PRODUCTS IN DERIVATIVES MARKET1A PROJECT REPORT ONPRODUCTS IN DERIVATIVES MARKETBY JASMEET SINGH
PRODUCTS IN DERIVATIVES MARKET2I. Derivatives markets, products and participants1. IntroductionDerivatives have been associated with a number of high-profile corporate eventsthat roiled the global financial markets over the past two decades. To some critics,derivatives have played an important role in the near collapses or bankruptcies ofBarings Bank in 1995,Long-term Capital Management in 1998, Enron in 2001, Lehman Brothers in andAmerican International Group (AIG) in 2008. Warren Buffet even viewed derivativesas time bombs for the economic system and called them financial weapons of massdestruction (Berkshire Hathaway Inc (2002)).But derivatives, if “properly” handled, can bring substantial economic benefits. TheseInstruments help economic agents to improve their management of market andcredit risks.The key differences of these markets will be highlighted. Section 6 reviews somerecent credit events and to what extent counterparty risk has played a role.
PRODUCTS IN DERIVATIVES MARKET32. ORIGIN OF FINANCIAL DERIVATIVESFinancial derivatives have emerged as one of the biggest markets of the world during the pasttwo decades. A rapid change in technology has increased the processing power of computers andhas made them a key vehicle for information processing in financial markets. Globalization offinancial markets has forced several countries to change laws and introduce innovative financialcontracts which have made it easier for the participants to undertake derivatives transactions.Early forward contracts in the US addressed merchants‘ concerns about ensuring that there werebuyers and sellers for commodities. ‗Credit risk‘, however remained a serious problem. To dealwith this problem, a group of Chicago businessmen formed the Chicago Board of Trade (CBOT)in 1848. The primary intention of the CBOT was to provide a centralized location (which wouldbe known in advance) for buyers and sellers to negotiate forward contracts. In 1865, the CBOTwent one step further and listed the first ‗exchange traded‖ derivatives contract in the US. Thesecontracts were called ‗futures contracts‖. In 1919, Chicago Butter and Egg Board, a spin-off ofCBOT, was reorganized to allow futures trading. Its name was changed to Chicago MercantileExchange (CME).The CBOT and the CME remain the two largest organized futures exchanges, indeed the twolargest ―financial‖ exchanges of any kind in the world today. The first exchange-traded financialderivatives emerged in 1970‘s due to the collapse of fixed exchange rate system and adoption offloating exchange rate systems. As the system broke down currency volatility became a crucialproblem for most countries. To help participants in foreign exchange markets hedge their risksunder the new floating exchange rate system. Foreign currency futures were introduced in 1972at the Chicago Mercantile Exchange.In 1973, the Chicago Board of Trade (CBOT) created the Chicago Board Options Exchange(CBOE) to facilitate the trade of options on selected stocks. The first stock index futures contractwas traded at Kansas City Board of Trade. Currently the most popular stock index futures
PRODUCTS IN DERIVATIVES MARKET43. Some concepts basic and Growth of Derivatives MarketThe Oxford dictionary defines a derivative as something derived or obtained fromanother, coming from a source; not original. In the field of financial economics, aderivative security is generally referred to a financial contract whose value is derivedfrom the value of an underlying asset or simply underlying.There are a wide range of financial assets that have been used as underlying,including equities or equity index, fixed-income instruments, foreignCurrencies, commodities, credit events and even other derivative securities.Depending on the types of underlying, the values of the derivative contracts can bederived from the corresponding equity prices, interest rates, exchange rates,commodity prices and the probabilities of certain credit events.The derivative market growth is spectacular. In order to understand modern day finance you must atleast have an idea about what derivatives are and how they function. Monitoring certain derivativesmarkets can be crucial in understanding market risk which has a direct effect on equities as equities areusually the last to respond to market developments in terms of other securities. For investors who donot have a large capital base or tons of money to invest with, understanding current market risk is vital.We may not have the cash/liquidity to ride out spouts of deflationary markets. Seeing your stockposition down over 50% can be disheartening. Above is a chart of the growth in the derivatives market.
PRODUCTS IN DERIVATIVES MARKET5II. Major types of derivativesThere are five main types of derivatives contracts: forwards; futures, optionswarrants and swaps.This section discusses the basics of these five types of derivatives with the help ofsome specific examples of these instruments.
PRODUCTS IN DERIVATIVES MARKET61. Forwards and futures contractsForward and futures contracts are usually discussed together as they share a similarfeature:a forward or futures contract is an agreement to buy or sell a specified quantity of anasset at a specified price with delivery at a specified date in the future.But there are important differences in the ways these contracts are transacted. First,participants trading futures can realise gains and losses on a daily basis whileforwards transaction requires cash settlement at delivery. Second, futures contractsare standardised while forwards are customised to meet the special needs of thetwo parties involved (counterparties). Third, unlike futures contracts which aresettled through established clearing house, forwards are settled between thecounterparties. Fourth, because of being exchange-traded, futures are regulatedwhereas forwards, which are mostly over-the-counter (OTC) contracts, and looselyregulated (at least in the run up to the global financial crisis).This importance of exchange-traded versus OTC instruments will be discussedfurther in later section.2. Options contractsOptions contracts can be either standardized or customized. There are two types ofoption: call and put options. Call option contracts give the purchaser the right to buya specified quantity of a commodity or financial asset at a particular price (theexercise price) on or before a certain future date (the expiration date). Similarly, putoption contracts give the buyer the right to sell a specified quantity of an asset at aparticular price on a before a certain future date. These definitions are based on theso-called American-style option. And for a European style option, the contract canonly be exercised on the expiration date.In options transaction, the purchaser pays the seller – the writer of the options – anamount for the right to buy or sell. This amount is known as the option premium.Note that an important difference between options contracts and futures andforwards contracts is that options do not require the purchaser to buy or sell theunderlying asset under all circumstances. In the event that options are not exercisedat expiration, the purchaser simply loses the premium paid. If the options areexercised, however, the option writer will be liable for covering the costs of anychanges in the value of the underlying that benefit the purchasers.
PRODUCTS IN DERIVATIVES MARKET73. SwapsSwaps are agreements between two counterparties to exchange a series ofcash payments for a stated period of time. The periodic payments can be chargedon fixed or floating interest rates, depending on contract terms. The calculation ofthese payments is based on an agreed-upon amount, called the notional principalamount or simply the notional.
PRODUCTS IN DERIVATIVES MARKET8III . FORWARDS1. MeaningA forward contract is a private transaction - a futures contract is not. Futures contracts arereported to the futures exchange, the clearing house and at least one regulatory agency. Theprice is recorded and available from pricing services.Forwards have credit risk, but futures do not because a clearing house guarantees against defaultrisk by taking both sides of the trade and marking to market their positions every night. Mark tomarket is the process of converting daily gains and losses into actual cash gains and losses eachnight. As one party loses on the trade the other party gains, and the clearing house moves thepayments for the counterparty through this process.Forwards are basically unregulated, while future contract are regulated at the federalgovernment level. The regulation is there to ensure that no manipulation occurs, that trades arereported in a timely manner and that the professionals in the market are qualified and honest.What are forward deals?A forward deal is a contract where the buyer and seller agree to buy or sell an asset or currencyat a spot rate for a specified date in the future (usually up to 60 days). Forward contracts areconducted as a way to cover (hedge) future movements in exchange rates. Margin spreads arehigher than in Day Trading but no renewal fees are charged. Forward deals with easy-forex®areonly offered in some world regions.
PRODUCTS IN DERIVATIVES MARKET9In Global Financial Markets, for many years, options have been a means of conveyingrights from one party to another at a specified price on or before a specific date. Options to buyand sell are commonly executed in real estate and equipment transactions, just as they have beenfor years in the securities markets. There are two types of option agreements: CALLS and PUTS.A CALL OPTION is a contract that conveys to the owner the right, but not theobligation, to purchase a prescribed number of shares or futures contracts of anunderlying security at a specified price before or on a specific expiration date.A PUT OPTION is a contract that conveys to the owner the right, but not obligation,to sell a prescribed number of shares or futures contracts of an underlying security at aspecified price before or on a specific expiration date.Consequently, if the market in a security were expected to advance, a trader wouldpurchase a call and, conversely, if the market in a security were expected to decline, a traderwould purchase a put. With the advent of listed options, the inconvenience and difficultiesoriginally associated with transacting options have been greatly diminished.Exchange-traded options have many benefits including flexibility, leverage, limitedrisk for buyers employing these strategies, and contract performance guaranteed by StockExchanges. Options allow you to participate in price movements without committing the largeamount of funds needed to buy stock outright. Options can also be used to hedge a stockposition, to acquire or sell stock at a purchase price more favorable than the current market price,or, in the case of writing (selling) options, to earn premium income. Options give you options.You‘re not just limited to buying, selling or staying out of the market. With options, you cantailor your position to your own financial situation, stock market outlook and risk tolerance.Whether you are a conservative or growth-oriented investor, or even a short-term,aggressive trader, your broker can help you select an appropriate options strategy. The strategiespresented do not cover all, or even a significant number, of the possible strategies utilizingoptions. These are the most basic strategies, however, and will serve well as building blocks formore complex strategies.
PRODUCTS IN DERIVATIVES MARKET10Despite their many benefits, options are not suitable for all investors. Individuals shouldnot enter into option transactions until they have read and understood the risk disclosure sectioncoming later in this document which outlines the purposes and risks thereof. Further, if you haveonly limited or no experience with options, or have only a limited understanding of the terms ofoption contracts and basic option pricing theory, you should examine closely another industrydocument.Options are currently traded on the following Indian exchanges: The Stock Exchange,Mumbai (BSE) and National Stock Exchange (NSE). Like trading in stocks, an option trading isregulated by the SEBI. These exchanges seek to provide competitive, liquid, and orderly marketsfor the Purchase and sale of standardized options. It must be noted that, despite the efforts ofeach exchange to provide liquid markets, under certain conditions it may be difficult orimpossible to liquidate an option position.
PRODUCTS IN DERIVATIVES MARKET112. Settlement of forward contractsForward Markets and Contracts: Settlement ProceduresThe differences between long and short positions in forward markets are as follows:The long position holder is the buyer of the contract and the short position holder is theseller of the contract.The long position will take the delivery of the asset and pay the seller of the asset thecontract value, while the seller is obligated to deliver the asset versus the cash value ofthe contract at the origination date of this transaction.When it comes to default, both parties are at risk because typically no cash is exchangedat the beginning of the transaction. However, some transactions do require that one orboth sides put up some form of collateral to protect them from the defaulted party.Procedures for Settling a Forward Contract at ExpirationA forward contact at expiration can be settled in one of two ways:1. Physical Delivery - Refers to an option or futures contract that requires the actualunderlying asset to be delivered on the specified delivery date, rather than being tradedout with offsetting contracts. Most derivatives are not actually exercised, but are tradedout before their delivery dates. However, physical delivery still occurs with some trades:it is most common with commodities, but can also occur with other financial instruments.Settlement by physical delivery is carried out by clearing brokers or their agents.Promptly after the last day of trading, the regulated exchanges clearing organization willreport a purchase and sale of the underlying asset at the previous days settlement price(also referred to as the "invoice price"). Traders who hold a short position in a physicallysettled security futures contract to expiration are required to make delivery of theunderlying asset. Those who already own the assets may tender them to the appropriateclearing organization. Traders who do not own assets are obligated to purchase them atthe current price.
PRODUCTS IN DERIVATIVES MARKET122. Exchanges specify the conditions of delivery for the contracts they cover. Acceptablelocations for delivery (in the case of commodities or energies) and requirements as to thequality, grade or nature of the underlying asset to be delivered are regulated by theexchanges. For example, only certain Treasury bonds may be delivered under theChicago Board of Trades Treasury bond future. Only certain growths of coffee may bedelivered under the Coffee, Sugar and Cocoa Exchanges coffee future. In manycommodity or energy markets, parties want to settle futures by delivery, but exchangerules are too restrictive for their needs. For example, the New York Mercantile Exchangerequires that natural gas be delivered only at the Henry Hub in Louisiana, a location thatmay not be convenient for all futures traders.3. Cash Settlement - Refers to an option or futures contract that requires the counterpartiesto the contract to net out the cash difference in the value of their positions. Theappropriate party receives the cash difference. In the case of cash settlement, no actualassets are delivered at the expiration of a futures contract. Instead, traders must settle anyopen positions by making or receiving a cash payment based on the difference betweenthe final settlement price and the previous days settlement price. Under normalcircumstances, the final settlement price for a cash-settled contract will reflect theopening price for the underlying asset. Once this payment is made, neither the buyer northe seller of the futures contract has any further obligations on the contract.Example: Settling a Forward ContractLets return to our sailboat example from the first part of this section. Assume that at the end of12 months you are a bit ambivalent about sailing. In this case, you could settle your forwardcontract with John in one of two ways:1. Physical Delivery - John delivers that sailboat to you and you pay him $150,000, asagreed.2. Cash Settlement - John sends you a check for $35,000. (The difference between yourcontracts purchase price of $150,000 and the sail boats current market value of$165,000.)The same options are available if the current market price is lower than the forward contractssettlement price. If Johns sailboat decreases in value to $135,000, you could simply pay John$15,000 to settle the contract, or you could pay him $150,000 and take physical possession of theboat. (You would still suffer a $15,000 loss when you sold the boat for the current price of$135,000.)
PRODUCTS IN DERIVATIVES MARKET133. KEY FEATURES OF FORWARD CONTRACTSA forward is an agreement between two counterparties - a buyer and seller. The buyer agrees tobuy an underlying asset from the other party (the seller). The delivery of the asset occurs at alater time, but the price is determined at the time of purchase. Key features of forward contractsare:Highly customized - Counterparties can determine and define the terms and features to fittheir specific needs, including when delivery will take place and the exact identity of theunderlying asset.All parties are exposed to counterparty default risk - This is the risk that the other partymay not make the required delivery or payment.Transactions take place in large, private and largely unregulated markets consisting ofbanks, investment banks, government and corporations.Underlying assets can be a stocks, bonds, foreign currencies, commodities or somecombination thereof. The underlying asset could even be interest rates.They tend to be held to maturity and have little or no market liquidity.Any commitment between two parties to trade an asset in the future is a forward contract.ExampleLets assume that you have just taken up sailing and like it so well that you expect you might buyyour own sailboat in 12 months. Your sailing buddy, John, owns a sailboat but expects toupgrade to a newer, larger model in 12 months. You and John could enter into a forward contractin which you agree to buy Johns boat for $150,000 and he agrees to sell it to you in 12 monthsfor that price. In this scenario, as the buyer, you have entered a long forward contract.Conversely, John, the seller will have the short forward contract. At the end of one year, you findthat the current market valuation of Johns sailboat is $165,000. Because John is obliged to sellhis boat to you for only $150,000, you will have effectively made a profit of $15,000. (You canbuy the boat from John for $150,000 and immediately sell it for $165,000.) John, unfortunately,has lost $15,000 in potential proceeds from the transaction.Like all forward contracts, in this example, no money exchanged hands when the contract wasnegotiated and the initial value of the contract was zero.
PRODUCTS IN DERIVATIVES MARKET144. Default Risk in Forward ContractA drawback of forward contracts is that they are subject to default risk. Regardlessof whether the contract is for physical or cash settlement, there exists a potentialfor one party to default, i.e. not honor the contract. It could be either the buyer orthe seller. This results in the other party suffering a loss. This risk of makinglosses due to any of the two parties defaulting is known as counter party risk.
PRODUCTS IN DERIVATIVES MARKET15VI. FUTURES1. IntroductionA futures contract is an agreement between a buyer and a seller that calls for the seller to deliverto the buyer a specified quantity and grade of an identified commodity or security , at a fixeddate in the future , at a price agreed to when the contract is first entered into. All futures contractshave to be bought and sold on designated contract markets known as futures exchanges.A financial futures contract is an exchange traded contract for the delivery of standardisedamounts of the underlying financial instrument at a future date. The price for the financialinstrument is agreed on the day the contract is bought or sold and gains or losses are incurred asa result of subsequent price fluctuations. Unlike 1forward contracts, futures contracts are readilytradeable , reflecting the standardisation of contract terms.The purchase or sale of a futures contract is, therefore, a commitment to make or take deliveryof a specific financial instrument, at a predetermined date in the future, for which the price isestablished at the time of the initial transaction. Transactions are actually entered into in thefutures exchange either through the ―open outcry‖ method on the exchange floor or through ascreen-based trading system.Contracts are standardised which means that participants can buy and sell them freely on thefutures exchange with precise knowledge of the contracts being traded.The contract specifies both the type of the financial instrument and its ‗quality‘ in terms of suchmatters as coupon rate and maturity. The instruments specified must be delivered at or during aspecified month in the future (known as delivery date) - usually in a cycle of March, June,September and December. Exact delivery details vary according to the nature of the instrumentor indicator. For contracts based on stock-market indices, no physical delivery can take place,and settlement is based on a cash payment calculated on movement of the index.Although contracts are traded between the buyer and the seller on the exchange floor, each hasan obligation not to the other, but to the clearing house. This feature ensures that futures marketsare free of credit risk.Participants may offset equal numbers of bought and sold contracts of the same type and deliverymonth and thereby close out a position without actually communicating the originalcounterparty..
PRODUCTS IN DERIVATIVES MARKET162. Evolution of futures markets -The modern day futures markets originated in the USA in the 19th century to facilitatethe grain trade. Much of their early history is directly linked to the city of Chicago and the needsof farmers and grain merchants. Forward pricing was regularised for only a few specificcommodities by the Chicago Board Of Trade in 1848. Formal futures trading was subsequentlyestablished in 1865, at the time of the American Civil War and at a time when the prices of staplecommodities such as cotton and grain would fluctuate dramatically and often quiteunpredictably.The result of all this wild fluctuations in prices was that the producers, mainly farmers,had no idea what was a fair price to accept for their goods. The buyers and processors, on theother hand had no control over their expenditures. All parties could see the benefits of having acontractual agreement wherein future commodities prices could be fixed. Thus, the mechanismof a futures contract was created and formalised specifically for the purpose of eliminating pricerisk.In 1960, 4 million contracts changed hands during the year on all futures exchanges inUSA. In 1990, nearly 280 million contracts were traded, more each week than in all of 1960. Inthe last decade alone, they have jumped from 98 million to 400 million contracts. Trading inforeign exchange futures began in 1972 and in treasury bill futures in 1977. The introduction ofstock-index futures in 1982 completed the transformation.The changing nature of futures has brought in new types of market participants. Today,the largest and most prestigious financial institutions such as banks, mutual funds, pension funds,insurance companies and other endowment funds all over the world use futures as a tool in theirinvestment strategy. Futures markets have become an integral part of how these institutionsmanage their risks and portfolio of assets.
PRODUCTS IN DERIVATIVES MARKET173. Classification of Futures Contracts:In a futures contract there are two parties:1. The long position, or buyer, agrees to purchase the underlying at a later date or at theexpiration date at a price that is agreed to at the beginning of the transaction. Buyersbenefit from price increases.2. The short position, or seller, agrees to sell the underlying at a later date or at theexpiration date at a price that is agreed to at the beginning of the transaction. Sellersbenefit from price decreases.Prices change daily in the marketplace and are marked to market on a daily basis.At expiration, the buyer takes delivery of the underlying from the seller or the parties can agreeto make cash settlement.
PRODUCTS IN DERIVATIVES MARKET18KEY FEATURES OF FUTURE CONTRACTSFuture contracts are also agreements between two parties in which the buyer agrees to buy anunderlying asset from the other party (the seller). The delivery of the asset occurs at a later time,but the price is determined at the time of purchase.Terms and conditions are standardized.Trading takes place on a formal exchange wherein the exchange provides a place toengage in these transactions and sets a mechanism for the parties to trade thesecontracts.There is no default risk because the exchange acts as a counterparty, guaranteeingdelivery and payment by use of a clearing house.The clearing house protects itself from default by requiring its counterparties to settlegains and losses or mark to market their positions on a daily basis.Futures are highly standardized, have deep liquidity in their markets and trade on anexchange.An investor can offset his or her future position by engaging in an opposite transactionbefore the stated maturity of the contract.Example: Future ContractsLets assume that in September the spot or current price for hydroponic tomatoes is $3.25 perbushel and the futures price is $3.50. A tomato farmer is trying to secure a selling price for hisnext crop, while McDonalds is trying to secure a buying price in order to determine how muchto charge for a Big Mac next year. The farmer and the corporation can enter into a futurescontract requiring the delivery of 5 million bushels of tomatoes to McDonalds in December at aprice of $3.50 per bushel. The contract locks in a price for both parties. It is this contract - andnot the grain per se - that can then be bought and sold in the futures market.Most transactions in the futures market are settled in cash, and the actual physical commodity isbought or sold in the cash market. For example, lets suppose that at the expiration date inDecember there is a blight that decimates the tomato crop and the spot price rises to $5.50 abushel. McDonalds has a gain of $2 per bushel on its futures contract but it still has to buytomatoes. The companys $10 million gain ($2 per bushel x 5 million bushels) will be offsetagainst the higher cost of tomatoes on the spot market. Likewise, the farmers loss of $10 millionis offset against the higher price for which he can now sell his tomatoes.
PRODUCTS IN DERIVATIVES MARKET19Margin MoneyIn the stock market, a margin is a loan that is made to the investor. It helps the investor to reducethe amount of her own cash that she uses to purchase securities. This creates leverage for theinvestor, causing gains and losses to be amplified. The loan must be paid back with interest.Margin % = Market Value of the stock - Market value of the debt divided by the marketvalue of the stockAn initial margin loan in the U.S can be as much as 50%. The market value of thesecurities minus the amount borrowed can often be less than 50%, but the investor mustkeep a balance of 25-30% of the total market value of the securities in the margin accountas a maintenance margin.A margin in the futures market is the amount of cash an investor must put up to open an accountto start trading. This cash amount is the initial margin requirement and it is not a loan. It acts as adown payment on the underlying asset and helps ensure that both parties fulfill their obligations.Both buyers and sellers must put up payments.Initial MarginThis is the initial amount of cash that must be deposited in the account to start trading contracts.It acts as a down payment for the delivery of the contract and ensures that the parties honor theirobligations.Maintenance MarginThis is the balance a trader must maintain in his or her account as the balance changes due toprice fluctuations. It is some fraction - perhaps 75% - of initial margin for a position. If thebalance in the traders account drops below this margin, the trader is required to deposit enoughfunds or securities to bring the account back up to the initial margin requirement. Such a demandis referred to as a margin call. The trader can close his position in this case but he is stillresponsible for the loss incurred. However, if he closes his position, he is no longer at risk of theposition losing additional funds.Futures (which are exchange-traded) and forwards (which are traded OTC) treat margin accountsdifferently. When a trader posts collateral to secure an OTC derivative obligation such as aforward, the trader legally still owns the collateral. With futures contracts, money transferredfrom a margin account to an exchange as a margin payment legally changes hands. A deposit in amargin account at a broker is collateral. It legally still belongs to the client, but the broker cantake possession of it any time to satisfy obligations arising from the clients futures positions
PRODUCTS IN DERIVATIVES MARKET20Variation MarginThis is the amount of cash or collateral that brings the account up to the initial margin amountonce it drops below the maintenance margin.Settlement PriceSettlement price is established by the appropriate exchange settlement committee at the close ofeach trading session. It is the official price that will be used by the clearing house to determinenet gains or losses, margin requirements and the next days price limits. Most often, thesettlement price represents the average price of the last few trades that occur on the day. It is theofficial price set by the clearing house and it helps to process the days gains and loses inmarking to market the accounts. However, each exchange may have its own particularmethodology. For example, on NYMEX (the New York Mercantile Exchange) and COMEX(The New York Commodity Exchange) settlement price calculations depend of the level oftrading activity. In contract months with significant activity, the settlement price is derived bycalculating the weighted average of the prices at which trades were conducted during the closingrange, a brief period at the end of the day. Contract months with little or no trading activity on agiven day are settled based on the spread relationships to the closest active contract month, whileon the Tokyo Financial Exchange settlement price is calculated as the theoretical value based onthe expected volatility for each series set by the exchange.
PRODUCTS IN DERIVATIVES MARKET214. TYPES OF FUTURES CONTRACTThe different types of futures contracts are:1. Commodity futures - These contracts relate to delivery of an underlying commodity.These are the oldest known futures contracts and are traded in almost every country.Oilseeds, cotton, grain, potato, gold, silver and copper are some of the commoditiescovered by futures contracts.2. Foreign exchange futures - These are futures contracts in which the underlying asset is aparticular currency. These contracts are traded most frequently in the forex markets of theworld primarily to hedge against unfavourable changes in currency rates.3. Treasury bill futures - These futures contracts are based on the underlying Treasury billinstruments. Specific futures contracts exist for specific duration of treasury bills. E.g. -91 day, 182 day, and 364 day T-bill futures.4. Futures on securities - These contracts are based on a specific underlying individual securityor share.
PRODUCTS IN DERIVATIVES MARKET225. Economic benefits of futures marketsPrice Discovery –The heart of the futures exchanges is the trading pit where buyers and sellers meet each day toconduct business. Each trader who enters the trading pits bring with him specific marketinformation such as supply and demand figures, current exchange rates, inflation rates, weatherforecasts, etc., that contributes to ongoing price discovery function. As trades between buyersand sellers are executed, the fair market value (price) of a given commodity or security isdiscovered and these prices are disseminated instantaneously to businesses throughout the world.Futures prices are viewed by businessmen and traders as leading price indicators. Price Risk Management –The second economic function provided by futures markets is price risk management, themost common method being hedging. In it‘s simplest form, hedging is the practice of offsettingthe price risk inherent in any cash market position by an equal and opposite position in thefutures markets. Hedgers use futures markets as buffers protect the business from adverse pricechanges that could negatively impact the bottom line profitability of the business.Benefits for the prudent financial managerToday‘s widespread use of futures has surprised veteran financial managers who believed theywere risky products. However, just the opposite has been proven true - major institutionalinvestors, faced with unprecedented changes in prices, have realised it was imprudent not to usefutures to manage cash- market price risks.Fund managers have seen that using futures often improves the rate of return and theoverall performance of the portfolio. By including futures in their investment strategies, fundmanagers may be able to reduce higher transaction costs, which they normally experience in thecash markets.The key benefits of using futures for the prudent financial manager are - Lower transaction costs. Ease of execution. Lower market impact costs (since bid-ask spreads reduce due to greater liquidity). Negligible counterparty default risk (since all transactions are through clearing house).
PRODUCTS IN DERIVATIVES MARKET23Stock index future contract and its advantagesA stock-index futures contract is a contract to buy or sell the face value of the underlyingstock index; where the face value is defined as being the value of the index multiplied by aspecified monetary amount (called the multiplier).This product makes it possible to equate the value of a stock index with that of a specificbasket of shares having the following specifications :-The total value of the shares must match the monetary value of the index.The shares selected must correspond to the set of shares used to create the index.The amount of each holding must be in proportion to the market capitalization of each of thecompanies included in the index.The profit or loss from a stock-index futures contract that is settled on delivery is thedifference between the value of the index at delivery date and the value on the date of enteringinto the contract. It is important to emphasise that the delivery at settlement date cannot be inunderlying stocks of the index, but must be in cash. The futures index at expiration is set equal tothe cash index on that day.Advantages:1. Actual Purchase Of Securities Not Involved - Stock index futures permit investment in thestock market without the trouble and expense involved in buying the individual securities.2. High Leverage Due To Margin System - Operating under a margining system, stock-indexfutures allow full participation in market moves without significant commitment of capital. Themargin levels allow leverage of between 10 to 40 times.3. Lower Transaction Costs - The transaction costs are typically 60 - 75 % lower than those forphysical share transactions.4. Hedging Of Share Portfolio - Portfolio managers for large share portfolios can hedge the valueof their investment against adverse fluctuations without having to alter the composition of theportfolio periodically.
PRODUCTS IN DERIVATIVES MARKET24Impact of stock-index futures on cash marketsSince the introduction of stock-index futures in USA in 1982, the trading of these products hasbecome very popular worldwide. The stock-index futures have outpaced the traditional cashmarkets in terms of volumes traded and popularity. One of the reasons for the success of stock-index futures is its ability to provide a new dimension to trading for a whole spectrum of tradersfrom long-term investors to aggressive speculatorsIntroduction of trading in stock-index futures would increase volume in the underlying secondarymarkets in India. The trading in stock-index futures would also make the markets more completethan before. Therefore, there is ample evidence to support the introduction of futures trading inIndia
PRODUCTS IN DERIVATIVES MARKET25Effects of the futures markets on spot market -Researchers have argued that futures contracts have a beneficial impact on the marketsfor reasons like completion of otherwise incomplete markets, expansion of information availableto market participants and the pooling of risk across securities and investors. On the other hand,it has been claimed by some, mainly market observers and policy makers, that futures contractsencourage speculation in the underlying assets market, with all its deleterious side effects, whichare accentuated by the rapid advances and disseminations, information processing, tradingtechnology and architecture of the markets.The most widespread argument is that futures markets are inherently more volatile thancash markets, presumably because their participants are more highly leveraged and speculativelyoriented than cash market investors. It is feared that such excess volatility may spill over fromthe futures markets by risk arbitrage and portfolio insurance. This fear stems from the belief thatfutures markets bring with them uninformed or irrational speculators, who trade in the cashmarket as well as the futures markets. It is argued that such speculators drive the prices up ordown in quest for short-run ―bandwagon‖ profits(Stein, 1961)1. Economists have analysed thesearguments and have concluded that it would take a considerable number of speculators todestabilse cash markets.Influence of Programmed trading on Share price volatilityProgrammed trading may increase the volatility of an index computed from the prices of the lasttrade in each share. An analysis of the effects of programmed trading on the volatility of the S&P500 index found that fluctuations in the last trade prices due to switching between the bid andask prices had led to a considerable increase in the spot volatility(Harris, Soriano‘s and Shapiro,1990)
PRODUCTS IN DERIVATIVES MARKET266. TRADE PROCESSIn electronic trading, customers (who have been pre-approved by a brokerage for electronictrading) send buy or sell orders directly from their computers to an electronic marketplaceoffered by the relevant exchange. There are no brokers involved in the process. Traders see thevarious bids and offers on their computers. The trade is executed by the traders lifting bids orhitting offers on their computer screens. The trading pit is, in essence, the trading screen and theelectronic market participants replace the brokers standing in the pit. Electronic trading offersmuch greater insight into pricing because the top five current bids and offers are posted on thetrading screen for all market participants to see. Computers handle all trading activity - thesoftware identifies matches of bids and offers and generally fills orders according to a first-in,first-out (FIFO) process. Dissemination of information is also faster on electronic trades. Tradesmade on CME® Globex®, for example, happen in milliseconds and are instantaneouslybroadcast to the public. In open outcry trading, however, it can take from a few seconds tominutes to execute a trade.Price LimitThis is the amount a futures contracts price can move in one day. Price limits are usually set inabsolute dollar amounts - the limit could be $5, for example. This would mean that the price ofthe contract could not increase or decrease by more than $5 in a single day.Limit MoveA limit move occurs when a transaction takes place that would exceed the price limit. Thisfreezes the price at the price limit.Limit UpThe maximum amount by which the price of a futures contract may advance in one trading day.Some markets close trading of these contracts when the limit up is reached, others allow tradingto resume if the price moves away from the days limit. If there is a major event affecting themarkets sentiment toward a particular commodity, it may take several trading days before thecontract price fully reflects this change. On each trading day, the trading limit will be reachedbefore the markets equilibrium contract price is met.Limit DownThis is when the price decreases and is stuck at the lower price limit. The maximum amount bywhich the price of a commodity futures contract may decline in one trading day. Some marketsclose trading of contracts when the limit down is reached, others allow trading to resume if theprice moves away from the days limit. If there is a major event affecting the markets sentimenttoward a particular commodity, it may take several trading days before the contract price fullyreflects this change. On each trading day, the trading limit will be reached before the marketsequilibrium contract price is met.Locked LimitOccurs when the trading price of a futures contract arrives at the exchanges predetermined limitprice. At the lock limit, trades above or below the lock price are not executed. For example, if afutures contract has a lock limit of $5, as soon as the contract trades at $5 the contract would no
PRODUCTS IN DERIVATIVES MARKET27longer be permitted to trade above this price if the market is on an uptrend, and the contractwould no longer be permitted to trade below this price if the market is on a downtrend. The mainreason for these limits is to prevent investors from substantial losses that can occur as a result ofthe volatility found in futures markets.Futures - Marking to Market Process Futures contracts are ―marked to market‖ daily. Generates cash flows to (or from) holders of foreign currency futures from(or to) the clearing house.At the initiation of the trade, a price is set and money is deposited in the account.At the end of the day, a settlement price is determined by the clearing house. The accountis then adjusted accordingly, either in a positive or negative manner, with funds eitherbeing drawn from or added to the account based on the difference in the initial price andthe settlement price.The next day, the settlement price is used as the base price.As the market prices change through the next day, a new settlement price will bedetermined at the end of the day. Again, the account will be adjusted by the difference inthe new settlement price and the previous nights price in the appropriate manner.If the account falls below the maintenance margin, the investor will be required to add additionalfunds into the account to keep the position open or allow it to be closed out. If the position isclosed out the investor is still responsible for paying for his losses. This process continues untilthe position is closed out. Mechanics: Buy a futures contract this morning at the price of f0,T At the end of the day, the new price is f1,T The change in your futures account will be:[f1,T - f0,T] x Contract Face Value = Cash Flow
PRODUCTS IN DERIVATIVES MARKET28V. Futures vs. ForwardsFutures differ from forwards in several instances:1. A forward contract is a private transaction - a futures contract is not. Futures contracts arereported to the futures exchange, the clearing house and at least one regulatory agency.The price is recorded and available from pricing services.2. A future takes place on an organized exchange where the all of the contracts terms andconditions, except price, are formalized. Forwards are customized to meet the usersspecial needs. The futures standardization helps to create liquidity in the marketplaceenabling participants to close out positions before expiration.3. Forwards have credit risk, but futures do not because a clearing house guarantees againstdefault risk by taking both sides of the trade and marking to market their positions everynight. Mark to market is the process of converting daily gains and losses into actual cashgains and losses each night. As one party loses on the trade the other party gains, and theclearing house moves the payments for the counterparty through this process.4. Forwards are basically unregulated, while future contract are regulated at the federalgovernment level. The regulation is there to ensure that no manipulation occurs, thattrades are reported in a timely manner and that the professionals in the market arequalified and honest.
PRODUCTS IN DERIVATIVES MARKET29Difference between Forward & Future Contract
PRODUCTS IN DERIVATIVES MARKET30Futures vs. Forwards
PRODUCTS IN DERIVATIVES MARKET31V. OPTIONS1. HISTORYAncient OriginsAlthough it isn‘t known exactly when the first option contract traded, it is known that theRomans and Phoenicians used similar contracts in shipping. There is also evidence that Thales, amathematician and philosopher in ancient Greece used options to secure a low price for olivepresses in advance of the harvest. Thales had reason to believe the olive harvest would beparticularly strong. During the off-season when demand for olive presses was almost non-existent, he acquired rights—at a very low cost—to use the presses the following spring. Later,when the olive harvest was in full-swing, Thales exercised his option and proceeded to rent theequipment to others at a much higher price.Early Options in AmericaIn America, options appeared on the scene around the same time as stocks. In the early19thCentury, call and put contracts—known as ―privileges‖—were not traded on an exchange.Because the terms differed for each contract, there wasn‘t much in the way of a secondarymarket. Instead, it was up to the buyers and sellers to find each other. This was typicallyaccomplished when firms offered specific calls and puts in newspaper ads.Chicago Board of TradeIn the late 1960s, as exchange volume for commodities began to shrink, the ChicagoBoard of Trade (CBOT) explored opportunities for diversification into the option market. JosephW. Sullivan, Vice President of Planning for the CBOT, studied the over-the-counter optionmarket and concluded that two key ingredients for success were missing.To replace the put-call dealers, who served only as intermediaries, the CBOT created asystem in which market makers were required to provide two-sided markets. At the same time,the presence of multiple market makers made for a competitive atmosphere in which buyers andsellers alike could be assured of getting the best possible price.
PRODUCTS IN DERIVATIVES MARKET32Chicago Board Options Exchange (CBOE)After four years of study and planning, the Chicago Board of Trade established the ChicagoBoard Options Exchange (CBOE) and began trading listed call options on 16 stocks on April 26, 1973.The CBOE‘s first home was actually a smoker‘s lounge at the Chicago Board of Trade. After achievingfirst-day volume of 911 contracts, the average daily volume skyrocketed to over 20,000 the followingyear. Along the way, the new exchange achieved several important milestones.As the number of underlying stocks with listed options doubled to 32, exchange membershipdoubled from 284 to 567. About the same time, new laws opened the door for banks and insurancecompanies to include options in their portfolios. For these reasons, option volume continued to grow. Bythe end of 1974, average daily volume exceeded 200,000 contracts.Exchange Traded OptionsThere are a variety of different types of options (e.g., stock options, index options). Once thebasic principles are understood, they can easily be applied to the other financial instruments. Exchange-traded stock options, also known as equity options, differ from those granted to employees by theircompany in a number of important ways.
PRODUCTS IN DERIVATIVES MARKET332. MeaningWHAT IS AN OPTION?We all know many opportunities exist in trading today. Everywhere you turn, someone iswaiting to inform you of the tremendous profits to be realized in the stock and futures markets.However, many people are unaware of the derivative trading possibilities that are availablewithin and across several different markets. Option trading is just one of the many ways toparticipate in these secondary markets. And contrary to popular belief, this potential tradingarena is not limited strictly to the practice of selling or writing options.Options are an important element of investing in markets, serving a function of managingrisk and generating income. Unlike most other types of investments today, options provide aunique set of benefits. Not only does option trading provide a cheap and effective means ofhedging one‘s portfolio against adverse and unexpected price fluctuations, but it also offers atremendous speculative dimension to trading.One of the primary advantages of option trading is that option contracts enable a trade tobe leveraged, allowing the trader to control the full value of an asset for a fraction of the actualcost. And since an option‘s price mirrors that of the underlying asset at the very least, anyfavorable return in the asset will be met with a greater percentage return in the option provideslimited risk and unlimited reward.With options, the buyer can only lose what was paid for the option contract, which is afraction of what the actual cost of the asset would be. However, the profit potential is unlimitedbecause the option holder possesses a contract that performs in sync with the asset itself. If theoutlook is positive for the security, so too will the outlook be for that asset‘s underlying options.Options also provide their owners with numerous trading alternatives. Options can becustomized and combined with other options and even other investments to take advantage ofany possible price dislocation within the market. They enable the trader or investor to acquire aposition that is appropriate for any type of market outlook that he or she may have, be it bullish,bearish, choppy, or silent.
PRODUCTS IN DERIVATIVES MARKET34CALL and PUT Call: gives the holder the right to buy Put: gives the holder the right to sellAn option is common form of a derivative. Its a contract, or a provision of a contract, that givesone party (the option holder) the right, but not the obligation to perform a specifiedtransaction with another party (the option issuer or option writer) according to specified terms.Options can be embedded into many kinds of contracts. For example, a corporation might issuea bond with an option that will allow the company to buy the bonds back in ten years at a setprice. Standalone options trade on exchanges or OTC. They are linked to a variety of underlyingassets. Most exchange-traded options have stocks as their underlying asset but OTC-tradedoptions have a huge variety of underlying assets (bonds, currencies, commodities, swaps, orbaskets of assets).There are two main types of options: calls and puts:Call options provide the holder the right (but not the obligation) to purchase anunderlying asset at a specified price (the strike price), for a certain period of time. If thestock fails to meet the strike price before the expiration date, the option expires andbecomes worthless. Investors buy calls when they think the share price of theunderlying security will rise or sell a call if they think it will fall. Selling an option is alsoreferred to as writing an option.Put options give the holder the right to sell an underlying asset at a specified price (thestrike price). The seller (or writer) of the put option is obligated to buy the stock at thestrike price. Put options can be exercised at any time before the option expires.Investors buy puts if they think the share price of the underlying stock will fall, or sellone if they think it will rise. Put buyers - those who hold a "long" - put are eitherspeculative buyers looking for leverage or "insurance" buyers who want to protect theirlong positions in a stock for the period of time covered by the option. Put sellers hold a"short" expecting the market to move upward (or at least stay stable) A worst-casescenario for a put seller is a downward market turn. The maximum profit is limited tothe put premium received and is achieved when the price of the underlyer is at or abovethe options strike price at expiration. The maximum loss is unlimited for an uncoveredput writer.
PRODUCTS IN DERIVATIVES MARKET35The Options GameCall Option Put OptionOption buyer oroption holderBuys the right to buy theunderlying asset at the specifiedpriceBuys the right to sell theunderlying asset at the specifiedpriceOption seller or optionwriterHas the obligation to sell theunderlying asset (to the optionholder) at the specified priceHas the obligation to buy theunderlying asset (from the optionholder) at the specified price
PRODUCTS IN DERIVATIVES MARKET363. BASICS OF OPTIONSBoth put and call options have three basic characteristics: exercise price, expiration date and timeto expiration. The buyer has the right to buy or sell the asset. To acquire the right of an option, the buyer of the option must pay a price to theseller. This is called the option price or the premium. The exercise price is also called the fixed price, strike price or just the strike andis determined at the beginning of the transaction. It is the fixed price at whichthe holder of the call or put can buy or sell the underlying asset. Exercising is using this right the option grants you to buy or sell the underlyingasset. The seller may have a potential commitment to buy or sell the asset if thebuyer exercises his right on the option. The expiration date is the final date that the option holder has to exercise herright to buy or sell the underlying asset. Time to expiration is the amount of time from the purchase of the option untilthe expiration date. At expiration, the call holder will pay the exercise price andreceive the underlying securities (or an equivalent cash settlement) if the optionexpires in the money. (We will discuss the degrees of moneyness later in thissession.) The call seller will deliver the securities at the exercise price and receivethe cash value of those securities or receive equivalent cash settlement in lieu ofdelivering the securities. Defaults on options work the same way as they do with forward contracts.Defaults on over-the counter option transactions are based on counterparties,while exchange-traded options use a clearing house.Example: Call OptionIBM is trading at 100 today. (June 1, 2005)The call option is as follows:Strike price = 120, Date = August 1, 2005,Premium on the call = $3In this case, the buyer of the IBM call today has to pay the seller of the IBM call $3 for the rightto purchase IBM at $125 on or before August 1, 2005. If the buyer decides to exercise the optionon or before August 1, 2005, the seller will have to deliver IBM shares at a price of $125 to thebuyer.Example: Put OptionIBM is trading at 100 today (June 1, 2005)
PRODUCTS IN DERIVATIVES MARKET37Put option is as follows:Strike price = 90, Date = August 1, 2005, Premium on the put = $3.00In this case, the buyer of the IBM put has to pay the seller of the IBM call $3 for the right to sellIBM at $90 on or before August 1, 2005. If the buyer of the put decides to exercise the option onor before August 1, 2005, the seller will have to purchase IBM shares at a price of $90.Example: Interpreting DiagramsFor the exam, you may be asked interpret diagrams such as the following, which shows the valueof a put option at expiration.A typical question about this diagram might be:Q: Ignoring transaction costs, which of the following statements about the value of the put optionat expiration is TRUE?A. The value of the short position in the put is $4 if the stock price is $76.B. The value of the long position in the put is $4 if the stock price is $76.C. The long put has value when the stock price is below the $80 exercise price.D. The value of the short position in the put is zero for stock prices equaling or exceeding $76.The correct answer is "C". A put option has positive monetary value when the underlyinginstrument has a current price ($76) below the exercise price ($80).4. OPTION TRADING
PRODUCTS IN DERIVATIVES MARKET38 Buyer of a call:– Assume purchase of August call option on Swiss francs with strike price of 58½($0.5850/SF), and a premium of $0.005/SF.– At all spot rates below the strike price of 58.5, the purchase of the option wouldchoose not to exercise because it would be cheaper to purchase SF on the openmarket.– At all spot rates above the strike price, the option purchaser would exercise theoption, purchase SF at the strike price and sell them into the market netting aprofit (less the option premium). Writer of a call:– What the holder, or buyer of an option loses, the writer gains.
PRODUCTS IN DERIVATIVES MARKET39– The maximum profit that the writer of the call option can make is limited to thepremium.– If the writer wrote the option naked, that is without owning the currency, thewriter would now have to buy the currency at the spot and take the loss deliveringat the strike price.– The amount of such a loss is unlimited and increases as the underlying currencyrises.– Even if the writer already owns the currency, the writer will experience anopportunity loss. Buyer of a Put:– The basic terms of this example are similar to those just illustrated with the call.
PRODUCTS IN DERIVATIVES MARKET40– The buyer of a put option, however, wants to be able to sell the underlyingcurrency at the exercise price when the market price of that currency drops (notrises as in the case of the call option).– If the spot price drops to $0.575/SF, the buyer of the put will deliver francs to thewriter and receive $0.585/SF.– At any exchange rate above the strike price of 58.5, the buyer of the put would notexercise the option, and would lose only the $0.05/SF premium.– The buyer of a put (like the buyer of the call) can never lose more than thepremium paid up front. Seller (writer) of a put:
PRODUCTS IN DERIVATIVES MARKET41– In this case, if the spot price of francs drops below 58.5 cents per franc, the optionwill be exercised.– Below a price of 58.5 cents per franc, the writer will lose more than the premiumreceived fro writing the option (falling below break-even).– If the spot price is above $0.585/SF, the option will not be exercised and theoption writer will pocket the entire premium.
PRODUCTS IN DERIVATIVES MARKET425. BASIC OPTION TERMINOLOGYUnderlying - The specific security / asset on which an options contract is based.Option Premium - This is the price paid by the buyer to the seller to acquire the right to buy orsell.Strike Price or Exercise Price - The strike or exercise price of an option is the specified/ pre-determined price of the underlying asset at which the same can be bought or sold if the optionbuyer exercises his right to buy/ sell on or before the expiration day.Expiration date - The date on which the option expires is known as Expiration Date. OnExpiration date, either the option is exercised or it expires worthless.Exercise Date - is the date on which the option is actually exercised. In case of EuropeanOptions the exercise date is same as the expiration date while in case of American Options, theoptions contract may be exercised any day between the purchase of the contract and itsexpiration date (see European/ American Option)Assignment - When the holder of an option exercises his right to buy/ sell, a randomly selectedoption seller is assigned the obligation to honor the underlying contract, and this process istermed as Assignment.Open Interest - The total number of options contracts outstanding in the market at any givenpoint of time.Option Holder - is the one who buys an option which can be a call or a put option. He enjoysthe right to buy or sell the underlying asset at a specified price on or before specified time. Hisupside potential is unlimited while losses are limited to the Premium paid by him to the optionwriter.
PRODUCTS IN DERIVATIVES MARKET43Option seller/ writer - is the one who is obligated to buy (in case of Put option) or to sell (incase of call option), the underlying asset in case the buyer of the option decides to exercise hisoption. His profits are limited to the premium received from the buyer while his downside isunlimited.Option Class - All listed options of a particular type (i.e., call or put) on a particular underlyinginstrument, e.g., all Sensex Call Options (or) all Sensex Put OptionsOption Series - An option series consists of all the options of a given class with the sameexpiration date and strike price. E.g. BSXCMAY3600 is an options series, which includes allSensex Call options that are traded with Strike Price of 3600 & Expiry in May.(BSX Stands for BSE Sensex (underlying index), C is for Call Option, May is expiry date andstrike Price is 3600)
PRODUCTS IN DERIVATIVES MARKET446. European vs. American Options and MoneynessEuropean OptionEuropeans Options can only be exercised on the expiry date. European options are typicallyvalued using the Black-Scholes or Black model formula. This is a simple equation with a closed-form solution that has become standard in the financial community.American OptionThis is an option that can be exercised at any time up to and including the expiry date. There areno general formulas for valuing American options, but a choice of models to approximate theprice is available (for example Whaley, binomial options model, Monte Carlo and others),although there is no consensus on which is preferable.American options are rarely exercised early. This is because all options have a non-negative timevalue and are usually worth more unexercised. Owners who wish to realize the full value of theiroptions will mostly prefer to sell them rather than exercise them early and sacrifice some of thetime value.Note that the names of these types of options are in no way related to Europe or the UnitedStates.
PRODUCTS IN DERIVATIVES MARKET45MoneynessThe concept of moneyness describes whether an option is in-, out-, at-, or in-the-money byexamining the position of strike vs. existing market price of the options underlying security.In the Money - Any option that has intrinsic value is in the money. A call option is saidto be in the money when the futures price exceeds the options strike price. A put is in themoney when the futures price is below the options strike price. For example, a MarchCME euro 90 call option will be in the money if March CME euro futures are above 90,meaning that the holder has the right to buy these futures at 90, regardless of how muchthe price has risen. The further in the money an option, the less time value it will have.Deep In the Money - These options represent a larger spread between the strike andmarket price of an underlying security. Options that are deep in the money generallytrade at or near their actual intrinsic values, calculated by subtracting the strike price fromthe underlying assets market price for a call option (and vice versa for a put option). Thisis because options with a significant amount of intrinsic value built in have a very lowchance of expiring worthless. Therefore, the primary value they provide is already pricedinto the option in the form of their intrinsic value. As an option moves deeper into themoney, the delta approaches 100% (for call options), which means for every point changein the underlying assets price, there will be an equal and simultaneous change in theprice of the option, in the same direction. Thus, investing in the option is similar toinvesting in the underlying asset, except the option holder will have the benefits of lowercapital outlay, limited risk, leverage and greater profit potential.Out of the Money - These options exist when the strike price of a call (put) is above(below) the underlying assets market price. (Essentially, it is the inverse of an in themoney option). Options that are out of the money have a high risk of expiring worthless,but they tend to be relatively inexpensive. As the time value approaches zero atexpiration, out of the money options have a greater potential for total loss if theunderlying stock moves in an adverse direction.At the Money - These options exist when the strike price of a call or put is equal to theunderlying assets market price. You can essentially think of at the money as thebreakeven point (excluding transaction costs).
PRODUCTS IN DERIVATIVES MARKET46Striking The PriceCall Option Put OptionIn-the-moneyStrike Price less than Spot Priceof underlying assetStrike Price greater thanSpot Price of underlyingassetAt-the-moneyStrike Price equal to Spot Priceof underlying assetStrike Price equal to SpotPrice of underlying assetOut-of-the-moneyStrike Price greater than SpotPrice of underlying assetStrike Price less than SpotPrice of underlying assetOptions are said to be deep in-the-money (or deep out-of-the-money) if the exercise priceis at significant variance with the underlying asset price.It is the time value portion of an option‘s premium that is affected by fluctuations involatility, interest rates, dividend amounts and the passage of time. There are other factors thatgive options value, therefore affecting the premium at which they are traded. Together, all ofthese factors determine time value.Option Premium = Intrinsic Value + Time Value
PRODUCTS IN DERIVATIVES MARKET477. Option Pricing & Valuation An option whose exercise price is the same as the spot price of the underlying currency issaid to be at-the-money (ATM). An option the would be profitable, excluding the cost of the premium, if exercisedimmediately is said to be in-the-money (ITM). An option that would not be profitable, again excluding the cost of the premium, ifexercised immediately is referred to as out-of-the money (OTM).Call PutIntrinsic value max(ST- X, 0) max(X - ST, 0)in the money ST– X > 0 X – ST> 0at the money ST– X = 0 X – ST= 0out of the money ST– X < 0 X – ST< 0Time Value CT– Int. value PT– Int. value
PRODUCTS IN DERIVATIVES MARKET48Forward vs. Options-$0.90-$0.75-$0.60-$0.45-$0.30-$0.15$0.00$0.15$0.30$0.45$0.60$0.75$0.90$0.00$0.10$0.20$0.30$0.40$0.50$0.60$0.70$0.80$0.90$1.00$1.10$1.20$1.30$1.40$1.50$1.60$1.70$1.80Spot Rate at ExpirationValueofForward/PutOptionatExpiration.Value of Forward Sale at ExpirationValue of Put at Expiration
PRODUCTS IN DERIVATIVES MARKET498. Factors Affecto the Value of an Option PremiumThere are two types of factors that affect the value of the option premium:Quantifiable Factors:Underlying stock price,The strike price of the option,The volatility of the underlying stock,The time to expiration and;The risk free interest rate.Non-Quantifiable Factors:Market participants varying estimates of the underlying assets future volatilityIndividuals varying estimates of future performance of the underlying asset, based onfundamental or technical analysisThe effect of supply & demand- both in the options marketplace and in the market forthe underlying assetThe "depth" of the market for that option - the number of transactions and thecontracts trading volume on any given day.Different pricing models for optionsThe theoretical option pricing models are used by option traders for calculating the fairvalue of an option on the basis of the earlier mentioned influencing factors. An option pricingmodel assists the trader in keeping the prices of calls & puts in proper numerical relationship toeach other & helping the trader make bids & offer quickly. The two most popular option pricingmodels are:Black Scholes Model which assumes that percentage change in the price of underlyingfollows a normal distribution.Binomial Model which assumes that percentage change in price of the underlyingfollows a binomial distribution.Options Premium is not fixed by the Exchange. The fair value/ theoretical price of anoption can be known with the help of pricing models and then depending on market conditionsthe price is determined by competitive bids and offers in the trading environment.
PRODUCTS IN DERIVATIVES MARKET50Covered and Naked CallsA call option position that is covered by an opposite position in the underlying instrument(for example shares, commodities etc), is called a covered call. Writing covered calls involveswriting call options when the shares that might have to be delivered (if option holder exerciseshis right to buy), are already owned.E.g. A writer writes a call on Reliance and at the same time holds shares of Reliance so that if thecall is exercised by the buyer, he can deliver the stock.Covered calls are far less risky than naked calls (where there is no opposite position in theunderlying), since the worst that can happen is that the investor is required to sell shares alreadyowned at below their market value.Intrinsic Value of an optionThe intrinsic value of an option is defined as the amount by which an option is in-the-money, or the immediate exercise value of the option when the underlying position is marked-to-market.For a call option: Intrinsic Value = Spot Price - Strike PriceFor a put option: Intrinsic Value = Strike Price - Spot PriceTime DecayGenerally, the longer the time remaining until an option‘s expiration, the higher itspremium will be. This is because the longer an option‘s lifetime, greater is the possibility that theunderlying share price might move so as to make the option in-the-money. All other factorsaffecting an option‘s price remaining the same, the time value portion of an option‘s premiumwill decrease (or decay) with the passage of time.Note: This time decay increases rapidly in the last several weeks of an option‘s life.When an option expires in-the-money, it is generally worth only its intrinsic value.
PRODUCTS IN DERIVATIVES MARKET51Expiration DayThe expiration date is the last day an option exists. For list-ed stock options, this is theSaturday following the third Friday of the expiration month. Please note that this is the deadlineby which brokerage firms must submit exercise notices to Stock Exchange Clearing; however,the exchanges and brokerage firms have rules and procedures regarding deadlines for an optionholder to notify his brokerage firm of his intention to exercise. This deadline, or expiration cut-off time, is generally on the third Friday of the month, before expiration Saturday, at some timeafter the close of the market. Please contact your brokerage firm for specific deadlines. The lastday expiring equity options generally trade is also on the third Friday of the month, beforeexpiration Saturday. If that Friday is an exchange holiday, the last trading day will be one dayearlier, Thursday.ExerciseIf the holder of an American-style option decides to exercise his right to buy (in the caseof a call) or to sell (in the case of a put) the underlying shares of stock, the holder must direct hisbrokerage firm to submit an exercise notice to Stock Exchange Clearing. In order to ensure thatan option is exercised on a particular day other than expiration, the holder must notify his broker-age firm before its exercise cut-off time for accepting exercise instructions on that day.Note: Various firms may have their own cut-off times for accepting exercise instructionsfrom customers. These cut-off times may be specific for different classes of options and differentfrom Stock Exchange Clearing‘s requirements. Cut-off times for exercise at expiration and forexercise at an earlier date may differ as well.What’s the Net?When an investor exercises a call option, the net price paid for the underlying stock on aper share basis will be the sum of the call‘s strike price plus the premium paid for the call.Likewise, when an investor who has written a call contract is assigned an exercise notice on thatcall, the net price received on a per share basis will be the sum of the call‘s strike price plus thepremium received from the call‘s initial sale.When an investor exercises a put option, the net price received for the underlying stockon per share basis will be the sum of the put‘s strike price less the premium paid for the put.Likewise, when an investor who has written a put contract is assigned an exercise notice on thatput, the net price paid for the underlying stock on per share basis will be the sum of the put‘sstrike price less the premium received from the put‘s initial sale.
PRODUCTS IN DERIVATIVES MARKET52VolatilityVolatility is the tendency of the underlying security‘s market price to fluctuate either upor down. It reflects a price change‘s magnitude; it does not imply a bias toward price movementin one direction or the other. Thus, it is a major factor in determining an option‘s premium. Thehigher the volatility of the underlying stock, the higher the premium because there is a greaterpossibility that the option will move in-the-money. Generally, as the volatility of an under-lyingstock increases, the premiums of both calls and puts overlying that stock increase, and vice versa.Option Greeks-Delta, Gamma, Vega, Theta, RhoThe price of an Option depends on certain factors like price and volatility of the underlying,time to expiry etc. The Option Greeks are the tools that measure the sensitivity of the optionprice to the above-mentioned factors. They are often used by professional traders for trading andmanaging the risk of large positions in options and stocks. These Option Greeks are:Delta: is the option Greek that measures the estimated change in option premium/pricefor a change in the price of the underlying.Gamma: measures the estimated change in the Delta of an option for a change in the priceof the underlyingVega: measures estimated change in the option price for a change in the volatility of theunderlying.Theta: measures the estimated change in the option price for a change in the time tooption expiry.Rho: measures the estimated change in the option price for a change in the risk freeinterest rates.
PRODUCTS IN DERIVATIVES MARKET539. How the greeks help in hedging?Spreading is a risk-management strategy that employs options as the hedging instrument,rather than stock. Like stock, options have directional risk (deltas). Unlike stock, options carrygamma, vega, and theta risks as well. Therefore, if a position involves any combination ofgamma, vega, and/or theta risk, this can be reduced or eliminated by adding one or more optionspositions. Table 1-1 summarizes the possible hedges and their gamma, vega and theta impact foreach of the six building blocks.Notice that owning option contracts be they puts or calls, means that you are addingpositive gamma, positive vega, and negative theta. Being short either of these contracts meansacquiring negative gamma, negative vega, and positive theta. This statement points out that as faras these Greeks are concerned, you get a package deal
PRODUCTS IN DERIVATIVES MARKET5510. Benefits of Options TradingBesides offering flexibility to the buyer in form of right to buy or sell, the majoradvantage of options is their versatility. They can be as conservative or as speculative as onesinvestment strategy dictates.Some of the benefits of Options are as under:High leverage as by investing small amount of capital (in form of premium), one can takeexposure in the underlying asset of much greater value.Pre-known maximum risk for an option buyerLarge profit potential and limited risk for option buyerOne can protect his equity portfolio from a decline in the market by way of buying aprotective put wherein one buys puts against an existing stock position.This option position can supply the insurance needed to overcome the uncertainty of themarketplace. Hence, by paying a relatively small premium (compared to the market valueof the stock), an investor knows that no matter how far the stock drops, it can be sold atthe strike price of the Put anytime until the Put expires.E.g. An investor holding 1 share of Infosys at a market price of Rs 3800/-thinks that the stock isover-valued and decides to buy a Put option at a strike price of Rs. 3800/- by paying a premiumof Rs 200/-If the market price of Infosys comes down to Rs 3000/-, he can still sell it at Rs 3800/- byexercising his put option. Thus, by paying premium of Rs 200,his position is insured in theunderlying stock.
PRODUCTS IN DERIVATIVES MARKET56Risks of an options buyerThe risk/ loss of an option buyer is limited to the premium that he has paid.Risks for an Option writerThe risk of an Options Writer is unlimited where his gains are limited to the Premiumsearned. When a physical delivery uncovered call is exercised upon, the writer will have topurchase the underlying asset and his loss will be the excess of the purchase price over theexercise price of the call reduced by the premium received for writing the call.The writer of a put option bears a risk of loss if the value of the underlying asset declinesbelow the exercise price. The writer of a put bears the risk of a decline in the price of theunderlying asset potentially to zero.Option writing is a specialized job which is suitable only for the knowledgeable investor whounderstands the risks, has the financial capacity and has sufficient liquid assets to meetapplicable margin requirements. The risk of being an option writer may be reduced by thepurchase of other options on the same underlying asset thereby assuming a spread position or byacquiring other types of hedging positions in the options/ futures and other correlated markets. Inthe Indian Derivatives market, SEBI has not created any particular category of options writers.Any market participant can write options. However, margin requirements are stringent foroptions writers.
PRODUCTS IN DERIVATIVES MARKET5711. Stock Index OptionsThe Stock Index Options are options where the underlying asset is a Stock Index for e.g.Options on NSE Nifty Index / Options on BSE Sensex etc.Index Options were first introduced by Chicago Board of Options Exchange in 1983 onits Index S&P 100. As opposed to options on Individual stocks, index options give an investorthe right to buy or sell the value of an index which represents group of stocks.Uses of Index OptionsIndex options enable investors to gain exposure to a broad market, with one tradingdecision and frequently with one transaction. To obtain the same level of diversification usingindividual stocks or individual equity options, numerous decisions and trades would benecessary. Since, broad exposure can be gained with one trade, transaction cost is also reducedby using Index Options. As a percentage of the underlying value, premiums of index options areusually lower than those of equity options as equity options are more volatile than the Index.Options on individual stocksOptions contracts where the underlying asset is an equity stock are termed as Options onstocks. They are mostly American style options cash settled or settled by physical delivery.Prices are normally quoted in terms of the premium per share, although each contract isinvariably for a larger number of shares, e.g. 100.Benefits of options in specific stocks to an investorOptions can offer an investor the flexibility one needs for countless investment situations.An investor can create hedging position or an entirely speculative one, through variousstrategies that reflect his tolerance for risk.Investors of equity stock options will enjoy more leverage than their counterparts whoinvest in the underlying stock market itself in form of greater exposure by paying a smallamount as premium.
PRODUCTS IN DERIVATIVES MARKET58Leaps - Long Term Equity Anticipation Securities(Currently not available in India )Long-term equity anticipation securities (Leaps) are long-dated put and call options oncommon stocks or ADRs. These long-term options provide the holder the right to purchase, incase of a call, or sell, in case of a put, a specified number of stock shares at a pre-determinedprice up to the expiration date of the option, which can be three years in the future.Exotic Options (Currently not available in India)Derivatives with more complicated payoffs than the standard European or American calls andputs are referred to as Exotic Options. Some of the examples of exotic options are as under:Barrier Options: where the payoff depends on whether the underlying assets price reaches acertain level during a certain period of time.CAPS traded on CBOE (traded on the S&P 100 & S&P 500) are examples of Barrier Optionswhere the payout is capped so that it cannot exceed $30.A Call CAP is automatically exercised on a day when the index closes more than $30 abovethe strike price. A put CAP is automatically exercised on a day when the index closes more than$30 below the cap level.Binary Options: are options with discontinuous payoffs. A simple example would be anoption which pays off if price of an Infosys share ends up above the strike price of say Rs. 4000& pays off nothing if it ends up below the strike.Over-The-Counter Options: are options are those dealt directly between counter-partiesand are completely flexible and customized. There is some standardization for ease of trading inthe busiest markets, but the precise details of each transaction are freely negotiable betweenbuyer and seller.
PRODUCTS IN DERIVATIVES MARKET59Options with OptionsWhen an option has value, meaning it is in-the-money, the trader can choose whether totrade the contract to another individual or exercise the contract and obtain the underlying asset.The ultimate decision that is made depends upon the individual investor, his or her trading style,his or her trading needs, and the situation at hand.Option is a contract which has a market value like any other tradable commodity. Oncean option is bought there are following alternatives that an option holder has:You can sell an option of the same series as the one you had bought and close out /squareoff your position in that option at any time on or before the expiration.You can exercise the option on the expiration day in case of European Option or; on orbefore the expiration day in case of an American option. In case the option is Out ofMoney at the time of expiry, it will expire worthless.#Please note that while options provide the right to acquire the underlying instrument, the ownermust still produce the necessary funds for the asset itself.In exercising a stock or futures put option, the option holder agrees to sell thestandardized quantity of the underlying asset to the option writer at the predetermined strikeprice. Because of their contract, the writer must purchase the asset from the option holder at thestrike price, regardless of the price at which the market is currently trading
PRODUCTS IN DERIVATIVES MARKET60Placing option ordersBefore participating in a market, regardless of which one, it is important that one becomefamiliar with may of the trading nuances and aspects which apply to that specific market. This isespecially true when trading options. Once these variables are addressed and an option contractis selected, the trader must then place the order. When placing an option order, a trader mustmake certain to supply the following trading instructions to the broker:1. Whether the option order is a buy or a sell2. The number of option contracts the trader wishes to transact3. The proper description of the option, including the specific option contract to be traded,the correct month and year, and the exercise price4. The price at which the trader wishes to buy or to sell the option5. The specific exchange the trader wishes to use to conduct the trade if more than oneexchange lists the option6. The stop loss level, or the price at which the trader wishes to exit an unprofitable trade7. The type of option to be executed, that is, an opening purchase, a closing purchase, anopening sale, or a closing saleReading an option price tableMany major newspaper and trading publications today provide option-pricing tables sotraders can track and follow the activity of certain listed options on a day-to-day basis. While theorganization of these price table may differ slightly for stock options, they all usually contain thesecurity that the option covers, the prior day‘s closing price of the underlying asset, the varyingstrike prices and expiration months, the prior day‘s volume and closing prices for each calloption, and the prior day‘s volume and closing prices for each put option. Other option listings,such as those for indices, also include items such as the net price change of the option from theprevious day‘s closing price and the open interest of the call or put option.
PRODUCTS IN DERIVATIVES MARKET61When not to buy an option?It is also important to consider the time or the date at which one should enter the optionmarket. While these option-buying suggestions are presented in the context of day tradingoptions, they apply equally as well to option position trading.When day trading, a trader must give the market adequate time to perform.Consequently, eliminate day trading within the final hour of trading. If one is position-trading options, this suggestion should not be a concern.Avoid trading in an illiquid option market.Avoid purchasing call options just prior to a stock going ex-dividend. Avoid buying orselling options based upon anticipated news (buyouts in particular). Besides borderingon unethical trading, the information received is more likely to be rumor than correct.Avoid purchasing options well after the market has established a defined trend – this isespecially true when day trading, as any option premium advantage will have dissipated.Avoid purchasing way out-of-the-money options when day trading, as any favorable pricemovement will have a negligible effect upon premium.Avoid purchasing call options when the underlying security is up for the day versus theprior day’s close, unless one intends to take a trend-following stance.Avoid purchasing put options when the underlying security is down for the day versus theprior day’s close, unless one intends to take a trend-following stance.Be careful when holding long option positions beyond Friday’s trading day’s close unlessone is option position trading. Many option theoreticians recalculate their volatility,delta, and time decay numbers once a week, usually after the close of trading on Fridaysor over the weekend. The resulting adjustments in these values most often have a negativeeffect on the value of the long option, which may be acceptable when holding an optionover an extended period of time but is detrimental when day trading.
PRODUCTS IN DERIVATIVES MARKET6212. Quick Snapshot of Options Trading StrategiesPlease note:All or part of your investments using Bullish Strategies has greater risk of loss in fallingmarket.Investments using Neutral Strategies have greater risk of loss in volatile marketsInvestments using Bearish Strategies have greater risk of loss in rising markets.BULLISH STRATEGIESLONG CALLSFor aggressive investors who are bullish about the short-term prospects for a stock, buying callscan be an excellent way to capture the upside potential with limited inside risk.COVERED CALLSFor conservative investors, selling calls against a long stock position can be an excellent way togenerate income without assuming the risks associated with uncovered calls. In this case,investors would sell one call contract for each 100 shares of stock they own.PROTECTIVE PUTFor investors who want to protect the stocks in their portfolio from falling prices, protective putsprovide a relatively low-cost form of portfolio insurance. In this case, investors would purchaseone put contract for each 100 shares of stock they own.BULL CALL SPREADFor bullish investors who want to a nice low risk, limited return strategy without buying orselling the underlying stock, bull call spreads are a great alternative. This strategy involvesbuying and selling the same number of calls at different strike prices to minimize both the cashoutlay and the overall risk.
PRODUCTS IN DERIVATIVES MARKET63BULL PUT SPREADFor bullish investors who want a nice low risk, limited return strategy, bull put spreads areanother alternative. Like the bull call spread, the bull put spread involves buying and selling thesame number of put options at different strike prices. Since puts with the higher strike are sold,the trade is initiated for a credit.CALL BACK SPREADFor bullish investors who expect big moves in already volatile stocks, call back spreads are agreat limited risk, unlimited reward strategy. The trade itself involves selling a call (or calls) at alower strike and buying a greater number of calls at a higher strike price.NAKED PUTFor bullish investors who are interested in buying a stock at a price below the current marketprice, selling naked puts can be an excellent strategy. In this case, however, the risk is substantialbecause the writer of the option is obligated to purchase the stock at the strike price regardless ofwhere the stock is trading.
PRODUCTS IN DERIVATIVES MARKET64BEARISH STRATEGIESLONG PUTFor aggressive investors who have a strong feeling that a particular stock is about to move lower,long puts are an excellent low risk, high reward strategy. Rather than opening yourself toenormous risk of short selling stock, you could buy puts (the right to sell the stock). While risk islimited to the initial investment, the profit potential is unlimited.NAKED PUTSelling naked calls is a very risky strategy which should be utilized with extreme caution. Byselling calls without owning the underlying stock, you collect the option premium and hope thestock either stays steady or declines in value. If the stock increases in value this strategy hasunlimited risk.PUT BACKSPREADFor aggressive investors who expect big downward moves in already volatile stocks, backspreads are great strategies. The trade itself involves selling a put at a higher strike and buying agreater number of puts at a lower strike price. As the stock price moves lower, the profitpotential is unlimited.BEAR CALL SPREADFor investors who maintain a generally negative feeling about a stock, bear spreads are a nicelow risk, low reward strategies. This trade involves selling a lower strike call, usually at or nearthe current stock price, and buying a higher strike, out-of-the-money call. This spread profitswhen the stock price decreases and both calls expire worthless.BEAR PUT SPREADFor investors who maintain a generally negative feeling about a stock, bear spreads are anothernice low risk, low reward strategy. This trade involves buying a put at a higher strike and sellinganother put at a lower strike. Like bear call spreads, bear put spreads profit when the price of theunderlying stock decreases.
PRODUCTS IN DERIVATIVES MARKET65NEUTRAL STRATEGIESREVERSALPrimarily used by professional traders, a reversal is an arbitrage strategy that allows traders toprofit when options are underpriced. To put on a reversal, a trader would sell stock and useoptions to buy an equivalent position that offsets the short stock.CONVERSIONPrimarily used by professional traders, a conversion is an arbitrage strategy that allows traders toprofit when options are overpriced. To put on a conversion, a trader wouldbuy stock and use options to sell an equivalent position that offsets the long stock.THE COLLARFor bullish investors who want to nice low risk, limited return strategy to use in conjunction witha long stock position, collars are a great alternative. In this case, the collar is created bycombining covered calls protective puts.LONG STRADDLEFor aggressive investors who expect short-term volatility yet have no bias up or down (i.e., aneutral bias), the long straddle is an excellent strategy. This position involves buying both a putand a call with the same strike price, expiration, and underlying. The potential loss is limited tothe initial investment. The potential profit is unlimited as the stock moves up or down.SHORT STRADDLEFor aggressive investors who dont expect much short-term volatility, the short straddle can be arisky, but profitable strategy. This strategy involves selling a put and a call with the same strikeprice, expiration, and underlying. In this case, the profit is limited to the initial credit received byselling options. The potential loss is unlimited as the market moves up or down.
PRODUCTS IN DERIVATIVES MARKET66LONG STRANGLEFor aggressive investors who expect short-term volatility yet have no bias up or down (i.e., aneutral bias), the long strangle is another excellent strategy. This strategy typically involvesbuying out-of-the-money calls and puts with the same strike price, expiration, and underlying.The potential loss is limited to the initial investment while the potential profit is unlimited as themarket moves up or down.SHORT STRANGLEFor aggressive investors who dont expect much short-term volatility, the short strangle can be arisky, but profitable strategy. This strategy typically involves selling out-of-the-money puts andcalls with the same strike price, expiration, and underlying. The profit is limited to the creditreceived by selling options. The potential loss is unlimited as the market moves up or down.THE BUTTERFLYIdeal for investors who prefer limited risk, limited reward strategies. When investors expectstable prices, they can buy the butterfly by selling two options at the middle strike and buyingone option at the higher and lower strikes. The options, which must be all calls or all puts, mustalso have the same expiration and underlying.RATIO SPREADFor aggressive investors who dont expect much short-term volatility, ratio spreads are a limitedreward, unlimited risk strategy. Put ratio spreads, which involve buying puts at a higher strikeand selling a greater number of puts at a lower strike, are neutral in the sense that they are hurtby market movement.CONDORIdeal for investors who prefer limited risk, limited reward strategies. The condor takes the bodyof the butterfly - two options at the middle strike - and splits between two middle strikes. In thissense, the condor is basically a butterfly stretched over four strike prices instead of three.