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4 2135 Derivative Instruments A Conceptual Framework National Mulus-Commodity Exchange of India (NMCE): It is the first de-mustustiged Electronic Multi Commodity Control Warehousing Corporation (CWC), National Agricumtural cooperative Marketing Federation of India (MAFED), Gujarat Agro-Industries Corporation Limited (AIC), Gujarat State Agricultural Marketing Board (GSAMB), National Institute of Agricultural Marketing (NIAM), and Neptune Overseas Limited (POL). 12. Write short notes on the need for Commodity Derivatives Market Instrumental Needs: Hedgers needs for price risk reduction are called as Instrumental Needs. Their main requirement is to reduce or eliminate Portfolio Risk at a Low Cost Convenience Needs: The other aspects that are to be considered are ability in doing business, easy access to the market and an efficient clearing system. These are called as Convenience Needs. It deals with the customer's need to able to use the services provided by the Exchange with ease. The edent of satisfaction of convenience needs determines the Process Quality 1 2 13. Write short notes on Commodity Derivatives. Meaning: Commodity Derivatives is a direct way to invest in Commodities, rather than investing in those Companies that trade in these Commodities. 2 Mechanism: Commodity Derivatives Trading is done by people who have no need for the Commodity itself, but who first speculate on the direction of the Prices of these Commodities, hoping to gain if the Price movement is in their favour. 3. Settlement: the most vital functior in a Commodity Derivatives Exchange is the settlement and clearing of trades. Commodity Derivatives can involve the exchange of funds and goods The Exchanges have a separate body to handle all the settlements known as the Clearing House) Example: The holder of a Futures Contract to buy Gold might choose to take delivery of Gold rather than dosing his position before maturity. The function of the Clearing House, in such a case, is to take care of possible problems. default by the other party involved, Ly starztarting and simplifying transaction processing between participants and the organisation 5. Features of Commodity Derivatives Trading: (a) Complement to investment in Companies that use commodities. (b) Defines pattern of Country's Production and Consumption (c) Gains are in the form of Price increases, not dividends. 1. 14. Explain the structure of Commodity Swaps, types and mode of their valuation. ) 1 Purpose: (a) To enable producers to protect themselves from the wide fluctuations in the prices of the commodities. (b) To fix prices for the commodities to be sold at a later point in time. 2. Types of Commodity Swaps: (a) Fixed - Floating Swaps: These are similar to foed-floating swaps in the Interest Rate Swap Market. However, in case of Commodity Swaps, both the indices are commodity based indices. (6) Commodity for Interest Swaps: These are similar to the Equity Swaps in which a total return on the commodity in consideration, is exchanged for some Money Market Rate spread. Valuation of Commodity Swaps: Swap is considered as a strip of forwards, each priced at inception with zero market value in PV terms. While valuing Commodity Swaps, the following factors must be considered - (a) Institutional structure of the particular commodity market, (b) Credit Risk, Capital Costs and Administrative Costs, (c) Variability of the Futures Bid a Offer Spread, (d) Brokerage Fees, (e) Liquidity of the underlying Commodity Market, () Cost of Hedging (9) Seasonal Fluctuations and its impact on the Market, etc 9.5 4 7 with affer 12000 and wild Computation of Marginis under Futures SENSEX Futures are traded at a Multiple of 50. Consider the following quotations of SENSEX futures in the 10 trading days during February Day 18 17 100 12 140 11 High 3306.40 3298.00 3256 20 3118.00 3233.00 3278.00 3283.50 3281.50 3315.00 3315.00 Low 3290,00 3262.50 3031.40 3249.50 3227.00 3201.50 3256.00 3257 10 3286.30 3260.00 Closing 3296 50 3294.40 310260 3257.80 3230.40 3212.30 3267.50 3309.30 3263.80 3292.00 Abhishek bought ano SENSEX Futures Contract on 4 February. The averago daily absoluta change in the value of Contract is 210.000 and Standard Deviation of these changes k + 2,000. The Maintenance Margin is 75% of Initial Margin. You are required to determine the daily balances in the Margin Account and payment on Margin Calis, if any. Solution: (a) Computation of Initial Margin 1. Computation of Margin Initial Margini - Average Daily Absolute Change in Value Times the Standard Deviation of such change * ? 10,000 + (3x + 2,000) = 10,000 + 26.000 = 3 16,000 (b) Maintenance Margin: Maintenance Margin = Initial Margin x 75% = ? 12,000 2. Daily Balances in Margin (MTM) IL is assumed that Abhishek bought the futures contract on the closing Future Price on 4 February L.e. at 3296.50. Changes in Future Values() Margin Alc() Call Money (3) 16,000 50 x (3294.10 - 3296.50) = -105 16,000 - 105 = 15,895 50 x (3230.40 - 3294.40) = -3,200 15,895 -3,200 = 12,695 50 x (3212.30 - 3230.40) = -905 (Note) 16,000 Pay 4,210 50 x (3267.50 - 3212.30) = 2,760 16,000 + 2,760 = 18,760 50 x (3263.80 - 3267.50) = -185 18,760 - 185 = 18,575 50 x (3292.00 - 3263.80) = 1,410 18,575 + 1,410 = 19,985 50 X (3309.30 - 3292.00) - 865 19,985 + 865 = 20,850 50 x (3257.80 - 3309, 30) = -2.575 20,850 - 2,575 = 18,275 50 x (3102.60 - 3257 80) = -7,760 16,000 Note: On 7th February, Margin Balance = 12,695 - 905 = 311,790, which is to be brought upto 16,000. Pay 5,485 and on 16000 como DP Day 4 February 5th February 6 February 7 February 10 February 11 February 12 February 14 February 17 February 18 February 2. Compounding - Periodic vs Continuous 3. Future Value --Continuous Compounding vs. Periodic Compounding Rajiv is planning to invest 10,00,000 in Bank Deposits for one year. All the Banks offer an Interest rate of 12% p.a. for 12 month deposits. Rajiv has enquired deposit application forms of 4 banks, particulars of which are as foliows - 1 Bank A: Interest will be credited at half-yearly basis. 2 Bank B: Interest will be credited at quarterly rests. 3. Bank C. Interest will be credited at monthly rests. 4. Bank D: Interest will be credited at weekly rests. If Rajiv cares for every extra rupee, which Bank will preferred? What should be the minimum rate Bank B should offer to attract Rajiv's deposit? If Bank A agrees to credit interest at Continuous Compounding basis, what will be return for itajiv? Solution: Compounding at Annual Interval / Rests 1. Computation of Factors Amount (A) at the end of the period A= P x (1 + r) am Less than Annual Interval / Rests A= P x 1+ 10.13 1 About Marin (TM) the transaction 2300 por un A Se of Ang Puurs al 2 Opera 2. Puteres at 2.400 per unit. SW and the Margin Money is 15% for July Futures and 20% for August Futures - Det Total Amount of Aarge Money Payable by Mr. A. Beet Margin at the end of Trading Day on 204, 214 and 22 July if the following quotes are Date Cash Market July Futures August Futures July 2,250 72,290 72,450 21 July 2,310 2,330 2,465 ENJOY 2,393 2,305 72,430 Solution 1. Computation of Initial Margin: Particulars July Futures - Buy August Futures - Buy July Futures - Sell Contacted the Contracted Pike x Lo 2,300 x 100 72,340 x 100 Sa 32,490 x 100 = 2,30,000 In Margin (Contracted Value X 2,34,000 32,49,000 2,30,000 x 15% X 3 Margin x No. of Contracts) 2,34,000 x 20% x 5 = 2,49,000 x 15% x 2 = 1,03,500 2,34,000 74,700 2. Marked-to-Market Margin: (a) y Wipro Futures (Buy) (Lot Size - 100 units x 3 Lots = 300) Contracted Price = 2,300 Closing Cumulative Date Gain / Loss p.u. Price Gain / Loss p.u. 2,290 (10) - (2,290 - 2,300] (10) 21" July 2,330 40 = (2,330 - 2,290) 30 2,395 65 - (2,395 - 2,330) 95 20 July Total Gain / Loss (3,000) 12,000 19,500 Total Cumulative Gain / Loss (3,000) 9,000 28,500 22 July (5) August Wipro Futures (Buy) (Lot Size -- 100 units x 5 Lots = 500) Contracted Price = 2,340 Closing Cumulative Date Gain / Loss p.u. Price Gain / Loss p.u. 2,450 110 = [2,450 - 2,340] 110 21" July 2,465 15 = [2,465 - 2,450) 125 2,430 (35) = (2,430 - 2,465) 90 20 July Total Gain / Loss 55,000 7,500 (17,500) Total Cumulative Gain / Loss 55,000 62,500 45,000 22 July (C) Luty Wipro Futures (Sell) (Lot Size - 100 units x 2 Lots = 200) Contracted Price = 2,490 Closing Cumulative Date Gain / Loss p.u. Price Gain / Loss p.u. 20 July 2,290 200 = (2,290 - 2,490) 200 2,330 (40) = (2,330 - 2,290] 160 22 July 2,395 (65) = (2,395 - 2,330] 95 21" July Total Gain / Loss 40,000 (8,000) (13,000) Total Cumulative Gain / Loss 40,000 32,000 19,000 10.12 tatt yo OS 0.00 1. Compareridt 0212 Years danys or 1667 y 90 days 0.25 Yes 0.00 50e -8.50 -8.3 7.50 743 Total PV of Dividends 10+ 8.33 8.73-2149 2. (ITP Spot Poe-Pof Dividends) - (1.00 - 21.45) *** 975.51 975.511 00045 -1.005 21 Spor Price - Spot Price (1.000 - 1.000 1,000 45 -1.000 30.45 1. We of Cost of Carry 22 Attrage using Different borrowings / Rates Ria re Rate in USA is 8% p.a. and in UK is 5% pa. Spot Exchange Rate between US $ & UK Els 13 = { 0.75. Assuming that rest is compounded on dally basis then at which Forvard Rate of 2 Year there will be no opportunity for Arbitrage, Further, show an investor could make Risk-Less Profit, it 2 Year Forward Price is 1$ = 0.85. Guns 4* = 0.9413 & 40.852,4 1.1735,-41 = 0.9051 Value E 0.75 1. Basic Factors Notation S 8% pa Solutions Particulars Spot Price Interest Rate in US fus 5% pa Tuk 2 Years Tone 2. Arbitrage Opportunity Particulars Result Theoretical Futures Price (TFP) TFP = $ 0.75 x 0.050 08)2 = 0,706 xe -0.03 - 0.75 x 0.9413 - 0.706 ak Actual Futures Price (AFP) E 0.85 (Given) Comparison & Decision AFP > TFP. Hence, Overvalued. Sell Ata Forward Pnce of 0.706, there will not be any arbitrage, since AFP - TFP. *Sxe 10.25 (b) Exchange Fixed Strike Price Price is een by the Rock Exchange, try the writer option (0 Series of Prices The Stock Exchange Axes a series prkos spaced appropriate in intervals for an (0) Exampler Strike Price for December Options Contract on Shares of Wipro expiring on 26 December will be 1.900,- 1.925, C 1.950, 1975, 2.000 etc. An Investor can choose to buy an option with an Exercise anderlying An Investor can choose his preferred trade from such a range of price . Price of 1,900, while another might choose