Forwards <ul><li>A forward contract is a customized contract between two entities, where settlement takes place as a specific date in the future at predetermined price. </li></ul>Ex: On 10th Novem, Ram enters into an agreement to buy 100 kgs of wheat on 1st May at Rs.10000 from Shyam, a farmer. It is a case of a forward contract where Ram has to pay Rs.10000 on 1st May to Shyam and Shyam has to supply 100 kgs of wheat. Ram has taken a long position assuming the price of the wheat will rise in the future six months . <ul><li>Normally traded outside exchange </li></ul>
Futures <ul><li>A financial contract obligating the buyer to purchase an asset, (or the seller to sell an asset), such as a physical commodity or a financial instrument, at a predetermined future date and price.
Futures contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures exchange.
Some futures contracts may call for physical delivery of the asset, while others are settled in cash. The futures markets are characterized by the ability to use very high leverage relative to stock markets.
Some of the most popular assets on which futures contracts are available are equity stocks, indices, commodities and currency. </li></ul>
Swaps <ul><li>Swaps are private agreement between two parties to exchange cash flows in the future according to a pre-arranged formula.
They can be regarded as portfolio of forward contracts.
The two commonly used Swaps are- </li></ul>i) Interest Rate Swaps: - A interest rate swap entails swapping only the interest related cash flows between the parties in the same currency. ii) Currency Swaps: - A currency swap is a foreign exchange agreement between two parties to exchange a given amount of one currency for another and after a specified period of time, to give back the original amount swapped.
Options… The owner of the option has option to sell or buy assets at a given price on or before given date . Options Put Option Call Option A right to sell the underlying assets , not a obligation A right to buy the underlying assets , not a obligation
American Option An option that may be exercised on any trading day on or before expiry . European Option An option that may only be exercised on expiry date
Important Concepts of Option <ul><li>In-the money </li></ul>A call option said to be in the money, when Future price> Option’s strike price A put option said to be in the money, when Future price < Option’s strike price <ul><li>At- the money </li></ul>A option is at the price, when Future price = Option’s strike price <ul><li>Out of the money </li></ul>A call option said to be out of the money, when Future price < Option’s strike price A put option said to be out of the money, when Future price > Option’s strike price
Types of Derivatives Markets Over-the-Counter derivatives- <ul><li>Contracts that are traded between two parties directly without going through a exchange.
Forward and swap contracts are OTC derivatives. </li></ul>Exchange -traded derivatives- <ul><li>Contracts that are traded in derivatives exchanges </li></ul>
Market Players <ul><li>Hedgers -Transfer of risk component of their portfolio. </li></ul><ul><li>Speculators - Intentionally taking the risk from the hedgers in pursuit of profit. </li></ul><ul><li>Arbitrageurs -Operating in different markets simultaneously, in pursuit of profit and eliminate mis-pricing. </li></ul>
Terminology <ul><li>Spot price- the price at which an assets trades in a spot markets.
Future price- the price at which the future contracts trades in future markets.
Strike price- the price specified in the option contract
Expiry date- the date specified in future and option contracts.
Contract size- the amount of assets that has to be delivered under one contract.
Derivatives users in India... Financial Institution- <ul><li>Financial Institution have not been heavy users of exchanges traded derivatives.
Financial Institution contribution to NSE trade being less than 8% in October 2005
Banks use derivatives on interest rates and currencies to manage credit risk
Non financial institution are regulated differently from financial institution, and this affects their incentives to use derivatives
Foreign Investor must register as FII to trade equity derivatives and be subject to position limit as specified by SEBI </li></ul>Retails Investor- <ul><li>Retail Investor are the major participants in equity derivatives .
Retail Investor are familiar with “BADLA” trade which shared some features of derivatives trading.
Retails Investor also dominate the market of commodity derivatives for their long-standing expertise in trading . </li></ul>
Regulatory Framework in India <ul><li>Regulatory framework in India is based on International Organization of Securities Commissions (IOSCO) principles. </li></ul><ul><li>L.C. Gupta committee provided regulatory responsibility between SEBI and exchange. </li></ul><ul><li>J.R. Verma committee reports suggested a methodology for risk containment. </li></ul>
L C Gupta Committee states…. Derivatives Exchanges: <ul><li>Existing exchanges may start Derivatives segments or separate exchanges may be set up