• Derivative comes from the word “ to derive”• A derivative is a contract whose value is derived from the value of another asset called underlying asset• If the price of underlying asset/security changes the price of derivative security also changes.
Commodity derivative – Underlying is wheat, cotton, pepper, corn, oats, soyabean, crude oil, natural gas, gold, silver, turmeric etc. Financial derivatives – Underlying is stocks, bonds, indexes, foreign exchange, Eurodollar etc.• Derivative minimises the risk of owning things that are subject to unexpected price fluctuations like foreign currencies, bulk of wheat, stocks & bonds.
Under lying DerivativePrice Change Price ChangeChange in Spot Change inor Cash Market Prices in Price of Derivatives Underlying market
FORWARDS• It is a contract between two parties to buy or sell an underlying asset at today’s pre-agreed price (known as Forward Price) on a specified date in the future. • This forward price is set at the inception of contract• It is the most basic form of derivative contract.• These contracts are not standardized, the end users can tailor make the contracts to fit their very specific needs.• Traded at Over The Counter exchange.
An Indian Company has ordered machinery from USA. The price of $ 5,00,000 is payable after six months. The current exchange rate is 49.08 as on 28th Feb 2012. At the current rate the company needs 49.03*5,00,000 = 2,45,40,000 If the company anticipates depreciation of Indian rupee over time. The company can enter into a forward contract & forget about any exchange rate fluctuations. Suppose the exchange rate becomes 50, then also the company has to pay Rs. 2,45,40,000 for buying $ 5,00,000 though the value is 2,50,00,000.
FUTURESFutures are financial contracts to eliminate therisk of change in price in the future date. Futuresare highly standardized exchange tradedcontracts to buy or sell specified quantity offinancial instruments/commodity in a designatedfuture month at a future price. Futures Price: The price agreed by the twotraders on the floor of exchange.
In India, two exchanges offer derivatives trading: the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). OTC derivative trading are considered as illegal in Indian Law. OTC Contract Exchange Traded Contract Customised Terms Standardized Terms Substantial Credit Risk No risk Unregulated Regulated Transparency Information Asymmetry Overleveraged positions Less leveraged
A farmer supplies Barley to a Breakfast cereal manufacturer, he fears fall in future prices of Barley, so he can enter into a futures contract for selling 20 metric ton of barley. If he wants to sell less than 20 metric ton he has to enter into a forward agreement & not futures. This is b’coz standard contract size for barley in barley international exchange is 20 metric ton or its multiples.
• It is the initial deposit required to open a trading account in a futures trading exchange.• The initial margin is fixed by the broker, but has to satisfy an exchange minimum. The variation margin i.e. the change in the amount of an account on a given day in response to a market –to-market process, is settled on daily basis.
The exchange requires both parties to put up an initial amount of cash, the margin. Additionally, since the futures price will generally change daily, the difference in the prior agreed-upon price and the daily futures price is settled daily The exchange will draw money out of one partys margin account and put it into the others so that each party has the appropriate daily loss or profit. If the margin account goes below a certain value, then a margin call is made and the account owner must replenish the margin account. This process is known as marking to market.
• Initial Margin – The amount that must be deposited in the margin account when establishing a position. The margin requirement is about 12% futures & 8% for options.• Marking to Market – In the futures market at the end of each trading day, the margin account is adjusted to reflect the investor’s gain or loss depending upon the futures closing account.• Maintenance Margin – This is set to ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin, the investor is expected to top up the initial level before trading commences on the next day.
For example say you have bought 100 shares of XYZ at Rs.100 andThreshold MTM Loss is 20% and the applicable margin % is 35%. Youwould be having a margin of Rs.3500 blocked on this position. Thecurrent market price is now say Rs.75. This means the MTM loss is 25%which is more than the threshold MTM loss % of 20% and henceadditional margin to be called in for. Additional margin to be calculated asfollows: (a) Margin available 100*100*35% Rs.3500 (b) Less : MTM Loss (100-75)*100 Rs.2500 (c) Effective available (a-b) Rs.1000 margin (d) Required Margin 75*100*35% Rs.2625 (e) Additional Margin (d-c) Rs.1625 required
NEAT F & O system is used. The minimum contract size in derivative market is 2 lakhs & it changes based upon the prices of stock. In 2005 the lot size in infosys shares was pruned from 200 to 100. Now lot size is 50 for most of the shares.
NSCCL settles all deals on NSE’s derivative segment. It acts as a legal counter party to all deals on derivative segment & guarantees settlement. Members are required to settle the mark to market losses by T + 1 day.
Major Derivatives Exchanges in the World• Chicago Board of Trade• Chicago Mercantile Exchange• Australian Options Market• Commodity Exchange, New York• London Commodity Exchange• London Securities and Derivatives Exchange• London Metal Exchange• Singapore International Financial Futures Exchange• Sydney Futures Exchange• Tokyo International Financial Futures Exchange• National Stock Exchange, India
On December 1999, the Securities Contract Regulation Act was amended to include derivatives within the sphere of securities. Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2000 on the recommendation of L. C Gupta committee. Securities and Exchange Board of India (SEBI) permitted the derivative segments of two stock exchanges, NSE and BSE, and their clearing house/corporation to commence trading and settlement in approved derivatives contracts.• Trading in index options commenced in June 2001, options on individual securities in July 2001 and Futures on individual stocks in November 2001.
Types of Futures• Commodity futures (Wheat, corn, etc.) and• Financial futures Financial futures include: – Foreign currencies – Interest rate – Market index futures (Market index futures are directly related with the stock market) – Individual stock.
Open Interest It is the number of outstanding futurescontracts. In other words, the number offutures contracts that have to be settled onor before maturity date.
OPTIONS• An option is a contract between two parties in which one party has the right but not the obligation to buy or sell some underlying asset on a specified date at a specified price.• The option buyer has the right not an obligation to buy or sell.• If the buyer decides to exercise his right the seller of the option has an obligation to deliver or take delivery of the underlying asset at the price agreed upon.
Types of Options On the basis of the nature of the rights and obligations in the option contract, options are classified in to two categories. They are:• Call Options and• Put Options.
CALL OPTIONS A call option is a contract that gives the optionholder the right to buy some underlying asset fromthe option seller at a specified price on or before aspecified date.Eg. The current market price Ashok Leyland isRs.69. An option contract is created and traded onthis share. A call option on the share would givethe right to buy the share at a specified price(Rs.70) during September 2010. This call optionwould be traded between two parties P (thepurchaser and S ( the seller). The purchaser Pwould be prepared to pay a small price known asoption premium (Rs.2) to S, the seller of theoption.
PUT OPTIONS A put option is a contract which givesits owner the right to sell some underlyingasset at a specified price on or before aspecified date. The seller of the put option has theobligation to take delivery of theunderlying asset, if the owner of the optiondecides to exercise the option.
• Option Writer or Option Grantor: The seller of option.• Strike price or Exercise price : The price at which the option holder may purchase the underlying asset from the option seller.• Time to Expiration or Time to Expiry : The period of time specified for exercising the option.• Expiration Date : The precise date on which the option right expires.
Types of Options On the basis of maturity pattern of options, option contracts are categorized in to two. They are:• European Style Options• American Style Options
• European Style Options Options which can be exercised only on the maturity date of the option or on the expiry date.• American Style Options Options which can be exercised at any time up to and including the expiry date. Most of the exchange traded options are American style. In India stock options are American style while index options are European style.
Types of Options Based on the mode of trading options are classified in to two:• Over-the-counter Options• Exchange Traded Options
Moneyness of Options Moneyness of an option describes the relationship between the strike price of the option and the current stock price. This takes three forms:1. In the Money2. At the Money3. Out of the Money
1. In the Money Options When the strike price of a call option is lower than the current stock price, the option is said to be in the money. This is because the owner of the option has the right to buy the stock at a price which is lower than the price which he has to pay if he had to buy it from the open market. Similarly in the case of put option, when the strike price is greater than the stock price, the option is said to be in the money. If an in the money option is exercised, there will be an immediate cash inflow.
When the strike price of a call optionis equal to the current stock price, theoption is said to be at the money option. In the case of a put option if the strikeprice of the option is equal to the stockprice, the put option is said to be at themoney.
When the strike price of a call option ismore than the stock price, the option istermed as out of the money option.In the case of put option, if the strikeprice is less than the stock price, theoption is said to be out of the moneyoption.
When the Shares of A Ltd. is Trading at Rs.450Strike Price (Rs.) Call Option Put Option 420 430 In the Money Out of the Money 440 450 At the Money At the Money 460 470 Out of the Money In the Money 480
1991 Liberalization process initiated14-Dec-95 NSE asked SEBI for permission to trade index futures. SEBI setup L.C.Gupta Committee to draft a policy framework for index18-Nov-96 futures.11-May-98 L.C.Gupta Committee submitted report. RBI gave permission for OTC forward rate agreements (FRAs) and interest07-Jul-99 rate swaps.24-May-00 SIMEX chose Nifty for trading futures and options on an Indian index.25-May-00 SEBI gave permission to NSE and BSE to do index futures trading.09-Jun-00 Trading of BSE Sensex futures commenced at BSE.12-Jun-00 Trading of Nifty futures commenced at NSE.25-Sep-00 Nifty futures trading commenced at SGX.02-Jun-01 Individual Stock Options & Derivatives