Derivatives

DerivativesPEOPLE FOR INDEX PLEASE REFER OTHERATTACHMENT. SORRY FOR THE INCONVENIENCE CHAPTER – 1  INTRODUCTION TO DERIVATIVES  DEFINITION OF DERIVATIVES 1

Derivatives CHAPTER 1INTRODUCTION : Derivatives are one of the most complex instruments. Theword derivative comes from the word „to derive‟. It indicates that it has noindependent value. A derivative is a contract whose value is derived fromthe value of another asset, known as the underlying asset, which could bea share, a stock market index, an interest rate, a commodity, or acurrency. The underlying is the identification tag for a derivative contract.When the price of the underlying changes, the value of the derivative alsochanges. Without an underlying asset, derivatives do not have anymeaning. For example, the value of a gold futures contract derives fromthe value of the underlying asset i.e., gold. The prices in the derivativesmarket are driven by the spot or cash market price of the underlying asset,which is gold in this example. Derivatives are very similar to insurance. Insurance protectsagainst specific risks, such as fire, floods, theft and so on. Derivatives on 2

Derivativesthe other hand, take care of market risks - volatility in interest rates,currency rates, commodity prices, and share prices. Derivatives offer asound mechanism for insuring against various kinds of risks arising in theworld of finance. They offer a range of mechanisms to improveredistribution of risk, which can be extended to every product existing,from coffee to cotton and live cattle to debt instruments. In this era of globalisation, the world is a riskier place andexposure to risk is growing. Risk cannot be avoided or ignored. Man,however is risk averse. The risk averse characteristic of human beingshas brought about growth in derivatives. Derivatives help the risk averseindividuals by offering a mechanism for hedging risks. Derivative products, several centuries ago, emerged ashedging devices against fluctuations in commodity prices. Commodityfutures and options have had a lively existence for several centuries.Financial derivatives came into the limelight in the post-1970 period; todaythey account for 75 percent of the financial market activity in Europe,North America, and East Asia. The basic difference between commodityand financial derivatives lies in the nature of the underlying instrument. Incommodity derivatives, the underlying asset is a commodity; it may bewheat, cotton, pepper, turmeric, corn, orange, oats, Soya beans, rice,crude oil, natural gas, gold, silver, and so on. In financial derivatives, theunderlying includes treasuries, bonds, stocks, stock index, foreignexchange, and Euro dollar deposits. The market for financial derivativeshas grown tremendously both in terms of variety of instruments andturnover. 3

Derivatives Presently, most major institutional borrowers and investorsuse derivatives. Similarly, many act as intermediaries dealing in derivativetransactions. Derivatives are responsible for not only increasing the rangeof financial products available but also fostering more precise ways ofunderstanding, quantifying and managing financial risk. Derivatives contracts are used to counter the price risksinvolved in assets and liabilities. Derivatives do not eliminate risks. Theydivert risks from investors who are risk averse to those who are riskneutral. The use of derivatives instruments is the part of the growing trendamong financial intermediaries like banks to substitute off-balance sheetactivity for traditional lines of business. The exposure to derivatives bybanks have implications not only from the point of capital adequacy, butalso from the point of view of establishing trading norms, business rulesand settlement process. Trading in derivatives differ from that in equitiesas most of the derivatives are market to the market.DEFINITION OF DERIVATIVES : Derivative is a product whose value is derived from the valueof one or more basic variables, called bases (underlying asset, index, orreference rate), in a contractual manner. The underlying asset can beequity, forex, commodity or any other asset. 4

Derivatives According to Securities Contracts (Regulation) Act, 1956{SC(R)A}, derivatives is  A security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security.  A contract which derives its value from the prices, or index of prices, of underlying securities. Derivatives are securities under the Securities Contract(Regulation) Act and hence the trading of derivatives is governed by theregulatory framework under the Securities Contract (Regulation) Act. 5

Derivatives CHAPTER – 2 HISTORY OF DERIVATIVES DERIVATIVES IN INDIA DEVELOPMENT OF DERIVATIVES MARKET IN INDIA 6

Derivatives  Factors contributing to the growth of derivatives CHAPTER 2HISTORY OF DERIVATIVES : The history of derivatives is quite colourful and surprisingly alot longer than most people think. Forward delivery contracts, stating whatis to be delivered for a fixed price at a specified place on a specified date,existed in ancient Greece and Rome. Roman emperors entered forwardcontracts to provide the masses with their supply of Egyptian grain. Thesecontracts were also undertaken between farmers and merchants toeliminate risk arising out of uncertain future prices of grains. Thus, forwardcontracts have existed for centuries for hedging price risk. 7

Derivatives The first organized commodity exchange came intoexistence in the early 1700‟s in Japan. The first formal commoditiesexchange, the Chicago Board of Trade (CBOT), was formed in 1848 inthe US to deal with the problem of „credit risk‟ and to provide centralisedlocation to negotiate forward contracts. From „forward‟ trading incommodities emerged the commodity „futures‟. The first type of futurescontract was called „to arrive at‟. Trading in futures began on the CBOT inthe 1860‟s. In 1865, CBOT listed the first „exchange traded‟ derivativescontract, known as the futures contracts. Futures trading grew out of theneed for hedging the price risk involved in many commercial operations.The Chicago Mercantile Exchange (CME), a spin-off of CBOT, wasformed in 1919, though it did exist before in 1874 under the names of‘Chicago Produce Exchange’ (CPE) and ‘Chicago Egg and ButterBoard’ (CEBB). The first financial futures to emerge were the currency in1972 in the US. The first foreign currency futures were traded on May 16,1972, on International Monetary Market (IMM), a division of CME. Thecurrency futures traded on the IMM are the British Pound, the CanadianDollar, the Japanese Yen, the Swiss Franc, the German Mark, theAustralian Dollar, and the Euro dollar. Currency futures were followedsoon by interest rate futures. Interest rate futures contracts were traded forthe first time on the CBOT on October 20, 1975. Stock index futures andoptions emerged in 1982. The first stock index futures contracts weretraded on Kansas City Board of Trade on February 24, 1982. The first of the several networks, which offered a trading linkbetween two exchanges, was formed between the Singapore 8

DerivativesInternational Monetary Exchange (SIMEX) and the CME on September7, 1984. Options are as old as futures. Their history also dates backto ancient Greece and Rome. Options are very popular with speculators inthe tulip craze of seventeenth century Holland. Tulips, the brightlycoloured flowers, were a symbol of affluence; owing to a high demand,tulip bulb prices shot up. Dutch growers and dealers traded in tulip bulboptions. There was so much speculation that people even mortgaged theirhomes and businesses. These speculators were wiped out when the tulipcraze collapsed in 1637 as there was no mechanism to guarantee theperformance of the option terms. The first call and put options were invented by an Americanfinancier, Russell Sage, in 1872. These options were traded over thecounter. Agricultural commodities options were traded in the nineteenthcentury in England and the US. Options on shares were available in theUS on the over the counter (OTC) market only until 1973 without muchknowledge of valuation. A group of firms known as Put and Call brokersand Dealer‟s Association was set up in early 1900‟s to provide amechanism for bringing buyers and sellers together. On April 26, 1973, the Chicago Board options Exchange(CBOE) was set up at CBOT for the purpose of trading stock options. Itwas in 1973 again that black, Merton, and Scholes invented the famousBlack-Scholes Option Formula. This model helped in assessing the fairprice of an option which led to an increased interest in trading of options. 9

DerivativesWith the options markets becoming increasingly popular, the AmericanStock Exchange (AMEX) and the Philadelphia Stock Exchange (PHLX)began trading in options in 1975. The market for futures and options grew at a rapid pace inthe eighties and nineties. The collapse of the Bretton Woods regime offixed parties and the introduction of floating rates for currencies in theinternational financial markets paved the way for development of anumber of financial derivatives which served as effective risk managementtools to cope with market uncertainties. The CBOT and the CME are two largest financial exchangesin the world on which futures contracts are traded. The CBOT now offers48 futures and option contracts (with the annual volume at more than 211million in 2001).The CBOE is the largest exchange for trading stockoptions. The CBOE trades options on the S&P 100 and the S&P 500 stockindices. The Philadelphia Stock Exchange is the premier exchange fortrading foreign options. The most traded stock indices include S&P 500, the DowJones Industrial Average, the Nasdaq 100, and the Nikkei 225. The USindices and the Nikkei 225 trade almost round the clock. The N225 is alsotraded on the Chicago Mercantile Exchange.DERIVATIVES IN INDIA : 10

Derivatives India has started the innovations in financial markets verylate. Some of the recent developments initiated by the regulatoryauthorities are very important in this respect. Futures trading have beenpermitted in certain commodity exchanges. Mumbai Stock Exchange hasstarted futures trading in cottonseed and cotton under the BOOE andunder the East India Cotton Association. Necessary infrastructure hasbeen created by the National Stock Exchange (NSE) and the BombayStock Exchange (BSE) for trading in stock index futures and thecommencement of operations in selected scripts. Liberalised exchangerate management system has been introduced in the year 1992 forregulating the flow of foreign exchange. A committee headed byS.S.Tarapore was constituted to go into the merits of full convertibility oncapital accounts. RBI has initiated measures for freeing the interest ratestructure. It has also envisioned Mumbai Inter Bank Offer Rate (MIBOR)on the line of London Inter Bank Offer Rate (LIBOR) as a step towardsintroducing Futures trading in Interest Rates and Forex. Badlatransactions have been banned in all 23 stock exchanges from July 2001.NSE has started trading in index options based on the NIFTY and certainStocks.A.} EQUITY DERIVATIVES IN INDIA – In the decade of 1990‟s revolutionary changes took place inthe institutional infrastructure in India‟s equity market. It has led to whollynew ideas in market design that has come to dominate the market. Thesenew institutional arrangements, coupled with the widespread knowledgeand orientation towards equity investment and speculation, have 11

Derivativescombined to provide an environment where the equity spot market is nowIndia‟s most sophisticated financial market. One aspect of thesophistication of the equity market is seen in the levels of market liquiditythat are now visible. The market impact cost of doing program trades ofRs.5 million at the NIFTY index is around 0.2%. This state of liquidity onthe equity spot market does well for the market efficiency, which will beobserved if the index futures market when trading commences. India‟sequity spot market is dominated by a new practice called „Futures – Stylesettlement‟ or account period settlement. In its present scene, trades onthe largest stock exchange (NSE) are netted from Wednesday morning tillTuesday evening, and only the net open position as of Tuesday evening issettled. The future style settlement has proved to be an ideal launchingpad for the skills that are required for futures trading. Stock trading is widely prevalent in India, hence it seemseasy to think that derivatives based on individual securities could be veryimportant. The index is the counter piece of portfolio analysis in modernfinancial economies. Index fluctuations affect all portfolios. The index ismuch harder to manipulate. This is particularly important given theweaknesses of Law Enforcement in India, which have made numerousmanipulative episodes possible. The market capitalisation of the NSE-50index is Rs.2.6 trillion. This is six times larger than the marketcapitalisation of the largest stock and 500 times larger than stocks such asSterlite, BPL and Videocon. If market manipulation is used to artificiallyobtain 10% move in the price of a stock with a 10% weight in the NIFTY,this yields a 1% in the NIFTY. Cash settlements, which is universally usedwith index derivatives, also helps in terms of reducing the vulnerability to 12

Derivativesmarket manipulation, in so far as the „short-squeeze‟ is not a problem.Thus, index derivatives are inherently less vulnerable to marketmanipulation. A good index is a sound trade of between diversification andliquidity. In India the traditional index- the BSE – sensitive index wascreated by a committee of stockbrokers in 1986. It predates a modernunderstanding of issues in index construction and recognition of thepivotal role of the market index in modern finance. The flows of this indexand the importance of the market index in modern finance, motivated thedevelopment of the NSE-50 index in late 1995. Many mutual funds havenow adopted the NIFTY as the benchmark for their performanceevaluation efforts. If the stock derivatives have to come about, the shouldrestricted to the most liquid stocks. Membership in the NSE-50 indexappeared to be a fair test of liquidity. The 50 stocks in the NIFTY areassuredly the most liquid stocks in India. The choice of Futures vs. Options is often debated. Thedifference between these instruments is smaller than, commonlyimagined, for a futures position is identical to an appropriately chosen longcall and short put position. Hence, futures position can always be createdonce options exist. Individuals or firms can choose to employ positionswhere their downside and exposure is capped by using options. Riskmanagement of the futures clearing is more complex when options are inthe picture. When portfolios contain options, the calculation of initial pricerequires greater skill and more powerful computers. The skills required forpricing options are greater than those required in pricing futures. 13

DerivativesB.} COMMODITY DERIVATIVES TRADING IN INDIA – In India, the futures market for commodities evolved by thesetting up of the “Bombay Cotton Trade Association Ltd.”, in 1875. Aseparate association by the name "Bombay Cotton Exchange Ltd” wasestablished following widespread discontent amongst leading cotton millowners and merchants over the functioning of the Bombay Cotton TradeAssociation. With the setting up of the „Gujarati Vyapari Mandali” in 1900,the futures trading in oilseed began. Commodities like groundnut, castorseed and cotton etc began to be exchanged. Raw jute and jute goods began to be traded in Calcutta withthe establishment of the “Calcutta Hessian Exchange Ltd.” in 1919. Themost notable centres for existence of futures market for wheat were theChamber of Commerce at Hapur, which was established in 1913. Othermarkets were located at Amritsar, Moga, Ludhiana, Jalandhar, Fazilka,Dhuri, Barnala and Bhatinda in Punjab and Muzaffarnagar, Chandausi,Meerut, Saharanpur, Hathras, Gaziabad, Sikenderabad and Barielly inU.P. The Bullion Futures market began in Bombay in 1990. After theeconomic reforms in 1991 and the trade liberalization, the Govt. of Indiaappointed in June 1993 one more committee on Forward Markets underChairmanship of Prof. K.N. Kabra. The Committee recommended thatfutures trading be introduced in basmati rice, cotton, raw jute and jutegoods, groundnut, rapeseed/mustard seed, cottonseed, sesame seed,sunflower seed, safflower seed, copra and soybean, and oils and oilcakesof all of them, rice bran oil, castor oil and its oilcake, linseed, silver and 14

Derivativesonions. All over the world commodity trade forms the major backbone ofthe economy. In India, trading volumes in the commodity market have alsoseen a steady rise - to Rs 5,71,000 crore in FY05 from Rs 1,29,000 crorein FY04. In the current fiscal year, trading volumes in the commoditymarket have already crossed Rs 3,50,000 crore in the first four months oftrading. Some of the commodities traded in India include AgriculturalCommodities like Rice Wheat, Soya, Groundnut, Tea, Coffee, Jute,Rubber, Spices, Cotton, Precious Metals like Gold & Silver, Base Metalslike Iron Ore, Aluminium, Nickel, Lead, Zinc and Energy Commodities likecrude oil, coal. Commodities form around 50% of the Indian GDP. Thoughthere are no institutions or banks in commodity exchanges, as yet, themarket for commodities is bigger than the market for securities.Commodities market is estimated to be around Rs 44,00,000 Crores infuture. Assuming a future trading multiple is about 4 times the physicalmarket, in many countries it is much higher at around 10 times.DEVELOPMENT OF DERIVATIVES MARKET IN INDIA : The first step towards introduction of derivatives trading inIndia was the promulgation of the Securities Laws (Amendment)Ordinance, 1995, which withdrew the prohibition on options in securities.The market for derivatives, however, did not take off, as there was noregulatory framework to govern trading of derivatives. SEBI set up a 24–member committee under the Chairmanship of Dr.L.C.Gupta onNovember 18, 1996 to develop appropriate regulatory framework forderivatives trading in India. The committee submitted its report on March 15

Derivatives17, 1998 prescribing necessary pre–conditions for introduction ofderivatives trading in India. The committee recommended that derivativesshould be declared as „securities‟ so that regulatory framework applicableto trading of „securities‟ could also govern trading of securities. SEBI alsoset up a group in June 1998 under the Chairmanship of Prof.J.R.Varma, torecommend measures for risk containment in derivatives market in India.The report, which was submitted in October 1998, worked out theoperational details of margining system, methodology for charging initialmargins, broker net worth, deposit requirement and real–time monitoringrequirements. The Securities Contract Regulation Act (SCRA) wasamended in December 1999 to include derivatives within the ambit of„securities‟ and the regulatory framework was developed for governingderivatives trading. The act also made it clear that derivatives shall belegal and valid only if such contracts are traded on a recognized stockexchange, thus precluding OTC derivatives. The government alsorescinded in March 2000, the three decade old notification, whichprohibited forward trading in securities. Derivatives trading commenced inIndia in June 2000 after SEBI granted the final approval to this effect inMay 2001. SEBI permitted the derivative segments of two stockexchanges, NSE and BSE, and their clearing house/corporation tocommence trading and settlement in approved derivatives contracts. Tobegin with, SEBI approved trading in index futures contracts based onS&P CNX Nifty and BSE–30 (Sense) index. This was followed by approvalfor trading in options based on these two indexes and options onindividual securities. 16

Derivatives The trading in BSE Sensex options commenced on June 4,2001 and the trading in options on individual securities commenced in July2001. Futures contracts on individual stocks were launched in November2001. The derivatives trading on NSE commenced with S&P CNX NiftyIndex futures on June 12, 2000. The trading in index options commencedon June 4, 2001 and trading in options on individual securitiescommenced on July 2, 2001. Single stock futures were launched onNovember 9, 2001. The index futures and options contract on NSE arebased on S&P CNX Trading and settlement in derivative contracts is donein accordance with the rules, byelaws, and regulations of the respectiveexchanges and their clearing house/corporation duly approved by SEBIand notified in the official gazette. Foreign Institutional Investors (FIIs) arepermitted to trade in all Exchange traded derivative products. The following are some observations based on the tradingstatistics provided in the NSE report on the futures and options (F&O):• Single-stock futures continue to account for a sizable proportion of the F&O segment. It constituted 70 per cent of the total turnover during June 2002. A primary reason attributed to this phenomenon is that traders are comfortable with single-stock futures than equity options, as the former closely resembles the erstwhile badla system.• On relative terms, volumes in the index options segment continues to remain poor. This may be due to the low volatility of the spot index. Typically, options are considered more valuable when the 17

Derivatives volatility of the underlying (in this case, the index) is high. A related issue is that brokers do not earn high commissions by recommending index options to their clients, because low volatility leads to higher waiting time for round-trips.• Put volumes in the index options and equity options segment have increased since January 2002. The call-put volumes in index options have decreased from 2.86 in January 2002 to 1.32 in June. The fall in call-put volumes ratio suggests that the traders are increasingly becoming pessimistic on the market.• Farther month futures contracts are still not actively traded. Trading in equity options on most stocks for even the next month was non- existent.• Daily option price variations suggest that traders use the F&O segment as a less risky alternative (read substitute) to generate profits from the stock price movements. The fact that the option premiums tail intra-day stock prices is evidence to this. If calls and puts are not looked as just substitutes for spot trading, the intra-day stock price variations should not have a one-to-one impact on the option premiums.FACTORS CONTRIBUTING TO THE GROWTH OFDERIVATIVES : 18

Derivatives Factors contributing to the explosive growth of derivativesare price volatility, globalisation of the markets, technologicaldevelopments and advances in the financial theories.A.} PRICE VOLATILITY – A price is what one pays to acquire or use something ofvalue. The objects having value maybe commodities, local currency orforeign currencies. The concept of price is clear to almost everybodywhen we discuss commodities. There is a price to be paid for thepurchase of food grain, oil, petrol, metal, etc. the price one pays for use ofa unit of another persons money is called interest rate. And the price onepays in one‟s own currency for a unit of another currency is called as anexchange rate. Prices are generally determined by market forces. In amarket, consumers have „demand‟ and producers or suppliers have„supply‟, and the collective interaction of demand and supply in the marketdetermines the price. These factors are constantly interacting in themarket causing changes in the price over a short period of time. Suchchanges in the price is known as „price volatility‟. This has three factors :the speed of price changes, the frequency of price changes and themagnitude of price changes. The changes in demand and supply influencing factorsculminate in market adjustments through price changes. These pricechanges expose individuals, producing firms and governments to 19

Derivativessignificant risks. The break down of the BRETTON WOODS agreementbrought and end to the stabilising role of fixed exchange rates and thegold convertibility of the dollars. The globalisation of the markets and rapidindustrialisation of many underdeveloped countries brought a new scaleand dimension to the markets. Nations that were poor suddenly became amajor source of supply of goods. The Mexican crisis in the south east-Asian currency crisis of 1990‟s have also brought the price volatility factoron the surface. The advent of telecommunication and data processingbought information very quickly to the markets. Information which wouldhave taken months to impact the market earlier can now be obtained inmatter of moments. Even equity holders are exposed to price risk ofcorporate share fluctuates rapidly. These price volatility risk pushed the use of derivatives likefutures and options increasingly as these instruments can be used ashedge to protect against adverse price changes in commodity, foreignexchange, equity shares and bonds.B.} GLOBALISATION OF MARKETS – Earlier, managers had to deal with domestic economicconcerns ; what happened in other part of the world was mostly irrelevant.Now globalisation has increased the size of markets and as greatlyenhanced competition .it has benefited consumers who cannot obtainbetter quality goods at a lower cost. It has also exposed the modernbusiness to significant risks and, in many cases, led to cut profit margins 20

Derivatives In Indian context, south East Asian currencies crisis of 1997had affected the competitiveness of our products vis-à-vis depreciatedcurrencies. Export of certain goods from India declined because of thiscrisis. Steel industry in 1998 suffered its worst set back due to cheapimport of steel from south east asian countries. Suddenly blue chipcompanies had turned in to red. The fear of china devaluing its currencycreated instability in Indian exports. Thus, it is evident that globalisation ofindustrial and financial activities necessitiates use of derivatives to guardagainst future losses. This factor alone has contributed to the growth ofderivatives to a significant extent.C.} TECHNOLOGICAL ADVANCES – A significant growth of derivative instruments has beendriven by technological break through. Advances in this area include thedevelopment of high speed processors, network systems and enhancedmethod of data entry. Closely related to advances in computer technologyare advances in telecommunications. Improvement in communicationsallow for instantaneous world wide conferencing, Data transmission bysatellite. At the same time there were significant advances in softwareprogrammes without which computer and telecommunication advanceswould be meaningless. These facilitated the more rapid movement ofinformation and consequently its instantaneous impact on market price. Although price sensitivity to market forces is beneficial to theeconomy as a whole resources are rapidly relocated to more productiveuse and better rationed overtime the greater price volatility exposes 21

Derivativesproducers and consumers to greater price risk. The effect of this risk caneasily destroy a business which is otherwise well managed. Derivativescan help a firm manage the price risk inherent in a market economy. Tothe extent the technological developments increase volatility, derivativesand risk management products become that much more important.D.} ADVANCES IN FINANCIAL THEORIES – Advances in financial theories gave birth to derivatives.Initially forward contracts in its traditional form, was the only hedging toolavailable. Option pricing models developed by Black and Scholes in1973 were used to determine prices of call and put options. In late 1970‟s,work of Lewis Edeington extended the early work of Johnson and startedthe hedging of financial price risks with financial futures. The work ofeconomic theorists gave rise to new products for risk management whichled to the growth of derivatives in financial markets. The above factors in combination of lot many factors led togrowth of derivatives instruments. 22

Derivatives CHAPTER – 3 Types of DERIVATIVES FUTURES VS. FORWARD MARKETS 23

Derivatives CHAPTER 3TYPES OF DERIVATIVES : There are mainly four types of derivatives i.e. Forwards,Futures, Options and swaps. Derivatives 24

Derivatives Forwards Futures Options Swaps1. FORWARDS - A contract that obligates one counter party to buy and theother to sell a specific underlying asset at a specific price, amount anddate in the future is known as a forward contract. Forward contracts arethe important type of forward-based derivatives. They are the simplestderivatives. There is a separate forward market for multitude ofunderlyings, including the traditional agricultural or physical commodities,as well as currencies and interest rates. The change in the value of aforward contract is roughly proportional to the change in the value of itsunderlying asset. These contracts create credit exposures. As the value ofthe contract is conveyed only at the maturity, the parties are exposed tothe risk of default during the life of the contract. Forward contracts arecustomised with the terms and conditions tailored to fit the particularbusiness, financial or risk management objectives of the counter parties.Negotiations often take place with respect to contract size, delivery grade,delivery locations, delivery dates and credit terms. 25

Derivatives2. FUTURES - A future contract is an agreement between two parties to buyor sell an asset at a certain time the future at the certain price. Futurescontracts are the special types of forward contracts in the sense that arestandardized exchange-traded contracts. Equities, bonds, hybrid securities and currencies are thecommodities of the investment business. They are traded on organisedexchanges in which a clearing house interposes itself between buyer andseller and guarantees all transactions, so that the identity of the buyer orthe seller is a matter of indifference to the opposite party. Futures contractprotect those who use these commodities in their business. Futures trading are to enter into contracts to buy or sellfinancial instruments, dealing in commodities or other financial instrumentsfor forward delivery or settlement on standardised terms. The futuresmarket facilitates stock holding and shifting of risk. They act as amechanism for collection and distribution of information and then performa forward pricing function. The futures trading can be performed whenthere is variation in the price of the actual commodity and there existseconomic agents with commitments in the actual market. There must be apossibility to specify a standard grade of the commodity and to measuredeviations from this grade. A futures market is established specifically tomeet purely speculative demands is possible but is not known. Conditionswhich are thought of necessary for the establishment of futures trading are 26

Derivativesthe presence of speculative capital and financial facilities for payment ofmargins and contract settlement. In addition, a strong infrastructure isrequired, including financial, legal and communication systems.3. OPTIONS - A derivative transaction that gives the option holder the rightbut not the obligation to buy or sell the underlying asset at a price, calledthe strike price, during a period or on a specific date in exchange forpayment of a premium is known as ‘option’. Underlying asset refers toany asset that is traded. The price at which the underlying is traded iscalled the ‘strike price’. There are two types of options i.e., CALL OPTION ANDPUT OPTION. a. CALL OPTION : A contract that gives its owner the right but not the obligation to buy an underlying asset-stock or any financial asset, at a specified price on or before a specified date is known as a ‘Call option’. The owner makes a profit provided he sells at a higher current price and buys at a lower future price. b. PUT OPTION : 27

Derivatives A contract that gives its owner the right but not the obligation to sell an underlying asset-stock or any financial asset, at a specified price on or before a specified date is known as a „Put option’. The owner makes a profit provided he buys at a lower current price and sells at a higher future price. Hence, no option will be exercised if the future price does not increase. Put and calls are almost always written on equities, althoughoccasionally preference shares, bonds and warrants become the subjectof options.4. SWAPS - Swaps are transactions which obligates the two parties tothe contract to exchange a series of cash flows at specified intervalsknown as payment or settlement dates. They can be regarded asportfolios of forwards contracts. A contract whereby two parties agree toexchange (swap) payments, based on some notional principle amount iscalled as a ‘SWAP’. In case of swap, only the payment flows areexchanged and not the principle amount. The two commonly used swapsare: a. INTEREST RATE SWAPS : Interest rate swaps is an arrangement by which one party agrees to exchange his series of fixed rate interest 28

Derivatives payments to a party in exchange for his variable rate interest payments. The fixed rate payer takes a short position in the forward contract whereas, the floating rate payer takes a long position in the forward contract.b. CURRENCY SWAPS : Currency swaps is an arrangement in which both the principle amount and the interest on loan in one currency are swapped for the principle and the interest payments on loan in another currency. The parties to the swap contract of currency generally hail from two different countries. This arrangement allows the counter parties to borrow easily and cheaply in their home currencies. Under a currency swap, cash flows to be exchanged are determined at the spot rate at a time when swap is done. Such cash flows are supposed to remain unaffected by subsequent changes in the exchange rates.c. FINANCIAL SWAP : Financial swaps constitute a funding technique which permit a borrower to access one market and then exchange the liability for another type of liability. It also allows the investors to exchange one type of asset for another type of asset with a preferred income stream. 29

Derivatives The other kind of derivatives, which are not, muchpopular are as follows :5. BASKETS - Baskets options are option on portfolio of underlying asset.Equity Index Options are most popular form of baskets.6. LEAPS - Normally option contracts are for a period of 1 to 12 months.However, exchange may introduce option contracts with a maturity periodof 2-3 years. These long-term option contracts are popularly known asLeaps or Long term Equity Anticipation Securities.7. WARRANTS - Options generally have lives of up to one year, the majorityof options traded on options exchanges having a maximum maturity ofnine months. Longer-dated options are called warrants and are generallytraded over-the-counter.8. SWAPTIONS - Swaptions are options to buy or sell a swap that will becomeoperative at the expiry of the options. Thus a swaption is an option on aforward swap. Rather than have calls and puts, the swaptions market has 30

Derivativesreceiver swaptions and payer swaptions. A receiver swaption is an optionto receive fixed and pay floating. A payer swaption is an option to payfixed and receive floating.Futures Market Forward MarketMargin deposits are to be required Typically, no money changes handsof all participants. until delivery, although a small margin deposit might be required of non-dealer customers on certain occasions.Contract terms are standardised All contract terms are negotiatedwith all buyers and sellers privately by the parties.negotiating only with respect toprice.Non-member participants deal Participants deal typically on athrough brokers (exchange principal-to-principal basis.members who represent them onthe exchange floor)Participants include banks, Participants are primarily institutionscorporations, financial institutions, dealing with one other and otherindividual investors, and interested parties dealing throughspeculators. one or more dealers. 31

DerivativesThe clearing house of the exchange A participant must examine thebecomes the opposite side to each credit risk and establish credit limitscleared transactions; therefore, the for each opposite party.credit risk for a futures marketparticipant is always the same andthere is no need to analyse thecredit of other market participants.Settlements are made daily through Settlement occurs on date agreedthe exchange clearing house. Gains upon between the parties to eachon open positions may be transaction.withdrawn and losses are collecteddaily.Long and short positions are usually Forward positions are not as easilyliquidated easily. offset or transferred to the other participants.Settlements are normally made in Most transactions result in delivery.cash, with only a small percentageof all contracts resulting actualdelivery.A single, round trip (in and out of No commission is typically chargedthe market) commission is charged. if the transaction is made directlyIt is negotiated between broker and with another dealer. A commissioncustomer and is relatively small in is charged to born buyer and seller,relation to the value of the contract. however, if transacted through a 32

Derivatives broker.Trading is regulated. Trading is mostly unregulated.The delivery price is the spot price. The delivery price is the forward price. CHAPTER – 4  Participants in derivatives market  role of derivatives 33

Derivatives CHAPTER 4PARTICIPANTS IN THE DERIVATIVES MARKET : The participants in the derivatives market are as follows:A.} TRADING PARTICIPANTS :1.] HEDGERS – The process of managing the risk or risk management iscalled as hedging. Hedgers are those individuals or firms who managetheir risk with the help of derivative products. Hedging does not meanmaximising of return. The main purpose for hedging is to reduce thevolatility of a portfolio by reducing the risk. 34

Derivatives2.] SPECULATORS – Speculators do not have any position on which they enterinto futures and options Market i.e., they take the positions in the futuresmarket without having position in the underlying cash market. They onlyhave a particular view about future price of a commodity, shares, stockindex, interest rates or currency. They consider various factors likedemand and supply, market positions, open interests, economicfundamentals, international events, etc. to make predictions. They takerisk in turn from high returns. Speculators are essential in all markets –commodities, equity, interest rates and currency. They help in providingthe market the much desired volume and liquidity.3.] ARBITRAGEURS – Arbitrage is the simultaneous purchase and sale of the sameunderlying in two different markets in an attempt to make profit from pricediscrepancies between the two markets. Arbitrage involves activity onseveral different instruments or assets simultaneously to take advantageof price distortions judged to be only temporary. Arbitrage occupies a prominent position in the futures world.It is the mechanism that keeps prices of futures contracts aligned properlywith prices of underlying assets. The objective is simply to make profitswithout risk, but the complexity of arbitrage activity is such that it isreserved to particularly well-informed and experienced professional 35

Derivativestraders, equipped with powerful calculating and data processing tools.Arbitrage may not be as easy and costless as presumed.B.} INTERMEDIARY PARTICIPANTS :4.] BROKERS – For any purchase and sale, brokers perform an importantfunction of bringing buyers and sellers together. As a member in anyfutures exchanges, may be any commodity or finance, one need not be aspeculator, arbitrageur or hedger. By virtue of a member of a commodityor financial futures exchange one get a right to transact with othermembers of the same exchange. This transaction can be in the pit of thetrading hall or on online computer terminal. All persons hedging theirtransaction exposures or speculating on price movement, need not be andfor that matter cannot be members of futures or options exchange. A non-member has to deal in futures exchange through member only. Thisprovides a member the role of a broker. His existence as a broker takesthe benefits of the futures and options exchange to the entire economy alltransactions are done in the name of the member who is also responsiblefor final settlement and delivery. This activity of a member is price risk freebecause he is not taking any position in his account, but his other risk isclients default risk. He cannot default in his obligation to the clearinghouse, even if client defaults. So, this risk premium is also inbuilt inbrokerage recharges. More and more involvement of non-members inhedging and speculation in futures and options market will increasebrokerage business for member and more volume in turn reduces the 36

Derivativesbrokerage. Thus more and more participation of traders other thanmembers gives liquidity and depth to the futures and options market.Members can attract involvement of other by providing efficient services ata reasonable cost. In the absence of well functioning broking houses, thefutures exchange can only function as a club.5.] MARKET MAKERS AND JOBBERS – Even in organised futures exchange, every deal cannot getthe counter party immediately. It is here the jobber or market maker playshis role. They are the members of the exchange who takes the purchaseor sale by other members in their books and then square off on the sameday or the next day. They quote their bid-ask rate regularly. The differencebetween bid and ask is known as bid-ask spread. When volatility in priceis more, the spread increases since jobbers price risk increases. In lessvolatile market, it is less. Generally, jobbers carry limited risk. Even byincurring loss, they square off their position as early as possible. Sincethey decide the market price considering the demand and supply of thecommodity or asset, they are also known as market makers. Their role ismore important in the exchange where outcry system of trading is present.A buyer or seller of a particular futures or option contract can approachthat particular jobbing counter and quotes for executing deals. Inautomated screen based trading best buy and sell rates are displayed onscreen, so the role of jobber to some extent. In any case, jobbers provideliquidity and volume to any futures and option market.C.} INSTITUTIONAL FRAMEWORK : 37

Derivatives6.] EXCHANGE – Exchange provides buyers and sellers of futures and optioncontract necessary infrastructure to trade. In outcry system, exchange hastrading pit where members and their representatives assemble during afixed trading period and execute transactions. In online trading system,exchange provide access to members and make available real timeinformation online and also allow them to execute their orders. Forderivative market to be successful exchange plays a very important role,there may be separate exchange for financial instruments andcommodities or common exchange for both commodities and financialassets.7.] CLEARING HOUSE – A clearing house performs clearing of transactions executedin futures and option exchanges. Clearing house may be a separatecompany or it can be a division of exchange. It guarantees theperformance of the contracts and for this purpose clearing house becomescounter party to each contract. Transactions are between members andclearing house. Clearing house ensures solvency of the members byputting various limits on him. Further, clearing house devises a goodmanaging system to ensure performance of contract even in volatilemarket. This provides confidence of people in futures and optionexchange. Therefore, it is an important institution for futures and optionmarket. 38

Derivatives8.] CUSTODIAN / WARE HOUSE – Futures and options contracts do not generally result intodelivery but there has to be smooth and standard delivery mechanism toensure proper functioning of market. In stock index futures and optionswhich are cash settled contracts, the issue of delivery may not arise, but itwould be there in stock futures or options, commodity futures and optionsand interest rates futures. In the absence of proper custodian orwarehouse mechanism, delivery of financial assets and commodities willbe a cumbersome task and futures prices will not reflect the equilibriumprice for convergence of cash price and futures price on maturity,custodian and warehouse are very relevant.9.] BANK FOR FUND MOVEMENTS – Futures and options contracts are daily settled for whichlarge fund movement from members to clearing house and back isnecessary. This can be smoothly handled if a bank works in associationwith a clearing house. Bank can make daily accounting entries in theaccounts of members and facilitate daily settlement a routine affair. Thisalso reduces a possibility of any fraud or misappropriation of fund by anymarket intermediary.10.] REGULATORY FRAMEWORK – 39

Derivatives A regulator creates confidence in the market besidesproviding Level playing field to all concerned, for foreign exchange andmoney market, RBI is the regulatory authority so it can take initiative instarting futures and options trade in currency and interest rates. Forcapital market, SEBI is playing a lead role, along with physical market instocks, it will also regulate the stock index futures to be started very soonin India. The approach and outlook of regulator directly affects the strengthand volume in the market. For commodities, Forward Market Commissionis working for settling up national National Commodity Exchange.ROLE OF DERIVATIVES : Derivative markets help investors in many different ways :1.] RISK MANAGEMENT – Futures and options contract can be used for altering the riskof investing in spot market. For instance, consider an investor who ownsan asset. He will always be worried that the price may fall before he cansell the asset. He can protect himself by selling a futures contract, or bybuying a Put option. If the spot price falls, the short hedgers will gain in thefutures market, as you will see later. This will help offset their losses in thespot market. Similarly, if the spot price falls below the exercise price, theput option can always be exercised. 40

Derivatives Derivatives markets help to reallocate risk among investors.A person who wants to reduce risk, can transfer some of that risk to aperson who wants to take more risk. Consider a risk-averse individual. Hecan obviously reduce risk by hedging. When he does so, the oppositeposition in the market may be taken by a speculator who wishes to takemore risk. Since people can alter their risk exposure using futures andoptions, derivatives markets help in the raising of capital. As an investor,you can always invest in an asset and then change its risk to a level that ismore acceptable to you by using derivatives.2.] PRICE DISCOVERY – Price discovery refers to the markets ability to determine trueequilibrium prices. Futures prices are believed to contain informationabout future spot prices and help in disseminating such information. As wehave seen, futures markets provide a low cost trading mechanism. Thusinformation pertaining to supply and demand easily percolates into suchmarkets. Accurate prices are essential for ensuring the correct allocationof resources in a free market economy. Options markets provideinformation about the volatility or risk of the underlying asset.3.] OPERATIONAL ADVANTAGES – As opposed to spot markets, derivatives markets involvelower transaction costs. Secondly, they offer greater liquidity. Large spottransactions can often lead to significant price changes. However, futuresmarkets tend to be more liquid than spot markets, because herein you can 41

Derivativestake large positions by depositing relatively small margins. Consequently,a large position in derivatives markets is relatively easier to take and hasless of a price impact as opposed to a transaction of the same magnitudein the spot market. Finally, it is easier to take a short position in derivativesmarkets than it is to sell short in spot markets.4.] MARKET EFFICIENCY – The availability of derivatives makes markets more efficient;spot, futures and options markets are inextricably linked. Since it is easierand cheaper to trade in derivatives, it is possible to exploit arbitrageopportunities quickly and to keep prices in alignment. Hence thesemarkets help to ensure that prices reflect true values.5.] EASE OF SPECULATION – Derivative markets provide speculators with a cheaperalternative to engaging in spot transactions. Also, the amount of capitalrequired to take a comparable position is less in this case. This isimportant because facilitation of speculation is critical for ensuring freeand fair markets. Speculators always take calculated risks. A speculatorwill accept a level of risk only if he is convinced that the associatedexpected return, is commensurate with the risk that he is taking. 42

Derivatives CHAPTER – 5 HOW BANKS USE DERIVATIVES • ASSET liability management 43

Derivatives CHAPTER 5HOW BANKS USE DERIVATIVES :ASSET LIABILITY MANAGEMENT - Banks have traditionally taken deposits from their customers andput those deposits to work as loans. Because the deposits and the loansare dominated in the same currency, this activity has no associated 44

Derivativesforeign exchange risk. But it does limit banks to lending to customerswhich need to borrow in the currencies which the banks have available ondeposits. If a bank is asked to lend to a customer in a currency other thanone of those it has on deposits it creates a currency exposure for thebank. Suppose a customer wants to borrow EUROS from a US Bank for 5years and that the US bank has no natural source of EUROS. It ispossible for the banks to cover this exposure in the forward market byselling EUROS forwards and buying US dollars. The transaction costsassociated with this, in particular the bid / offer spread in the medium termforeign exchange forward market, would make the resultant cost of theloan prohibitively expensive for the borrower. Currency swaps provide an economic alternative to this problem forbanks. In order to cover the exposure created by a loan to a customer inEUROS funded by a bank‟s deposit in US dollar, a bank could receivefixed rate US dollars in a currency swap and pay fixed rate EUROS. One of the consequences of the development of the currency swapmarket is that banks now often make much more competitive mediumterm forward foreign exchange prices than they used to. Most banks quoteforward foreign exchange and currency swap prices from the same deskand increases liquidity in the latter has improved liquidity in the former.Banks therefore, need no longer restrict their lending activities to thecurrencies in which they have natural deposits. They are free to fundthemselves in the most competitively priced currency and to lend to their 45

Derivativescustomers in the currency of the customer‟s preference, using a currencyswap as an asset and liability matching tool The “Normal yield curve”, reflects that it is much easier for banks toborrow at the short end of the curve than the long end. This means thatbanks can fund themselves much more effectively in the inter bank marketin maturities such as the overnight, tom / next (overnight from tomorrow,or tomorrow to the next day), spot / next, one week, one month, threemonths and six months than they can in maturities such as five years or20 years. With the development of the swaps market it is possible for banksto satisfy their customers demands for fixed rate funding while ensuringthat the banks assets and liabilities are matched. Suppose a bank has acustomer who needs 5 years fixed rate funds. Let us say that the bankfinances in this loan in the interbank market at 3 month LIBOR. The banknow has a 3 month liability and a 5 year asset (Figure 1). 46

Derivatives The bank is short floating rate interest at 3 month LIBOR and longfixed rate interest at the rate at which it lends to its customer. This is calledthe asset liability mismatch. So in order to hedge its position the banksneeds to match its exposure to 3 month LIBOR by receiving on a floatingrate basis in an interest rate swap, and match its exposure on a fixed ratebasis by paying a fixed rate in a interest rate swap. This is a hedge whichis ideally suited to an interest rate swap which the bank receives a floatingrare of interest and pays a fixed rare (Figure 2). This structure has the benefit for the bank that it eliminates thebank‟s exposure to interest rate risk. The bank can no longer profit from afall in interest rates but it cannot lose money on its asset and liabilitymismatch as a result of an increase in rates. The bank will make or losemoney based on its pricing of the credit risk in the transaction and itsoverall loan exposure rather than on its ability to forecast interest rates.Hence the interest rate swaps provide banks with an opportunity tochange their risks from interest rate to credit. 47

Derivatives CHAPTER – 6 CASE STUDIES • hedging interest rate risk • Hedging foreign exchange risk 48

Derivatives CHAPTER 6CASE STUDIES :CASE STUDY 1Hedging interest rate risk 49

DerivativesScenarioA major aircraft manufacturer has decided to replace his mainframecomputer. The cost after trade in is $ 10 million, payable on delivery.DeliveryMid December, 2006.FundingA projected cash flow short fall will create a $ 10 million borrowingrequirement.Borrowing RateLIBOR + 50 Basis pointsOutlookThe treasurer is worried that the central bank‟s future policy directions willlead to an increase in short term rates.Market ConditionsCurrent LIBOR - 8.38 %Euro-Dollar Options On Futures : 50

DerivativesDecember 91.25 (implied rate of 8.75%) Put, Premium of .25December 91.00 (implied rate of 9.00%) Put, Premium of .15StrategyThe treasurer buys the December Put Option with a strike price of 91.25(implied rate of 8.75%), which allows the manufacturer to enter into a Euro– Dollar futures contract for a premium price of .25. the notional principal,that is the size of the contract is $ 1 million, so ten contracts are taken tocover the full short-term borrowing cost. The put will make money only ifthe underlying future falls below the strike price less the price paid for theoption. Remember, the Euro-Dollar future is quoted as an index on a baseof 100, a lower price means a higher rate of interestResultsIn Mid-December, depending upon how the LIBOR rate has changed, thetreasurer will use or not use the put option on the future which waspurchased. If the cost of short-term borrowing has remained the same ordeclined, the put option will expire worthless. The money expended uponthe premium, of 0.25 % per $ 1 million contract, will have been lost. If,however, interest rates were to rise, the put option contract on the Euro-Dollar future will be exercised. If, for example, Euro – Dollar Rates rise to10.76% (89.10 on the index) which would have given the treasurer aborrowing cost of 11.26% (LIBOR + 50 bases points), the Put would beutilised, exercising the right to sell the option on the future at the strikeprice of 91.25, for an intrinsic value of 2.1 (Or 2% in interest terms). 51

DerivativesThe gain in value on the Put options contract compensates for theincreased cost of borrowing on the LIBOR Rate. The risk of funding thenew mainframe computer has been managed.CASE STUDY 2Hedging foreign exchange rate riskScenarioAn American manufacturer of clothing imports fabric from the UnitedKingdom. In 6 months time, in anticipation of the 2005-06 winter season,he will need to purchase 1 million Pounds Sterling, in order to pay for thedesired imports, in order for his finished goods to be competitive andensure adequate margins, the exchange rate must not fluctuatesignificantly. A weakening of the US dollar by more than 5% may createproblems in terms of price competitiveness and profit margins.Delivery 52

DerivativesIn Mid June, 2005, the manufacturer is scheduled to receive and pay forthe imports.FundingThe manufacturer has no funding exposure as the imports will be paidfrom working capital.Exchange RateThe present rate is STG/ USD = 1.50, which is satisfactory with respect tocommercial objectives, but a weakening of more than 5% will result indiminished margins or a non competitive position.OutlookThe manufacturer is worried that because of declining rates of interestsand the current account deficits, the US dollar may waken against thePound Sterling, from its current rate of 1.50.Market ConditionsCurrent spot rate - STG/USD = 1.50June calls @ strike price of STG/USD = $1.51, premium of 2.50% percontract, that is 4 US cents. 53

DerivativesJune calls @ Strike price of STG/USD = $1.52, premium of 2.00% percontract, that is 3 US cents.StrategyThe manufacturer buys one call option contract with a Strike or Exerciseprice of 1.51. If the US dollar weakens the call contract will be used to buythe Pounds – Sterling at the set price. If, the US dollar stays the same orstrengthens, the contract will expire worthless and the premium paid forthe option will have been lost.ResultsIn June 2005, the Us dollar does weaken and the new spot exchange rateis STG/USD = 1.60. Hence, the call option at 1.51 has intrinsic value of 9US cents. Instead of the 1 million Pound Sterling required by themanufacturer costing 1.6 million US dollars, the exercise of the callcontract will net $ 90000 US ( $ 1.6 million – $ 1.51 million).After subtracting the price of the premium of 2.5%, the net gain will be $50000 US ( $ 1.6 million – $ 1.55 million), which partially off-sets thedepreciation in the US Dollar exchange Rate, and is within themanufacturer‟s target range of 5% to remain competitive on pricing.Through this hedging technique the underlying commercial objective willbe ensured. If the US Dollar exchange rate had not weakened, the 54

Derivativesexpenditure on the premium would still have kept his net cost of theimports within the self imposed 5% competitive range. RECOMMENDATIONS  RBI should play a greater role in supporting derivatives.  Derivatives market should be developed in order to keep it at par with other derivative markets in the world.  Speculation should be discouraged.  There must be more derivative instruments aimed at individual investors. 55

Derivatives SEBI should conduct seminars regarding the use of derivatives to educate individual investors.BIBLIOGRAPHY :BOOKS  Futures markets – Sunil. K. Parameswaran  Understanding futures market – Robert. W. Klob  Derivatives Market in India – Susan Thomas  Financial Derivatives – V. K. Bhalla  Financial Services and Markets – Dr. S. Guruswamy 56

Derivatives  Futures and Options – D. C. GardnerINTERNET  www.cxotoday.com  www.indiainfoline.com  www.indiamart.com ABBREVIATIONAAMEX - American Stock Exchange.BBSE - Bombay Stock Exchange. 57

DerivativesCCHE - Calcutta Hessian Exchange Ltd.CBOE - Chicago Board options Exchange.CBOT - Chicago Board of Trade.CEBB - Chicago Egg and Butter Board.CME - Chicago Mercantile Exchange.CPE - Chicago Produce Exchange.IIMM - International Monetary Market.LLIBOR - London Inter Bank Offer Rate.LEAPS - Long term Equity Anticipation Securities. 58

DerivativesMMCX – Multi Commodity ExchangeMIBOR - Mumbai Inter Bank Offer Rate.NNCDX – National Commodities and Derivatives ExchangeNSE - National Stock Exchange.OOTC - Over the counter.PPHLX - Philadelphia Stock Exchange.S 59

DerivativesSIMEX - Singapore International Monetary Exchange.S&P - Standard and Poor.SC(R) A - Securities Contracts (Regulation) Act, 1956. 60

Derivatives

by vinodab1 on Jul 07, 2012

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Derivatives Document Transcript