DERIVATIVES (Instrument for risk reduction)
INTRODUCTION
The past decade witness the multiple growths in the volume of
int...
DERIVATIVES (Instrument for risk reduction)
WHAT IS A DERIVATIVE?
Derivatives is a product/ contract, which does not have ...
DERIVATIVES (Instrument for risk reduction)
CLASSIFICATION OF DERIVATIVES
Derivatives markets can basically be classified ...
DERIVATIVES (Instrument for risk reduction)
HISTORY OF DERIVATIVES
The first centralized commodities market in Britain was...
DERIVATIVES (Instrument for risk reduction)
FACTORS DRIVING THE GROWTH OF FINANCIAL
DERIVATIVES:
1. Increased volatility i...
DERIVATIVES (Instrument for risk reduction)
TYPES OF DERIVATIVES
Forwards: A forward contract is a customized contract bet...
DERIVATIVES (Instrument for risk reduction)
Swaps: Swaps are private agreements between two parties to exchange
cash flows...
DERIVATIVES (Instrument for risk reduction)
DERIVATIVES MEMBERSHIP
The Derivatives Segment membership is open to the exist...
DERIVATIVES (Instrument for risk reduction)
.
Financial requirement for derivatives membership
The most basic means of con...
DERIVATIVES (Instrument for risk reduction)
CAPITAL ADEQUACY REQUIREMENT
Every Clearing Member of the Derivatives Segment ...
DERIVATIVES (Instrument for risk reduction)
TYPES OF DERIVATIVES
TYPES OF DERIVATIVES
 FORWARD CONTRACT
 FUTURE CONTRACT...
DERIVATIVES (Instrument for risk reduction)
will be when the season comes. You therefore agree with a merchant to sell
all...
DERIVATIVES (Instrument for risk reduction)
Counter party risk is also referred to as ‘default’ risk or ‘credit’ risk.
FUT...
DERIVATIVES (Instrument for risk reduction)
FEATURES OF FUTURES
• Contract between two parties through an exchange
• Excha...
DERIVATIVES (Instrument for risk reduction)
FUTURE TERMINOLOGY
• Spot price: The price at which an asset trades in the spo...
DERIVATIVES (Instrument for risk reduction)
• Marking-to-market: In the futures market, at the end of each trading day,
th...
DERIVATIVES (Instrument for risk reduction)
For example, a February Futures contract will expire on the last Thursday of
F...
DERIVATIVES (Instrument for risk reduction)
WHAT TYPE OF MARGINS ARE PAYABLE ON
FUTURES?
Both buyers and sellers of Future...
DERIVATIVES (Instrument for risk reduction)
Methodology for calculating closing price for daily mark to
market:
The daily ...
DERIVATIVES (Instrument for risk reduction)
If you do not square up till the day of expiry, it will be automatically squar...
DERIVATIVES (Instrument for risk reduction)
example, if the margin is 20%, you would pay only Rs 56. If Satyam goes upto
R...
DERIVATIVES (Instrument for risk reduction)
can earn Rs 3 as difference. You will then buy Satyam in the cash market and
a...
DERIVATIVES (Instrument for risk reduction)
TRADERS/ PARTICIPANTS/ OPERATORS OF
FUTURE MARKETS
 HEDGER
 SPECULATOR
 ARB...
DERIVATIVES (Instrument for risk reduction)
 HEDGER
A Hedging is a position taken in futures or other markets for the pur...
DERIVATIVES (Instrument for risk reduction)
Ram is a trader but has no time to track and analyze the stocks.
However, he f...
DERIVATIVES (Instrument for risk reduction)
 Take the case of the NSE Nifty.
 Assume that Nifty is at 1200 and 3 month’s...
DERIVATIVES (Instrument for risk reduction)
TYPES OF FUTURES
Futures contract are broadly divided into two types:
 COMMOD...
DERIVATIVES (Instrument for risk reduction)
A commodity futures is a contract in commodity like agricultural products,
met...
DERIVATIVES (Instrument for risk reduction)
For example, lets take the underlying asset on SENSEX. If you believe the
SENS...
DERIVATIVES (Instrument for risk reduction)
For eg: Three month maturity instruments like treasury bills & , including
for...
DERIVATIVES (Instrument for risk reduction)
Underlying index BSE sensitive index (SENSEX)
Contract Multiplier 50
Tick size...
DERIVATIVES (Instrument for risk reduction)
Features Stock Futures
Underlying Stock Respective Stock (Annexure)
Contract M...
DERIVATIVES (Instrument for risk reduction)
PAYOFF FOR FUTURES
Futures contracts have linear payoffs. In simple words, it ...
DERIVATIVES (Instrument for risk reduction)
1220
0 Nifty
Loss
( FIGURE 1)
PAYOFF FOR SELLER OF FUTURES: SHORT
FUTURES
The ...
DERIVATIVES (Instrument for risk reduction)
moves up, it starts making losses. Figure 2 shows the payoff diagram for the
s...
DERIVATIVES (Instrument for risk reduction)
OPTIONS
Option is a security that represents the right, but not the obligation...
DERIVATIVES (Instrument for risk reduction)
Options are different from futures in many ways. Not only both the
instrument ...
DERIVATIVES (Instrument for risk reduction)
are discussed later. These are the basic four payoffs are at the heart of
the ...
DERIVATIVES (Instrument for risk reduction)
• Stock options: Stock options are options on individual stocks. Options
curre...
DERIVATIVES (Instrument for risk reduction)
call is said to be deep ITM. In the case of a put, the put is ITM if the index...
DERIVATIVES (Instrument for risk reduction)
CALL OPTION
Call Options give the buyer the right to buy a specified underlyin...
DERIVATIVES (Instrument for risk reduction)
 At the money - These result in a zero-cash flow to the investor
 Out of mon...
DERIVATIVES (Instrument for risk reduction)
the put option holder can sell the Sensex at 4400, an amount greater than
the ...
DERIVATIVES (Instrument for risk reduction)
American and European Exercise Style of Options
American and European are prim...
DERIVATIVES (Instrument for risk reduction)
tailored agreement sold directly by the dealer rather than through the
organiz...
DERIVATIVES (Instrument for risk reduction)
1. The option buyer may not exercise the current, allowing the option
to expir...
DERIVATIVES (Instrument for risk reduction)
These are explained as follows.
1. Stocks options
2. Stocks indices,
3. Foreig...
DERIVATIVES (Instrument for risk reduction)
Contract Multiplier: As specified
Ticker Symbol: As specified
Strike Prices: m...
DERIVATIVES (Instrument for risk reduction)
2. INDEX OPTION.
Many different index options are currently traded on the diff...
DERIVATIVES (Instrument for risk reduction)
us dollar, Australian dollar, British pounds, Canadian dollar, German mark,
Fr...
DERIVATIVES (Instrument for risk reduction)
payoff is exactly the opposite. His profits are limited to the option premium,...
DERIVATIVES (Instrument for risk reduction)
Nifty-close and the strike price. The profits possible on this option are
pote...
DERIVATIVES (Instrument for risk reduction)
The figure shows the profits/losses for the seller of a three-month Nifty 1250...
DERIVATIVES (Instrument for risk reduction)
price, he lets his option expire un-exercised. His loss in this case is the
pr...
DERIVATIVES (Instrument for risk reduction)
the seller’s loss. If upon expiration, the spot price happens to be below the
...
DERIVATIVES (Instrument for risk reduction)
Trader’s
rights and
obligation
s
Right and
obligation
to buy
Right and
obligat...
DERIVATIVES (Instrument for risk reduction)
applicable rates. Swaps contracts also include other provisional specified by
...
DERIVATIVES (Instrument for risk reduction)
Currency swaps can be defined as a legal agreement between two or more
parties...
DERIVATIVES (Instrument for risk reduction)
The first step towards introduction of derivatives trading in India was the
pr...
DERIVATIVES (Instrument for risk reduction)
The trading in BSE Sensex options commenced on June 4, 2001 and the
trading in...
DERIVATIVES (Instrument for risk reduction)
and Reserve Bank of India’s (RBI) efforts in creating currency forward market....
DERIVATIVES (Instrument for risk reduction)
Financial institution are very sensitive to the risk exposer measures so they
...
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Derivative

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Derivative

  1. 1. DERIVATIVES (Instrument for risk reduction) INTRODUCTION The past decade witness the multiple growths in the volume of international trade business due to the wave of globalization and liberalization all over the world. As a result, the demand for the international money and financial instruments increased significantly at the global level. In this respect, changes in the interest rate, exchange rate, and stock market price at the different financial market have increased the financial risk to the corporate world. It is therefore to manage such risks; the new financial instrument has been developed in this financial market, which is also known as financial Derivatives. The basic purpose of this instrument is to provide commitment to price for future date for giving protection against adverse movement in future price in order to reduce the extent of financial risks. Not only this, they also provide opportunity to earn profit for those who are ready to go for high risks. This instrument facilitates to transfer the risks from those who wish to avoid it to those who are willing to accept the risks. TYBBI 1
  2. 2. DERIVATIVES (Instrument for risk reduction) WHAT IS A DERIVATIVE? Derivatives is a product/ contract, which does not have any value on its own i.e. it, derives its value from some underlying. Derivatives or derivatives securities are contracts which are written between two parties (counter parties) and whose values is derived from underlying widely held and easily marketable assets such as agricultural and other physical (tangible) commodities or currencies or short term and long term financial instruments tangible things like commodities price index (inflation rate), equity price index or bond price index. The counter parties to such contract are those other than the original issuer (holder ) of the underlying assets . The exchange-traded derivatives are quit liquid and have low transaction cost. It is possible to combine them to match specific requirements. The value of derivatives and those of their underlying assets are closely related. Usually in trading derivatives, the taking or making of delivery of underlying assets is not involved ; the transactions are mostly settled by taking offsetting positions in the derivatives themselves. There is therefore, no effective limit on the claims, which can be traded in respect of underlying assets. Derivatives are ‘off balance’ instruments, a fact is said to be obscure the leverage and financial might give to the party. They are mostly secondary market instruments and have little usefulness in mobilizing fresh capital by the companies. Although the standardized, general exchange traded derivatives are being increasingly evolved, still there are many privately negotiated, customized, OTC- traded financial contracts which are in vogue and which expose the uses to operational risk. There is also and uncertainty about the regulatory status of such derivatives. Derivatives are used to facilitate hedging of price risk of inventory holding or a financial / commercial transaction over a certain period. In practice, every derivatives “contract” has a fixed expiration date , mostly in the range of 1 to 12 months from the date of commencement of the contract. (Presently 1,2,3, month’s contracts are available in India) Example: A very simple example of derivatives is curd, which is derivative of milk. The price of curd depends upon the price of milk which in turn depends upon the demand & supply of milk. TYBBI 2
  3. 3. DERIVATIVES (Instrument for risk reduction) CLASSIFICATION OF DERIVATIVES Derivatives markets can basically be classified into commodity and Financial Derivatives market. Commodity markets are further classified into tangible commodities & intangible commodities. Financial derivatives broadly has four branches viz. Real Estate, Forex, Equity derivatives and Debt Derivatives. Equity derivatives are further divided into index Products and derivatives on securities and Debt derivatives are further divided into Interest rate Products and GOI Securities , bonds, T-bills. TYBBI 3
  4. 4. DERIVATIVES (Instrument for risk reduction) HISTORY OF DERIVATIVES The first centralized commodities market in Britain was founded in the 1560s in the Royal Exchange (later to become the first home of the London International Financial Futures Exchange). Unfortunately the Great Fire of London destroyed the Royal Exchange in 1666, although trading continued in the various coffee houses that were springing up in the City of London at the time. Eventually each coffee house started to specialize in one particular product: the London Commodity Exchange in the Virginian and Baltic coffee house the London Metal Exchange in Jerusalem and the London Stock Exchange in Jonathans. At the same time there was an options market in Holland at the Amsterdam Trade Center based on tulips. Unfortunately the speculative use of these options brought about the collapse of the Dutch economy Organized futures markets, as we know them today really developed in the last century, primarily in the US, when the Chicago Board of Trade (CBOT) was established in 1848. At that time Chicago was not only at the center of the railroads; it was also an important port on the Great Lakes and close to the Midwest farmlands. With Chicago being such an important center for agricultural markets the CBOT was established to provide farmers with a central market place to guarantee the prices for their livestock and grain. THE NEED FOR A DERIVATIVES MARKET The derivatives market performs a number of economic functions: 1. They help in transferring risks from risk averse people to risk oriented people 2. They help in the discovery of future as well as current prices 3. They catalyze entrepreneurial activity 4. They increase the volume traded in markets because of participation of risk averse people in greater numbers 5. They increase savings and investment in the long run TYBBI 4
  5. 5. DERIVATIVES (Instrument for risk reduction) FACTORS DRIVING THE GROWTH OF FINANCIAL DERIVATIVES: 1. Increased volatility in asset prices in financial markets, 2. Increased integration of national financial markets with the international markets, 3. Marked improvement in communication facilities and sharp decline in their costs, 4. Development of more sophisticated risk management tools, providing economic agents a wider choice of risk management strategies, and 5. Innovations in the derivatives markets, which optimally combine the risks and returns over a large number of financial assets leading to higher returns, reduced risk as well as transactions costs as compared to individual financial assets. WHAT KINDS OF RISKS DO PARTICIPANTS IN THE DERIVATIVES MARKETS FACE? Some examples of risks are provided below: Counterparty (or default) risk – very low or almost zero because the exchange takes on the responsibility Operational risk – risk that operational systems might fail Legal risk – risk that legal objections might be raised, regulatory framework might disallow some activities Market risk – risk that market prices may move ups or down Liquidity risk – risk that unwinding of transactions might be difficult if the market is illiquid. TYBBI 5
  6. 6. DERIVATIVES (Instrument for risk reduction) TYPES OF DERIVATIVES Forwards: A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at today’s pre-agreed price. Futures: A futures contract is an agreement between two parties to buy or Profit contracts are special types of forward contracts which are standardized exchange-traded contracts. Options: Options are of two types - calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date. Warrants: Options generally have life of upto one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter. LEAPS: The acronym LEAPS means Long -Term Equity Anticipation Securities. These are options having a maturity of upto three years. LEAPS are not currently available in India. Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average or a basket of assets. Equity index options are a form of basket options. TYBBI 6
  7. 7. DERIVATIVES (Instrument for risk reduction) Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are 1. Interest rate swaps 2. Currency swaps Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency. Currency swaps: These entail swapping both principal and interest between the parties with the cashflows in one direction being in a different currency than those in the opposite direction. Swaption: Swaption are options to buy or sell a swap that will become operative at the expiry of the options. Thus a Swaption is an option on a forward swap. Rather than have calls and puts, the Swaption market has receiver Swaption and payer Swaption. A receiver Swaption is an option to receive fixed and pay floating interest. A payer Swaption is an option to pay fixed and receives floating interest. TYBBI 7
  8. 8. DERIVATIVES (Instrument for risk reduction) DERIVATIVES MEMBERSHIP The Derivatives Segment membership is open to the existing members of the Cash Segment as well as non-members provided they fulfill the membership required as laid down from time to time. The following are the different types of membership presently available for the Derivatives Segment: 1) Professional Clearing Member (PCM): PCM means a Clearing Member, who is permitted to clear and settle trades on his own account, on account of his clients and / or on account of trading members and their clients. 2) Custodian Clearing Member (CCM): CCM means Custodian registered as Clearing Member, who may clear and settle trades on his own account, on account of his clients and / or on account of trading members and their clients. 3) Trading Cum Clearing Member (TCM): A TCM means a Trading Member who is also a Clearing Member and can clear and settle trades on his own account, on account of his clients and on account of associated Trading Members and their clients. 4) Self Clearing Member (SCL): A SCM means a Trading Member who is also a Clearing Member and can clear and settle trades on his own account and on account of his clients. 5) Trading Member (TM): ATM is a member of the Exchange who has only trading rights and whose trades are cleared and settled by the Clearing Member with whom he is associated. 6) Limited Trading Member (LTM): A LTM is a member, who is not the members of the Cash Segment of the Exchange, and would like to be a Trading Member in the Derivatives Segment at BSE. An LTM has only the trading rights and his trades are cleared and settled by the clearing member with whom he is associated. As on January 1, 2003, there are 1 Professional Clearing Member, 3 Custodian Clearing Members, 75 Trading cum Clearing Members, 93Trading Members and 17 Limited Trading Members in the Derivative Segment of the Exchange. TYBBI 8
  9. 9. DERIVATIVES (Instrument for risk reduction) . Financial requirement for derivatives membership The most basic means of controlling counter-party credit and liquidity risks is to deal only with creditworthy counter-parties. The Exchange seek to ensure that their members are creditworthy by laying down a set of financial requirements for membership. The members are required to meet, both initially and on an ongoing basis, minimum networth requirement. Unlike Cash Segment membership where all the trading members are also the clearing members,in the derivatives Segment the trading and clearing rights are segregated. In other words, a member may opt to have both clearing and trading rights or he may opt for trading rights only in which case his trades are cleared and settled by his associated Clearing Member. Accordingly, the networth requirement is based on the type of membership and is as under: TYBBI 9
  10. 10. DERIVATIVES (Instrument for risk reduction) CAPITAL ADEQUACY REQUIREMENT Every Clearing Member of the Derivatives Segment is required to maintain a minimum capital deposit of Rs. 50 lakhs with the Exchange, of which, the 25% is to be deposited in cash, 25% by way of cash / fixed deposit receipts of bank(s) and the balance by way of bank guarantee(s) or eligible securities. In addition to above, a Clearing Member is required to deposit Rs. 7.5 lakhs with the Exchange in the specified form for every TM / LTM associated with him. Amount deposited by a Clearing Member in addition to Rs. 50 lakhs is treated as his additional capital deposit or initial margin deposit. 50% of the additional capital deposit should be in the form of cash or cash equivalents, viz., Cash, FDRs, bank guarantees. At all points of time, a Clearing Member’s liquid networth, i.e., total capital deposited less capital used towards margin should be greater than or equal to Rs. 50 lakhs. TYBBI 10 TYPES OF MEMBERSHIPS NET WORTH REQUIREMENTS (RS. LAKHS) Professional Clearing Member, Custodian Clearing Member and Trading cum Clearing Member 300 Self Clearing Member 100 Trading Member 25 Limited Trading Member 25 Limited Trading Member (for members of other stock exchange whose Clearing Member is a subsidiary company of a Regional Stock Exchange) 10
  11. 11. DERIVATIVES (Instrument for risk reduction) TYPES OF DERIVATIVES TYPES OF DERIVATIVES  FORWARD CONTRACT  FUTURE CONTRACT  OPTION CONTRACT  SWAP CONTRACT FORWARD CONTRACT A forward contract is an agreement to buy or sell an asset on a specified date for a specified price agreed upon today . It is a deal for the purchase or sale of a commodity, security or other asset in the spot or forward market. The essential idea of entering into a forward contract is to peg the price and thereby avoid the price risk. Usually no party changes hands when forward contracts are entered. Although a forward contract is a good means of avoiding price risk but it entails an element of risk that the party to the contract may not honor its part of the obligation. Once a position of buyer or seller is taken an investor cannot retreat except through mutual consent or buy entering into an identical contract by reversing his position. With forward contracts entered into on a one to one basis and with no standardization the forward contracts have a very low degree of liquidity. Therefore, the problem associated with the forward contracts led to the emergence of future contracts. EXAMPLE Imagine you are a farmer. You grow 1,000 dozens of mangoes every year. You want to sell these mangoes to a merchant but are not sure what the price TYBBI 11
  12. 12. DERIVATIVES (Instrument for risk reduction) will be when the season comes. You therefore agree with a merchant to sell all your mangoes for a fixed price for Rs 2 lakhs. This is a forward contract wherein you are the seller of mangoes forward and the merchant is the buyer. The price is agreed today in advance and the delivery will take place sometime in the future. WHERE ARE FORWARDS USED? Forwards have been used in the commodities market since centuries. Forwards are also widely used in the foreign exchange market. ESSENTIAL FEATURES OF A FORWARD CONTRACT • Contract between two parties (without any exchange between them) • Price decided today • Quantity decided today (can be based on convenience of the parties) • Quality decided today (can be based on convenience of the parties) • Settlement will take place sometime in future (can be based on convenience of the parties) • No margins are generally payable by any of the parties to the other LIMITATIONS OF FORWARDS Forwards involve counter party risk. In the above example, if the merchant does not buy the mangoes for Rs 2 lakhs when the season comes, what can you do? You can only file a case in the court, but that is a difficult process. Further, the price of Rs 2 lakhs was negotiated between you and the merchant. If somebody else wants to buy these mangoes from you, there is no mechanism of knowing what the right price is. Thus, the two major limitations of forwards are: • Counter party risk • Price not being transparent TYBBI 12
  13. 13. DERIVATIVES (Instrument for risk reduction) Counter party risk is also referred to as ‘default’ risk or ‘credit’ risk. FUTURE CONTRACT Futures trading was started in the mid – western part of USA during 1970’s , but today it is traded through out the world. Futures markets were designed to solve the problems that exist in forward markets. A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures are similar to forwards but unlike forward contracts, the futures contracts are standardized and exchange traded. . Prices are available to all those who want to buy or sell because the trading takes place on a transparent computer system. To facilitate liquidity in the futures contracts, the exchange specifies certain standard features of the contract. It is a standardized contract with standard underlying instrument, a standard quantity and quality of the underlying instrument that can be delivered, (or which can be used for reference purposes in settlement) and a standard timing of such settlement. A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. More than 99% of futures transactions are offset this way. The standardized items in a futures contract are: - • Quantity of the underlying • Quality of the underlying • The date and the month of delivery • The units of price quotation and minimum price change • Location of settlement TYBBI 13
  14. 14. DERIVATIVES (Instrument for risk reduction) FEATURES OF FUTURES • Contract between two parties through an exchange • Exchange is the legal counter party to both parties • Price decided today • Quantity decided today (quantities have to be in standard denominations specified by the exchange) • Quality decided today (quality should be as per the specifications decided by the exchange) • Tick size (i.e. the minimum amount by which the price quoted can change) is decided by the exchange • Delivery will take place sometime in future (expiry date is specified by the exchange) • Margins are payable by both the parties to the exchange • In some cases, the price limits (or circuit filters) can be decided by the exchange. LIMITATION OF FUTURE: Futures suffer from lack of flexibility. Suppose you want to buy 103 shares of Satyam for a future delivery date of 14th February, you cannot. The exchange will have standardized specifications for each contract. Thus, you may find that you can buy Satyam futures in lots of 1,200 only. You may find that expiry date will be the last Thursday of every month. Thus, while forwards can be structured according to the convenience of the trading parties involved, futures specifications are standardized by the exchange. TYBBI 14
  15. 15. DERIVATIVES (Instrument for risk reduction) FUTURE TERMINOLOGY • Spot price: The price at which an asset trades in the spot market. • Futures price: The price at which the futures contract trades in the futures market. • Contract cycle: The period over which a contract trades. The index futures contracts on the NSE have one-month, two-months and three- months expiry cycles, which expire on the last Thursday of the month. Thus a January expiration contract expires on the last Thursday of January and a February expiration contract ceases trading on the last Thursday of February. On the Friday following the last Thursday, a new contract having a three-month expiry is introduced for trading. • Expiry date: It is the date specified in the futures contract. This is the last day on which the contract will be traded, at the end of which it will cease to exist. • Contract size: The amount of asset that has to be delivered under one contract. For in-stance, the contract size on NSE’s futures market is 200 Nifties. • Basis: In the context of financial futures, basis can be defined as the futures price minus the spot price. There will be a different basis for each delivery month for each contract. In a normal market, basis will be positive. This reflects that futures prices normally exceed spot prices. • Cost of carry: The relationship between futures prices and spot prices can be summarized in terms of what is known as the cost of carry. This measures the storage cost plus the interest that is paid to finance the asset less the income earned on the asset. • Initial margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin. TYBBI 15
  16. 16. DERIVATIVES (Instrument for risk reduction) • Marking-to-market: In the futures market, at the end of each trading day, the margin ac-count is adjusted to reflect the investor’s gain or loss depending upon the futures closing price. This is called marking–to– market. Maintenance margin: This is somewhat lower than the initial 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 receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day. Maturity of futures contract Index futures of different maturities trade simultaneously on the exchanges. For instance, BSE trades three contracts on BSE SENSEX with one, two and three month’s maturity. These contracts of different maturities are called near month (one month), middle month (two months) and far month (three months) contracts. At any point of time there will be three futures contracts available for trading. Meaning of expiry of Futures Futures contracts will expire on a certain pre-specified date. In India, futures contracts expire on the last Thursday of every month. TYBBI 16
  17. 17. DERIVATIVES (Instrument for risk reduction) For example, a February Futures contract will expire on the last Thursday of February. In this case, February is referred to as the Contract month. If the last Thursday is a holiday, Futures and Options will expire on the previous working day. On expiry, all contracts will be compulsorily settled. Settlement can be effected in cash or through delivery. Convergence at Expiration Futures pricing have expectations and a time value built into them. This is the reason as time period expires the expectation value and the time value decays and the futures price converges into the cash market price. This process of convergence results in price discovery of cash index at a given point in time. Convergence also forces the respective market participants to square off their respective exposures or rollover their exposures to the next contract month. Convergence also reiterates the fact that derivatives instruments have limited life. TYBBI 17
  18. 18. DERIVATIVES (Instrument for risk reduction) WHAT TYPE OF MARGINS ARE PAYABLE ON FUTURES? Both buyers and sellers of Futures should pay an Initial Margin to the exchange at the point of entering into Futures contracts. This Initial Margin is retained by the exchange till these transactions are squared up. Further, Mark to Market Margins are payable based on closing prices at the end of each trading day. These Margins will be paid by the party who suffered losses and will be received by the party who made profits. The exchange thus collects these margins from the losers and pays them to the winners on a daily basis. MARK – TO- MARKET Every day all the open positions in Futures contracts are marked to the closing price and the variation, if any, is collected / paid to the members by debiting / crediting their settlement bank accounts with the respective clearing banks on T + 1 morning. Also, where the positions are closed, profit / loss on such positions is also credited / debited to the member’s bank accounts. TYBBI 18
  19. 19. DERIVATIVES (Instrument for risk reduction) Methodology for calculating closing price for daily mark to market: The daily closing price of the futures contract for calculating mark-to-market margin is arrived at using following algorithm:- Weighted average price of all the trades in last half an hour of the continuous trading session. If there are no trades during last half an hour, then the theoretical price would be taken as the official closing price. The theoretical price is arrived at by using the following algorithm:- Theoretical price = Closing value of underlying + ( closing value of underlying * No. of days to expiry * risk free interest rate ( at present 7.5% ) / 365 ). HOW CAN I SQUARE UP A FUTURES CONTRACT? If you have bought a Futures contract, you can sell it and thus square up. If you sold a Futures contract, you can buy it back and square up. TYBBI 19
  20. 20. DERIVATIVES (Instrument for risk reduction) If you do not square up till the day of expiry, it will be automatically squared up by the exchange. HOW TO BENEFIT FROM STOCK FUTURES You are bullish on a stock say Satyam, which is currently quoting at Rs 280 per share. You believe that in one month it will touch Rs 330. Question: What do you do? Answer: You buy Satyam. Effect: It touches Rs 330 as you predicted – you made a profit of Rs 50 on an investment of Rs 280 i.e. a Return of 18% in one month – Fantastic !! Wait: Can it get any better ? Yes !! Question: What should you do ? Answer: Buy Satyam Futures instead. Effect: On buying Satyam Futures, you get the same position as Satyam in the cash market, but you pay a margin and not the entire amount. For TYBBI 20
  21. 21. DERIVATIVES (Instrument for risk reduction) example, if the margin is 20%, you would pay only Rs 56. If Satyam goes upto Rs 330, you will still earn Rs 50 as profit. Now that translates into a fabulous return of 89% in one month. Unbelievable !!But True nevertheless !! This is the advantage of ‘leverage’ which Stock Futures provide. By investing a small margin (ranging from 10 to 25%), you can get into the same positions as you would be able to in the cash market. The returns therefore get accordingly multiplied. Question : What are the risks? Answer : The risks are that losses will be get leveraged or multiplied in the same manner as profits do. For example, if Satyam drops from Rs 280 to Rs 250, you would make a loss of Rs 30. The Rs 30 loss would translate to an 11% loss in the cash market and a 54% loss in the Futures market. Question : what is the main advantage of Futures? Answer : A great advantage of Futures (at the moment) is that they are not linked to ‘delivery’. Which means, you can sell Futures (short sell) of Satyam even if you do not have any shares of Satyam. Thus, you can benefit from a downturn as well as from an upturn. If you predict an upturn, you should buy Futures and if you predict a downturn, you can always sell Futures – thus you can make money in a falling market as well as in a rising one – an opportunity that till recently was available only to brokers/operators and not easily to retail investors. You should look for opportunities where futures prices are higher than cash prices. For example, if Satyam is quoting at Rs 250 in the cash market and one month Satyam futures are quoting at Rs 253 in the futures market, you TYBBI 21
  22. 22. DERIVATIVES (Instrument for risk reduction) can earn Rs 3 as difference. You will then buy Satyam in the cash market and at the same time, sell Satyam one month futures. On or around the expiry day (last Thursday of each month), you will square up both the positions, i.e. you will sell Satyam in the cash market and buy futures. The two prices will be the same (or very nearly the same) as cash and futures prices will converge on expiry. It does not matter to you what the price is. You will make your profit of Rs 3 anyway. For example, if the price is Rs 270, you will make a profit of Rs 20 on selling your Cash market Satyam and a loss of Rs 17 on buying back Satyam futures. The net profit is Rs 3. On the other hand, if the price is Rs 225, you make a loss of Rs 25 on selling Cash market Satyam and a profit of Rs 28 on Satyam futures. The net profit remains Rs 3. Your investment in this transaction will be Rs 250 on cash market Satyam plus a margin of say 20% on Satyam futures (say Rs 50 approx). Thus an investment of Rs 300 has generated a return of Rs 3 i.e. 1% per month or 12% per annum. Now take a situation where only 15 days are left for expiry and you spot the same opportunity as above. You will still generate Rs 3 which will translate into a return of 2% per month or 24% per annum. In this manner, you will generate returns whenever the futures prices are above cash market prices. TYBBI 22
  23. 23. DERIVATIVES (Instrument for risk reduction) TRADERS/ PARTICIPANTS/ OPERATORS OF FUTURE MARKETS  HEDGER  SPECULATOR  ARBITRAGEURS  SPREADERS Future contracts are bought and sold buy large number of individuals, business organizations, governments and others for variety of purposes. The trader in the future market can be categorized on the basis of the purposes for which they deal in the market. Usually financial derivatives attract following types of traders as under: TYBBI 23
  24. 24. DERIVATIVES (Instrument for risk reduction)  HEDGER A Hedging is a position taken in futures or other markets for the purpose of reducing exposure to one or more types of risk. A person who undertakes such position is called as “Hedger”. In other words, a hedger uses future markets to reduce risk caused by the movement in prices of securities, commodities, exchange rate, interest rate, indices, etc. as such, a hedger will take an opposite position to a perceived risk is called (hedging strategy in future markets”. The essence of hedging strategy is the adoption of future position that, on average, generates profits when the market value of the commitment is higher than the expected value.  SPECULATOR A Speculator may be defined as investors who are willing to take a risk by taking future position with the expectation to earn profits. The speculators forecast the future economic condition and decide which position (long and short) to be taken that will yield a profit if the forecast is realized. In other words, Speculators are those who do not have any position on which they enter in futures and options market. They only have a particular view on the market, stock, commodity, etc. In short, speculators put their money at risk in the hope of profiting from an anticipated price change. They consider various factors such as demand, supply, market positions, open interests, economic fundamentals and other data to take their positions. Illustration: Speculators usually trade in the future markets to earn profits on the basis of difference in spot and future prices of the underlying asset. TYBBI 24
  25. 25. DERIVATIVES (Instrument for risk reduction) Ram is a trader but has no time to track and analyze the stocks. However, he fancies his chances in predicting the market trend. So instead of buying different stocks, he buys SENSEX futures. On May 1, 2001, he buys 100 SENSEX futures @ 3600 on the expectations that the index will rise in future. On June 1, 2001, the SENSEX rises to 4000 and at that time he sells an equal number of contracts to close out his position. Selling price : 4000 x 100 = Rs. 4,00,000 Less: Purchase Cost : 3600 x 100 = Rs 3,60,000 Net Gain Rs 40,000 Ram has made a profit of Rs 40,000 by taking a call on the future value of the SENSEX. However if the SENSEX had fallen, he would have made a loss. In Index futures, players can have a long-term view of the market up to atleast 3 months….  ARBITRAGEURS Arbitrageurs are another important group of participants in the future markets. An arbitrageur is a trader who attempts to make profits by locking in a risk less trading by simultaneously entering into two or mare markets. In other words arbitrageurs try to earn risk less profit from discrepancies between future and spot prices and among future prices. An arbitrageur is basically risk averse. He enters into those contracts were he can earn risk less profits. When markets are imperfect, buying in one market and simultaneously selling in other market gives risk less profit. Arbitrageurs are always in the look out for such imperfections. In the futures market one can take advantages of arbitrage opportunities by buying from lower priced market and selling at the higher priced market. In Index futures arbitrage is possible between the spot market and the futures market (NSE has provided a special software for buying all 50 Nifty stocks in the spot market). TYBBI 25
  26. 26. DERIVATIVES (Instrument for risk reduction)  Take the case of the NSE Nifty.  Assume that Nifty is at 1200 and 3 month’s Nifty futures is at 1300.  The futures price of Nifty futures can be worked out by taking the interest cost of 3 months into account.  If there is a difference then arbitrage opportunity exists. Let us take the example of single stock to understand the concept better. If Wipro is quoted at Rs 1000 per share and the 3 months futures of Wipro is Rs 1070 then one can purchase ITC at Rs1000 in spot by borrowing @ 12% annum for 3 months at Rs 1070. Sale = 1070 Cost = 1000+30 = 1030 Arbitrage profit = 40 These kind of imperfections continue to exist in the markets but one has to be altert to the opportunities as they tend to get exhausted very fast.  SPREADERS Spreading is a specific activity trading activity in which offsetting futures position is involved by creating almost net position. So the spreads believes in lower expected return but at the less risk. A successful trading in spreading, the spreaders must forecast the relevant factors which affect the changes in the spreads. Interest rate behaviour is an important factor which causes changes in the spreads. In a profitable spread position, normally, there is a large gain on one side of the spread in comparison to the loss on the other side of the spread. In this way, a spread reduces the risks even if the forecast is incorrect. On the other hand, the pure speculators would make money by taking only the profitable side of the market but at very high risk. TYBBI 26
  27. 27. DERIVATIVES (Instrument for risk reduction) TYPES OF FUTURES Futures contract are broadly divided into two types:  COMMODITY FUTURES  FINANCIAL FUTURES COMMODITY FUTURES TYBBI 27
  28. 28. DERIVATIVES (Instrument for risk reduction) A commodity futures is a contract in commodity like agricultural products, metals & minerals etc. in organized commodity futures markets, contractscontracts are standardized with standard quantities. Of course this standard varies from commodity to commodity .they also have fixed delivery dates in each month or a few months on a year. In India commodity futures in agricultural products are popular. Some of the well established commodity futures are as follows: 1. London metal stock exchange (LME) to deal in gold 2. Chicago board of trade (CBT) to deal in soyabean oil 3. New York cotton exchange (CTN) to deal in cotton 4. Commodity exchange, NEW York (COMEX) to deal in agricultural products 5. International petroleum exchange of London (IPE) to deal in crude oil FINANCIAL FUTURES The standardized features or specification make Futures tradable like a contract. And since Futures are derivatives, the Futures contracts are based on an underlying. It is the movement of the underlying that decides how the Futures price will move. There are only two possible trades with a futures contract – Buy or Sell. If investor’s expectations for the underlying asset are bullish they should buy futures. If the expectations prove to be correct, the futures contract will rise in value allowing them to close out the position at a profit. If, on the other hand, investors view the underlying asset as bearish, then they should sell the futures contract. If the view is correct, they will be able to buy back the futures at a lower price than they were sold for, the difference being the profit they have made. Index Futures contracts can be used to take a view on the directions of the overall market with the added advantage of gearing. TYBBI 28
  29. 29. DERIVATIVES (Instrument for risk reduction) For example, lets take the underlying asset on SENSEX. If you believe the SENSEX will rise you can buy the futures contract (by going long on the SENSEX futures) or if you believe the SENSEX will fall, you can sell the SENSEX futures (by going short on the SENSEX futures). Financial Derivatives like futures do not generally terminate in delivery. Most positions are closed out before expiry. So if investor, “A” had bought two SENSEX futures contracts giving them a long position, then he is required to sell two SENSEX futures, which will result in the investor having a short position. This will mean that as far as the Clearing House is concerned the investor is both long and short of two contracts.  Sell it back into the market (If he is long)  Buy it back from the market (If he is short) These two positions are then filed away together netting one off with the other. Not only this will result in the investors having no outstanding position in the futures, but will also enable investors either to realize their profits or reduce their losses. TYPES OF FINANCIAL FUTURE 1) INTEREST RATE FUTURE CONTRACT: It is one of the important financial future instruments in the world. Future trading on interest bearing securities started only in 1975, but growth in the market has been tremendous. Important interest bearing securities are like treasury bills, notes, bonds, debenture, euro dollar time deposits and municipal bonds. In this market almost entire ranges of maturities bearing securities are traded. TYBBI 29
  30. 30. DERIVATIVES (Instrument for risk reduction) For eg: Three month maturity instruments like treasury bills & , including foreign debt instruments at CME, British govt. bond at London International . financial future exchange (LIFFE), Japanese govt. bond at CBOT etc. are traded. 2) FOREIGN CURRENCY FUTURE CONTRACT: This financial future , as the name indicates, trade in Foreign currencies , thus known as exchange rate futures . active future trading in certain currencies started in the early 1970s. Important Foreign currencies in which this future contract are made are US $ ,Pound sterling, Yen French Francs etc. these contracs have directly corresponding to spot market, known as inter bank foreign currency market , and also have a parallel inter bank foreign market. Normally this contracts are used for hedging purpose by the exporters, importers, bankers, financial institutions and large companies. 3) STOCK INDEX FUTURE: A futures contract is a standardized contract to buy or sell a specific security at a future date at an agreed price. An index future is, as the name suggests, a future on the index i.e. the underlying is the index itself. There is no underlying security or a stock, which is to be delivered to fulfill the obligations as index futures are cash settled. As other derivatives, the contract derives its value from the underlying index. The underlying indices in this case will be the various eligible indices and as permitted by the Regulator from time to. CONTRACT SPECIFICATIONS OF SENSEX FUTURES Features SENSEX Futures TYBBI 30
  31. 31. DERIVATIVES (Instrument for risk reduction) Underlying index BSE sensitive index (SENSEX) Contract Multiplier 50 Tick size or minimum price difference 0.1 index point or Rs. 5 Last trading day/expiration day Last Thursday of the expiration month. If it happens to be a holiday, the contract will expire on the previous day. Contract months 3 contracts of 30, 60 and 90 days maturity. Thus, at any point of time, there will be 3 contracts available for trading Daily settlement price Closing price of the futures contract. Final settlement price Closing price of the cash index on the expiry date of the futures contract. 4) STOCK FUTURE CONTRACT A stock futures contract is a standardized contract to buy or sell a specific stock at a future date at an agreed price. A stock future is, as the name suggests, a future on a stock i.e. the underlying is a stock. The contract derives its value from the underlying stock. Single stock futures are cash settled. CONTRACT SPECIFICATIONS OF STOCK FUTURES TYBBI 31
  32. 32. DERIVATIVES (Instrument for risk reduction) Features Stock Futures Underlying Stock Respective Stock (Annexure) Contract Multiplier Varies from Stock to Stock (Annexure) Tick size or minimum price difference - Last trading day/expiration day Last Thursday of the expiration month. If it happens to be a holiday, the contract will expire on the previous day. Contract months 3 contracts of 30, 60 and 90 days maturity. Thus, at any point of time, there will be 3 contracts available for trading Daily settlement price Closing price of the futures contract. Final settlement price Closing price of the underlying scrip on the expiry date of the futures contract. PAYOFF A payoff is the likely profit/loss that would accrue to a market participant with change in the price of the underlying asset. This is generally depicted in the form of payoff diagrams which show the price of the underlying asset on the X–axis and the profits/losses on the Y–axis. TYBBI 32
  33. 33. DERIVATIVES (Instrument for risk reduction) PAYOFF FOR FUTURES Futures contracts have linear payoffs. In simple words, it means that the losses as well as profits for the buyer and the seller of a futures contract are unlimited. These linear payoffs are fascinating as they can be combined with options and the underlying to generate various complex payoffs. 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. Take the case of a speculator who buys a two-month Nifty index futures contract when the Nifty stands at 1220. The underlying asset in this case is the Nifty portfolio. When the index moves up, the long futures position starts making profits, and when the index moves down it starts making losses. Figure 1 shows the payoff diagram for the buyer of a futures contract. PAYOFF FOR A BUYER OF NIFTY FUTURES The figure shows the profits/losses for a long futures position. The investor bought futures when the index was at 1220. If the index goes up, his futures position starts making profit. If the index falls, his futures position starts showing losses. Profit TYBBI 33
  34. 34. DERIVATIVES (Instrument for risk reduction) 1220 0 Nifty Loss ( FIGURE 1) PAYOFF FOR SELLER OF FUTURES: SHORT FUTURES The payoff for a person who sells a futures contract is similar to the payoff for a person who shorts an asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Take the case of a speculator who sells a two-month Nifty index futures contract when the Nifty stands at 1220. The underlying asset in this case is the Nifty portfolio. When the index moves down, the short futures position starts making profits, and when the index TYBBI 34
  35. 35. DERIVATIVES (Instrument for risk reduction) moves up, it starts making losses. Figure 2 shows the payoff diagram for the seller of a futures contract. PAYOFF FOR A SELLER OF NIFTY FUTURES The figure shows the profits/losses for a short futures position. The investor sold futures when the index was at 1220. If the index goes down, his futures position starts making profit. If the index rises, his futures position starts showing losses. Profit 1220 0 Nifty Loss (FIGURE 2) FORWARD V/S FUTURE TYBBI 35
  36. 36. DERIVATIVES (Instrument for risk reduction) OPTIONS Option is a security that represents the right, but not the obligation, to buy or sell a specified amount of an underlying security (stock, bond, futures contract, etc.) at a specified price within a specified time. Option Holder is the buyer of either a call or put option. Option Writer is the seller of either a call or put option. TYBBI 36 Features Forward Contract Future Contract Operational Mechanism Not traded on exchange Traded directly between 2 parties. Traded on exchange Contract Specifications Differs from trade to trade. Contracts are standardized contracts. Counter party Risk Exists Exists, but assumed by Clearing Corporation/ house. Liquidation Profile Poor Liquidity as contracts are tailor maid contracts. Very high Liquidity as contracts are standardized contracts. Price Discovery Poor; as markets are fragmented. Better; as fragmented markets are brought to the common platform. Examples Currency market in India Index, Stock& commodity futures
  37. 37. DERIVATIVES (Instrument for risk reduction) Options are different from futures in many ways. Not only both the instrument have separate payoff profiles but also Options have host of parameters that affect their pricing compared to just expectations and time in the case of Futures pricing. The risk return profile of options is different from futures. Options unlike futures are also concerned with speed of the trend and not just the underlying trend. This makes them a little more complex than Futures, but then it's this inbuilt complexity in them that also makes them more versatile instruments. With Options traders can play non - directional strategies i.e. strategies which will make money for you no matter whether markets move up, down or remain sideways. Even Directional strategies can be implemented using Options. Just like Futures there can be an underlying view even in Options, a view to buy or a view to sell. But the buyer pays up an upfront premium to protect himself if his view is incorrect. The seller on the other hand though is playing on a view wants to be the one to book an upfront premium, as a trade off against a possible loss. The seller gets paid only because he is providing the hedge to the long positions at his own risk. Options can be categorized as call and put options. The option, which gives the buyer a right to buy the underlying asset, is called Call option and the option, which gives the buyer a right to sell the underlying asset, is called Put option. Options are instruments that give the buyer a right and the seller an obligation. However, a buyer can buy a right to buy or right to sell an underlying security. The writer on the other hand charges a premium to fulfil both these obligations. We will discuss this at length later. Long option (a call or a put) position has no downside risk as his loss is protected to the premium he pays whereas a seller (of a call or put) aka writer can suffer an unlimited loss if the market moves against him. There are four basic payoffs that an option has a long call, a short call, a long put and a short put. The four payoffs or as we call them strategies TYBBI 37
  38. 38. DERIVATIVES (Instrument for risk reduction) are discussed later. These are the basic four payoffs are at the heart of the Option theory. HISTORY OF OPTIONS Although options have existed for a long time, they were traded OTC, without much knowledge of valuation. Today exchange-traded options are actively traded on stocks, stock indexes, foreign currencies and futures contracts. The first trading in options began in Europe and the US as early as the eighteenth century. It was only in the early 1900s that a group of firms set up what was known as the put and call Brokers and Dealers Association with the aim of providing a mechanism for bringing buyers and sellers together. If someone wanted to buy an option, he or she would contact one of the member firms. The firm would then attempt to find a seller or writer of the option either from its own clients or those of other member firms. If no seller could be found, the firm would undertake to write the option itself in return for a price. This market however suffered from two deficiencies. First, there was no secondary market and second, there was no mechanism to guarantee that the writer of the option would honor the contract. It was in 1973, that Black, Merton and Scholes invented the famed Black Scholes formula. In April 1973, CBOE was set up specifically for the purpose of trading options. The market for options developed so rapidly that by early ’80s, the number of shares underlying the option contract sold each day exceeded the daily volume of shares traded on the NYSE. Since then, there has been no looking back. OPTION TERMINOLOGY • Index options: These options have the index as the underlying. Some options are European while others are American. Like index futures contracts, index options contracts are also cash settled. TYBBI 38
  39. 39. DERIVATIVES (Instrument for risk reduction) • Stock options: Stock options are options on individual stocks. Options currently trade on over 500 stocks in the United States. A contract gives the holder the right to buy or sell shares at the specified price. • Buyer of an option: The buyer of an option is the one who by paying the option premium buys the right but not the obligation to exercise his option on the seller/writer. • Writer of an option: The writer of a call/put option is the one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him. There are two basic types of options, call options and put options. Call option: A call option gives the holder the right but not the obligation to buy an asset by a certain date for a certain price. Put option: A put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price. • Option price: Option price is the price which the option buyer pays to the option seller. • Expiration date: The date specified in the options contract is known as the expiration date, the exercise date, the strike date or the maturity. • Strike price: The price specified in the options contract is known as the strike price or the exercise price. • American options: American options are options that can be exercised at any time upto the expiration date. Most exchange-traded options are American. • European options: European options are options that can be exercised only on the expiration date itself. European options are easier to analyze than American options, and properties of an American option are frequently deduced from those of its European counterpart. • In-the-money option: An in-the-money (ITM) option is an option that would lead to a positive cashflow to the holder if it were exercised immediately. A call option on the index is said to be in-the-money when the current index stands at a level higher than the strike price (i.e. spot price > strike price). If the index is much higher than the strike price, the TYBBI 39
  40. 40. DERIVATIVES (Instrument for risk reduction) call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the strike price. • At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cashflow if it were exercised immediately. An option on the index is at-the-money when the current index equals the strike price (i.e. spot price = strike price)._ • Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to a negative cashflow it it were exercised immediately. A call option on the index is out-of- the-money when the current index stands at a level which is less than the strike price (i.e. spot price < strike price). If the index is much lower than the strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the index is above the strike price. • Intrinsic value of an option: The option premium can be broken down into two components - intrinsic value and time value. The intrinsic value of a call is the amount the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero. Putting it another way, the intrinsic value of a call isN½P which means the intrinsic value of a call is Max [0, (St – K)] which means the intrinsic value of a call is the (St – K). Similarly, the intrinsic value of a put is Max [0, (K -St )] ,i.e. the greater of 0 or (K - St ). K is the strike price and St is the spot price. • Time value of an option: The time value of an option is the difference between its premium and its intrinsic value. A call that is OTM or ATM has only time value. Usually, the maximum time value exists when the option is ATM. The longer the time to expiration, the greater is a call’s time value, all else equal. At expiration, a call should have no time value. 1 TYPES OF OPTIONS  Call option  Put option 1 TYBBI 40
  41. 41. DERIVATIVES (Instrument for risk reduction) CALL OPTION Call Options give the buyer the right to buy a specified underlying at a set price on or before a particular date. For example, Satyam 260 Feb Call Option gives the Buyer the right to buy Satyam at a price of Rs 60 per share on or before the last Thursday of February. The price of 260 in the above example is called the strike price or the exercise price. Call Options are also called teji in the Indian markets. PUT OPTION Put Options give the buyer the right to sell a specified underlying at a set price on or before a particular date. For example, Satyam 260 Feb Put Option gives the Buyer the right to sell Satyam at a price of Rs 260 per share on or before the last Thursday of February. Put Options are also called mandi in the Indian markets. OPTIONS CLASSIFICATIONS Options are often classified as:  In the money - These result in a positive cash flow towards the investor TYBBI 41
  42. 42. DERIVATIVES (Instrument for risk reduction)  At the money - These result in a zero-cash flow to the investor  Out of money - These result in a negative cash flow for the investor 'IN THE MONEY','AT THE MONEY'& ‘OUT OF THE MONEY' OPTIONS.  OPTION: An option is said to be 'at-the-money', when the option's strike price is equal to the underlying asset price. This is true for both puts and calls.  CALL OPTION: A call option is said to be ‘in the money’ when the strike price of the option is less than the underlying asset price. For example: A Sensex call option with strike of 3900 is 'in-the-money', when the spot Sensex is at 4100 as the call option has value. The call option holder has the right to buy a Sensex at 3900, no matter by what amount the spot price exceeded the strike price. With the spot price at 4100, selling Sensex at this higher price can make a profit. On the other hand, a call option is out-of-the-money when the strike price is greater than the underlying asset price. Using the earlier example of Sensex call option, if the Sensex falls to 3700, the call option no longer has positive exercise value. The call holder will not exercise the option to buy Sensex at 3900 when the current price is at 3700 and allow his ‘option’ right to lapse.  PUT OPTION : A put option is in-the-money when the strike price of the option is greater than the spot price of the underlying asset. For example, a Sensex put at strike of 4400 is in-the-money when the Sensex is at 4100. When this is the case, the put option has value because TYBBI 42
  43. 43. DERIVATIVES (Instrument for risk reduction) the put option holder can sell the Sensex at 4400, an amount greater than the current Sensex of 4100. Likewise, a put option is out-of-the-money when the strike price is less than the spot price of underlying asset. In the above example, the buyer of Sensex put option won't exercise the option when the spot is at 4800. The put no longer has positive exercise value and therefore in this scenario, the put option holder Will allow his ‘option’ right to lapse. CALL OPTION PUT OPTION In-the- money Strike price < Spot price of underlying asset Strike price > Spot price of underlying asset At-the- money Strike price = Spot price of underlying asset Strike price = Spot price Of underlying asset Out-of-the- money Strike price > Spot price of underlying asset Strike price < Spot price Of underlying asset AMERICAN & EUROPEAN OPTION There are two kind of options based on the date. The first is the European Option, which can be exercised only on the maturity date. The second is the American Option, which can be exercised before or on the maturity date. TYBBI 43
  44. 44. DERIVATIVES (Instrument for risk reduction) American and European Exercise Style of Options American and European are primarily natures of exercise or settlement of Options. American Options can be Exercised anytime prior to the the expiration date. European options in the other hand can only be exercised at the Expiration day. Indian stock options have the American Exercise settlement while Index Options can only be settles at Expiration. In India, both styles are available. Index Options are European style, while individual stock options are American style. EXCHANGE TRADE AND OTC – TRADE OPTIONS:- The option can be traded like other financial assets either on an organized exchange or on the over-the counter (OTC) market. Exchange option contracts, like future contracts are traded on the recognized exchanges. On the other hand, over the counter (OTC) option are customer TYBBI 44
  45. 45. DERIVATIVES (Instrument for risk reduction) tailored agreement sold directly by the dealer rather than through the organized exchange. The terms and conditions of these contracts are negotiated by the parties to the contracts. Both the option has have different mechanism of functioning, which are discussed here as under: • Exchange traded option like futures contracts, are standardized and are traded on organized (or government designated) exchanges. On the other hand, the OTC options are written on the counters of the large commercial and investment bankers. • Exchange traded option have certain specified norms relating to quantity, maturity date, underlying assets, etc. which are determined by the exchanges how ever in the case of OTC option all such terms are subject to negotiation and mutually determined by buyer and seller of the option contracts. • Being standardize in nature an option contract traded through the recognized exchange has uniform underlying assets, limited no of strike prices, limited expiration dates and so on. • Exchange traded option are performed and cleared through a clearing house corporation which interposes it self as a thirty party to the all options contracts. Since, these options are guaranteed by the exchanges, hence default risks is almost eliminated. • On buying an option contracts from a recognized exchange, the obligation can be fulfilled in one of the three ways which are mentioned as follows: TYBBI 45
  46. 46. DERIVATIVES (Instrument for risk reduction) 1. The option buyer may not exercise the current, allowing the option to expire. The entire premium is retained by the seller and seller’s obligation is discharged. 2. In case of the parties to the option, the buyer can exercise his right on or before the expiration date. 3. Either of the parties to the option contract can execute an offsetting transaction in the option market to eliminate the obligation. THE UNDERLYING ASSET IN EXCHANGE TRADED OPTION Various assets , which are actively traded on recognized exchanges are stocks, stocks indices, foreign currencies and future contract . TYBBI 46
  47. 47. DERIVATIVES (Instrument for risk reduction) These are explained as follows. 1. Stocks options 2. Stocks indices, 3. Foreign currencies 4. Futures Option 5. Interest rate Option 1. STOCKS OPTIONS: Options on Individual Stocks are options contracts where the underlyings are individual stocks. Based on eligibility criteria and subject to the approval from the regulator, stocks are selected on which options are introduced. These contracts are cash settled and are American style. Trading on standardized call option on equity shares started in 1973 on CBOE where as on Put option began in 1977. Stock options are most popular asset , which are traded on various exchanges all over the world. In India, NSE and BSE have started option trading in certain stock from the year 2001. CONTRACT SPECIFICATIONS OF STOCK OPTIONS Underlying: Individual scrip TYBBI 47
  48. 48. DERIVATIVES (Instrument for risk reduction) Contract Multiplier: As specified Ticker Symbol: As specified Strike Prices: minimum of 5 strikes (2 in the money, 1 near the money, 2 Out of the money). Premium Quotation: Rupees per share. Last Trading Day: Last Thursday of the month. If it is a holiday than the preceding business day. Expiration Day: Last Thursday of contract month. If it is a holiday than the preceding business day. Note: Business day is a day during which the underlying stock market is open for trading Contract Month: 1, 2 and 3 months Exercise Style: American. Settlement Style: Cash Trading Hours: 9:30 A.M. to 3:30 P.M. Tick Size: 0.01 TYBBI 48
  49. 49. DERIVATIVES (Instrument for risk reduction) 2. INDEX OPTION. Many different index options are currently traded on the different exchanges in different countries. For ex .S$P 100 index at CBOE and major index at AMEX are traded in the US option markets. Similarly, in India, such index option has been started on national stock exchange and Bombay stock exchange. Like stock option, index options strike prices are the index value at which the buyer of the option can buy or sell the underlying stock index. The strike index is converted into dollar (rupee) value by multiplying the strike index by the multiple for the contract. If the buyer of the stock index option indented to exercise the option then the stock must be delivered. It would be complicated settle a stock index option by delivering all the stock that makes the particular index. If the option is exercise, the stock exchange assigned option writer pays cash to the option buyer, and there will no delivery of any share. The money value of the stock index underlying an index option is equal to the current cash index value multiplied by the contracts multiplied. Rupees value of the underlying index = cash index value x contract multiplies 3. FOREIGN CURRENCIES OPTION. Foreign currencies is another important assets, which is traded on varies stock exchanges. Foreign exchange option has traded on the Philadelphia stock exchange since 1984. Major currencies traded in the option markets are TYBBI 49
  50. 50. DERIVATIVES (Instrument for risk reduction) us dollar, Australian dollar, British pounds, Canadian dollar, German mark, French franc, Japanese yen, Swiss franc, etc. Call option gives the owner the right to buy stated amount of foreign exchange at strike rate. The strike price is itself exchange rate. Foreign currencies puts give the owner the right to sell foreign exchange at strike prices. The exchange traded currency option market is quit liquid. 4. FUTURE OPTION. In the future option (or option on futures), the underlying assets is a future contract at a designated price at a time during life of the options. If the future option is call option, the buyer has the right to acquire a long future position. Similarly, a put option on a future contract grants the buyer the right. 5. INTEREST RATE OPTION. Interest rate options are another important option contract, which are popular in the international financial markets. Interest rate option can be written on cash instrument or future. These are various debt instruments which are used as underlying instrument for interest rate option in different exchanges. These contracts are referred as option on physicals. Recently, these instrument rate option have also gained popularity on the over the – counter markets like on treasury bounds, agency debentures, large banking firms, and mortgage - backed – securities OPTIONS PAY OFFS The optionality characteristic of options results in a non-linear payoff for options. In simple words, it means that the losses for the buyer of an option are limited, however the profits are potentially unlimited. For a writer, the TYBBI 50
  51. 51. DERIVATIVES (Instrument for risk reduction) payoff is exactly the opposite. His profits are limited to the option premium, however his losses are potentially unlimited. These non-linear payoffs are fascinating as they lend themselves to be used to generate various payoffs by using combinations of options and the underlying. PAYOFF PROFILE FOR BUYER OF CALL OPTIONS: LONG CALL A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. If upon expiration, the spot price exceeds the strike price, he makes a profit. Higher the spot price, more is the profit he makes. If the spot price of the underlying is less than the strike price, he lets his option expire un-exercised. His loss in this case is the premium he paid for buying the option. Figure 3 gives off for the buyer of a three month call option (often referred to as long call) with a strike of 1250 bought at a premium of 86.60. PAY OFF FOR BUYER OF CALL OPTION The figure shows the profits/losses for the buyer of a three-month Nifty 1250 call option. As can be seen, as the spot Nifty rises, the call option is in-the- money. If upon expiration, Nifty closes above the strike of 1250, the buyer would exercise his option and profit to the extent of the difference between the TYBBI 51
  52. 52. DERIVATIVES (Instrument for risk reduction) Nifty-close and the strike price. The profits possible on this option are potentially unlimited. However if Nifty falls below the strike of 1250, he lets the option expire. His losses are limited to the extent of the premium he paid for buying the option. Profit 1250 0 Nifty 86.60 Loss ( FIGURE 3 ) PAYOFF PROFILE FOR WRITER OF CALL OPTIONS: SHORT CALL A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option. For selling the option, the writer of the option charges a premium. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. Whatever is the buyer’s profit is the seller’s loss. If upon expiration, the spot price exceeds the strike price, the buyer will exercise the option on the writer. Hence as the spot price increases the writer of the option starts making losses. Higher the spot price, more is the loss he makes. If upon expiration the spot price of the underlying is less than the strike price, the buyer lets his option expire un-exercised and the writer gets to keep the premium. Figure 4 gives for the writer of a three month call option (often referred to as short call) with a strike of 1250 sold at a premium of 86.60. PAYOFF FOR WRITER OF CALL OPTIONS TYBBI 52
  53. 53. DERIVATIVES (Instrument for risk reduction) The figure shows the profits/losses for the seller of a three-month Nifty 1250 call option. As the spot Nifty rises, the call option is in-the-money and the writer starts making losses. If upon expiration, Nifty closes above the strike of 1250, the buyer would exercise his option on the writer who would suffer a loss to the extent of the difference between the Nifty-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.86.60 charged by him. Profit Profit 86.60 1250 0 Nifty Loss (FIGURE 4) PAYOFF PROFILE FOR BUYER OF PUT OPTIONS: LONG PUT A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. If upon expiration, the spot price is below the strike price, he makes a profit. Lower the spot price, more is the profit he makes. If the spot price of the underlying is higher than the strike TYBBI 53
  54. 54. DERIVATIVES (Instrument for risk reduction) price, he lets his option expire un-exercised. His loss in this case is the premium he paid for buying the option. Figure 5gives the payoff for the buyer of a three-month put option (often referred to as long put) with a strike of 1250 bought at a premium of 61.70. PAYOFF FOR BUYER OF PUT OPTIONS The figure shows the profits/losses for the buyer of a three-month Nifty 1250 put option. As can be seen, as the spot Nifty falls, the put option is in-the- money. If upon expiration, Nifty closes below the strike of 1250, the buyer would exercise his option and profit to the extent of the difference between the strike price and Nifty-close. The profits possible on this option can be as high as the strike price. However if Nifty rises above the strike of 1250, he lets the option expire. His losses are limited to the extent of the premium he paid for buying the option. Profit 1250 0 Nifty 61.70 Loss ( FIGURE 5 ) PAYOFF PROFILE FOR WRITER OF PUT OPTIONS: SHORT PUT A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option. For selling the option, the writer of the option charges a premium. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. Whatever is the buyer’s profit is TYBBI 54
  55. 55. DERIVATIVES (Instrument for risk reduction) the seller’s loss. If upon expiration, the spot price happens to be below the strike price, the buyer will exercise the option on the writer. If upon expiration the spot price of the underlying is more than the strike price, the buyer lets his option expire un-exercised and the writer gets to keep the premium. Figure 6gives the payoff for the writer of a three-month put option (often referred to as short put) with a strike of 1250 sold at a premium of 61.70. PAYOFF FOR WRITER OF PUT OPTIONS The figure shows the profits/losses for the seller of a three-month Nifty 1250 put option. As the spot Nifty falls, the put option is in-the-money and the writer starts making losses . If upon expiration, Nifty closes below the strike of 1250, 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 Nifty-close. The loss that can be incurred by the writer of the option is a maximum extent of the strike price(Since the worst that can happen is that the asset price can fall to zero) whereas the maximum profit is limited to the extent of the up-front option premium of Rs.61.70 charged by him. Profit 61.70 1250 0 Nifty Loss ( FIGURE 6 ) FUTURE V/S OPTIONS Long Futures Short Futures Long Call Short Call Long Put Short Put TYBBI 55
  56. 56. DERIVATIVES (Instrument for risk reduction) Trader’s rights and obligation s Right and obligation to buy Right and obligation to sell Right but not the obligation to buy Obligation to deliver Right but not the obligation to sell Obligation to buy Premium paid or received - - Paid Received Paid Received Margin requireme nt Yes Yes None Yes None Yes Risk (loss) Unlimited in case of a decline in prices Unlimited in case prices rise. Loss and risk limited to the premium paid upfront. Unlimited in case prices rise Loss and risk limited to the premium paid upfront Unlimited in case of a decline in prices Return (Profit) Unlimited, if prices rise Unlimited in case of a decline in prices Unlimited in case prices rise Return limited the premium received upfront Unlimited, in case prices decline Return limited to the extent of the premium received upfront WHAT ARE SWAPS? A contract between two parties, referred to as counterparties, to exchange two streams of payments for agreed period of time. The payments, commonly called legs or sides, are calculated based on the underlying notional using TYBBI 56
  57. 57. DERIVATIVES (Instrument for risk reduction) applicable rates. Swaps contracts also include other provisional specified by the counterparties. Swaps are not debt instrument to raise capital, but a tool used for financial management. Swaps are arranged in many different currencies and different periods of time. US$ swaps are most common followed by Japanese yen, sterling and Deutsche marks. The length of past swaps transacted has ranged from 2 to 25 years. WHY DID SWAPS EMERGE? In the late 1970's, the first currency swap was engineered to circumvent the currency control imposed in the UK. A tax was levied on overseas investments to discourage capital outflows. Therefore, a British company could not transfer funds overseas in order to expand its foreign operations without paying sizeable penalty. Moreover, this British company had to take an additional currency risks arising from servicing a sterling debt with foreign currency cash flows. To overcome such a predicament, back-to-back loans were used to exchange debts in different currencies. For example, a British company wanting to raise capital in the France would raise the capital in the UK and exchange its obligations with a French company, which was in a reciprocal position. Though this type of arrangement was providing relief from existing protections, one could imagine, the task of locating companies with matching needs was quite difficult in as much as the cost of such transactions was high. In addition, back-to-back loans required drafting multiple loan agreements to state respective loan obligations with clarity. However this type of arrangement lead to development of more sophisticated swap market of today. TYPES OF SWAP 1) Currency swaps TYBBI 57
  58. 58. DERIVATIVES (Instrument for risk reduction) Currency swaps can be defined as a legal agreement between two or more parties to exchange interest obligation or interest receipts between two different currencies. It involves three steps: • Initial exchange of principal between the counter parties at an agreed upon rate of exchange which is usually based on spot exchange rate. This exchange is optional and its sole objective is to establish the quantum of the respective principal amounts for the purpose for calculating the ongoing payments of interest and to establish the principal amount to be re-exchanged at the maturity of the swap. • Ongoing exchange of interest at the rates agreed upon at the outset of the transaction. • Re-exchange of principal amount on maturity at the initial rate of exchange. This straight forward, three step process results in the effective transformation of the debt raised in one currency into a fully hedged liability in other currency. 2) Interest Rate Swap An Interest Rate Swap (IRS) is a financial contract between two parties exchanging or swapping a stream of interest payments for a notional principal amount of multiple occasions on specified periods. Accordingly, on each payment date that occurs during the swap period-Cash payments based on fixed/floating and floating rates are made by the parties to one another. 3) Debt – Equity Swap In Debt – Equity Swap , a firm buy a counter debt on the secondary loan market at a discount & Swap it into local eqyuity . in other words , the debt’s are exchanged for equity by one firm with another. DEVELOPMENT OF DERIVATIVES MARKET IN INDIA TYBBI 58
  59. 59. DERIVATIVES (Instrument for risk reduction) The first step towards introduction of derivatives trading in India was the promulgation of options in securities. The market for derivatives, however, did not take off, as there was no regulatory framework to govern trading of derivatives. SEBI set up a 24–member committee under the Chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop appropriate regulatory framework for derivatives trading in India. The committee submitted its report on March 17, 1998 prescribing necessary pre–conditions for introduction of derivatives trading in India. The committee recommended that derivatives should be declared as ‘securities’ so that regulatory framework applicable to trading of ‘securities ’ could also govern trading of securities. SEBI also set up a group in June 1998 under the Chairmanship of Prof.J.R.Varma, to recommend measures for risk containment in derivatives mark et in India. The report, which was submitted in October 1998, worked out the operational details of margining system, methodology for charging initial margins, broker net worth, deposit requirement and real–time monitoring requirements. The Securities Contract Regulation Act (SCRA) was amended in December 1999 to include derivatives within the ambit of ‘securities’ and the regulatory framework was developed for governing derivatives trading. The act also made it clear that derivatives shall be legal and valid only if such contracts are traded on a recognized stock exchange, thus precluding OTC derivatives. The government also rescinded in March 2000, the three– decade old notification, which prohibited forward trading in securities. Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2001. 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. To begin with, SEBI approved trading in index futures contracts based on S&P CNX Nifty and BSE–30(Sensex) index. This was followed by approval for trading in options based on these two indexes and options on individual securities. TYBBI 59
  60. 60. DERIVATIVES (Instrument for risk reduction) The trading in BSE Sensex options commenced on June 4, 2001 and the trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001. The derivatives trading on NSE commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in index options commenced on June 4, 2001 and trading in options on individual securities commenced on July 2, 2001. Single stock futures were launched on November 9, 2001. The index futures and options contract on NSE are based on S&P CNX. Trading and settlement in derivative contracts is done in accordance with the rules, byelaws, and regulations of the respective exchanges and their clearing house/corporation duly approved by SEBI and notified in the official gazette. INDIAN DERIVATIVES MARKET Starting from a controlled economy, India has moved towards a world where prices fluctuate every day. The introduction of risk management instruments in India gained momentum in the last few years due to liberalisation process TYBBI 60
  61. 61. DERIVATIVES (Instrument for risk reduction) and Reserve Bank of India’s (RBI) efforts in creating currency forward market. Derivatives are an integral part of liberalisation process to manage risk. NSE gauging the market requirements initiated the process of setting up derivative markets in India. In July 1999, derivatives trading commenced in India. CHRONOLOGY OF INSTRUMENTS 1991 Liberalisation process initiated 14 December 1995 NSE asked SEBI for permission to trade index futures. 18 November 1996 SEBI setup L.C.Gupta Committee to draft a policy framework for index futures. 11 May 1998 L.C.Gupta Committee submitted report. 7 July 1999 RBI gave permission for OTC forward rate agreements (FRAs) and interest rate swaps. 24 May 2000 SIMEX chose Nifty for trading futures and options on an Indian index. 25 May 2000 SEBI gave permission to NSE and BSE to do index futures trading. 9 June 2000 Trading of BSE Sensex futures commenced at BSE. 12 June 2000 Trading of Nifty futures commenced at NSE. 25 September 2000 Nifty futures trading commenced at SGX. 2 June 2001 Individual Stock Options & Derivatives CONCLUSION This project conclude that derivatives are powerful and innovative product which transfer the risk from those who do not want to take it at a price to those who are capable of and expert in managing risk. Hedger, Speculator and Arbitrageurs are the people who are prepared to deal wIth the risk. TYBBI 61
  62. 62. DERIVATIVES (Instrument for risk reduction) Financial institution are very sensitive to the risk exposer measures so they look Forward to derivatives market and use various innovative products like Forward, Future, Options and Swaps. Indian derivatives market is strongly routed through the stock exchanges and commodities market derivatives. Future traders deal through the stock exchanges in a standardize manner. NSE India is the Pioneer of derivatives product in India. Derivatives are important tools which help in growth of Indian Capital Markets. SEBI on time to time issue various guidelines to all the dealers of derivatives to bring transparency in the working. TYBBI 62

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