CA KAMAL GARG

Nevertheless, derivative instruments give a lot of options, and flexibility to the businesses. A decision gone right or gone wrong can turn the fortunes of the firms and sometimes the industry. Traders have to be on their toes and, each second counts. Opportunities are unlimited; the returns are high, and a lot is at stake. But all this come, with a warning – “Handle with Care”. Irrespective of the traditional use of derivatives as instruments for hedging risk , they have been historically used by traders to speculate and gamble in pursuit of windfall gains .  Traders in lure of big money take positions which are out of their authority and control. The MONEY at stake is sometimes so huge that a derivative decision gone wrong WIPES OUT the complete company and spoils the hard reputation earned by the firm IN SECONDS .  There are numerous instances of huge losses from derivatives trading but there are a few cases in the derivatives history which stand out.  Let’s look at some of the bigg

Real vs Financial Options Financial options are on assets such as stocks that are traded in markets.  Real options are options on some underlying that are not traded in any market. Example of real options include valuation of a company, deciding to invest in R&D project, valuing natural resource options. Option to delay an investment opportunity Growth Option - Valuing the growth potential of a firm Growth Option – Option to expand a business Valuing Natural Resource Options Option to Delay an Investment Opportunity Investment To open a restaurant in your city as part of a major chain, which can be opened immediately or after 1 year. If you do neither, you lose the right. Cost of opening the restaurant is $5 million now or after 1 year. If you open now, you will get free cash flow (FCF) of $600,000 which will grow @2% p.a. Cost of capital is 12%. After 1 year, cost of opening is still $5 million. The risk-free interest rate is 5%. The volatility of the value of the restaurant as ob

Definition of Derivatives Derivative is a product  whose value is derived  from the value of one or more variables, called underlying.  The underlying asset can be equity, index, foreign exchange (forex), bonds, commodity, precious metals or any other asset.  Derivative products initially emerged as hedging devices against fluctuations in commodity prices and commodity derivatives remained the sole form of such products for almost three hundred years.  The financial derivatives came into spotlight in post-1970 period due to growing instability in the financial markets. However, since their emergence, these products have become very popular and by 1990s, they accounted for approx 66% of total transactions in derivative products.  Types of Derivatives Four most common examples of derivative instruments are Forwards, Futures, Options and Swaps. Forwards Futures Options Swaps Long and Short Positions Long and short positions are used to denote buying and selling respectively.  Long posit

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Forward Contracts Forward contract is an over-the-counter (OTC) contract between two parties  to exchange  agreed quantity of an asset*  for cash  at a certain date in future  at a predetermined price, specified in that agreement.  *Asset may be currency, commodity, instrument, etc. OTC contracts involve only the buyer and the seller. Both the parties have to perform the contract. There is no payment of any initial margin. The maturity and size of the contract may be customized. Settlement takes place only on the date of maturity. Credit or counter party risk is high. Markets for forward contracts are not very liquid. Physical delivery takes place on the maturity date. Some major forward contracts traded in India are: a) Currency Forward One of the most popular examples of a forward market in India is the Dollar Forward Market. In a dollar-forward contract; importers, exporters and foreign currency borrowers hedge their risk. An importer and foreign currency borrower having dollar paya