement again between buyer and seller is a contract or agreement between one party and exchange it is between one party and exchange to buy or sell the underlying at a future date for a fixed price okay margin requirements are there margin needs to be deposited initially okay standardized transaction value of the contract today is zero when you enter the value is zero okay why do we say no counterparty or credit risk H so so it is not that okay because it is with okay it is not that because it is with the exchange you don't have any loss okay because it is with exchange and exchange has its mechanism of margin requirements exchange is self-sufficient how now anyone and everyone cannot go and do the trades with exchange first kyc has to be done only if you are credible only if your uh kyc is proper okay only if your credibility is there you'll be allowed to trade point one point two you have to deposit initial some margin money what is margin money based on the value of the transaction a certain portion okay now margin requirements for different underlyings differ for example equity and what is the margin requirement H it it ranges from 10 to 40% okay at different times different margin requirements are there okay that means if the value of the transaction that I'm entering into is one lakh I'm dealing into shares worth one lakh rupees I may have to deposit 30,000 rupees I don't have to pay one lakh but I have to deposit 30,000 right so that tomorrow if my loss is becoming 10,000 margin uh exchange will deduct this 10,000 from this 30,000 they will not wait for the settlement date which is after 3 months to come and pay 10,000 or 20,000 what will be the money now what if margin money is getting exhausted okay square of a you'll get a margin call okay you'll be notified to deposit additional money otherwise your contract will be squared off your trade will be closed okay now how this works let us see let's say I'm entering into Equity shares okay I'm I'm buying a Futures Contract okay uh for some XYZ underlying Equity the settlement date is 30th September and the agreement is to buy okay at agreed prices let's say at 100 okay today's date is 9th July motional you can say one lakh rupees okay so 9th July I'm entering into the contract okay what will happen is on 9th of July EOD end of day 9th July okay the price will change Dynamic Market the price keeps changing every second right at the end of the day on this day the spot price okay the spot price is 80 rupees okay end of the day the spot price becomes 81 rupees okay spot price huh St price is becoming 81 Rupees at the end of the day the future not for the future price is becoming P5 rupees understand the difference are we dealing in the spot Market or are we dealing in the Futures market futures market so this 81 I will not even look at it's 81 we will not even look at right we are not concerned about spot market so if at the end of the day if I have to enter into a similar forward Futures Contract with 30th September maturity I have to pay how much 100.5 that means on 30th September I have to pay 100.5 okay clear now what is the value of this future contract here and here zero here rece basically five right into how much into 1,000 which is 500 rupees your gain is 500 rupees because you have entered to buy something at 100 whose value is now 100 point five so your this we call it as to market gain right in financial markets term this is also called as day one pnl in financial reporting we call it as day one pnl okay 500 rupees that will get added to your margin correct yes so you have this 500 rupees right so it will get added to the margin whatever is your margin amount it will get added to your margin let's say your margin money is that pay 20,000 so then you today you made 500 this 500 will go you don't have to deposit this is automatically getting added 100 is the and 100.5 is this is that is what this is the spot price today this is the future price at the end of the day evening if you enter into this contract this contract is available for 100.5 Futures price only evening let's say today 10:00 you entered at 100 okay evening 5:00 or close of the market at that time if you want to enter you will get at 100.5 81 81 is the spot price to buy the market to buy it then everyone understands this how we got the 500 100.5 this is 100 is my price okay you can say lot size is how much 1,00,000 into .5 right this is called as MTM gain now let's say on 10th July EOD okay this Futures price becomes 98.5 okay in that case what is MTM gain minus first minus or Plus take 100.5 because you have marked your position to 100.5 The the value in your balance sheet is at 100.5 . 5 right and next day the value of that asset is becoming 98.5 so you will show a loss of 2,000 you're marking it to the market yes overall so day one you are having pnl of 500 day two pnl is 2,000 minus 2,000 so net net 1,500 okay how will your balance sheet look at this point or at the end of the day one how will your balance sheet look on day one how will your balance sheet look one end of the day H inventory cash are you receiving cash tradeables how much 500 or 500 or 1 lak 5,000 1 lak 500 huh okay okay tell me tell me when I'm entering into the contract morning that day when I'm entering into the contract how will my balance sheet look H receivable so how will balance it look payable to home when I'm entering into the contract what will be there in my balance sheet so what okay journal entry journal entry to bank account how much payable to bank account so payable account is pay to okay how much you are paying one lak you are paying how much are we paying just margin if you pay one lakh you will go and enter in spot Market why do you want to come to Futures you do not want to pay that one lak that is why you entering into Futures right okay and balance sheet will look like this only nothing will be there on the balance sheet except for that margin money margin money you paid to The Exchange so reable 20,000 cash will go out 20,000 okay that is why we said value of the contract is zero because the value is zero there is nothing in the balance sheet this we have to understand this we covered in income statement all those who haveed FSA in income statement we covered pnl financial instruments okay because the value is zero nothing will come at the end of the first day only this margin amount will come that is as a receivable at the end of the first day okay derivative Financial instrument is how much 500 and reserves basically your pnl is 500 right day two it will be 2000us 2,000 where huh it because you're having a liability now of course this will be offset against the margin money right so this 1,500 will be offset against the margin money what margin you have from that it will get justed unrealized gain we call it as unrealized gain or loss which will go to PN which will go to PN right for some time you'll not touch margin also right you have maintenance margin okay variable margin and all those things are there right only when you get the margin call you'll go and deposit additional money if you are making gain then no problem okay so this is basically MTM process Mark to Market process day in and day out basis you are marking it to Market you're supposed to Market to Market and whether you don't follow it in your books of accounts exchange will do and you'll daily get a notification how much is your margin money what is your accumulated loss or gain exchange will keep doing it okay so if EX is doing it you also have to do it and we do it in forward contract also in forward contract exchange is not there but if I am a reportable entity what is reportable entity the one which is required to publish financials to the public or to The Regulators then according to IFRS or based on the government's requirement okay based on your company's act and all you have to show MTM gain or loss on your all your derivatives including forward contracts so on your forward contract also this process has to be followed whenever you are reporting right so in certain cases in certain financial institutions right in certain industries this process is done on a daily basis on a daily basis you will prepare the pnl and you'll send it to the Senior Management and The Regulators also in case of banks okay otherwise all other companies also on a daily basis for derivatives there has to be a Process Management cannot say no it's okay we don't want to see no as an audit requirement as an internal control requirement this a key audit requirement where are you tracking your financial instruments on a day in and day out basis is that mechanism is there are those reports being presented to the Senior Management is Senior Management looking into it are they taking any decisions based out of that that is a key control requirement for all the bigger companies okay so for forward contracts also we follow this MTM process for all the derivatives we follow this MTM process okay so because of this MTM process literally the counterparty or credit risk becomes zero absolutely zero or close to zero why I telling close to zero is what is happening in my experience in last two three years especially one is covid earlier we would not see end of the world events now these are all end of the world events like those only so till date I've never seen a case where exchange is defaulting or there are problems because of exchange but this happened in last two years and all what happened One exchange in London it stopped doing transactions it stopped taking trades and people incurred loss because of that okay this was a exchange so without going into the details to explain it because it's very complex right to explain it at high level Metals okay Commodities or Metals you can say uh there were people who had taken short positions especially this was linked to uh China okay so there were people who had taken short positions so what is short position so I have so I don't have something but I'm selling it or agreed to sell it I've agreed to sell this at let's say 100 rupees okay now if in the spot Market when I will make a gain only if the price is less than 100 rupees right so if I have agreed to sell it so someone else has agreed to buy at 100 okay so let's say I am one I'm on the one side of the exchange on the other side this this flow is there right so in the spot Market the prices skyrocketed it became 500 600,000 something like that right and this expired date has come so when the expired date came what I did what I did is I because I'm a large institution like me there are large institutions who have taken short positions I told because I am running the exchange now I told the exchange stop doing the transactions so what happened so this fellow wanted to buy he standing outside okay I want to buy I want to buy why because he is agreed to buy at 100 it is available for 500,000 rupees in the market right and I had to sell and I'm not selling it so now this is like an extreme event doesn't happen on a daily basis it is an extreme event where exchange has stopped taking transactions or trades telling technical issues you see so earlier used to say these things in in books it will mention no counterparty risk and all now I think theyve amended I check they will say there are extreme scenarios where counter party risk is there in exchange also why because it's are privately run right ultimately human beings are involved right so where human beings are involved uh you can you have to assume you cannot assume that everything is fine okay so this is about uh Futures Contract effectively today the difference between forwards and Futures now the question is about why Futures and why not forwards or why forwards and why not Futures it all depends upon what your requirement is right if you're comfortable with forward you'll go with forward if you're com comfortable with Futures you'll go with Futures all right and OTC OTC trades are also regulated in some Market if it is see all the transactions are regulated you're legally Bound in all the transactions everything is done through a contract right so so that that point is taken okay any doubts on forwards and Futures did we understand now there are questions relating to this okay little complex examples are there I will work it out later right in the subsequent class first we'll try to understand what are this derivatives okay forwards Futures option swaps then we will solve some of the examples okay that are given in the material or example similar to what is given in the material okay any doubts okay so we'll take a break now 10 minutes break then come back and continue further

derivatives okay so generally before starting any topic I try to discuss about the why of it okay uh in your CFA syllabus where does derivatives F in where does derivatives fit in h so okay what are the subjects in your CFA so this derivatives Equity alternative investment fixed income what are this asset classes right so derivatives is one of the asset classes okay that is one thing uh from exam perspective what is the weightage of the subject 5 to 8% the least weightage that uh if any topic is there it is derivatives okay derivatives and portfolio management and uh AI okay these three topics have least weightage however I think I have told in the past also the weightage concept is purely from uh assigning the number of questions okay uh if it is having 5 to 8% weightage means 5 to 8% questions will be from derivatives okay however before the scenario was different if I had ignored derivatives it was okay or if I had ignored AI it was okay even if I did not prepare AI it was okay but now you have to score 70% in derivatives also 60% or more in derivatives also in AI also in all the topics in ethics to score 80% or more okay so um weightage wise this only proportion of questions otherwise all the topics are important okay all the topics are important uh FSA what is the weightage 15 to 20 15 to 20 is only ethics 13 to 17 okay FSA is 13 to 17% how many modules are there in FSA 12 how many modules are there in derivatives 10 now that 10 is actually three okay in the syllabus that you had before actually two only okay like 2022 syllabus if you see not 23 that two only has been split into nine or 10 okay nine if I&#39;m not wrong how many modules you have 10 okay 10 right effectively I see I look at it as two modules only okay two readings and FSA was 12 readings before also now also 12 readings so for 12 readings I&#39;m getting how much marks roughly around 17% of the marks or 15% of the marks for two readings how much marks I&#39;m getting so which is more beneficial okay okay wrong wrong wrong analysis wrong example with less effort you are getting four marks right so that I will complete derivatives first I&#39;m not telling don&#39;t study FSA you have to study you don&#39;t have choice this is important but the smaller weightage topics I will try to finish quickly or the readings which are less I will complete picker okay so this is one aspect from exam perspective this is important what is the relevance of this practically why are we studying this subject right why it is included why it is an asset class okay that is also important okay practically speaking it has lot of significance okay uh be it in terms of markets okay it is not only for the purpose of trading okay it is for the purpose of edging okay it is mainly used more used for edging okay and the speculation is also there okay for speculation purpose also this is in terms of your participation in Market without participation how do I use it don&#39;t want to invest right then where is the use for derivatives okay from employment perspective from employment and jobs perspective right the entire IB operations right lot of roles relate to derivative even though you don&#39;t have to have in-depth understanding of derivatives but lot of roles thousands of roles in Chennai in Bangalore in India you have in operations okay and then IB Finance okay Investment Banking Finance in lot of this is like you can say little higher level than this from a technical standpoint okay better job here also lot of roles are there this is apart from your trading and those things from jobs perspective how do I use why derivatives are relevant in fact more openings are there in this compared to equity okay compared to lot of people think Equity Equity Equity yes for investing for investment for participation equity is more uh important or more it has more number of opportunities but from a job&#39;s perspective derivatives has a much more broader scope from that perspective it becomes important so then so practically why it is important is this reason okay so if I prepare properly tomorrow where it will come and use where it will come and hit me then I go for interview point one okay Step One is exam step two is interview step three is on the job role right I have to have the understanding for example my own case I don&#39;t have any participation experience I have not traded a single trade in derivative on myself on my behalf neither on others behalf I&#39;ve done but my entire experience is from my job on derivatives right so likewise the Practical applicability can be either through jobs which is like much more uh uh possible and if you are going to trade then participation okay so this is the Practical aspect of it okay as to how derivatives are important and how derivatives are relevant clear okay fine now let us look at the topic what are derivatives yes Rohan it&#39;s a kind of agreement between two parties and it&#39;s a financial instrument examples include f h options H SPS H derived from an original contract or a security contract derived from a security or an index contract derived from a security ah yes sir okay yes good any other response deres value from an yes anything else purely based on an underlying ass prices in future I come yes contract for future contract for a future date very good any the response it has an expired date H yes I got the definition already if I combine all these options all these points h see my effort is less I&#39;ll ask you guys only yes any other point what is the derivative also not to predict the future also [Music] in whe the price going up or down and it also used to the demands and other than the investment market and how it example example if you are saying that the job right so while analing the present hisory data I can able to no no but how is derivative useful how is a derivative applicable in that so able to determine one seconder of the company how it&#39;s performing and how is growth going up or down due to that and based on that I will I predict the future performance compy correct but that is forecasting yeah what is derivatives here you&#39;re telling it helps in forecasting yeah okay fine yes online someone was participating it helps it it is used as an hedg okay question what is derivative basically okay yes so all the answers are correct okay meaning is it derives its value from an underlying okay the underlying could be an asset it could be anything okay the underlying could be anything underlying could be an asset asset means it could be your Equity your Commodities right so basically Equity Commodities okay uh bonds fixed income securities okay it could be interest rates okay gold silver all these things defa swaps yes come again credit default swaps CDs okay credit default swaps okay swaps H then it can be on it can be on whether derivatives we have whether it is going to rain today or not you have derivative on that indexes sir the stock index index also on entire index you have derivative right you have a derivative linked to an index&#39;s performance okay so derivative can derive its value from this is only a indicative list not an exhaustive list okay there can be many more like this okay derivatives is not cryptocurrency okay cryptocurrency is shooting in the air okay without knowing what it is this is purely for the purpose of the whole purpose of derivatives was to hedge okay the exposure hedge the risk that was the purpose why derivatives were used for mainly how old are derivatives L were basically introduced in the 200 fin the insurance against open your material read the first par or first page IND deres I think new material it will not be there changed REM actually you can lot of things anyways so derivatives have been there in the financial markets right from 1980s 1970s 1980s okay uh but it is not only from the financial markets it has been there in existence for thousands of years okay Cal stock trade agriculture deres have been there okay today also informally it is being done once the crop is produced right wherever the market is uh unorganized Market okay where it is not part of a chain where government is involved in case of unorganized sector in agriculture once the crop is ready once the produce is ready or even before the produce is ready they will agree with the traders to sell at some rate okay and for example I will agree and I will have a token or a piece of paper where I&#39;ve told that okay I&#39;ve agreed to sell this to this person for XY Z price okay and when the crop is ready when the produce is ready I will deliver it or the other option is instead of delivering it I will sell this price this token to someone else right because the other person has let&#39;s say you are the other person you are also having one one pair of token I have one token and the other pair of the token is with you which says that you have the right to receive the delivery of this produce okay at X price okay let&#39;s say tomato today for example you have a piece of paper which says you can take two trucks of tomatoes at 20 rupees a kg okay you have this piece of paper this was agreed 6 months back 3 months back now this piece of paper is valued at much more higher rate right because there is very high demand the prices in the market actual Market are totally different if this piece of paper can be given to another person he can also take the delivery then that becomes a derivative if the agreement says that only tanig nadan and Kamal Kish can trade only I can sell and only he can buy then this is not transferable right in that case it may not be called as derivative so derivatives have been there for thousands of years okay in the trade in the financial markets right from 80s 90s it has started into being then it exploded in 90s and early 2000s then after 2008 it came down okay because of the crisis but it is being used as hedging mechanism and also for trade purpose before 2008 before 2009 before 2010 there was regulation was there it was not enforced much okay it was not enforced much after 2008 2009 2010 the uh enforcement came in okay you have this um uh act socks okay you can go and check what is socks act in the US okay it was there before also but started getting applied much more stringently in 20191 then one more example you can read as to what is the risk of derivatives okay what is the problem with derivatives one more example you can read is about okay this was this fellow was employed in UBS okay he was a Trader there and he was involved in a scandal which cost this bank around $2 billion at that time 12 years back okay he traded on derivatives okay he traded on derivatives and uh uh the loss because of on the back of those trades okay ballooned okay it went uncontrolled and finally it it went beyond the point it got exploded then it came to know it came out in the news okay and it so happened that this company this Bank UBS had to uh incur a loss of $2 billion okay now he was playing on the back of all this derivative positions uh like this lot of examples this is this is close to my heart because when I was in the peak of my work this was happening okay parall I was doing the same thing I was not doing scandals but I was working on the same thing and something similar is happening okay so this becomes and I think this was a very big thing at that point in time I don&#39;t think anything bigger than this happened after that okay in last 10 years other kind of scandals are there but involving derivatives and accounting frauds okay this was one like biggest Scandal one of the biggest scandles you can say in the fin markets in last 10 15 years okay so this is something you can go and read okay very interesting this fellow was jailed and he&#39;s already out from jail now he&#39;s in his hometown and uh you can read his part of story then he became a hero in Africa actually okay he became a hero in Africa why because he was talking about what are the ill or bad things about the financial markets in the Western World right this is always there right the Western world and the other part of the things so he was talking about the other stuff also which is also interesting you can go and read about this okay so the point is derivatives were used for or the main purpose is to cover the exposure okay to cover the exposure to cover the risk that is the main objective okay now how this exposure or risk is covered let us look at one example yes definitely of derivatives is that&#39;s all it deres its value from an underline underline could be anything right it could be Equity it could be asset it could be anything okay it could be currency also FX okay Forex also so looking at this Forex we will look at one very simple example I generally regularly use this example only okay let&#39;s say I am an importer I&#39;m a Trader of this projector Epson projector okay and let&#39;s say I import it from Singapore it is not manufactured in India I import it from Singapore okay I imported from Singapore and sell locally here in India okay let&#39;s say each project of cost okay 6,000 sdd what is sdd Singapore dollars okay roughly what is the uh rate of one Singapore dollar roughly 60 now it is 60 okay so roughly rate is 60 so 60,000 Rupees import price okay um I have placed orders for 100 numbers what is my total bill huh in as well as in SD what is the total bill total bill today is 100k sdd right 100,000 SVD and value is 3 lakh rupees okay this is the bill today now I&#39;m not paying it today the vendor is giving me time right two months three months time I&#39;m getting it okay so I&#39;ll pay after 3 months let&#39;s say I&#39;ll pay on October okay in October I&#39;ll pay or let us say on 30th September I&#39;ll pay on 13th September okay how much I have to pay 60 lakh rupees I pay 60 lakh rupees or should I pay 100,000 sjd 100,000 sjd my invoice will be in inv will mention 100,000 SD it will not mention 60 lakh rupees but in my books of accounts the liability is at what value today 60 lakhs okay so on 30th September payment date okay when I paying right this is INR 60 per sdd this day will the price be same of the Singapore dollar it can be more or less let&#39;s say it is 62 Min 62 per SD right so what will be how much will I be paying I&#39;ll be paying 100K SD which will translate to how much 62 lakh rupees that means what I will do on that day I will buy 100 K sdd okay for 62 for INR 62 per sdd each SD right so my total outflow my total outflow is 62 lakh rupees okay keep writing okay this examples your books has your your material is also having this examples but little complicated okay they made actually the syllabus they made little complicated right you don&#39;t have easy examples you have little difficult examples but once you understand the topic then you can work out those examples so my total outflow is 62 L rupees now my liability was how much 60 L rupees but how much I&#39;m paying 62 lakh now this two lakhs is what loss so I will debit my pnl right now this loss is because of what this is because of change in FX rates my vendor he is not concerned he is telling me you pay me $100,000 Singapore dollars that&#39;s all he&#39;s not concerned about you are incurring 62 lakh rupees or 58 lakh rupees but as a dealer or as a business have lost 2 lakh rupees two lakhs on a bill off 60 lakhs 3% impact on my GP margin right 3.33% on GP margin correct because I&#39;m purchasing and selling this my selling price will not change because FX rate changed right 3% impact on GP margin that means my GP margin directly will go up or come down by 3% it will translate to 10% on my net profit margin which is a big money on a bill of 60 lakh rupees you&#39;re incurring a loss of 2 lakh rupees it&#39;s a big money the margin will be 10% on this trade not more than that right so as a business as a finance manager as a CFO I cannot afford to lose this 2 lakh rupees like this right so what is happening this 60 lakhs is an open exposure in my books this 100,000 Singapore dollar in my balance sheet in my balance sheet when I&#39;m having this liability trade payables right even though I will mention 60 lakh rupees in notes I have to say or it is there that the exposure that I have is 100k SVD and this is open exposure we call it as naked exposure open exposure why open exposure because this 100K SD can translate to any amount it can become 60 lakhs it can become 70 lakhs it can become 50 lakhs it can remain 60 lakhs but this is an open exposure that means this is a risk this risk needs to be addressed covered right so this risk is coming because of what because of currency right so because you have a currency where you have an open exposure whose value can s in any which ways right then you are supposed to cover it if you have an option if you have a uh if you have an option in place if you have a way out you should cover it now the question is for that matter everything in balance sheet is open everything in balance sheet value can change for example yesterday we were talking about inventories right I have inventory right inventory value can change then am I covering that also assets I have other assets we were talking about PP right are we covering those also in a way yes your insurance if you take insurance you&#39;re cover that right inventory also insurance is there insurance is there protection from damage protection from test protection from fire and all those things but not protection from change in value that risk you have to take right there is no there is no cover for decrease in the value of the inventory because of Market forces you don&#39;t have an option that is a risk you&#39;re doing business that risk you have to take this is also risk only you can say this is also business risk we are doing import export the currency value can change yes this is a risk but as a finance manager as a CFO my responsibility is risk management risk management is my responsibility risk management which risk management Financial Risk Management is my responsibility right then I have to see whether I can cover it or not right so one way is is it only through derivatives you can cover it no there are a lot of other options also right because we are in the context of derivatives we will see how derivatives can be used to cover this so it is not only through derivatives I can hedge this hedge means what hedge means protection Edge means cover edging edging is a process means in local language or in lman term we can say it is a cover it is a production like your umbrella okay so it is not only through derivatives we can do all the things there are other ways also to do it but how we can do through derivatives is what we are going to see so now what I will do here huh huh so we will see now how I can use derivatives to cover this okay clear did we understand the this is very simple uh a normal day-to-day business activity business transaction how a business is facing risk okay without and there is absolutely zero control over these things by a business business right these are macroeconomic factors okay now what do we do okay so derivatives how we will see how derivatives can be used to address this this is one example uh similar example you can talk about trading in equity stocks right I&#39;m taking a position on Equity I&#39;m buying the shares which company got listed recently IDE huh IDE idea for I do not know I&#39;m asking you what was the rate so 635 was initial rate ah listing rate listing price 15% 15% gain 15% is not th000 40% is th000 50% 60% is th000 15 15 means it would have got listed for 750 rupees or something so let&#39;s say Okay I I purchased it at 635 rupees okay then I had a fear whether this price will go come down or not so then I&#39;m using a derivative to cover this exposure okay so let us see how we can use derivatives what are different types of derivatives anyone has any doubts so far okay the first derivatives set of derivatives are forwards and we have to understand derivatives is not only for stock market this we have to keep in mind okay derivatives are there for entire all the businesses use derivatives all bigger businesses use derivatives okay in one form or another forwards the first thing is a forward contract okay so you have different types of derivatives within that forward is one type of derivative what is a forward contract think agreement between buyer and a seller to yes what is the forward contract an agreement between a buyer and a seller to buy at a I mean to take delivery of the Securities or any contract hey hold on hold on hold on man agreement between buyer and a seller H to buy or or take delivery at a certain price uh within a certain period with an expiry date with an expiry date or something with the date attached at a certain date yes sir right right is this what you wanted to convey yes sir good the response your example you no no we will see I&#39;ll come to that point I&#39;ll clarify yes any other response what is a forward contract H okay something similar at a predetermined price okay at predetermined dat okay anything else no intermed no intermediaries involved happens in an unorganized manner unorganized means [Music] what OTC okay cont ciz your contract okay h coming out is difficult okay now oblation toct but not obligation toy toy and there an obligation for the seller to ex execute the but there nobl for that is options okay now we&#39;ll come to the features but what is forwards features of the forwards will come characteristics what are forward contracts that in future whatever happens this price and the profit and loss be equal example the profit is 100 for other zero some game okay so sir the forward is basically is entered today for a future date to exchange the commod underlying asset at a price at a fixed price so Ed today to exchange the goods or the asset on the future dates so to mitigate the risk and to speculate so this this a basic idea of the forward contracts this is okay okay welcome I&#39;ll give one more example all what is being discussed is correct let us take the discussion little further telling it is an agreement between buyer and seller to take delivery at certain price at a certain date okay now let&#39;s say I&#39;m a Trader okay I am or okay in this case itself let us talk about thison itself so this case what are we did is it an agreement between buyer and seller right delivery will happen after certain date right at a certain price yes then is this a forward contract forget about this risk exposure and all this first transaction this as of today whatever have happened this delivery will come after 1 month 2 months or 10 days 15 days but this transaction is it a derivative is it a forward contract depends that this is the what depends I told everything where is the question of right to right of backing it is not a forward contract why because you only don&#39;t know agreement between and to take deliver been delivered at earlier itself sir the projectors have been delivered earlier itself no projector can be delivered after 1 month also today I I given the order so then it is a forward contract then it is a forward contract this is a forward contract but without expiry dates and also expiry date delivery payment date is given is this forward contract no deres undering can be anything can be anything months perod three months is credit period one month is delivery delivery can happen later also right ah what Financial Market you and I can enter a forward contract now yes or no then is this a forward contract who told derivatives is only for edging now forget edging and all what did you tell me agreement between buyer and seller right at a predetermined price at a predetermined date no intermediary right no happens in an unorganized on unorganized meaning was a different meaning not who told I&#39;m I enter into trades uh to make money speculation to cover my risk so is this what is the difference between this definition which you guys told and uh this definitions which you guys told and this transaction the transaction was like 100 that person will say irrespective of what the exchange rate will be on 30th you pay 6 was fixed likeed price no no price is predetermine 100,000 Singapore dollars th000 Singapore dollars no forward contract also agreement is between buyer and seller to buy and sell now if I&#39;m entering into at whatever be the cost or whatever be the condition if I have agreed to deliver to you I will have to deliver to you no purpose there is no defined purpose of D I can use derivative for anything you cannot main difference is the forward premium sir one second one second one second huh cover not necessary is what I&#39;m telling derivatives that is why I&#39;m telling it is was used for Hing purpose but it is not only used foring purpose it is used for speculation purpose also I can take a derivative position to make money simply assume risk and make money not for the only for the purpose of covering the risk yes sir uh the main difference with between that example and we have discussing is the the factor of forward premium there is no any additional consideration we are going to pay to the seller for that what projector we are buying so it&#39;s just th000 that 100,000 SG Singapore dollar only we&#39;re going to pay with or without the currency fluctuation so the forward premium is the basic thing which we should we will pay for fixing the prices in future date that is the main difference between this uh discussion and the example no see forward premium is basically from a pricing perspective yes sir okay premium is what small it is not going to be 65 rupees 66 rupees yes sir okay that is more from a pricing perspective but per say the contract we are talking about two transactions one is 9th July and the other one is which we have discussed here what is the difference no here also in this case also I can make the payment after 3 months after two months after four months that is my agreement with the uh with the vendor right delivery can happen at a different time at an agreed date what you said at agreed date at agreed price it can be tomorrow also right not necessarily 6 months then where that the other party is not concerned right in case of forward also other part is not concerned he&#39;s what he&#39;s telling you have agreed to buy I have agreed to sell we have to both both of us have to honor our commitments come what may tomorrow price changes whatever change happens you have to buy and I have to sell no if deliverable forward huh sir forward contracts can be cancelled off can we can back it off but this is honored commitment we should honor it anyway right forward contract you canot you cannot back off how can you back off you&#39;re bound by a legal agreement yes sir right Bound by legal agreement if I don&#39;t want that cushion of that edging the currency or what I&#39;m committed I can I can cancel it off I can pay the charges I can come right this is between also here also I can cancel the order no I can cancel the order right Amazon 7 Days return back policy I can cancel the order I can talk to vendor what will happen I&#39;ll go to Singapore one day and come back go meet him convince him pay some damages and come back what one one trip cost what 20 30,000 rupes not a big deal no if I want to cancel the order I&#39;ll go and seek apologies I&#39;ll write a letter I&#39;ll take some sweets from here over that fellow will get convinced okay good good discussion lot of your points they&#39;re close enough very simple here the liability to pay is now this is a normal business transaction I am liable to pay from now order has been given my liability I am showing the liability in my books even though you have agreed to pay after two months three months four months I&#39;m liable to pay now and is liable to dispatch now 7 Days 10 days whatever is a great period here liability to pay will happen when on the expired on the uh fixed date future date there is no liability assumed today here you have already bought delivery is pending payment is pending in this kind of transactions payment could have happened before also right payment could have happened on this day itself on 9th July also payment can happen payment can happen after three months also similarly delivery could have happened on 9th July delivery can happen after 3 months also after two months also that doesn&#39;t matter but here delivery will also happen on the certain date and obligation to pay will also happen on certain date same date yes correct are we getting it the minute difference is this here you are agreeing to do the transaction at a future date here you have already done the transaction and you have agreed the outcome of the transaction what is the outcome of the transaction payment and delivery delivery could have happened before payment could have happened before or both will happen in the future or one can happen at a different time one can happen at another time here the transaction itself will take place at a future date not today I&#39;m only agreeing to transact at a future date and you have to do the transaction on the future date if you are agreeing to buy you have to buy you&#39;re agreeing to sell you s so this is a normal business transaction this is a derivative contract okay what is a forward contract I will take from this only agreement it is a contract or agreement okay between two parties to buy or sell the underline write like this only don&#39;t write in a sentence write like this okay it is a contract or agreement between two parties these two parties could be you and me it could be you and a bank it could be you and a company it could be you and a shop it could be you and anyone or it could be one shop and another shop could be one business and another business it could be one company and another company it could be one financial institution and another financial institution generally it is between a firm a company and a financial institution okay to buy yourself the underlying okay at future date okay or a fixed price okay so very important understand this is not a book definition this is a practical definition okay it is a contract okay what is the implication of it is a contract that means you are legally bound whether tomorrow that fellow is not honoring his commitment that a different thing but he&#39;s legally bound you can take him to the court okay this we have to understand because what happens many times people say forwards and Futures in forwards I can back off in Futures I cannot back off in forward also I cannot back off I can I can take you to the court very simple okay contract or agreement it is between two individual parties okay it is between two individual parties individual means not individual it is between one company and another or individual and individual like that okay what is the purpose to buy or sell I can either buy or I can sell and the other party will be selling or buying okay the opposite what the underline there has to be some underline underline can be currency it can be an asset commodity Equity Bond anything okay then at a future date for a future price okay nothing is paid today you don&#39;t pay anything today except for transaction charges which is very very minimal can be uh what 50 basis points 20 basis points what is 50 100 basis points means what huh 1% is 100 basis points okay it can be 1% half a perc some transaction charges apart from that you don&#39;t pay anything on the contract payment will happen only at a future date okay nothing is paid today and these are customized Transaction what is customized transaction I can enter into a derivative okay to buy let&#39;s say here we talked about, 100,000 Singapore dollars it could be 95,000 Singapore dollars it could be $11,000 Singapore dollars okay the delivery date could be um uh 9th sorry 7th October 2023 right it could be 36 Days it could be 45 days it could be 34 days it could be 97 days right customize the way I want the way both of us can want we can customize to suit our requirements okay what is a very good example of a forward contract H Farmers something relating to you guys how many dollars 1,500 22 or 90 $22 so let&#39;s say I want to register after 3 months right all of you can go today to a bank and take a forward contract all those who have not registered $1,522 I have to pay right today let&#39;s say dollar is how much 803 83 okay 83 let&#39;s say you expect you have studied CFA you have done some analysis you expect the price to go to 86 right so what is the difference in terms of INR 4,500 rupees you can save you can buy the CFA calculator right lot of people don&#39;t buy the calculator 4,000 rupees 4,000 rupees he already committed one and half lakh rupees 4,000 that fellow will not buy the calculator okay telling it is costly costly C okay so nothing is paid today it is customized transaction this is the meaning of a forward contract okay and because it is a customized transaction because it is between two individual parties okay let us understand the implication so that means this is legally bound to obl both the parties okay because it is between two individual parties there is a counterparty or credit risk there is always a risk that the other person may not oblig okay there is a risk that other person may default okay this is the implication of these things there is a counterparty or credit risk okay nothing is paid today okay so tell me if that be the case what is the value of this forward contract which I entered now let&#39;s say I&#39;ve entered okay three rupees I&#39;m going to the bank okay and I&#39;m telling that okay I want a forward contract okay I want this so many dollars on 9th October okay bank will say 84 rupees let&#39;s say okay and he says okay I&#39;m fine for it okay I will go for this contract then you&#39;ll say okay the total value of this transaction is 15228 84 okay into let&#39;s say 5% okay pay 640 rupees roughly I do not know the charges okay point he&#39;ll say Okay pay 640 rupees sign this and this is the paper you come on 9th October I&#39;ll give you the dollars I&#39;ll credit to your account or payment will be done okay so this is a transaction charges now you have the slip with you what is the value of that slip now so if you give that slip to me will I pay you $522 charges you can ignore small number small huh expiry amount which is how much that is the value of the slip so if you lose the slip what is your loss are you you are you okay how much are you paying today so if you lose this paper what is your loss 639 your loss is not 127,000 and if you if I have to buy this slip from you how much should I pay which I can I can go to the bank and buy myself right why should I buy it from you so the value of this clip is zero so value of the forward contract at the beginning for that matter value of any derivative at the beginning is zero okay this is important we will be discussing about valuation probably in the next class or the subsequent class very very important to understand why value is zero today value today is zero because you&#39;re not paying anything today you not paid anything today right there is no value attached to it today correct okay now 9th October okay let&#39;s say I&#39;m I&#39;m at 9th September at that day how much you have agreed for8 84 okay on 9th September the spot Market if you go and buy dollars now on 9th September let&#39;s say that is 85 rupees okay then what is the value of the slip on 9th September one month before this9 hey ignore 639 okay don&#39;t get confused can ignore 639 the correct the value of this slip okay on 9th September when in the spot Market dollar price is 85 rupees hm okay on 9th September will the slip have any value will the value change so today I told no value on 9th September will the value change what did we say so under L value is changing or not changing it has changed right okay now what is happening now let&#39;s say the slip is there okay the slip is giving me a right to buy the dollars at what price 84 one month H okay today what is the price 85 so obviously it has got a value because if today it is 85 you expecting it to increase inrease further already one rupee gain is there from 84 to 85 and one month H you may expect it to increase further that means you are getting a right to buy something at 84 okay which is available in the Market at 85 so obviously that you have this premium right so this is like okay in your language very simple your Amazon vouchers if you have Amazon voucher the price is little lesser right you you get some code and all those things if you enter that code discount same thing right so at this time on 9th September the value of the slip is how much 1,522 how 10522 1,522 into 84 minus 10522 into 85 which is 1,522 clear are we getting this now let&#39;s say on 15th September this becomes 87 on 25th September this becomes 8 2 tell me like this this is the value of the slip on this day tell me what is the value of the slip on this day and on this day h how much 522 into 3 and here minus 1522 into two you got a loss here okay so basically this is what we call it as deriving the value from underline the value will keep changing immediately after today in fact immediately after this point so let&#39;s say if I&#39;ve entered into the contract now right and if it is a dynamic Market the the prices will keep changing every second then after one hour the price will be different right after to at the end of today the price will be different so at the end of today there will be a value to the contract but at the beginning of the cont cont which is now there is no value getting it okay so this is your forward contract understood okay now come to absent um example so here we have an open exposure so here tell me what do we do to cover this exposure take forward how do we how do we take forward huh h no no you will not you cannot buy it if you okay good point if you buy it at spot Market how much you have to pay so you have to pay 60 lakhs F to fix the price you&#39;ll not buy at a spot rate the forward rate so you&#39;ll buy 100,000 Singapore 60 not 60 Rupees at the forward Price Right forward price can be 62 rupees 63 rupees it can be anything okay you will agree with the bank or with the financial institution to buy so many dollars at a future date you&#39;ll enter into a forward contract okay so let&#39;s say you are entering into a forward contract enter into forward contract okay to buy 100K sdd at let&#39;s say 61 at INR 61 for sdd one 39 23 okay now tell me tell me the steps okay tell me what will happen to my business on 30th September what all transaction I will do on 30th September how much to the expor and to the from the financial insti where taken the for contract I 61 that&#39;s all right so what will happen on 30th September you will pay Bank okay 61s this is per as for the forward contract right so you&#39;ll pay minus 61 lakhs okay receive from Bank 100K SD a SG vendor what sdd your net outflow is 61 lakhs your liability was 60 lakhs but your outflow is 61 lakhs your loss is one lakh so by this process your loss is limited right your loss has has been C correct right to some extent it has been arrested okay now this is a normal way in which the transaction will happen for a deliverable but generally what will happen is this is normal transaction generally what will happen or what happens is I will LAX is my is the rate okay you&#39;ll also see what is the spot rate on that day right the spot rate on uh 30th September okay 30th September is what 62 INR 62 per SD this is the spot rate what will happen is you need to know about Apple is&#39;s website okay I will what will happen is instead of taking the delivery all right we&#39;ll settle the difference okay with the bank okay what is the difference one lakh right so I&#39;ll pay the bank the difference between spot and future or the forward price between spot and the forward price which is how much 62 minus 61 your spot price is 62 and your um agreed forward price is 61 so one lak you will pay and if it is a gain you will receive from the bank okay minus one lakh you will pay boom you will pay you&#39;ll pay with the counterparty with whom you entered into the forward contract okay then I sdd from the spot Market hold on will this be minus one lakh or plus one lakh why plus one lakh because so what I&#39;ve told is Ive told that from you I will buy it at 61 but in the market it is available 6 2 right so if you have to give me you have to give me at1 61 right so that means I have one rupee gain so that one rupee gain is this okay buy Singapore dollar from the spot Market which is at what 62 right so the outflow that I&#39;m doing isus 62 lakhs and receive 100K SGD and pay s vender 100K SGD from the market receive from the spot Market 100K SGD and pay the SG vendor Singapore vendor 100K so net net your outflow is minus 61 lakhs okay this is for ndf non deliverable forwards this is for deliverable forwards non deliverable means you settle the difference generally you settle the differential amount here how forward can be used as a hedging mechanism okay as a as a tool to cover your open exposure and it is not as I said it is not only the forward contract or it is not only a derivative which can help you to cover the risk there are different ways okay in which you can cover the risk one of the ways is to use a derivative and within derivatives one of the ways is to use forwards you can also use similarly futures or options also for this clear with this did you understand forward contract how do we execute this in in an agricultural CR do we do we the same mechanism no no see what will happen is understand how does iture agriculture also see here my view is the the dollar rate will go up but if my view is dollar rate will not go up it will come down I&#39;ll keep Qui I&#39;ll not do anything right so similarly in the other Market which you&#39;re talking about agricultural Market if I&#39;m confident that my crops will fetch a higher price I will not do anything right and if my crops are not going to if I&#39;m concerned the prices may come down I may enter into a forward contract option no that is a different discussion to where where now here also what will happen lot of companies in finance they&#39;ll have a policy that you cannot time the market by default you have to take forward contract by default you have to take a future contract by default you have to cover the risk right you cannot opine telling that my face the price dollar price will come down so let us not go and hedge are you getting it because as a CFO my role is not to make money from currency movements my role is to help the business to make money from the underlying business right my role is to cover the risk any open Financial Risk is there I should cover it so a lot of companies have this default policy the moment you give the order the moment you do some trade business trade if it is coming up with an open exposure immediately go and cover it in fact Banks itself will give this facility right where you are taking your term loans or your loans wherever you&#39;re doing transaction with bank right Bank itself will give the option to immediately take a forward cover okay and especially if it is an import transaction import transaction will be supported by this LC&#39;s letter of credits and all those things right so for that for LC I have to go to the bank bank will Bank will know that okay if you&#39;re coming for LC that means it&#39;s an import transaction right then bank will say that okay you have to take forward right this finance manager who is not that very well qualified he&#39;ll ask okay what is forward cover and bank will explain give some PP we&#39;ll tell okay you bring your management we&#39;ll do a meeting in a conference room they&#39;ll present a PP they&#39;ll say this is forward cover this is hedge this is absent projector okay and then they&#39;ll say take forward cover and they will charge premium initially then our finance manager fellow will understand what it is then he will realize then no premium at all normal prices okay clear can we proceed further huh super very good uh question okay I will take this when we discuss swaps or okay very simple you have come to buy dollars from me Singapore dollars he will come to sell dollars from me dollars with me right uh I don&#39;t think so this generation is going to bank branches how many of you have visited Branch recently bank branch H very rare if you have noticed if that branch has an fx desk where they buy and sell this foreign currencies they will say the board there will be a board electronic board it will be displayed okay we by us83 we sell 87 we buy GBP 98 we sell 105 this where you makeone huh basically so if he comes to buy I will buy from him at 98 GBP and when you come to sell 105 so it is a Marketplace for the bank so putting a forward contract to my C for CF and all don&#39;t take forward contract and all whatever is a fees go and pay contct my for 84 rupees sir so on that same date while paying that date so I&#39;m paying 84 rupees after that process they will pay that one rup for me which one rupe yeah no no cont3 cont entering the contract contct so on the payment date I&#39;m paying 84 they repay me that one you&#39;ll pay how much 83 you&#39;re entering the contract at what rate 84 84 so pay 84 so now 83 no at what rate you ENT 848 let&#39;s say you have entered at 84 on the matur the dollar go up for8 on that day dollar can go to any value you have to pay 84 okay 84 and they&#39;ll give you the dollars okay now that operationally how they will give whether they&#39;ll give you the currency or will they&#39;ll credit to your bank account okay what happens in like the small transaction they&#39;ll give the currency okay they will take one kyc okay and uh they will also not the currency they will credit an equivalent amount to your bank account they&#39;ll ask for what purpose do you need to use this currency you&#39;ll say no I have a friend to whom I have to remit this money in us or for this payment I have to do then say okay give the bank details we will make the payment they&#39;ll not give you dollars dollars banks will not give dollars dollars you&#39;ll get from the this money exchange fellow okay and larger businesses bigger businesses or businesses when they open the current accounts I will open a dollar account I will open a Singapore currency account I will open a US dollar account I will open a GBP account if my transactions are like in different currencies sitting in China sitting in India with these Banks we&#39;ll open a foreign currency account with permission from the RBI they&#39;ll ask me why do you want so then I have to get trade licenses permissions and all that will get covered in different regulations FEA and all we have okay yes any doubts okay fine now let us look Ates okay people online following anyone has any doubt clear so what is Futures Contract okay so then I will say wa same as forward can I write like this so Futures Contract okay first I&#39;ll go to the definition later tell me what is Futures Contract more standard huh exchange traded okay correct h mark to Market settlement H zero counterpart standardized traes okay then have to pay margins okay regulated regulated how exch the exchange okay cont cont that you can do in forwards also 7 if the view is the prices are going to come down and if the other part is agreeing yes can do it initi that margin Mar basically customized uh standardized settlement dates then spot price iMed you have to make immediate payment that whatever rate Futures is available you can buy very simple at the end of the day margins in forward example don&#39;t but in fut the price supposed to assume margin requirement settlement is not there okay all right yes so it is agreement again between buyer and seller is a contract or agreement between one party and exchange it is between one party and exchange to buy or sell the underlying at a future date for a fixed price okay margin requirements are there margin needs to be deposited initially okay standardized transaction value of the contract today is zero when you enter the value is zero okay why do we say no counterparty or credit risk H so so it is not that okay because it is with okay it is not that because it is with the exchange you don&#39;t have any loss okay because it is with exchange and exchange has its mechanism of margin requirements exchange is self-sufficient how now anyone and everyone cannot go and do the trades with exchange first kyc has to be done only if you are credible only if your uh kyc is proper okay only if your credibility is there you&#39;ll be allowed to trade point one point two you have to deposit initial some margin money what is margin money based on the value of the transaction a certain portion okay now margin requirements for different underlyings differ for example equity and what is the margin requirement H it it ranges from 10 to 40% okay at different times different margin requirements are there okay that means if the value of the transaction that I&#39;m entering into is one lakh I&#39;m dealing into shares worth one lakh rupees I may have to deposit 30,000 rupees I don&#39;t have to pay one lakh but I have to deposit 30,000 right so that tomorrow if my loss is becoming 10,000 margin uh exchange will deduct this 10,000 from this 30,000 they will not wait for the settlement date which is after 3 months to come and pay 10,000 or 20,000 what will be the money now what if margin money is getting exhausted okay square of a you&#39;ll get a margin call okay you&#39;ll be notified to deposit additional money otherwise your contract will be squared off your trade will be closed okay now how this works let us see let&#39;s say I&#39;m entering into Equity shares okay I&#39;m I&#39;m buying a Futures Contract okay uh for some XYZ underlying Equity the settlement date is 30th September and the agreement is to buy okay at agreed prices let&#39;s say at 100 okay today&#39;s date is 9th July motional you can say one lakh rupees okay so 9th July I&#39;m entering into the contract okay what will happen is on 9th of July EOD end of day 9th July okay the price will change Dynamic Market the price keeps changing every second right at the end of the day on this day the spot price okay the spot price is 80 rupees okay end of the day the spot price becomes 81 rupees okay spot price huh St price is becoming 81 Rupees at the end of the day the future not for the future price is becoming P5 rupees understand the difference are we dealing in the spot Market or are we dealing in the Futures market futures market so this 81 I will not even look at it&#39;s 81 we will not even look at right we are not concerned about spot market so if at the end of the day if I have to enter into a similar forward Futures Contract with 30th September maturity I have to pay how much 100.5 that means on 30th September I have to pay 100.5 okay clear now what is the value of this future contract here and here zero here rece basically five right into how much into 1,000 which is 500 rupees your gain is 500 rupees because you have entered to buy something at 100 whose value is now 100 point five so your this we call it as to market gain right in financial markets term this is also called as day one pnl in financial reporting we call it as day one pnl okay 500 rupees that will get added to your margin correct yes so you have this 500 rupees right so it will get added to the margin whatever is your margin amount it will get added to your margin let&#39;s say your margin money is that pay 20,000 so then you today you made 500 this 500 will go you don&#39;t have to deposit this is automatically getting added 100 is the and 100.5 is this is that is what this is the spot price today this is the future price at the end of the day evening if you enter into this contract this contract is available for 100.5 Futures price only evening let&#39;s say today 10:00 you entered at 100 okay evening 5:00 or close of the market at that time if you want to enter you will get at 100.5 81 81 is the spot price to buy the market to buy it then everyone understands this how we got the 500 100.5 this is 100 is my price okay you can say lot size is how much 1,00,000 into .5 right this is called as MTM gain now let&#39;s say on 10th July EOD okay this Futures price becomes 98.5 okay in that case what is MTM gain minus first minus or Plus take 100.5 because you have marked your position to 100.5 The the value in your balance sheet is at 100.5 . 5 right and next day the value of that asset is becoming 98.5 so you will show a loss of 2,000 you&#39;re marking it to the market yes overall so day one you are having pnl of 500 day two pnl is 2,000 minus 2,000 so net net 1,500 okay how will your balance sheet look at this point or at the end of the day one how will your balance sheet look on day one how will your balance sheet look one end of the day H inventory cash are you receiving cash tradeables how much 500 or 500 or 1 lak 5,000 1 lak 500 huh okay okay tell me tell me when I&#39;m entering into the contract morning that day when I&#39;m entering into the contract how will my balance sheet look H receivable so how will balance it look payable to home when I&#39;m entering into the contract what will be there in my balance sheet so what okay journal entry journal entry to bank account how much payable to bank account so payable account is pay to okay how much you are paying one lak you are paying how much are we paying just margin if you pay one lakh you will go and enter in spot Market why do you want to come to Futures you do not want to pay that one lak that is why you entering into Futures right okay and balance sheet will look like this only nothing will be there on the balance sheet except for that margin money margin money you paid to The Exchange so reable 20,000 cash will go out 20,000 okay that is why we said value of the contract is zero because the value is zero there is nothing in the balance sheet this we have to understand this we covered in income statement all those who haveed FSA in income statement we covered pnl financial instruments okay because the value is zero nothing will come at the end of the first day only this margin amount will come that is as a receivable at the end of the first day okay derivative Financial instrument is how much 500 and reserves basically your pnl is 500 right day two it will be 2000us 2,000 where huh it because you&#39;re having a liability now of course this will be offset against the margin money right so this 1,500 will be offset against the margin money what margin you have from that it will get justed unrealized gain we call it as unrealized gain or loss which will go to PN which will go to PN right for some time you&#39;ll not touch margin also right you have maintenance margin okay variable margin and all those things are there right only when you get the margin call you&#39;ll go and deposit additional money if you are making gain then no problem okay so this is basically MTM process Mark to Market process day in and day out basis you are marking it to Market you&#39;re supposed to Market to Market and whether you don&#39;t follow it in your books of accounts exchange will do and you&#39;ll daily get a notification how much is your margin money what is your accumulated loss or gain exchange will keep doing it okay so if EX is doing it you also have to do it and we do it in forward contract also in forward contract exchange is not there but if I am a reportable entity what is reportable entity the one which is required to publish financials to the public or to The Regulators then according to IFRS or based on the government&#39;s requirement okay based on your company&#39;s act and all you have to show MTM gain or loss on your all your derivatives including forward contracts so on your forward contract also this process has to be followed whenever you are reporting right so in certain cases in certain financial institutions right in certain industries this process is done on a daily basis on a daily basis you will prepare the pnl and you&#39;ll send it to the Senior Management and The Regulators also in case of banks okay otherwise all other companies also on a daily basis for derivatives there has to be a Process Management cannot say no it&#39;s okay we don&#39;t want to see no as an audit requirement as an internal control requirement this a key audit requirement where are you tracking your financial instruments on a day in and day out basis is that mechanism is there are those reports being presented to the Senior Management is Senior Management looking into it are they taking any decisions based out of that that is a key control requirement for all the bigger companies okay so for forward contracts also we follow this MTM process for all the derivatives we follow this MTM process okay so because of this MTM process literally the counterparty or credit risk becomes zero absolutely zero or close to zero why I telling close to zero is what is happening in my experience in last two three years especially one is covid earlier we would not see end of the world events now these are all end of the world events like those only so till date I&#39;ve never seen a case where exchange is defaulting or there are problems because of exchange but this happened in last two years and all what happened One exchange in London it stopped doing transactions it stopped taking trades and people incurred loss because of that okay this was a exchange so without going into the details to explain it because it&#39;s very complex right to explain it at high level Metals okay Commodities or Metals you can say uh there were people who had taken short positions especially this was linked to uh China okay so there were people who had taken short positions so what is short position so I have so I don&#39;t have something but I&#39;m selling it or agreed to sell it I&#39;ve agreed to sell this at let&#39;s say 100 rupees okay now if in the spot Market when I will make a gain only if the price is less than 100 rupees right so if I have agreed to sell it so someone else has agreed to buy at 100 okay so let&#39;s say I am one I&#39;m on the one side of the exchange on the other side this this flow is there right so in the spot Market the prices skyrocketed it became 500 600,000 something like that right and this expired date has come so when the expired date came what I did what I did is I because I&#39;m a large institution like me there are large institutions who have taken short positions I told because I am running the exchange now I told the exchange stop doing the transactions so what happened so this fellow wanted to buy he standing outside okay I want to buy I want to buy why because he is agreed to buy at 100 it is available for 500,000 rupees in the market right and I had to sell and I&#39;m not selling it so now this is like an extreme event doesn&#39;t happen on a daily basis it is an extreme event where exchange has stopped taking transactions or trades telling technical issues you see so earlier used to say these things in in books it will mention no counterparty risk and all now I think theyve amended I check they will say there are extreme scenarios where counter party risk is there in exchange also why because it&#39;s are privately run right ultimately human beings are involved right so where human beings are involved uh you can you have to assume you cannot assume that everything is fine okay so this is about uh Futures Contract effectively today the difference between forwards and Futures now the question is about why Futures and why not forwards or why forwards and why not Futures it all depends upon what your requirement is right if you&#39;re comfortable with forward you&#39;ll go with forward if you&#39;re com comfortable with Futures you&#39;ll go with Futures all right and OTC OTC trades are also regulated in some Market if it is see all the transactions are regulated you&#39;re legally Bound in all the transactions everything is done through a contract right so so that that point is taken okay any doubts on forwards and Futures did we understand now there are questions relating to this okay little complex examples are there I will work it out later right in the subsequent class first we&#39;ll try to understand what are this derivatives okay forwards Futures option swaps then we will solve some of the examples okay that are given in the material or example similar to what is given in the material okay any doubts okay so we&#39;ll take a break now 10 minutes break then come back and continue further

Transcript for:Derivatives Lecture Notes

Transcript for:
Derivatives Lecture Notes