Introduction to derivatives

The emergence of the market for derivative products, most notably forwards,

futures and options, can be traced back to the willingness of risk-averse

economic agents to guard themselves against uncertainties arising out

of fluctuations in asset prices. By their very nature, the financial markets are

marked by a very high degree of volatility. Through the use o f de r iva t ive

p roduc t s , i t i s poss ib le to pa r t i a l ly o r fu l ly t r ans fe r p r i ce

r i sks by lock ing- in a s se t p r i ces . As ins t rument s o f r i sk

management , t hese genera l ly do no t influence the fluctuations in the

underlying asset prices. However, by locking-in asset prices, derivative products

minimize the impact of fluctuations in asset prices on the profitability and cash

flow situation of risk-averse

investors.Der iva t ive  p roduc t s   in i t i a l ly   emerged ,   a s  hedg ing  dev i

ces   aga ins t   f luc tua t ions   incommodity prices and commodity-linked

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 about two-thirds of total transactions in derivative products. In recent years,

the marketfor financial derivatives has grown tremendously both in terms

of variety of instrumentsavailable, their complexity and also turnover. In the

class of equity derivatives, futuresand op t ions on s tock ind ices have

ga ined more popu la r i ty than on ind iv idua l s tocks , especially

among institutional investors, who are major users of index-linked

derivatives.Even small investors find these useful due to high correlation of the

popular indices withvarious portfolios and ease of use. The lower costs

associated with index derivatives vis-vis derivative products based on individual

securities is another reason for their growing use.

The following factors have been driving the growth of financial

derivatives:1.Increased volatility in asset prices in financial

markets,2.Increased integration of national financial markets with the

international markets,3.Marked improvement in communication

facilities and sharp decline in their costs,4 .Deve lopment o f  more

soph i s t i ca t ed r i sk manag ement too l s , p rov i d ing  economicagents

a wider choice of risk management strategies, and5 . Innova t ions   in the

de r iva t ives marke t s , wh ich op t ima l ly combine the r i sks

andreturns over a large number of financial assets, leading to higher returns,

reducedrisk as well as trans-actions costs as compared to individual financial

assets.

1.1 Derivatives defined

Der iva t ive i s a p roduc t whose va lue i s de r ived f rom the va lue

o f one o r more bas icva r i ab les , ca l l ed bases (under ly ing asse t ,

i ndex , o r r e fe rence ra t e ) , i n a con t rac tua l manner. The

underlying asset can be equity, forex, commodity or any other asset.

For example, wheat farmers may wish to sell their harvest at a future

date to eliminate therisk of a change in prices by that date. Such a

transaction is an example of a derivative.The price of this derivative is

driven by the spot price of wheat which is the “underlying”.In the Indian

context the Securities Contracts (Regulation) Act, 1956 (SC(R)

A) defines“equity derivative” to include

– 1 . A   s e c u r i t y   d e r i v e d   f r o m   a   d e b t   i n s t r u m e n t ,   s h a r

e ,   l o a n   w h e t h e r   s e c u r e d   o r   u n s e c u r e d ,   r i s k   i n s t r u m e n

t   o r   c o n t r a c t   f o r   d i f f e r e n c e s   o r   a n y   o t h e r   f o r m   o f   security.

2 . A   c o n t r a c t ,   w h i c h   d e r i v e s   i t s   v a l u e   f r o m   t h e   p r i c

e s ,   o r   i n d e x   o f   p r i c e s ,   o f   underlying securities.The derivatives

are securities under the SC(R) A and hence the trading of derivatives

isgoverned by the regulatory framework under the SC(R) A.

1

1.2 Types of derivatives

The most commonly used derivatives contracts are forwards, futures

and options whichwe shall discuss in detail later. Here we take a brief look at

various derivatives contractsthat have come to be used.

Forwards

: A fo rward con t rac t i s a cus tomized con t rac t be tween two

en t i t i e s , where settlement takes place on a specific date in the future at

today’s pre-agreed price.

Futures

: A futures contract is an agreement between two parties to buy or sell an asset

ata ce r t a in t ime in the fu tu re a t a ce r t a in p r i ce . Fu tu res

con t rac t s a re spec ia l t ypes o f   forward contracts in the sense that the

former are standardized exchange-traded contracts.

Options

: Options are of two types - calls and puts. Calls give the buyer the

right but notthe ob l iga t ion to buy a g iven quan t i ty o f the

under ly ing asse t , a t a g iven p r i ce on o r    before a given future

date. Puts give the buyer the right, but not the obligation to sell

agiven quantity of the underlying asset at a given price on or before a given

date.

Swaps

: Swaps are private agreements between two parties to exchange cash flows in

thefuture according to a prearranged formula. They can be regarded as

portfolios of forwardcontracts. The two commonly used swaps are:

•

Interest rate swaps

: These entail swapping only the interest related cash flows  between

the parties in the same currency.

•

Currency swap

s

: These entail swapping both principal and interest between

the pa r t i e s , w i th the cash f lows in one d i rec t ion be ing in a

d i f f e ren t cu r rency than those in the opposite direction.

Warrants

: Options generally have lives of upto one year, the majority of options tradedon

options exchanges having a maximum maturity of nine months. Longer-dated

optionsare called warrants and are generally traded over-the-counter.

1.3 Participants and Functions

Three broad categories of participants - hedgers, speculators, and

arbitrageurs - trade inthe derivatives market.

Hedgers

face risk associated with the price of an asset. They usefutures or

options markets to reduce or eliminate this risk.

Speculators

wish to be t on future movements in the price of an asset. Futures and options

contracts can give them anextra leverage; that is, they can increase both the

potential gains and potential losses in aspeculative venture.

Arbitrageurs

a re in bus iness to t ake advan tage o f a d i sc repancy  between

prices in two different markets. If,  for example, they see the futures

price of anasset getting out of line with the cash price, they will take offsetting

positions in the twomarkets to lock in a profit.The de r iva t ive marke t

pe r fo rms a number o f economic func t ions . F i r s t , p r i ces in

anorganized derivatives market reflect the perception of market participants

about the futureand lead the prices of underlying to the perceived future

level. The prices of derivativesconverge with the prices of the

underlying at the expiration of derivative contract. Thusderivatives

help in discovery of future as well as current prices. Second, the

derivativesmarket helps to transfer risks from those who have them

but may not like them to thosewho have  appetite for them. Third,

derivatives, due to their inherent nature, are linked tothe underlying

cash markets. With the introduction of derivatives, the underlying

marketwitnesses higher trading volumes because of participation by

more players who wouldnot otherwise participate for lack of an

arrangement to transfer risk. Fourth, speculativetrades shift to a  more

controlled environment of derivatives market. In the absence of

ano r g a n i z e d   d e r i v a t i v e s   m a r k e t ,   s p e c u l a t o r s   t r a d e   i n   t h e  

u n d e r l y i n g   c a s h   m a r k e t s . Margining, monitoring and

surveillance of the activities of various participants become.

extremely difficult in these kind of mixed markets. Fifth, an important

incidental benefitthat flows from derivatives trading is that it acts as a

catalyst for new entrepreneurialactivity. The derivatives have a history of

attracting many bright, creative, well-

educated peop le  wi th   an  en t repreneur i a l   a t t i t ude .  They

o f t en  ene rg ize  o the r s   to   c rea te  new businesses, new products and

new employment opportunities, the benefit of which are immense. Sixth,

derivatives markets help increase savings and investment in the long

run.T r a n s f e r   o f   r i s k   e n a b l e s   m a r k e t   p a r t i c i p a n t s   t o   e x p a n

d   t h e i r   v o l u m e   o f   a c t i v i t y . Derivatives thus promote economic

development to the extent the later depends on therate of savings and

investment.

1.4 Development of exchange-traded derivatives

Derivatives have probably been around for as long as people have

been trading with oneanother. Forward contracting dates back at least

to the 12th century, and may well have  been around before then.

Merchants entered into contracts with one another for futuredelivery of

specified amount of commodities at specified price. A primary motivation

for  prearranging a buyer or seller for a stock of commodities in early

forward contracts wasto lessen the possibility that large swings would inhibit

marketing the commodity after

aharvest.Al though  ea r ly   fo rward  con t rac t s   in   the  US  addressed  

merchan t s ’   conce rns   abou tensuring that there were buyers and

sellers for commodities, “credit risk” remained a serious problem. To

deal with this problem, a group of Chicago businessmen formed the

Chicago Board of Trade

(CBOT) in 1848. The primary intention of the CBOT was to  p rov ide

a cen t ra l i zed loca t ion known in advance fo r buyers and se l l e r s

to nego t i a t e forward contracts. In 1865, the CBOT went one step further and

listed the first “exchangetraded” derivatives contract in the US; these contracts

were called “futures contracts”. In1919 , Ch icago But t e r and Egg

Board , a sp in -o f f o f CBOT, was reo rgan ized to a l low futures

trading. Its name was changed to

Chicago Mercantile Exchange

(CME). TheCBOT and the CME remain the two largest organized futures

exchanges, indeed the twolargest “financial” exchanges of any kind in the world

today.

1.5 Exchange-traded vs. OTC derivatives markets

The OTC derivatives markets have witnessed rather sharp growth over the last

few years,which has accompanied the modernization of commercial

and investment banking

andglobalisation of financial activities. The recent

developments in information technologyhave contributed to a great

extent to these developments. While both exchange-tradedand OTC

der iva t ive con t rac t s o f fe r many benef i t s , t he fo rmer have r ig id

s t ruc tu res compared to the latter. It has been widely discussed that the highly

leveraged institutionsand the i r OTC der iva t ive pos i t ions were the

ma in cause o f tu rbu lence in f inanc ia l markets in 1998. These episodes

of turbulence revealed the risks posed to market stabilityoriginating in features

of OTC derivative instruments and markets.The OTC derivatives markets

have the following features compared to exchange-

tradedderivatives:1.The management of counter-party (credit) risk is

decentralized and located withinindividual

institutions,2 . T h e r e   a r e   n o   f o r m a l   c e n t r a l i z e d   l i m i t s   o n   i n d i

v i d u a l   p o s i t i o n s ,   l e v e r a g e ,   o r   margining,3 .There a re no

fo rmal ru le s fo r r i sk and burden-sha r ing , 4 . T h e r e   a r e   n o

f o r m a l   r u l e s   o r   m e c h a n i s m s   f o r   e n s u r i n g   m a r k e t   s t a b i l i t

y   a n d integrity, and for safeguarding the collective interests of market

participants, and5 .The OTC con t rac t s a re  gene ra l ly no t

r egu la t ed  by a r egu la to ry au thor i ty and the exchange’s self-

regulatory organization, although they are affected indirectly

bynational legal systems, banking supervision and market surveillance.Some

o f the f ea tu res o f OTC der iva t ives marke t s embody r i sks to

f inanc ia l

marke t stability.T h e   f o l l o w i n g   f e a t u r e s   o f   O T C   d e r i v a t i v e s  

m a r k e t s   c a n   g i v e   r i s e   t o   i n s t a b i l i t y   i n institutions, markets,

and the international financial system: (i) the dynamic nature of  gross

credit exposures; (ii) information asymmetries; (iii) the effects of

OTC derivativeactivities on available aggregate credit; (iv) the high

concentration of OTC derivativeactivities in major institutions; and (v) the

central role of OTC derivatives markets in theg loba l f inanc ia l sys t em.

Ins t ab i l i ty a r i ses when shocks , such as coun te r -pa r ty

c red i t even t s and sha rp movement s in a s se t p r i ces tha t under l i e

de r iva t ive con t rac t s , occur  which significantly alter the perceptions of

current and potential future credit exposures.When asset prices change

rapidly, the size and configuration of counter-party exposurescan

become unsustainably large and provoke a rapid unwinding of positions.There

has been some progress in addressing these risks and perceptions.

However,

the p rogres s  has  been   l imi t ed   in   implement ing   re fo rms   in   r i sk  

management ,   i nc lud ingcounter-party, liquidity and operational

risks, and OTC derivatives markets continue to  pose a th rea t to

in t e rna t iona l f inanc ia l s t ab i l i ty . The p rob lem i s more acu te a s

heavy reliance on OTC derivatives creates the possibility of systemic

financial events, whichfall outside the more formal clearing house

structures. Moreover, those who provide OTCderivative products, hedge

their risks through the use of exchange traded derivatives. In v iew of

the inhe ren t r i sks a s soc ia t ed wi th OTC der iva t ives , and the i r

dependence on exchange traded derivatives, Indian law considers them

illegal.

2.0 Indian Derivatives Market

Sta r t ing f rom a con t ro l l ed economy, Ind ia has moved towards

a wor ld where p r i ces fluctuate every day. The introduction of risk

management instruments in India gainedmomentum in the last few years

due to liberalisation process and Reserve Bank of India’s(RBI) efforts in

creating currency forward market. Derivatives are an integral part

of liberalisation process to manage risk. NSE gauging the market requirements

initiated the p rocess o f se t t ing up de r iva t ive marke t s in Ind ia . In

Ju ly 1999 , de r iva t ives t r ad ing commenced in India

Table 2.1

Chronology of instruments1991 Liberalisation process initiated14 December

1995NSE asked SEBI fo r pe rmiss ion to t r ade index fu tu res . 18

November 1996SEBI setup L.C.Gupta Committee to draft  a

policy framework for index

futures.1 1   M a y   1 9 9 8 L . C . G u p t a   C o m m i t t e e   s u

b m i t t e d   r e p o r t . 7 J u l y   1 9 9 9 R B I   g a v e

p e r m i s s i o n f o r O T C   f o r w a r d   r a t e

a g r e e m e n t s ( F R A s )   a n d interest rate

swaps.2 4   M a y   2 0 0 0 S I M E X   c h o s e N i f t y   f o r

t r a d i n g   f u t u r e s   a n d o p t i o n s o n a n

I n d i a n index.2 5   M a y   2 0 0 0 S E B I   g a v e   p e r m i s s i o n   t o

N S E   a n d B S E   t o   d o   i n d e x

f u t u r e s   t r a d i n g . 9   J u n e   2 0 0 0 T r a d i n g   o f   B S E  

S e n s e x   f u t u r e s   c o m m e n c e d   a t   B S E . 1 2

J u n e 2 0 0 0 T r a d i n g o f N i f t y f u t u r e s

c o m m e n c e d a t N S E . 25 Sep tember 2000Ni f ty fu tu res

t r ad ing commenced a t

SGX.2   J u n e   2 0 0 1 I n d i v i d u a l   S t o c k   O p t i o

n s   &   D e r i v a t i v e s

2.1 Need for derivatives in India today

In less than three decades of their coming into vogue, derivatives

markets have becomethe most important markets in the world. Today,

derivatives have become part and parcelo f   t h e   d a y - t o -

d a y   l i f e   f o r   o r d i n a r y   p e o p l e   i n   m a j o r   p a r t  

o f   t h e   w o r l d . Until the advent of NSE, the Indian capital

market had no access to the latest tradingmethods and was using

traditional out-dated methods of trading. There was a huge

gap between the investors’ aspirations of the markets and the available means

of trading. Theopening of Indian economy has precipitated the process of

integration of India’s

financialmarke t s  wi th   the   in t e rna t iona l   f inanc ia l  marke t s .   In t rod

uc t ion  o f   r i sk  management instruments in India has gained

momentum in last few years thanks to Reserve Bank of  Ind ia ’ s

e f fo r t s in a l lowing fo rward con t rac t s , c ross cu r rency op t ions

e t c . wh ich have developed into a very large market. 2.2 Myths and realities

about derivatives

In less than three decades of their coming into vogue, derivatives

markets have becomethe most important markets in the world.

Financial derivatives came into the spotlightalong with the rise in

uncertainty of post-1970, when US announced an end to the BrettonWoods

System of fixed exchange rates leading to introduction of currency

derivativesfollowed by other innovations including stock index

futures. Today, derivatives have become part and parcel of the day-

to-day life for ordinary people in major parts of thewor ld . Whi le

th i s i s t rue fo r many coun t r i e s , t he re a re s t i l l apprehens ions

abou t the introduction of derivatives. There are many myths about derivatives

but the realities thatare different especially for Exchange traded derivatives,

which are well regulated with allthe safety mechanisms in place.

What are these myths behind derivatives?

•

Derivatives increase speculation and do not serve any economic purpose

•

Indian Market is not ready for derivative trading

•

D i s a s t e r s   p r o v e   t h a t   d e r i v a t i v e s   a r e   v e r y   r i s k y   a n d   h i g h

l y   l e v e r a g e d instruments

•

Derivatives are complex and exotic instruments that Indian investors will

finddifficulty in understanding

•

Is the existing capital market safer than Derivatives?

2.2.1 Derivatives increase speculation and do not serve any economic purpose

While the fact is... Numerous s tud ies o f de r iva t ives ac t iv i ty have

l ed to a b road consensus , bo th in the  private and public sectors

that derivatives provide numerous and substantial benefits tothe

users. Derivatives are a low-cost, effective method for users to hedge

and

managet h e i r   e x p o s u r e s   t o   i n t e r e s t   r a t e s ,   c o m m o d

i t y   p r i c e s ,   o r   e x c h a n g e   r a t e s . The need fo r

de r iva t ives a s hedg ing too l was fe l t f i r s t i n the commodi t i e s

marke t .Agricultural futures and options helped farmers and processors hedge

against commodity price risk. After the fallout of Bretton wood agreement, the

financial markets in the worldstarted undergoing radical changes. This

period is marked by remarkable innovations inthe financial markets

such as introduction of floating rates for the currencies,

increasedtrading in variety of derivatives instruments, on-line trading

in the capital markets, etc

3.0 SWAPS

A contract between two parties, referred to as counter parties, to exchange two

streams of  payments for agreed period of time. The payments,

commonly called legs or sides, arecalculated based on the underlying

notional using applicable rates. Swaps contracts alsoinclude other

provisional specified by the counter parties. Swaps are not debt instrument

to raise capital, but a tool used for financial management. Swaps are

arranged in manydifferent currencies and different periods of time. US$

swaps are most common followed by Japanese yen, sterling and Deutsche

marks. The length of past swaps transacted hasranged from 2 to 25 years.

3.1 Why did swaps emerge?

In the late 1970's, the first currency swap was engineered to

circumvent the currencycon t ro l imposed in the UK. A t ax was

l ev ied on ove rseas inves tmen t s to d i scourage capital outflows.

Therefore, a British company could not transfer funds overseas in

order to expand its foreign operations without paying sizeable penalty.

Moreover, this Britishcompany had to take an additional currency

risks arising from servicing a sterling debtwith foreign currency cash

flows. To overcome such a predicament, back-to-back loanswere

used to exchange deb t s in d i f f e ren t cu r renc ies . For example , a

Br i t i sh company wanting to raise capital in the France would raise

the capital in the UK and exchange itsobligations with a French company,

which was in a reciprocal position. Though this typeof arrangement was

providing relief from existing protections, one could imagine, the task

of locating companies with matching needs was quite difficult in as much as the

costof such transactions was high. In addition, back-to-back loans required

drafting multipleloan agreements to state respective loan obligations

with clarity. However this type of arrangement lead to development of

more sophisticated swap market of today.

Facilitators

The problem of locating potential counter parties was solved through dealers

and brokers.A swap dea le r t akes on one s ide o f the t r ansac t ion a s

coun te rpa r ty . Dea le r s work fo r   investment, commercial or merchant

banks. "By positioning the swap", dealers earn bid-ask spread for the

service. In other words, the swap dealer earns the difference

betweenthe amount r ece ived f rom a pa r ty and the amount pa id

to the o the r pa r ty . In an

idea l s i t u a t i o n ,   t h e   d e a l e r   w o u l d   o f f s e t   h i s   r i s k s   b y   m a t c

h i n g   o n e   s t e p   w i t h   a n o t h e r   t o streamline his payments. If the

dealer is a counterparty paying fixed rate payments andreceiving

floating rate payments, he would prefer to be a counterparty receiving

fixed payments and paying floating rate payments in another swap. A perfectly

netted positionas just described is not necessary. Dealers have the flexibility to

cover their exposure by

matching multiple parties and by using other tools such as futures to

cover an exposed position until the book is complete.Swap b rokers ,

un l ike a dea le r do no t t ake on a swap pos i t ion themse lves bu t

s imply loca te coun te r pa r t i e s wi th ma tch ing needs . There fo re ,

b rokers a re f r ee o f any r i sks involved with the transactions. After the

counter parties are located, the brokers negotiateon behalf of the counter

parties to keep the anonymity of the parties involved. By doingso, if

the swap transaction falls through, counter parties are free of any

risks associatedwith releasing their financial information. Brokers receive

commissions for their services.

3.2 Swaps Pricing:

There are four major components of a swap price.

•

Benchmark price

•

Liquidity (availability of counter parties to offset the swap).

•

Transaction cost

•

Credit risk

7

Swap rates are based on a series of benchmark instruments. They may

be quoted as asp read ove r the y ie ld on these benchmark

ins t rument s o r on an abso lu te in t e res t r a t e  basis. In the Indian

markets the common benchmarks are MIBOR, 14, 91, 182 & 364 dayT-bills,

CP rates and PLR rates.Liquidity, which is function of supply and

demand, plays an important role in swaps  pricing. This is also

affected by the swap duration. It may be difficult to have

counter  parties for long duration swaps, specially so in India Transaction costs

include the cost of hedging a swap. Say in case of a bank, which has

a floating obligation of 91 day T. Bill. Now in order to hedge the bank

would go long on a 91 day T. Bill. For doing so the bank must obtain funds. The

transaction cost would thus involve such a difference.Yield on 91 day T. Bill -

9.5%Cost of fund (e.g.- Repo rate) – 10%The transaction cost in this case would

involve 0.5%

Credit risk must also be built into the swap pricing. Based upon the

credit rating of thecounterparty a spread would have to be incorporated. Say

for e.g. it would be 0.5% for anAAA rating.

4.0 Forward contracts & Futures & Options

A forward con t rac t i s an ag reement to buy o r se l l an a s se t on

a spec i f i ed da te fo r a specified price. One of the parties to the

contract assumes a long position and agrees to  buy the underlying

asset on a certain specified future date for a certain specified

price.The other party assumes a short position and agrees to  sell the

asset on the same date for the same price. Other contract details like

delivery date, price and quantity are negotiated b i l a t e ra l ly by the pa r t i e s

to the con t rac t . The fo rward con t rac t s a re normal ly

t r adedoutside the exchanges.The salient features of forward contracts are:

•

They are bilateral contracts and hence exposed to counter–party risk.

•

Each contract is custom designed, and hence is unique in terms of

contract size,expiration date and the asset type and quality

•

The contract price is generally not available in public domain.

•

On the expiration date, the contract has to be settled by delivery of the asset.

•

If the party wishes to reverse the contract, it has to compulsorily go

to the samecounter-party, which often results in high prices being

charged.However forward contracts in certain markets have become

very standardized, as in thecase of  foreign exchange, thereby

reducing transaction costs and increasing transactionsvolume. This

process of standardization reaches its limit in the organized futures

market.Forward con t rac t s a re ve ry use fu l in hedg ing and

specu la t ion . The c l a s s i c hedg ing application would be that of an

exporter who expects to receive payment in dollars threemonths l a t e r . He

i s exposed to the r i sk o f exchange ra t e f luc tua t ions . By us ing

t hecurrency forward market to sell dollars forward, he can lock on to a rate

today and reducehis uncertainty. Similarly an importer who is required

to make a payment in dollars twomonths hence can reduce his

exposure to exchange rate fluctuations by buying dollars forward.If a

speculator has information or analysis, which forecasts an upturn in a

price, then hecan go long on the forward market instead of the cash

market. The speculator would golong on the forward, wait for the

price to rise, and then take a reversing transaction to  book profits.

Speculators may well be required to deposit a margin upfront. However, thisis

generally a relatively small proportion of the value of the assets underlying the

forwardcontract. The use of forward markets here supplies leverage to the

speculator.

4.1 Limitations of forward markets

•

Forward markets world-wide are afflicted by several problems:

•

Lack of centralization of trading

•

Illiquidity, and Counter party risk In the first two of these, the basic

problem is that of too much flexibility and generality.The forward

market is like a real estate market in that any two consenting adults can

formcontracts against each other. This often makes them design terms

of the deal, which arevery convenient in that specific situation, but makes

the contracts non-tradable.

4.2 Introduction to futures

Futures markets were designed to solve the problems that exist in

forward markets. Afutures contract is an agreement between two

parties to buy or sell an asset at a certain time in the future at a certain

price. But unlike forward contracts, the futures contracts arestandardized and

exchange traded. To facilitate liquidity in the futures contracts,

theexchange specifies certain standard features of the contract. It is a

standardized contractwith standard underlying instrument, a standard

quantity and quality of the underlyingi n s t r u m e n t t h a t c a n b e

d e l i v e r e d , ( o r w h i c h c a n b e u s e d f o r r e f e r e n c e p u r p o s e s

i n settlement) and a standard timing of such settlement. A futures

contract may be offset prior to maturity by entering into an equal and

opposite transaction. More than 99% of futures transactions are offset this

way.The standardized items in a futures contract are:

-

•

Quantity of the underlying

•

Quality of the underlying

•

The date and the month of delivery

•

The units of price quotation and minimum price change

•

Location of settlement

4.3 Distinction between futures and forwards contracts

Forward contracts are often confused with futures contracts. The

confusion is primarily because bo th se rve e ssen t i a l ly the same

economic func t ions o f a l loca t ing r i sk in the  presence of future

price uncertainty. However futures are a significant improvement over the

forward contracts as they eliminate counter party risk and offer more liquidity.

Table3.1 lists the distinction between the two.

Futures Terminology

•

Spot price:

The price at which an asset trades in the spot market.

•

Futures price:

The price at which the futures contract trades in the futures market.

•

Contract cycle:

The period over which a contract trades. The index futures contractson the

NSE have one -month , two-months and th ree -months exp i ry

cyc les , wh ich expire on the last Thursday of the month. Thus  a

January expiration contract expireson the last Thursday of January

and a February expiration contract ceases trading onthe l a s t

Thursday o f Februa ry . On the Fr iday fo l lowing the l a s t

Thursday , a new contract having a three-month expiry is introduced for

trading.

•

Expiry date:

It is the date specified in the futures contract. This is the last day

onwhich the contract will be traded, at the end of which it will cease to exist.

•

Contract size:

The amount of asset that has to be delivered under one contract.

For in-stance, the contract size on NSE’s futures market is 200 Nifties.

•

Basis:

In the context of financial futures, basis can be defined as the futures

priceminus the spot price. There will be a different basis for each delivery

month for eachcontract. In a normal market, basis will be positive. This

reflects that futures pricesnormally exceed spot prices.

•

Cost  o f   carry:

The re l a t ionsh ip be tween fu tu res p r i ces and spo t p r i ces can

besummarized in terms of what is known as the cost of carry. This measures

the storagecost plus the interest that is paid to finance the asset less the

income earned on theasset.

•

Initial margin:

The amount that must be deposited in the margin account at the timea futures

contract is first entered into is known as initial margin.

•

Marking-to-market:

In the futures market, at the end of each trading day, the marginac-count is

adjusted to reflect the investor’s gain or loss depending upon the

futuresclosing price. This is called marking–to–market.

•

Maintenance margin:

This is somewhat lower than the initial margin. This is set toensure

that the balance in the margin account never becomes negative. If the balancein

the margin account falls below the maintenance margin, the investor

receives amargin call and is expected to top up the margin account to

the initial margin level before trading commences on the next day.

4.5 Introduction to options

In this section, we look at the next derivative product to be traded on

the NSE, namelyop t ions . Opt ions a re fundamenta l ly d i f f e ren t

f rom fo rward and fu tu res con t rac t s . An option gives the holder of the

option the right to do something. The holder does not haveto exercise this

right. In contrast, in a forward or futures contract, the two parties

havecommi t t ed themse lves to do ing someth ing . Whereas i t

cos t s no th ing (excep t marg in requirements) to enter into a futures

contract, the purchase of an option requires an up– front payment.

4.5.1 History of options

Although options have existed for a long time, they were traded OTC,

without muchknowledge of valuation. Today exchange-traded options

are actively traded on stocks,stock indexes, foreign currencies and futures

contracts. The first trading in options beganin Europe and the US as early

as the eighteenth century. It was only in the early 1900s tha t a g roup

o f f i rms se t up wha t was known as the pu t and ca l l Brokers

and Dea le r sAssoc ia t ion wi th the a im of p rov id ing a

mechan i sm fo r b r ing ing buyers and se l l e r s together. If someone

wanted to buy an option, he or she would contact one of the member firms.The

firm would then attempt to find a seller or writer of the option either

from its ownc l i en t s o r those o f o the r member f i rms . I f no se l l e r

cou ld be found , the f i rm would undertake to write the option itself

in return for a price. This market however suffered

from two deficiencies. First, there was no secondary market and

second, there was nomechanism to guarantee that the writer of the

option would honor the contract. It was in1973 , tha t B lack , Mer ton

and Scho les inven ted the f amed Black Scho les fo rmula . In April

1973, CBOE was set up specifically for the purpose of trading options. The

marketfor options developed so rapidly that by early ’80s, the

number of shares underlying theoption contract sold each day

exceeded the daily volume of shares traded on the NYSE. Since then,

there has been no looking back.

4.6 Option Terminology

•

Index options:

These options have the index as the underlying. Some options

areEuropean whi l e o the r s a re Amer ican . L ike index fu tu res

con t rac t s , i ndex op t ions contracts are also cash settled.

•

Stock options:

Stock options are options on individual stocks. Options currently trade

on over 500 stocks in the United States. A contract gives the holder the right

to buy or sell shares at the specified price.

•

Buyer of an option:

The buyer o f an op t ion i s the one who by pay ing the

op t ion   p r e m i u m   b u y s   t h e   r i g h t

b u t   n o t   t h e   o b l i g a t i o n   t o   e x e r c i s e   h i s   o p t i o n   o n   t h e seller/

writer.

•

Writer of an option:

The wr i t e r o f a ca l l /pu t op t ion i s the one who rece ives

theoption premium and is thereby obliged to sell/buy the asset if  the

buyer exercises onhim. There are two basic types of options, call options and

put options.

Call optio

n: Acall option gives the holder the right but not the obligation to buy an asset

by a certaindate for a certain price.

Put optio

n: A put option gives the holder the right but not theobligation to sell an asset by

a certain date for a certain price.

•

Option price:

Option price is the price which the option buyer pays to the

optionseller.

•

Expiration date:

T h e   d a t e   s p e c i f i e d   i n   t h e   o p t i o n s   c o n t r a c t   i s   k n o w n   a s   t

h e expiration date, the exercise date, the strike date or the maturity.

Strike price:

The price specified in the options contract is known as the strike

priceor the exercise price.

•

American options:

American options are options that can be exercised at any timeupto the

expiration date. Most exchange-traded options are American.

•

European options:

European options are options that can be exercised only on

theexpiration date itself. European options are easier to analyze

than American options,and p roper t i e s o f an Amer ican op t ion a re

f r equen t ly deduced f rom those o f i t s European counterpart.

•

In-the-money option:

An in-the-money (ITM) option is an option that would lead toa positive

cashflow to the holder if it were exercised immediately. A call option

onthe index is said to be in-the-money when the current index stands

at a level higher than the strike price (i.e. spot price > strike price). If the

index is much higher than thestrike price, the call is said to be deep ITM.

In the case of a put, the put is ITM if theindex is below the strike price.

•

At-the-money option:

An at-the-money (ATM) option is an option that would leadto zero

cashflow if it were exercised immediately. An option on the index is

at-the-money when the current index equals the strike price (i.e. spot price =

strike price)._

•

Out-of-the-money option:

An ou t -o f - the -money (OTM) op t ion i s an op t ion tha t would lead

to a negative cashflow it it  were exercised immediately. A call option

onthe index is out-of- the-money when the current index stands at a

level which is lessthan the strike price (i.e. spot price < strike price). If the

index is much lower than thestrike price, the call is said to be deep OTM.

In the case of a put, the put is OTM if  the index is above the strike price.

•

Intrinsic value of an option:

The op t ion p remium can be b roken down in to twocomponen t s

- i n t r ins i c va lue and t ime va lue . The in t r ins i c va lue o f a ca l l

i s t heamount the option is ITM, if it is ITM. If the call is OTM, its

intrinsic value is zero.Putting it another way, the intrinsic value of a

call isN½P which means the intrinsicvalue of a call is Max [0, (S

t

– K)] which means the intrinsic value of a call is the (S

t

– K). Similarly, the intrinsic value of a put is Max [0, (K -S

t

)] ,i.e. the greater of 0 or (K - S

t

). K is the strike price and S

t

is the spot price

Derivatives – Indian Scenario - 39 -

•

Time value of an option:

The time value of an option is the difference between its  premium and

its intrinsic value. A call that is OTM or ATM has only time

value.Usually, the maximum time value exists when the option is

ATM. The longer thetime to expiration, the greater is a call’s time value, all

else equal. At expiration, a callshould have no time value.

4.7 Futures and options

An interesting question to ask at this stage is - when would one use

options instead of futures? Options are different from futures in several

interesting senses.At a practical level, the option buyer faces an interesting

situation. He pays for the optionin full at the time it is purchased. After this, he

only has an upside. There is no possibilityof the options position generating any

further losses to him (other than the funds already paid for the option). This

is different from futures, which is free to enter into, but

cang e n e r a t e   v e r y   l a r g e   l o s s e s .   T h i s   c h a r a c t e r i s t i c   m a k e s  

o p t i o n s   a t t r a c t i v e   t o   m a n y occasional market participants, who

cannot put in the time to closely monitor their futures positions.Buying put

options is buying insurance. To buy a put option on Nifty is to buy

insurance,which reimburses the full extent to which Nifty drops below

the strike price of the put

option. This is attractive to many people, and to mutual funds creating

“guaranteed return products”. The Nifty index fund industry will find it

very useful to make a bundle of a  Nifty index fund and a Nifty put option

to create a new kind of a Nifty index fund, whichgives the investor protection

against extreme drops in Nifty.

4.8 Index derivatives

Index derivatives are derivative contracts, which derive their value

from an underlyingindex. The two most popular index derivatives are index

futures and index options. Indexderivatives have become

very popular worldwide. In his report, Dr.L.C.Gupta attributesthe

popularity of index derivatives to the advantages they offer.

•

I n s t i t u t i o n a l   a n d   l a r g e   e q u i t y - h o l d e r s   n e e d   p o r t f o l i o -

h e d g i n g   f a c i l i t y .   I n d e x –   derivatives are more suited to them and

more cost–effective than derivatives based onindividual stocks. Pension

funds in the US are known to use stock index futures for  risk hedging

purposes.

•

Index de r iva t ives o f fe r ease o f use fo r hedg ing any por t fo l io

i r r e spec t ive o f i t s composition.

•

Stock index is difficult to manipulate as compared to individual stock prices,

more soi n I n d i a , a n d t h e p o s s i b i l i t y o f c o r n e r i n g i s

r e d u c e d . T h i s i s p a r t l y b e c a u s e a n individual stock has a limited

supply, which can be cornered.

•

Stock index, being an average, is much less volatile than individual stock prices.

Thisimplies much lower capital adequacy and margin requirements.

•

Index derivatives are cash settled, and hence do not suffer from settlement

delays and problems related to bad delivery, forged/fake certificates.The

L.C.Gupta committee which was setup for developing a regulatory

framework for derivatives trading in India had suggested a phased

introduction of derivative products inthe following order:1. Index futures2.

Index options

3. Options on individual stocksWith all the above infrastructure in place,

trading of index futures and index optionscommenced at NSE in June

2000 and June 2001 respectively.

5 . 0   P a y o f f   &   P r i c i n g   o f   F u t u r e

s   a n d Options

A payoff is the likely profit/loss that would accrue to a market participant with

change int h e p r i c e o f t h e u n d e r l y i n g a s s e t . T h i s i s

g e n e r a l l y d e p i c t e d i n t h e f o r m o f

p a y o f f   d i a g r a m s   w h i c h   s h o w   t h e   p r i c e   o f   t h e   u n d e r l

y i n g   a s s e t   o n   t h e   X – a x i s   a n d   t h e  profits/losses on the Y–axis.

In this section we shall take a look at the payoffs for buyersand sellers of futures

and options.

5.1 Payoff for futures

Futures contracts have linear payoffs. In simple words, it means that the losses

as well as profits for the buyer and the seller of a futures contract are

unlimited.These l inea r payof f s a re f a sc ina t ing a s they can be

combined wi th op t ions and the underlying to generate various complex

payoffs.

5.1.1 Payoff for buyer of futures: Long futures

The payoff for a person who buys a futures contract is similar to the

payoff for a personwho ho lds an a sse t . He has a po ten t i a l ly

un l imi ted ups ide a s we l l a s a po ten t i a l ly unlimited downside.Take

the case of a speculator who buys a two-month Nifty index futures

contract whenthe Nifty stands at 1220. The underlying asset in this case is the

Nifty portfolio. When theindex moves up , the long fu tu res pos i t ion

s t a r t s mak ing p ro f i t s , and when the index moves down it starts

making losses. Figure 5.1 shows the payoff diagram for the buyer of a futures

contract.

5.1.2 Payoff for seller of futures: Short futuresThe payoff for a person who sells

a futures contract is similar to the payoff for a person who shor t s an

a sse t . He has a po ten t i a l ly un l imi ted ups ide a s we l l a s a

po ten t i a l ly unlimited downside. Take the case of a speculator who

sells a two-month Nifty indexfutures contract when the Nifty stands

at 1220. The underlying asset in this case is the  Nifty portfolio. When

the index moves down, the short futures position starts

making p ro f i t s , and when the index moves up , i t s t a r t s mak ing

losses . F igure 5 .2 shows the  payoff diagram for the seller of a futures

contract

5.2 Options payoffs

The optionality characteristic of options results in a non-linear payoff

for options. Insimple words, it means that the losses for the buyer of an option

are limited, however the profits are potentially unlimited. For a writer,

the payoff is exactly the opposite. His profits are limited to the option

premium, however his losses are potentially unlimited.These non-linear

payoffs are fascinating as they lend themselves to be used to

generatevarious payoffs by using combinations of options and the underlying.

We look here at thesix basic payoffs.

5.2.1 Payoff profile of buyer of asset: Long asset

In this basic position, an investor buys the underlying asset, Nifty for instance,

for 1220,and sells it at a future date at an unknown price,S

4

it is purchased, the investor is said to be “long” the asset. Figure 5.3

shows the payoff for a long position on the Nifty.

5.2.2 Payoff profile for seller of asset: Short asset

In this basic position, an investor shorts the underlying asset, Nifty for instance,

for 1220,and buys it back at a future date at an unknown price S

4

Once it is sold, the investor issaid to be “short” the asset. Figure 5.4 shows

the payoff for a short position on the Nifty