DERIVATIVES MARKET

UNDERSTANDING DIFFERENT TYPES OF ASSET CLASSES

ALTERNATIVE ASSET,
DERIVATIVE EXPOSURE & HEDGE FUNDS.

ASSIGNMENT 2

SIMRAN SAWLANI- 20020448119

RITU SHARMA- 20020448154
YOGESH SHARMA- 20020448143
FARHANA PAKKA- 20020448043
ROHIT CHELLANI - 20020448032
SUNIT SHAH- 20020448152
 UNDERSTANDING ASSET CLASSES

Why do people Invest?

Investment is necessary to support your financial needs when you do not earn money.
• By investing a portion of your income, you allow money to grow and work for you.
• 3 parameters to assess suitability of any investment avenue are –
Return potential
Safety
Liquidity
• Various avenues where money can be invested, are broadly classified into some groups, known as ‘Asset
Class’. Stocks or Equity shares are most popular class of assets.
 WHAT IS MEANT BY ASSET
CLASS?
1. An Asset Class is a group of different financial assets or
instruments which have some common ground in terms of safety,
returns and liquidity.
2. Typically various investment avenues under one asset class
respond similarly to market conditions.
3. Historically, asset classes have shown significantly different
performance in different market conditions.
4. Therefore, it pays to allocate different amounts to different asset
classes.
5. This process of allocating or investing some amount to different
financial assets or financial instruments is called ‘Asset
Allocation’.
 TYPE OF ASSET CLASSES

Real Estate Gold Equity Cash and Cash

Fixed Income
Equivalent
 An alternative investment is a financial asset that does not fall into one of the
conventional investment categories. Conventional categories include stocks, bonds,
and cash. Alternative investments include private equity or venture capital, hedge
funds, managed futures, art and antiques, commodities, and derivatives contracts.
Real estate is also often classified as an alternative investment.

Alternative investments typically have a low correlation with those of standard asset
classes. This low correlation means they often move counter—or the opposite—to the
stock and bond markets. This feature makes them a suitable tool for portfolio
ALTERNATIV diversification. Investments in hard assets, such as gold, oil, and real property, also
provide an effective hedge against inflation, which hurts the purchasing power of

E ASSETS paper money.

Because of this, many large institutional funds such as pension funds and private
endowments often allocate a small portion of their portfolios—typically less than
10%—to alternative investments such as hedge funds.  

The non-accredited retail investor also has access to alternative investments.

Alternative mutual funds and exchange-traded funds—aka alt funds or liquid alts—
are now available
 ALTERNATIVE ASSETS

• Private Equity:
Private equity is a broad category that refers to capital investment made into private companies, or those not listed on a public exchange, such
as the National Stock Exchange.
Examples: Venture capital, Growth capital, Buyouts etc.
• Private Debt:
Private debt refers to investments that are not financed by banks (i.e., a bank loan) or traded on an open market. The “private” part of the term
is important—it refers to the investment instrument itself, rather than the borrower of the debt, as both public and private companies can
borrow via private debt.
• Hedge Funds:
Hedge funds are investment funds that trade relatively liquid assets and employ various investing strategies with the goal of earning a high
return on their investment. Hedge fund managers can specialize in a variety of skills to execute their strategies, such as long-short equity,
market neutral, volatility arbitrage, and quantitative strategies.
 ALTERNATIVE ASSETS

Real Estate:
There are many types of real assets. For example, land, timberland, and farmland are all real assets, as is intellectual property like artwork. But real estate is the
most common type and the world’s biggest asset class. In addition to its size, real estate is an interesting category because it has characteristics similar to
bonds—because property owners receive current cash flow from tenants paying rent—and equity, because the goal is to increase the long-term value of the
asset, which is called capital appreciation.  
Commodities:
Commodities are also real assets and mostly natural resources, such as agricultural products, oil, natural gas, and precious and industrial metals. Commodities
are considered a hedge against inflation, as they're not sensitive to public equity markets. Additionally, the value of commodities rises and falls with supply and
demand—higher demand for commodities results in higher prices and, therefore, investor profit.
Collectibles:
Collectibles include a wide range of items, from rare wines to vintage cars to baseball cards. Investing in collectibles means purchasing and maintaining
physical items with the hope the value of the assets will appreciate over time.
Structured Products:
Structured products usually involve fixed income markets—those that pay investors dividend payments like government or corporate bonds—and derivatives,
or securities whose value comes from an underlying asset or group of assets like stocks, bonds, or market indices.
 HEDGE FUNDS
 Hedge funds are actively managed alternative investments that typically use non-traditional and risky investment strategies or
asset classes.
 Hedge funds are private investment partnerships, with the objective of delivering exceptional returns. The risks are reduced by
using an approach called hedging.
 Hedge funds charge much higher fees than conventional investment funds and require high minimum deposits.
 Each hedge fund is designed to take advantage of specific market opportunities. They can be categorized into a number of
broad hedge fund strategies such as event-driven investing and fixed-income arbitrage. They are often classified according to
the investment style of the fund's manager.
 Investments in hedge funds are illiquid as they often require investors to keep their money in the fund for at least one year, a
time known as the lock-up period. Withdrawals may also only happen at certain intervals such as quarterly or bi-annually.
 Hedge fund strategies range from long/short equity to market neutral
 KEY CHARACTERISTICS OF HEDGE FUNDS
Hedge Funds Exclude Small Investors:
Securities and Exchange Commission considers "qualified" investors—individuals with an annual income that exceeds $200,000 for the
past two years to be suitable to handle the potential risks that hedge funds are permitted to take.
Managers Have a Wide Latitude:
A hedge fund's investment universe is limited only by its mandate. A hedge fund can basically invest in anything—land,  real estate,
stocks, derivatives, and currencies.
They Often Use Leverage:
Hedge funds often use borrowed money to amplify their returns and allow them to take aggressive short positions.
Hedge Funds Have a “2 and 20” Fee Structure
Hedge funds, by contrast, use a fee structure that is called, in shorthand, "2-and 20." That's 2% of the assets under management plus a
20% cut of any profits generated.
 TYPES OF HEDGE FUNDS

 Fund managers use various strategies that are classified by a combination of the instruments in which they are invested, the trading philosophy
followed, and the types of risks assumed,
Hedge fund strategies can be distinguished by the following categories:
 Event Driven -There are few event driven hedge funds that invest to take advantage of price movements generated by corporate events. Example :
Merger arbitrage funds and distressed asset funds
 Market Neutral -There are also some market neutral funds that seek to minimize market risks. This category included convertible bonds, short and
long equity funds and funds income arbitrage.
 Long / Short selling -Short selling means that you sell a security without actually buying it but with the notion of buying it at a predetermined
future date and price. Hoping for the share price to drop on this predetermined future date and book profits.
 Arbitrage- An arbitrage-oriented strategy means buying a security in one market where the security is trading at a lower price and then selling the
same security at a higher price in another market to book some profit. This can also be used for buying and selling two very highly correlated
securities simultaneously to book profit when markets are moving sideways. This is called relative value arbitrage.
 Market-drive- Hedge funds also take advantage of global market trends before they make the decision to invest in securities. They look at global
macros and how they impact interest rates, equities, commodities and currencies.
 Diversify across managers, as most alternative investment products’ performances rely
on manager’s ability to generate alpha return
 Carefully analyze the reported performance numbers of the past or existing products.

 Know as much details as possible about the use of leverage by the manager.

 Performance fee structures need to be studied. Whether the fee charged is reasonable
enough to justify the returns being discussed to be delivered
 The honesty of the company’s staff needs to be carefully reviewed Strategies for
 The investment policy committee’s composition and experience as well as the impetus
given to the involvement such committee in the process of whitelisting of securities need
to be studied.
managing risk
 The exit strategies of investments, including timing and realization price should be
understood
when having
 Independent valuation of illiquid underlying assets should be performed on a regular
basis.
alternate assets
 Limits on security type, leverage, sector, geography, and individual positions should be
well defined in the offering memorandum, and the positions should be carefully
monitored by the manager and regularly reported to clients.
 A check in terms of presence of a CRO (Chief Risk Officer) needs to be carried out. Also,
the extent to which he is independent of any influence by the business development team
should be investigated.
 DERIVATIVE EXPOSURE

• Derivative Exposure means the maximum liability (including costs, fees and expenses), based upon a
liquidation or termination as of the date of the applicable covenant compliance test, of any Person under
any interest rate swap, collar, cap or other interest rate protection agreements, treasury locks, foreign
currency exchange agreements, commodity purchase or option agreements or other interest or exchange
rate or commodity price hedging agreements.
 OBJECTIVE OF DERIVATIVE EXPOSURE

The objective to use derivatives is purely to protect the portfolio in case of a severe market correction. The four
major types of derivative contracts are

a. Options - Options are a type of derivative product that allow investors to speculate on or hedge against the
volatility of an underlying stock. 

b. Forwards - A forward contract is a customizable derivative contract between two parties to buy or sell an asset
at a specified price on a future date.

c. Futures - Futures are derivative financial contracts that obligate the parties to transact an asset at a
predetermined future date and price.

d. Swaps - A swap is a derivative contract through which two parties exchange the cash flows or liabilities from
two different financial instruments.

 
 DERIVATIVES EXPOSURE CALCULATIONS

• Identify Derivatives Transactions:

We will find a summary of “derivatives transactions,” all of

which may be included in a Fund’s derivatives exposure. We
assume that a Limited Derivatives User will not elect to treat
reverse repurchase agreements as derivatives transactions
because that would increase the Fund’s derivatives exposure.

• Quantify the Derivatives Transactions Derivatives

transactions cab be quantified (their “Exposure Amount”)
for purposes of calculating a Fund’s derivatives exposure in
below format.
 DERIVATIVES EXPOSURE CALCULATIONS
• Identify Excluded Currency and Interest Rate Hedges:

Qualifying IRDs and currency derivatives transactions do not count toward derivatives exposure. These include derivatives transactions
that were entered into and maintained in order to hedge currency or interest rate risks associated with one or more specific equity or fixed-
income investments held by the Fund or the Fund’s borrowings. For these purposes, a derivatives transaction for foreign currency can only
be used to hedge risks associated with an equity or fixed-income investment that is denominated in a currency other than U.S. dollars.

To be excluded from the derivatives exposure calculation, the aggregate Exposure Amounts of these hedging IRDs and currency
derivatives may not exceed the value of the hedged equity investments, the par value of the hedged fixed-income investments, or the
principal amount of any hedged borrowings by more than 10%.

• Identify Closed-Out Positions:

A Fund should identify derivatives that directly offset and close-out a derivatives transaction with the same counterparty. Note that a
derivative that is not a “derivatives transaction” can be used for this purpose. For example, an option purchased by a Fund (which is not a
derivatives transaction) can offset an option written by the Fund (which would be). These offset derivatives transactions do not count
toward a Fund’s derivatives exposure if they do not result in credit or market exposure to the Fund.
 DERIVATIVES EXPOSURE CALCULATIONS

• Fund’s Derivatives Exposure Calculation:

Sum the Exposure Amounts of the Fund’s derivatives transactions after excluding the derivatives transactions
identified in Steps c and d. The result is the Fund’s derivatives exposure.

• Determine Whether the Fund is a Limited Derivatives User

A Fund will be a Limited Derivatives User if its derivatives exposure does not exceed 10% of its net assets.
 Unsurprisingly, derivatives exert a significant impact on modern finance because they
provide numerous advantages to the financial markets:

 Hedging risk exposure:

Since the value of the derivatives is linked to the value of the underlying asset, the
contracts are primarily used for hedging risks. For example, an investor may purchase a
derivative contract whose value moves in the opposite direction to the value of an asset
the investor owns. In this way, profits in the derivative contract may offset losses in the
underlying asset.
 Underlying asset price determination
ADVANTAGES Derivatives are frequently used to determine the price of the underlying asset. For
OF example, the spot prices of the futures can serve as an approximation of a commodity
price.
DERIVATIVES  Market efficiency
It is considered that derivatives increase the efficiency of financial markets. By using
derivative contracts, one can replicate the payoff of the assets. Therefore, the prices of the
underlying asset and the associated derivative tend to be in equilibrium to avoid arbitrage
opportunities.
 Access to unavailable assets or markets
Derivatives can help organizations get access to otherwise unavailable assets or markets.
By employing interest rate swaps, a company may obtain a more favorable interest rate
relative to interest rates available from direct borrowing.
 Despite the benefits that derivatives bring to the financial markets, the financial
instruments come with some significant drawbacks. The drawbacks resulted in
disastrous consequences during the Global Financial Crisis of 2007-2008. The rapid
devaluation of mortgage-backed securities and credit-default swaps led to the
collapse of financial institutions and securities around the world.

1. High risk

The high volatility of derivatives exposes them to potentially huge losses. The
sophisticated design of the contracts makes the valuation extremely complicated or
even impossible. Thus, they bear a high inherent risk.

DISADVANTAGES 2. Speculative features

OF DERIVATIVES Derivatives are widely regarded as a tool of speculation. Due to the extremely risky
nature of derivatives and their unpredictable behavior, unreasonable speculation may
lead to huge losses.

3. Counter-party risk

Although derivatives traded on the exchanges generally go through a thorough due

diligence process, some of the contracts traded over-the-counter do not include a
benchmark for due diligence. Thus, there is a possibility of counter-party default.
THANK YOU !