Diamond Derivative

PROJECT REPORT ON DIAMOND DERIVATIVE SUBMITTED BY: SUBMITTED TO: AVIJIT BHATTACHARYYA - 91PROF. ANANDADEEP MANDAL DIPTAKSHYA BANERJEE - 76 MRIDUL CHATTERJEE - 24 ACKNOWLEDGEMENT We are thankful to Prof.Anandadeep Mandal to give such kind of assignment which help us to innovate a derivative instrument. INDEX TOPIC PAGE NO EXECUTIVE SUMMARY…………………………………………………………………4 DIAMOND DERIVATIVE AND ITS NEED …………………………………………….5 PARTICIPENTS…………………………………………………………………………….5 SPOT PRICE DETARMINATION METHODOLOGY…………………………………5 PRICING FUTURES CONTRACTS OF DIAMOND……………………………………7 PAYOFF FOR FUTURE CONTRACT……………………………………………………9 PAYOFF FOR OPTION CONTRACT……………………………………………………10 RISK RESOLVED………………………………………………………………………………...12 VARIOUS MANAGERIAL STRATEGY……………………………………………………………………………......13 PROS AND CONS OF DIAMOND DERIVATIVE IN INDIA…………………………19 APPENDIX…………………………………………………………………………………19 EXECUTIVE SUMMARY In India Aluminium,Nickel ,Copper ,Copper Cathode ,Zinc ,Lead ,Tin ,Gold ,Gold-M ,Pure Gold - Mumbai ,Kilo - Gold ,Gold - HNI ,SONA995MUM ,Pure Gold - Mumbai - 1 Kg ,Silver ,Silver-M ,Pure Silver - New Delhi - 30 Kg (Mega),Pure Silver - New Delhi,Silver - HNI , ChandidelSteel, Steel - Long ,Steel - Flat ,Mild Steel Ingots - Ghaziabad ,Steel Long Bhavnagar ,Steel Long Govindgarh ,sponge iron,Gold Ahmedabad,Gold Delhi ,Gold Kolkata ,Gold Mumbai ,Gold Mini Delhi ,Gold Mini Kolkata,Gold Mini Mumbai ,Gold Mini Ahmedabad are traded over different commodity exchange as Metal commodity.But no diamond trading takes palce in the exchange.But diamond has high importance to Indian Economy. It Contributes over 15% exports (USD 16 billion) & 6% imports (USD 10 billion).In India diamond accounts for over 90% volumes & 55% value in cutting & polishing of diamonds.we see that there is Increasing trend in retail appetite for diamond jewellery, high GDP growth, higher net disposable income, Continued Government support to promote this sector. So diamond derivative can be introduce as a hedging tools for trading participents of diamond.How this financial instrument helps to hedge,how price(spot and future) can detarmine, you able to understand to read the report. DIAMOND DERIVATIVES: Derivative is a financial instrument whose value depends on the underlying assets. These underlying assets can be Equity, commodity or forex etc. In case of diamond derivative, underlying asset is diamond. NEED FOR DIAMOND DERIVATIVE: The lack of a structured OTC or listed diamond derivative means that industry players are not able to hedge their future diamond demand or supply, when they know that this will be subject to peaks and troughs at pre-determined times in the future. The lack of a forward market, normally the pre-cursor to the establishment of a derivative market, means that all trades are done for cash or credit settlement, where credit is becoming increasingly extended, so the only way to speculate on future price movements is to increase buys or sales of physical diamonds in the physical portfolio. This has a consequent knock on effect on funding requirements from banks and is a more expensive mechanism than using a hedging tool, where margin is required to be lodged which does not represent the whole value of the stone. Posting margin with a clearer gives leverage to the diamantine since for the same amount of money he would use to buy one stone he is now able to buy additional stones synthetically through the derivative contract. PROBABLE PARTICIPENTS: Mining or Polishing Company Jewelry Company Trader SPOT PRICE DETARMINATION MECHANISM: Diamonds are mostly traded in the western part of the country. The diamond trading centers are concentrated mostly in following areas: 
Surat
Ahmedabad
Mumbai
Every Commodity Exchange in India (e.g. MCX, NCDEX, NMCE) when wants to introduce a new kind of contract, they set up a team. The team visits the places where the commodity is mostly traded. They identify the various participants (i.e., Traders, Exporters, Importers) related to the commodity. After collecting the names & contact details of the participants, the team makes a database for the particular commodity. In such a way, for the Diamond derivative contract, the team made by the particular exchange, can take the required information from the above mentioned places. Now the Exchange makes the “Contract Specification” for introducing the new contract. CONTRACT SPECIFICATION OF DIAMOND DERIVATIVE: Symbol DIAMOND WDescription DIAMONDMMYY Contracts available for trading: February contract After approval of the Commission to 5th February of the contract year April contract After approval of the Commission to 5th April of the contract year June contract After approval of the Commission to 5th June of the contract year Trading Trading period Mondays through Saturdays Trading session Mondays to Friday: 10.00 a.m. to 11.30 p.m. Saturday: 10.00 a.m. to 2.00 p.m. Trading unit 1 kg Quotation / Base value 10 grams Price quote Ex- Surat (inclusive of all taxes and levies relating to import duty, customs but excluding sales tax and VAT, any other additional tax or surcharge on sales tax, local taxes and octroi) Maximum order size 10 kg Tick size (minimum price movement) Re. 1 per 10 gramsDaily price limit 3%Initial margin 4% Delivery Delivery unit 1 kg Delivery period margin 25% of the value of the open position during the delivery period Delivery center(s) Surat, Ahmedabad and Mumbai at designated Clearing House facilities of Group 4 Securitas at these centers and at additional delivery centers at Chennai, New Delhi and HyderabadQuality Specifications Diamond whiteDelivery Logic Compulsory Delivery and Settlement Procedure of Diamond Contracts Settlement period Tender period 1st to 6th day of the contract expiry month. Delivery period 1st to 6th day of the contract expiry month. Pay-in of commodities (delivery by seller member) On any tender days by 6.00 p.m. except Saturdays, Sundays and Trading Holidays. Marking of delivery will be done on the tender days based on the intentions received from the sellers after the trading hours. On expiry all the open positions shall be marked for delivery. Delivery pay-in will be on E + 1 basis. Pay-in of funds By 11.00 a.m. on Tender day +1 basis Pay-out of funds and commodities (delivery to buyer member) By 05.00 p.m. on Tender day +1 basis. After making Contract Specification, the same should be forwarded to the Forward Market Commission (FMC) for approval. If the FMC approves the contract, then the Exchange to decide the Spot price of the commodity conduct “polling” (see appendix) after seeing the database in a random basis. After getting polls from the participants, applying “BOOT STRAPPING”(see appendix ) methodology it determines the Spot price of the diamond contract. PRICING FUTURES CONTRACTS OF DIAMOND: Now let us try to extend this logic to a futures contract on a diamond. Let us take the example of a futures contract on a diamond and work out the price of the contract. The spot price of diamond is Rs.7000/ 10 gms. If the cost of financing is 15% annually, what should be the futures price of 10 gms of diamond one month down the line ? Let us assume that we're on 1st January 2004. How would we compute the price of a diamond futures contract expiring on 30th January? From the discussion above we know that the futures price is nothing but the spot price plus the cost-of-carry. Let us first try to work out the components of the cost-of-carry model. 1.What is the spot price of diamond? The spot price of diamond, S= Rs.7000/ 10 gms. What is the cost of financing for a month? What are the holding costs? Let us assume that the storage cost = 0. In this case the fair value of the futures, works out to be = Rs.7086.80 If the contract was for a three-month period i.e. expiring on 30th March, the cost of financing would increase the futures price. Therefore, the futures price would be Rs.7263.75 In the example above we saw how a futures contract on diamond could be priced using arbitrage arguments and the cost-of-carry model. In the example we considered, the diamond contract was for 10 grams of diamond. Hence we ignored the storage costs. However, if the one-month contract was for a 100 kgs of diamond instead of 10 gms, then it would involve non-zero holding costs which would include storage and insurance costs. The price of the futures contract would then be Rs.7086.80 plus the holding costs. Warehouse charges include a fixed charge per deposit of commodity into the warehouse, and a per unit per week charge. The per unit charges include storage costs and insurance charges. We saw that in the absence of storage costs, the futures price of a commodity that is an investment asset is given by F = SerT Storage costs add to the cost of carry. If U is the present value of all the storage costs that will be incurred during the life of a futures contract, it follows that the futures price will be equal to : F = (S + U)erT where: r Cost of financing (annualised) T Time till expiration U Present value of all storage costs For ease of understanding let us consider a one-year futures contract on diamond. Suppose the fixed charge is Rs.310 per deposit upto 500 kgs. and the variable storage costs are Rs.55 per week, it costs Rs.3170 to store one kg of diamond for a year(52 weeks). Assume that the payment is made at the beginning of the year. Assume further that the spot diamond price is Rs.6000 per 10 grams and the risk-free rate is 7% per annum. What would the price of one year diamond futures be if the delivery unit is one kg? F = (S+ U)erT = (600000 + 310 + 2860)e0.07 x 1 = 646904.76 We see that the one-year futures price of a kg of diamond would be Rs.6,46,904.76. The one-year futures price for 10 grams of diamond would be about Rs.6469. Now let us consider a three-month futures contract on diamond. We make the same assumptions - the fixed charge is Rs.310 per deposit upto 500 kgs. and the variable storage costs are Rs.55 per week. It costs Rs.1025 to store one kg of diamond for three months (13 weeks). Assume that the storage costs are paid at the time of deposit. Assume further that the spot diamond price is Rs.6000 per 10 grams and the risk-free rate is 7% per annum. What would the price of three month diamond futures if the delivery unit is one kg? F = (S + U)erT = (600000 + 310 + 715)e0.07 x 0.25 = 611635.50 We see that the three-month futures price of a kg of diamond would be Rs.6,11,635.50. The three-month futures price for 10 grams of diamond would be about Rs.6116. PAYOFF FOR BUYER OF FUTURES: LONG FUTURES The payoff for a person who buys a futures contract is similar to the payoff for a person who holds an asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Payoff for a buyer of Diamond The figure shows the profits/losses from a long position on diamond. The investor brought diamond at Rs. 6000 per 10 gms. If the price of diamond rises, he makes profits. If price of diamond falls he makes loses. PAYOFF FOR SELLER OF FUTURES: SHORT FUTURES Profit + 500 5500 6000 6500 Diamond - 500 Loss The investor sells diamond at Rs. 6000 per 10 gms. If the price of diamond falls, he makes profits. If price of diamond raises he makes loses. PAYOFF FOR OPTIONS PAYOFF FOR BUYER OF CALL OPTION ON DIAMOND The figure shows the profits/ losses for the buyer of a three-month call option on diamond at a strike of Rs.7000 per 10 gms. As can be seen, as the prices of diamond rise in the spot market, the call option becomes in-the-money. If upon expiration, diamond trades above the strike of Rs.7000, the buyer would exercise his option and profit to the extent of the difference between the spot diamond -close and the strike price. The profits possible on this option are potentially unlimited. However if the price of diamond falls below the strike of Rs.7000, he lets the option expire. His losses are limited to the extent of the premium he paid for buying the option. PAYOFF FOR WRITER OF CALL OPTION ON DIAMOND The figure shows the profits/ losses for the seller of a three-month call option on diamond with a strike price of Rs.7000 per 10 gms. As the price of diamond in the spot market rises, the call option becomes in-the-money and the writer starts making losses. If upon expiration, diamond price is above the strike of Rs.7000, the buyer would exercise his option on the writer who would suffer a loss to the extent of the difference between the spot diamond -close and the strike price. The loss that can be incurred by the writer of the option is potentially unlimited, whereas the maximum profit is limited to the extent of the up-front option premium of Rs.500 charged by him. PAYOFF FOR BUYER OF PUT OPTION ON DIAMOND The figure shows the profits/ losses for the buyer of a three-month put option on diamond. As can be seen, as the price of diamond in the spot market falls, the put option becomes in-the-money. If at expiration, diamond prices fall below the strike of Rs.6000 per 10 gm, the buyer would exercise his option and profit to the extent of the difference between the strike price and diamond -close. The profits possible on this option can be as high as the strike price. However if spot price of diamond on the day of expiration of the contract is above the strike of Rs.6000, he lets the option expire. His losses are limited to the extent of the premium he paid for buying the option, Rs.400 in this case. sold at a premium of Rs.400 PAYOFF FOR WRITER OF PUT OPTION ON DIAMOND The figure shows the profits/ losses for the seller of a three-month put option on diamond. As the price of diamond in the spot market falls, the put option becomes in-the-money and the writer starts making losses. If upon expiration, diamond prices fall below the strike of Rs.6000 per 10 grms, the buyer would exercise his option on the writer who would suffer a loss to the extent of the difference between the strike price and spot diamond -close. The profit that can be made by the writer of the option is limited to extent of the premium received by him, i.e. Rs.400, whereas the losses are unlimited (actually they are limited to the strike price since the worst that can happen is that the price of the underlying asset falls to zero. RISK RESOLVED There are a number of applications that stakeholders could use the new contracts for which are described below: Mining or Polishing Company A mining company with the expectation that prices are going to fall in the future can sell the futures thereby establishing a higher selling price for their output and locking in some additional profit that can later be used to offset losses or reduced profits on the sale of their physical stones at the future lower price. Jewelry Company A buyer of polished stones with the expectation of price rises can establish a lower buying price for stones by buying the future and holding it pass first notice date so that he is delivered the basket of stones at the price that he purchased the future, less the funding differential between the cost of borrowing the funds and the interest received on the cash margin placed with the futures’ clearer. HEDGING OF DIAMOND INVENTORY Anyone holding diamond inventory by its nature can only be long stones, a future will offer a way for a trader to be able to take short positions in diamonds in the same way as a short sale does in the equity market. Providing the diamantine rolls his future position before first notice date on the future he can maintain the short position and is not required to deliver stones. By shorting an index diamond future a diamantine would be able to have a proxy hedge against a decline in the value of their inventory, for the financing cost of the margins he would need to post with the exchange. MANAGERIAL STRATEGIES: Below mentioned strategies can be applied by the participents to minimize the risk due to flactiation of diamond price. COVERED CALL The Pay-off Chart (Covered Call) + = BUY DIAMOND SELL CALLCOVERED CALL Example Mr. A bought diamond future for Rs 3850 and simultaneously sells a Call option at an strike price ofRs 4000. Which means Mr. A does not think that the price of diamond . will rise aboveRs. 4000. However, incase it rises above Rs.4000, Mr. A does not mind getting exercisedat that price and exiting the diamond at Rs. 4000(TARGET SELL PRICE = 3.90% return on thestock purchase price). Mr. A receives a premium of Rs 80 for selling the Call. Thus net outflow to Mr. A is (Rs. 3850 – Rs. 80) = Rs. 3770. He reduces the cost of buying the diamond by this strategy. If the diamond price stays at or below Rs. 4000, the Call option will not get exercised and Mr. A can retain the Rs. 80 premium, which is an extra income. If the diamond price goes above Rs 4000, the Call option will get exercised by the Call buyer. The entire position will work like this : Strategy : Buy diamond future + Sell Call Option Mr. A buys the Diamond Future Market Price (Rs.) 3850 Call Options Strike Price (Rs.) 4000 Mr. A receives Premium (Rs.) 80 Break Even Point (Rs.)3770 (Stock Price paid - Premium Received) The payoff schedule Diamond price closes at (Rs.) Net Payoff(Rs.) 3600 170 3700 70 3740 30 3770 0 3800 30 3900 130 4000 230 4100 230 4200 230 4300 230 LONG COMBO : SELL A PUT,BUY A CALL The Payoff Chart (Long Combo) + = SELL PUTBUY CALL LONG COMBO A diamond is trading at Rs. 450. Mr. XYZ is bullish on the diamond. But does not want to invest Rs.450. He does a Long Combo. He sells a Put option with a strike price Rs. 400 at a premium of Rs. 1.00 and buys a Call Option with a strike price of Rs. 500 at a premium of Rs. 2. The net cost of the strategy (netdebit) is Rs. 1.Strategy : Sell a Put + Buy a Call Diamond Current Market Price (Rs.)450 Sells Put Strike Price (Rs.) 400 Mr. XYZ receives Premium (Rs.) 1.00 Buys Call Strike Price (Rs.) 500 Mr. XYZ pays Premium (Rs.) 2.00 Net Debit (Rs.) 1.00 Break Even Point (Rs.) (Higher Strike + Net Debit) Rs. 501 The payoff schedule diamoand closes (Rs.) Net Payoff fromthe Net Payoff from the Net Payoff(Rs.) Put Sold(Rs.) Call purchased 700 1 198 199 650 1 148 149 600 1 98 99 550 1 48 49 501 1 -1 0 500 1 -2 -1 450 1 -2 -1 400 1 -2 -1 350 -49 -2 -51 300 -99 -2 -101 250 -149 -2 -151 LONG STRADDLE The Payoff Chart (Long Straddle) + = BUY PUTBUY CALL LONG STRADDLE Suppose diamond is at 4450 on 27th April. An investor, Mr. A enters a long straddle by buying a May Rs 4500 diamond Put for Rs. 85 and a May Rs. 4500 diamond Call for Rs. 122. The net debit taken to enter the trade is Rs 207, which is also his maximum possible loss. Strategy : Buy Put + Buy Call Diamond Current Value 4450 Call and Put Strike Price (Rs.) 4500 Mr. A pays Total Premium (Call + Put) (Rs.)207 Break Even Point(Rs.)4707(U)(Rs.) 4293(L) SHORT STRADDLE The Payoff Chart (Short Straddle) + = SELL PUTSELL CALLSHORT STRADDLE Example Suppose diamond is at 4450 on 27th April. An investor, Mr. A, enters into a short straddle by selling a May Rs 4500 diamond Put for Rs. 85 and a May Rs. 4500 diamond Call for Rs. 122. The net credit received is Rs. 207, which is also his maximum possible profit. Strategy : Sell Put + Sell Call Nifty index Current Value 4450 Call and Put Strike Price (Rs.) 4500 Mr. A receives Total Premium(Call + Put) (Rs.)207 Break Even Point(Rs.)*4707(U)(Rs.)* 4293(L) LONG STRANGLE The Payoff Chart (Long Strangle) += BUY OTM PUT BUY OTM CALL LONG STRANGLE Suppose diamond is at 4500 in May. An investor, Mr.A, executes a Long Strangle by buying a Rs. 4300 diamond Put for a premium of Rs. 23 and a Rs 4700 diamond Call for Rs 43. The net debit taken to enter the trade is Rs. 66, which is also his maximum possible loss. Strategy : Buy OTM Put + Buy OTM Call Diamond Current Value 4500 Buy Call Option Strike Price (Rs.) 4700 Mr. A pays Premium (Rs.) 43 Break Even Point (Rs.)4766 Buy Put Option Strike Price (Rs.) 4300 Mr. A pays Premium (Rs.) 23 Break Even Point (Rs.)4234 SHORT STRANGLE The Payoff Chart (Short Strangle) + = SELL OTM PUT SELL OTM CALLSHORT STRANGLE Suppose diamond is at 4500 in May. An investor, Mr. A, executes a Short Strangle by selling a Rs. 4300 diamond Put for a premium of Rs. 23 and a Rs.4700 diamond Call for Rs 43. The net credit is Rs.66, which is also his maximum possible gain. Strategy : Sell OTM Put + Sell OTM Call Diamond Current Value 4500 Sell Call Option Strike Price (Rs.) 4700 Mr. A receives Premium (Rs.) 43 Break Even Point (Rs.)4766 Sell Put Option Strike Price (Rs.) 4300 Mr. A receives Premium (Rs.) 23 Break Even Point (Rs.)4234 LONG CALL BUTTERFLY: SELL 2 ATM CALL OPTIONS, BUY 1 ITM CALL OPTION AND BUY 1 OTM CALL OPTION The Payoff Chart (Long Call Butterfly) + + = BUY LOWERSELL MIDDLE SELL MIDDLEBUY HIGHER LONG CALLSTRIKE CALLSTRIKE CALL STRIKE CALL STRIKE CALL BUTTERFLY Example: Diamond is at 3200. Mr. XYZ expects very little movement in diamond. He sells 2 ATM diamond Call Options with a strike price of Rs. 3200 at a premium of Rs. 97.90 each, buys 1 ITM diamond Call Option with a strike price of Rs. 3100 at apremium of Rs. 141.55 and buys 1 OTM diamond Call Option with a strike price of Rs. 3300 at a premium of Rs. 64. The Net debit is Rs. 9.75. STRATEGY : SELL 2 ATM CALL, BUY 1 ITM CALL OPTION AND BUY 1 OTM CALL OPTION Diamond Current Value 3200 Sell 2 ATM Call Option Strike Price (Rs.) 3200 Mr. XYZ receives Premium (Rs.) 195.80 Buy 1 ITM Call Option Strike Price (Rs.) 3100 Mr. XYZ pays Premium (Rs.) 141.55 Buy 1 OTM Call Option Strike Price (Rs.) 3300 Mr. XYZ pays Premium (Rs.) 64 Break Even Point (Rs.)3290.25 Break Even Point (Lower) (Rs.)3109.75 SHORT CALL BUTTERFLY: BUY2 ATM CALL OPTIONS, SELL 1 ITM CALL OPTION AND SELL 1 OTM CALL OPTION The Payoff Chart (Short Call Butterfly) + + = SELL LOWERBUY MIDDLEBUY MIDDLESELL HIGHER SHORT CALL STRIKE CALLSTRIKE CALLSTRIKE CALLSTRIKE CALL BUTTERFLY Diamond is at 3200. Mr. XYZ expects large volatility in the Diamond irrespective of which direction the movement is, upwards or downwards. Mr. XYZ buys 2 ATM Diamond Call Options with a strike price of Rs. 3200 at a premium of Rs. 97.90 each, sells 1 ITM diamond Call Option with a strike price of Rs. 3100 at a premium of Rs. 141.55 and sells 1OTM Diamond Call Option with a strike price of Rs. 3300 at a premium of Rs. 64. The Net Credit is Rs. 9.75. STRATEGY BUY 2 ATM CALL OPTIONS, SELL 1 ITM CALL OPTION AND SELL 1 OTM CALL OPTION. Diamond Current Market Price 3200 Buy 2 ATM Call Option Strike Price (Rs.) 3200 Mr. XYZ pays Premium (Rs.) 195.80 Sells 1 ITM Call Option Strike Price (Rs.) 3100 Mr. XYZ receives Premium (Rs.) 141.55 Sells 1 OTM Call Option Strike Price (Rs.) 3300 Mr. XYZ receives Premium (Rs.) 64 Break Even Point(Upper) (Rs.)3290.25 Break Even Point(Lower) (Rs.)3109.75 PROS AND CONS OF DIAMOND DERIVATIVE TRADING IN INDIA Pros 
Natural linkages with the industry
Market players to provide liquidity
Commodity Exchanges and Electronic trading platforms available
Provides arbitrage opportunities if listed elsewhere internationally
Cons 
Entry restrictions for foreign players
Initial regulatory interference
Option trading is not allowed in commodity trading.
APPENDIX: Polling- Get the price qoute by taking phone call from different participent.It can be done one to three times a day depending upon the volatility of the commodity. BOOTSTRAPING METHOD: For taking price 10-30 sources (including traders, millers, whole sellers, exporters, importers, and different service provider etc.) are selected. In case of higher price volatility, price are polled from large number of participants. In some commodities like menthe oil, potato, pulses prices is polled from minimum 30 sources. The collected BID and ASK quotes are sorted in ascending order. Depending on the market convention the participant provides both BID and ASK quotes or only the ask quote. Extreme quotes are trimmed from the total quote with the the help of the software using an adaptive procedure. Trimming of quotes depends upon the sample size on a given date. Larger the sample size, more number of quotes are trimmed. These value are sampled with replacement multiple number of times, where software gives different averages with their standard deviation. The average with least standard deviation will be determined and disseminated as bootstrapped price. Let us take an example NAMENUMBERPRICE(Rs)REMARKSA1111111200A2222221205A3333331206A4444441200A5555551205A6666661209EliminatedA7777771195EliminatedA8888881206A9999991205Spot Price1203.85 Here out of the range prices i.e. Rs 1209 and Rs 1195 are eliminated from the polled prices and average of remaining prices taken i.e. Rs 1203.85. BIBLIOGRAPHY We have collected information from the following website: www.fmc.gov.in www.mcxindia.com www.ncdex.com

Diamond Derivative

by skyranger_007

Accessibility

Categories

Upload Details

Usage Rights

1 Embed 1

Statistics

Diamond Derivative Document Transcript