derivatives v 2

7/31/2019 Derivatives v 2

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Derivatives

Chitra Potdar


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Derivatives - Definition Derivative is a product whose value is

derived from the value of one or more

basic variables, called bases (underlyingasset, index or reference rate) in acontractual manner

Examples


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Definition The Securities Contracts (Regulation) Act,

1956 defines derivative to include

1. A security derived from a debt instrument,share, loan whether secured or unsecured,risk instrument or contract for differences orany other form of security

2. A contract which derives its value from theprices, or index of prices of underlyingsecurities


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Features of Derivatives They can be designed in such a way so as to

cater to the varied requirements of the userseither by simply using any one of the above

instruments or by using combination of twoor more such instruments

They can be traded on the basis of theexpectations regarding the Future price

movements of underlying assets They are off balance sheet instruments They are used for reducing the risk of

fluctuations in asset values


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History of Derivatives Initially emerged as hedging devices against

fluctuation in commodity prices The commodity linked derivatives existed

almost 300 years ago Financial derivatives emerged post 1970 due

to growing instability in the financial markets Recently the market for financial derivatives

has grown up by leaps and bound The futures and options on the stock indices

have gained more popularity


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Need for Derivatives Free market economy

Corporates were exposed to

Exchange Rate Risk Interest Rate Risk

Economic Risk

Political Risk


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Need for Derivatives in India The need was felt for the corporate

clients to protect their operating profits

by shifting some uncontrollable risk byway of Risk Management

Derivatives occupies an important place

in the Risk Management


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Participants of a Derivative

Market Hedgers

Speculators

Arbitrageurs


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Factors driving growth of

derivatives1. Increased volatility of asset prices in financial markets

2. Increased integration of the national financial marketswith international markets

3. Marked improvement in communication facilities &sharp decline in their costs

4. Development of more sophisticated risk managementtools

5. Innovations in the derivatives markets which optimallycombine the risks & returns over a large no of financialassets leading to higher returns, reduced risk &transactional costs


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Derivative Products1. Forwards

2. Futures

3. Options

4. Swaps


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Forwards1. Forwards is a customized contract

between two entities where settlement

takes place on a specific date in the futureat todays pre-agreed price and other terms& conditions. The promised asset may becurrency, commodity, instrument etc.

There is an obligation to honour thiscontract at any cost, failing which there willbe some penalty


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Forwards contd. In a forward contract a user (holder) who

promises to buy the specified asset at anagreed price at a fixed future date is said tobe in the Long position & the user (holder)who promises to sell the specified asset at anagreed price at a fixed future date is said to

be in the Short position Rupee Dollar exchange rate is big forward

contract market in India for banks, financialinstitutions, exporters


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Forward Contract - Features1. Over The Counter Trading customized

contract in terms of the contract size,expiration date & the asset type

2. No down payment promise to supply orreceive specified asset at a future date

3. Settlement at maturity4. Linearity symmetrical gains or losses due

to price fluctuation of the underlying assetSpot price > Contract price = Gain ofForward Buyer


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Forward Contract - Features5. No Secondary Market purely private

contract

6. Necessity of a Third Party in the absence ofExchange

7. Delivery is subject matter of the contract & isa must


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Forward Contracts -Illustrations

Forward Rate Currency Contract is acontract where exchange of currencies is

promised at an agreed exchange rate at aspecified future date

Forward Rate Contract on Interest Rate onthe date of maturity the difference between

the forward interest rate as mentioned in theagreement and the interest rate prevailing inthe spot market is paid/received


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Futures

2. Futures A future contract is an agreementbetween two parties to buy or sell an asset at

a certain time in the future at a certain priceFuture contracts are special types of Forwardcontracts in the sense that the former arestandardized exchange traded contracts


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Future Contract - Features

1. Highly Standardized & legally enforceable2. No down payment by the parties but a deposit

called initial margin is placed

3. Settlement need not be at maturity. Futureinstruments are marked to the market, theexchange records on a daily basis profit & losses toboth the parties


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Future Contract - Features

5. Linearity symmetrical gains or losses due to pricefluctuation of the underlying asset

Spot price > Contract price = Gain of Future Buyer

Spot price < Contract price = Loss to Future Buyer

When is the Gain/Loss to the Seller?

6. Secondary Market Futures are dealt in an organizedmarket as a result they have secondary market too

7. Delivery of the asset is not must. The parties simplyexchange the difference between the future & spotprices on the date of maturity


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Commodity Futures

It is a Future contract in commodities likeagricultural products, metals & minerals etc.

Few well established commodity exchangesare

1. London Metal Exchange2. Chicago Board of trade (soyabean oil)3. New York Cotton Exchange4. Commodity Exchange, New York5. International Petroleum Exchange of

London


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Commodity Futures

Commodities traded are sugar, jute,pepper, gur, castorseeds, coffee etc.

MCX, NMCEX AND NCDEX are thecommodity exchanges


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Financial Futures

Financial Futures deal in treasury bills,commercial paper, stock market index,

interest rate It is very popular hedging instrument used

against exchange rate, interest ratefluctuations

The stock index futures contract are used bythe portfolio managers to protect the pricesof the assets in the clients portfolio


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Futures vs. Forwards

Trade on an organizedexchange

Standardized contract

terms Hence more liquid Requires margin

payments Follows daily settlement Settlement is done by

merely exchanging thedifference between thefuture and stock prices

OTC in nature

Customized contractterms

Hence less liquid

No margin payment

Settlement happens atthe end of period

The asset is deliveredon settlement


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Futures vs. Forwards

Which is superior?

Why?

Futures are superior than Forwards as theyeliminate counterparty risk & offer more liquidity


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Advantages of Forwards &Futures

1. Protection against price fluctuations

2. Avoidance of carrying costs

3. Proper planning for buying & selling4. Proper Portfolio Management

5. Proper Cash Management

6. Purchase & Sales in bulk7. Highly Flexible

8. Boon to Financial Intermediaries


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Options

3. Options are of two types call & put

Call option gives the buyer right but not the

obligation to buy a given quantity of the underlyingasset, at a given price on or before a given futuredate

Put option gives the seller right but not the obligation

to sell a given quantity of the underlying asset at agiven price on or before a given future date


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Options

The seller is referred as writer whoreceives premium from the buyer

The premium is the price required topay for the purchase of right to buy orsell


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Features of options

1. Highly flexible

2. Down payment

3. Settlement

4. Non-Linearity

5.

No obligation to buy or sell


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Participants in the DerivativeMarket

1. Hedgers

2. Speculators

3. Arbitrageurs


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Hedgers

Every investment by nature is riskprone

Hedgers try to protect themselvesagainst the risk of price change byusing derivatives like forwards, options

etc. Examples wheat, portfolio, forex


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An example of Hedging UsingForward Contracts

If today an Indian Import Co. realizes that it will haveto pay $ 1 million to US based company after 3months for the consignment received from them.

The Co can hedge entering into 3 months forwardcontract @ 47 per $

If after 3 months the exchange rate proves to bemore than 47 per $ the Co will wish that it hadhedged

If exchange rate proves to be less than 47 per $ theCo will be pleased that it had not done so


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Speculators

They are willing to take risk

They take positions in the market either

expecting the movement in the prices andbetting on it

They may take long or short positions onfutures or options or hold spread positions

A participant can speculate in futures andoptions, they are either positional traders orday traders


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Arbitrageurs

Arbitrageurs thrives on market imperfections They undertake two simultaneous actions in

an attempt to make risk less profit The opportunities will soon vanish as more

and more arbitrageurs enter the market They help in bringing equilibrium in prices of

same securities in different markets As futures and options with various expiration

dates are traded in the market offeringopportunities to the arbitrageurs


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Options : A HistoricalPerspective

In 17th century there was an active optionmarket in Holland

Options were traded in the USA & UK during

the 19th Century In USA options on Equity stocks of the

companies were available on the over-the-counter market, until 1973

In India options on the stocks of companies,though illegal, have been traded for manyyears in the form of Teji and Mandi


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Development of OptionMarket

In the year 1973, Black and Scholespublished a paper on option pricing and

hedging In the same year CBOE was created


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NSEs Derivatives Market

The derivatives trading on the NSE commenced withS & P Nifty Index futures on June 12, 2000

The trading on index options commenced on July 4,

2001 and trading in options on individuals securitiescommenced on July 2, 2001

Single stock futures were launched on November 9,2001

The Derivatives contract has a maximum 3 monthexpiration i.e. contracts are available for trading with1 month, 2 months and 3 months expiry


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Functions performed byDerivatives markets

Price Discovery

Risk Transfer

Market Completion


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Participants and Functions

Clearing Member (CM) does clearing forall the Trading Members (TM)

The 3 types of CMs are Self Clearing Member (SCM)

Trading Member Clearing Member (TMCM)

Professional Clearing Member (PCM)


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Trading Mechanism

The futures & options trading system of NSEis called NEAT F&O trading system

It provides fully automated screen based

trading for Index futures & options and Stockfutures & options

It provides online monitoring and surveillancemechanism

There are two operators Trading Members Clearing Members


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NSE F&O turnover standsRs 504.88 bnon July 27 Expiry

Symbol No ofContractsTraded

TradedQuantity

Total TradedValue (Rs in

mn.)

Open interest(Qty.) as at end oftrading hrs.

NIFTY 405,077 20,253,850 92,556.60 28,517,600

MINIFTY 48,520 970,400 44,34.50 937,560

BANKNIFTY 20,754 1,037,700 7,694.50 803,100

CNXIT 66 6600 27.1 12,600

Index Futures


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NSE F&O turnover standsRs 504.88 bnon July 27 Expiry

Symbol No ofContractsTraded

TradedQuantity

Total TradedValue (Rs in

mn.)

Open interest(Qty.) as atendof trading hrs.

NIFTY 842,222 42,111,100 191,577.10 101,613,800

MINIFTY 303 6,060 27.9 35,900

BANKNIFTY 98 4,900 38.8 172,700

Index Options


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Nifty Futures Turnover

As on 7-Aug-09 5:30:21 hours IST

Type ofInvestment

Date ofExpiry Last Price

UnderlyingValue

Future Index Nifty 27-Aug-09 4480.85 4481.40

24-Sep-09 4489.50 4481.40

29-Oct-09 4490.15 4481.40


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Clearing House & its role

Obligations without a Clearing House

Buyer Seller

Assets

Funds


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Clearing House & its role

Obligations with a Clearing House

Buyer SellerAssets

Funds

Clearing

House

Assets

Funds


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Functions of Clearing House

It provides guarantee that all the trades in futuremarket will honor their obligations

All the buying & selling futures contracts require daily

collections & payment of funds to parties of futuretransactions. Clearing House monitors this

Members of exchange provide daily reports to theclearing house regarding future trades

The Clearing House does not hold any long or shortpositions but act as an intermediary

If all the outstanding long & short positions areadded the total is zero


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The concept of Margin

The basic objective of margin is to provide afinancial safeguard for ensuring that the

investors will perform their contractobligations

An investor who enters into a future contractis required to deposit funds with the broker is

called margin The exchange may set the minimum margin

but the brokers may require long margin


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The concept of Margin

The amount of margin may vary from thecontract to contract and broker to broker

The margin may be deposited in the differentforms like cash, banks, letter of credit andtreasury securities

No interest is paid on margin in money This

loss of interest is the cost of marginrequirement


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The types of Margin

1. Initial Margin

2. Maintenance Margin

3. Clearing Margin


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Initial Margin

It is original amount that must be depositedinto account to establish future position itvaries from stock to stock

The initial margin may be 5% or 10% of thevalue of the contract

To determine the initial margin the exchangeconsiders the degree of volatility of price

movements of the underlying asset in thepast Example


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Initial Margin - Advantages

It enables the clearing house to coverthe losses on the position even in the

most adverse situation It approximately equals the maximum

daily price fluctuations permitted by the

exchange


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Maintenance Margin

It is the minimum amount which maybe kept in the margin account

It is normally 75% of the initial margin If the future prices move against the

investor resulting in the fall in themargin account below maintenancemargin the broker will make a call i.e.the demand for additional funds


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Maintenance Margin

The function of a maintenance margin isprevent catastrophic losses due to the over-

extension of credit to investors When a given position declines in value to a

point where a margin call is issued, theinvestor is given the choice to add funds to the

account to maintain the position or to close theposition at a loss and eliminate the risk offurther margin calls


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Margin Call

a margin call on futures contracts is triggered whenthe value of your account drops below themaintenance level

For example, you hold five futures contracts thathave an initial margin of 10,000 and a maintenancemargin of 7,000. The value of your account falls to6,500. You will get a margin call requiring you to add

3,500 to your account to bring it back to the initialmargin

You also have the option of closing your positions toeliminate the margin call

M i t M i


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Maintenance MarginIllustration

TradingDay

FuturePrice

Daily Gain(Loss)

CummulativeGain (Loss)

MarginAccountBalance

01-Aug 5000

02-Aug 4000

03-Aug 3500

04-Aug 3700

05-Aug 2200

08-Aug 1900


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Clearing Margin

A margin which a clearing house member is requiredto maintain with the clearing house

There is no maintenance margin

The margin is calculated on the gross basis & netbasis

Gross margin All the long positions are added to allthe short positions and margin is provided

Net margin The long positions are netted againstthe short positions and the margins for net positionsare determined

derivatives v 2

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