Professor – It is “B” for banking and “I” for information technology…. (Learning 4)

Contd from Learning 3:

“Anyone who believes you can't change history has never tried to write his memoirs” says a famous Quote.

Well then am I here to write memoirs, I thought for a while. Well to make my thought simple, I again remembered another quote which says “A bad book is as much of a labor to write as a good one; it comes as sincerely from the author's soul”.
So, be it bad or be it good, I want to be sincere in translating my thought process. And let me not worry on how the write-up shapes up, but the article should reflect the immediate first thought and off course, if it could benefit some, then you are on a great road-track.

“So sir, it is great to note that you coming back to writing” Said J

I looked up while sipping my tea (supposed to be tea – as usual a tea kadai) and thought “When was I a full-fledged writer first”

Well, I was an editor of a house-journal in my previous concern and writing was one of my passion (not necessarily a forte), and it has been so- all through my years of growth and that was well reflected when I was working for this nice concern in Chennai. Being an IT professional and being a Project Manager, I was busy garnering more of business knowledge than executing the wonderful passion that I have. So, I decided that yes, it is time that I start writing.

M Joined us shortly. We took off to the nearby place where we settled in comfortably.

M: Sir, I was just wondering – rather pondering with one question that was put forth to me recently. It was a question at the grass root level, which I was not able to answer convincingly.

Me: What is that?

M: How do you elicit an example to showcase the risk in derivative trading?

Me: Haa..ha… ok – here it goes - Selling a contract with a derived value on top of an asset is similar to selling your CV with the contents derived from your experience. You might click sometime and you might not. Does this answer your question?

Both M and J gave out a loud laugh and I was sure that this should suffice a question of the order which is seldom put forth. (I would call it as a good basic question)

M: Last time, we discussed about Future contracts and the way it is traded in Exchange house. You promised that you will take a session on the exchange house protocols and other related concepts.

Me: That is right. I will do that. Btw- J – has M briefed you about Forwards and Futures.

J: Yes and further I read the blog as well. So, I am ready.

Me: Good. Primarily, There are two facets to how trading happens. One is called “OTC” and the other is called “Exchange house Governed” OTC stands for “Over the counter”. Contracts trading such as Forward contracts and Interest rate swaps come under OTC. Contracts such as Futures and Options come under Exchange house.

M: Ok…

Me: Basically, to ply in the Futures market, you need to open an account called “Margin”. Margin is an account to which where the traders will deposit a “Margin amount” as designated by the exchange house. This margin amount will be used as safe money, when the position of the contract falls on that day.

J: Sorry Narasimhan, I am not able to get it.

Me: Ok, let me make it more lucid. For anyone to start playing in the futures market, it is imperative that a “Margin” is created first. It is mandatory that the traders will have to keep some designated amount in that account. Is this clear first?

J: Yes

Me: Good. Next markets such as these will use Mark-to model to find the position of that contract on that day. Mark to Model – something like Mark-to –Market is an accounting methodology by which the position of the futures is calculated on that day. Based on this calculation, the position of the contract is decided. It is also called “Fair Value accounting”. If the position of the contract increases that day, then the respective profit will be credited to the Margin account. Likewise, if the position drops down, then the amount from margin will be used to settle for that day. If the amount in the margin is less than the designated amount, then a “Margin call” is made by the exchange house indicating that the trader must credit more amounts into the margin account.

M: Great. So, how does this Mark to Market model exactly work and I am sure it must be precise as well

Me: Well not exactly. In fact, Mark to Market works on Hypothetical value assessment and therefore have given room for accounting frauds. The most famous would be Enron scandal. Yes, there are financial standards which one has to adhere to. The latest is FAS 157 for fair value accounting.

J: FAS!!

Me: Financial Accounting standard

J: Oh! Ok…

M: Just a question out of curiosity. In OTC, what happens when the counter party does not honor the commitment?

Me: In such a case, they are governed by the ISDA contract. ISDA contract is a master agreement on basis of which OTC transactions are goverened. In the case when a counter party defaults in Exchange house, the counter party’s position is immediately closed and the clearing house is substituted for that counter party’s position. So, in nutshell, what does this mean?

M: Elimination of Credit risk

Me: Precisely Watson… (LOL!) This at the outset explains how the exchange governed market works. You have some terminologies like Expirations, Series and Basis, then initial market volatility. This we can take it up some other time.

J: I want to know about Options? Is this the right time to go for it?

Me: Sure – We can take it up as the next topic. Let us catch up tonight at the lakeside, where I can give you a brief insight into options.

J: Sir, You were also planning to talk on this ID card plans which the Government has planned to launch.

Me: Yes, that is a good initative. See my blog tommorow, there will be an article on that. Then we will talk...

Adios….

Professor – It is “B” for banking and “I” for information technology…. (Learning 3)

note: contd from the previous post "Learning 2"

We met again yesterday. This meeting was a specific one. “To learn and re-learn derivatives”. Re-learning is a methodology which I believe every professional should imbibe. Re-learning enables better understanding in terms of achieving good clarity, multi dimensional conceptualization, large scale refined introspection and most importantly preservation of the learning for a longer period of time. Thus, I always say that re-learning is indeed the passport for success – which everyone aspires.

Having said this, we settled for a good cup of filter coffee at Ratna Café hotel.

M: I went through a lot of material on derivatives on the web. I was able to grasp some concepts hither and thither – but I was not able to make out as to why there are so many of type of derivatives and what are its specific usages and what made new type of derivatives to evolve?

Me: Yes, that is a very important question. Many of us just accept the concept straight away and mug up the definitions without proper reasoning. A hands-on dealer would be able to explicitly elicit the practical evolvement of different types of derivatives – as he would know the practical implication of each type of trade. Let me take the same route – so that you can also understand and reason the concepts better. Let us go first on forward contracts.

M: Narasimhan, why don’t we go to futures first as they are most used trade in the market.

Me: No, that will not be the correct approach. You wanted to know on the evolution of each type of derivative trading. Think for a moment with proper reasoning. It must now be obvious that new type of trade would have evolved because of something lacking in the previous one and learning step by step would make our understanding better.

M: Oh, Ok.

Me: Previously, we talked about what are derivatives and why it is traded in general. Now, let us come to the first derivative type “Forward contract”.
A forward contract is a type of derivative trading where the buyer and seller mutually agree to buy or sell an asset, on a specified date in future at a specific price. (“The specific price being agreed today”). I hope you have got this definition right.

M: Ok – hmm, can I have an example.

Me: Good. Let us take a simple case – A rice farmer agrees to sell the rice that he is going to harvest at a specific price and on a specific date to the buyer. (Assume that the buyer is a whole sale dealer). Now, “Rice” is the asset, the seller and buyer agree on the price and they fix the settlement date in the future.

Like wise, Assume a scenario, where petrol bunk dealer agrees to buy the oil from the merchant at an agreed price and on an agreed date. The asset – here -being the “Oil”.

Now, tell me what do you see here?

M: It is hedging – as what you told me yesterday and that any fluctuation in the prices in the physical market is negated.

Me: Excellent. You have understood it well. This is forward contract and this is the basic advantage of doing one such derivative trade.

M: Cool- thanks. Now, how did the futures contract arrive then?

Me: (Smiles) Well, there are some disadvantages in doing a forward contract. First and foremost, when I gave you an example for the forward contracts, you would have seen that it is a bi-lateral agreement. This means that it is not governed by any monitoring body. This would mean, there is no obligation on both the sides. One might honor or dishonor the agreement on his whims and fancies. So, to sum it up, the following disadvantages exists in a forward contract

1) No monitoring body – which I call it is as the exchange house which acts as a centralized trading center or console
2) No proper standardization of the contracts.
3) No obligation scenario ( which I would term it as counter party risk)

So, the above following disadvantages gave birth to future contracts.

M: Ok, now I get the picture. I thought Forward contracts are monitored. No wonder, Future contracts are more popular.

Me: Yes, so what are future contracts then? They carry the same definition of forward contracts with some modification. Future contracts are exchange controlled trades happening between a buyer and seller to buy or sell an asset at an agreed price on an agreed future date. (The price is agreed today). The asset can be live stock, bullion, cross currency rate, rice, wheat etc. The advantages here are as follows:

1) There is an obligation for both the buyer and seller and thus, no counter party risk of dishonor
2) The buyer need not know the seller and vice versa as the exchange house takes the responsibility of clearing and settlement
3) Trading is standardized
4) And highly liquid.

M: This is nice. So, what is the protocol that is to be adhered while doing futures in exchange house?

Me: This again is a concept - where you have to understand Margins, Mark to market, basis, expirations, tick size etc. I will let you know on that in our next outing. Let us go slowly – so that we can pick up the concepts better.

M: Ok, so what is the plan for tonight?

Me: I have to complete Irvin wallace’ novel “The second lady”. It is a pretty good novel and off course, to spend some time on the idiot box as well – for there is the super singer finals today.

M: Great.

Me: Chalo, let us catch up later…adios…

Professor – It is “B” for banking and “I” for information technology…. (Learning 2)

note: contd from the previous post "Learning 1"

M came up with a basic question “Why did the concept of derivatives come in picture and what is it by the way”

Me:“Well, as you know financial markets are volatile in nature. Volatility would then mean involvement of high level of risk. It is this risk factor that becomes a concerning factor to the financial agents. To negate or possibly lower the risk, the concept of derivatives came into existence.
Now to your second question, Let us rewind ourselves to the years when we studied mathematics in school. If you remember, in mathematics, when we started learning derivatives, we understood that derivative – by itself does not have any value and that it derives its value from the preceding one. Like wise, in financial terms, a derivative is nothing but a financial instrument that derives its value from an underlying asset. The derivative here does not have any meaning by itself, but it acquires its value from the asset that it is based on. The underlying asset can be livestock, bullion, currency etc.

I hope that you have got this definition right.

M: That is nice buddy. Thanks – but how does this negate or lower the risk

Me: Ok. To understand let me explain the concept of hedging and futures. I am hopeful that you can understand the market terminology to some extent. Assuming the answer to be yes, let me try to make my explanation as lucid as possible. Basically, here there are two markets. One is the futures market and the other is the physical market. Now, the concept of hedging says, take a position in futures market opposite to that of physical market. Take an opposite position would then nullify the risks that arise.

M: Sorry Narasimhan. Can you explain with an example?

Me: Ok, imagine that I am an automobile manufacturer. Now I have already decided on the pricing of my automobile in the market. Obviously, the pricing would depend on raw materials which can include say – Steel. And this I would have done based on the present prices of steel in the market (Taking into consideration the projection prices of steel in the market as well)

Now, how sure I am that the steel prices would not increase after 6 months. (Beyond the projected pricing as well) An increase in steel prices (In physical market) would drain out my profit margin that I have estimated. Thus to negate this risk, I buy steel futures (in futures market). This means that I buy future contract (derivative) whose value will depend on the underlying asset (steel).

Now let us take up different possibilities to show how buying steel futures benefit the automobile manufacturer.

Case 1: Assume that the steel prices go up appreciably in the physical market. This would mean that automobile manufacturer would incur loss (if he had not bought the steel futures) . Now, since the steel prices have gone up, the rate of steel futures also goes up. This mean the loss that is seen in physical market is well compensated in the futures market – as the automobile manufacturer gains from the increase in steel futures. (This is what I meant taking a position in futures market opposite to that of physical market)

Case 2: Likewise, if the price of steel goes down in the physical market, it does not have an impact on him, as he is going to make a profit anyway.

This concept would technically mean, hedging and this how derivatives help in minimizing the risk.

M: This is nice and great. Thanks and what about other type of derivatives that you were saying?

Me: Well basically, you have futures, forwards, options, Interest rate swaps, baskets, leaps and swapations. And adding to it, you should also understand who are the players in this market, margin, mark to market concept, strike price, premium, discount and various other things. This being a party, I would not like to make it very detailed. Let us hold up a separate session for this alone. What do you say?

M: It is fine with me. Thanks

Me: Thanks.And may I take your permission to put forth our discussions in my blog, so that others can also benefit and that it also becomes a revision to me.

M: Sure, you don’t need my permission sir.

Me: Ok, I am hitting the floor and mate thanks for the party once again.

Cheers and adios for now….

Professor – It is “B” for banking and “I” for information technology…. (Learning 1)

“Toast to the THEE” we all said in Chorus.

It was a nice get together and I initiated the conversation by shouting “Well – a new saying has come up in the derivatives market and that is “Implied volatility. It is like predicting whether it will rain today by counting how many people are carrying umbrellas to work in the morning.”

My friends in the banking – investment sector gave out a loud laugh – and for those alien to banking – it still remained yet another English sentence. “So banking is the vertical that you have been working all through” remarked “J” to me. “Yes” I said quite beamingly.

” I think you have taken a wise decision of being in the same vertical for nearly a decade”

I agreed with a satisfactory smile. I know that the financial markets across the globe have gone through a distinguished metamorphosis in more than last one decade. Yes, it has indeed opened a vista of opportunities – of Himalayan altitude - in every gamut of industrial sphere that could possibly evolve.

Precedence to learn banking concepts in Information technology sector and the inclination to imbibe different disciplines and aspects of banking has become a “sine qua non”.

Yes, banks have evolved as one of the main staple diets of the modern day information technology industry. And vice versa, we cannot imagine banks without technology these days. Well, you may call it as a beautiful example of “Symbiosis and synergy”.

My good friend “M” was giving us a treat for his new job- which he managed to get in one of the reputed IT concerns in Chennai. J and M were working on a different domain till last year. M was supposedly going to work on a derivatives application and he was pretty perturbed over the fact, that he could not understand the fundamentals of the derivatives concept. And that was when I was approached for a teaching session to “M” and I agreed –for I knew that session would benefit me as well. “La-revision”

“Shoot out your questions mate” I said...and the journey of learning starts....