Derivatives

Chitra Potdar

Derivatives - Definition

Derivative is a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index or reference rate) in a contractual manner Examples

Definition

1.

2.

The Securities Contracts (Regulation) Act, 1956 defines derivative to include A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security A contract which derives its value from the prices, or index of prices of underlying securities

Features of Derivatives

They can be designed in such a way so as to cater to the varied requirements of the users either by simply using any one of the above instruments or by using combination of two or more such instruments They can be traded on the basis of the expectations regarding the Future price movements of underlying assets They are off balance sheet instruments They are used for reducing the risk of fluctuations in asset values

History of Derivatives

Initially emerged as hedging devices against fluctuation in commodity prices The commodity linked derivatives existed almost 300 years ago Financial derivatives emerged post 1970 due to growing instability in the financial markets Recently the market for financial derivatives has grown up by leaps and bound The futures and options on the stock indices have gained more popularity

Need for Derivatives

Free market economy Corporates were exposed to

Exchange Rate Risk Interest Rate Risk Economic Risk Political Risk

Need for Derivatives in India

The need was felt for the corporate clients to protect their operating profits by shifting some uncontrollable risk by way of Risk Management Derivatives occupies an important place in the Risk Management

Participants of a Derivative Market

Hedgers Speculators Arbitrageurs

Factors driving growth of derivatives

1.

2.

3.

4.

5.

Increased volatility of asset prices in financial markets Increased integration of the national financial markets with international markets Marked improvement in communication facilities & sharp decline in their costs Development of more sophisticated risk management tools Innovations in the derivatives markets which optimally combine the risks & returns over a large no of financial assets leading to higher returns, reduced risk & transactional costs

Derivative Products
1. 2. 3.

4.

Forwards Futures Options Swaps

Forwards
1. Forwards is a customized contract between two entities where settlement takes place on a specific date in the future at todays pre-agreed price and other terms & conditions. The promised asset may be currency, commodity, instrument etc. There is an obligation to honour this contract at any cost, failing which there will be some penalty

Forwards contd.

In a forward contract a user (holder) who promises to buy the specified asset at an agreed price at a fixed future date is said to be in the Long position & the user (holder) who promises to sell the specified asset at an agreed price at a fixed future date is said to be in the Short position Rupee Dollar exchange rate is big forward contract market in India for banks, financial institutions, exporters

Forward Contract - Features

1.

2.

3.
4.

Over The Counter Trading customized contract in terms of the contract size, expiration date & the asset type No down payment promise to supply or receive specified asset at a future date Settlement at maturity Linearity symmetrical gains or losses due to price fluctuation of the underlying asset Spot price > Contract price = Gain of Forward Buyer

Forward Contract - Features

5. No Secondary Market purely private contract 6. Necessity of a Third Party in the absence of Exchange 7. Delivery is subject matter of the contract & is a must

Forward Contract Limitations

Lack of centralized trading Illiquidity Counterparty risk

Forward Contracts Illustrations

Forward Rate Currency Contract is a contract where exchange of currencies is promised at an agreed exchange rate at a specified future date Forward Rate Contract on Interest Rate on the date of maturity the difference between the forward interest rate as mentioned in the agreement and the interest rate prevailing in the spot market is paid/received

Futures
2. Futures A future contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price Future contracts are special types of Forward contracts in the sense that the former are standardized exchange traded contracts

Future Contract - Features

1.

2.
3.

Highly Standardized & legally enforceable No down payment by the parties but a deposit called initial margin is placed Settlement need not be at maturity. Future instruments are marked to the market, the exchange records on a daily basis profit & losses to both the parties

Future Contract - Features

5. Linearity symmetrical gains or losses due to price fluctuation of the underlying asset Spot price > Contract price = Gain of Future Buyer Spot price < Contract price = Loss to Future Buyer When is the Gain/Loss to the Seller? 6. Secondary Market Futures are dealt in an organized market as a result they have secondary market too 7. Delivery of the asset is not must. The parties simply exchange the difference between the future & spot prices on the date of maturity

Commodity Futures
1. 2. 3. 4.

5.

It is a Future contract in commodities like agricultural products, metals & minerals etc. Few well established commodity exchanges are London Metal Exchange Chicago Board of trade (soyabean oil) New York Cotton Exchange Commodity Exchange, New York International Petroleum Exchange of London

Commodity Futures

Commodities traded are sugar, jute, pepper, gur, castorseeds, coffee etc. MCX, NMCEX AND NCDEX are the commodity exchanges

Financial Futures

Financial Futures deal in treasury bills, commercial paper, stock market index, interest rate It is very popular hedging instrument used against exchange rate, interest rate fluctuations The stock index futures contract are used by the portfolio managers to protect the prices of the assets in the clients portfolio

Futures vs. Forwards

Trade on an organized exchange Standardized contract terms Hence more liquid Requires margin payments Follows daily settlement Settlement is done by merely exchanging the difference between the future and stock prices

OTC in nature Customized contract terms Hence less liquid No margin payment Settlement happens at the end of period The asset is delivered on settlement

Futures vs. Forwards

Which is superior? Why?

Futures are superior than Forwards as they eliminate counterparty risk & offer more liquidity

Advantages of Forwards & Futures

1. 2. 3. 4. 5. 6. 7. 8.

Protection against price fluctuations Avoidance of carrying costs Proper planning for buying & selling Proper Portfolio Management Proper Cash Management Purchase & Sales in bulk Highly Flexible Boon to Financial Intermediaries

Options
3.

Options are of two types call & put Call option gives the buyer right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date Put option gives the seller right but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given future date

Options

The seller is referred as writer who receives premium from the buyer The premium is the price required to pay for the purchase of right to buy or sell

Features of options
1. 2. 3.

4.
5.

Highly flexible Down payment Settlement Non-Linearity No obligation to buy or sell

Participants in the Derivative Market

1. 2. 3.

Hedgers Speculators Arbitrageurs

Hedgers

Every investment by nature is risk prone Hedgers try to protect themselves against the risk of price change by using derivatives like forwards, options etc. Examples wheat, portfolio, forex

An example of Hedging Using Forward Contracts

If today an Indian Import Co. realizes that it will have to pay $ 1 million to US based company after 3 months for the consignment received from them. The Co can hedge entering into 3 months forward contract @ 47 per $ If after 3 months the exchange rate proves to be more than 47 per $ the Co will wish that it had hedged If exchange rate proves to be less than 47 per $ the Co will be pleased that it had not done so

Speculators

They are willing to take risk They take positions in the market either expecting the movement in the prices and betting on it They may take long or short positions on futures or options or hold spread positions A participant can speculate in futures and options, they are either positional traders or day traders

Arbitrageurs

Arbitrageurs thrives on market imperfections They undertake two simultaneous actions in an attempt to make risk less profit The opportunities will soon vanish as more and more arbitrageurs enter the market They help in bringing equilibrium in prices of same securities in different markets As futures and options with various expiration dates are traded in the market offering opportunities to the arbitrageurs

Options : A Historical Perspective

In 17th century there was an active option market in Holland Options were traded in the USA & UK during the 19th Century In USA options on Equity stocks of the companies were available on the over-thecounter market, until 1973 In India options on the stocks of companies, though illegal, have been traded for many years in the form of Teji and Mandi

Development of Option Market

In the year 1973, Black and Scholes published a paper on option pricing and hedging In the same year CBOE was created

NSEs Derivatives Market

The derivatives trading on the NSE commenced with S & P Nifty Index futures on June 12, 2000 The trading on index options commenced on July 4, 2001 and trading in options on individuals securities commenced on July 2, 2001 Single stock futures were launched on November 9, 2001 The Derivatives contract has a maximum 3 month expiration i.e. contracts are available for trading with 1 month, 2 months and 3 months expiry

Functions performed by Derivatives markets

Price Discovery Risk Transfer Market Completion

Participants and Functions

Clearing Member (CM) does clearing for all the Trading Members (TM) The 3 types of CMs are

Self Clearing Member (SCM) Trading Member Clearing Member (TMCM) Professional Clearing Member (PCM)

Trading Mechanism

The futures & options trading system of NSE is called NEAT F&O trading system It provides fully automated screen based trading for Index futures & options and Stock futures & options It provides online monitoring and surveillance mechanism There are two operators

Trading Members Clearing Members

NSE F&O turnover stands Rs 504.88 bn on July 27 Expiry

Index Futures
Symbol No of Contracts Traded 405,077 48,520 20,754 66 Traded Quantity 20,253,850 970,400 1,037,700 6600 Total Traded Value (Rs in mn.) 92,556.60 44,34.50 7,694.50 27.1 Open interest (Qty.) as at end of trading hrs. 28,517,600 937,560 803,100 12,600

NIFTY MINIFTY BANKNIFTY CNXIT

NSE F&O turnover stands Rs 504.88 bn on July 27 Expiry

Index Options
Symbol No of Contracts Traded 842,222 Traded Quantity 42,111,100 Total Traded Value (Rs in mn.) 191,577.10 Open interest (Qty.) as atend of trading hrs. 101,613,800

NIFTY

MINIFTY

303

6,060

27.9

35,900

BANKNIFTY

98

4,900

38.8

172,700

Nifty Futures Turnover

As on 7-Aug-09 5:30:21 hours IST Type of Investment Future Index Nifty Date of Expiry 27-Aug-09 24-Sep-09 29-Oct-09 Last Price 4480.85 4489.50 4490.15 Underlying Value 4481.40 4481.40 4481.40

Open Interest

It is the number of outstanding contracts at any point of time The open interest does not increase with every contract traded Examples

Clearing House & its role

Obligations without a Clearing House

Assets
Buyer Funds Seller

Clearing House & its role

Obligations with a Clearing House

Assets
Buyer Funds

Clearing House

Assets
Funds Seller

Functions of Clearing House

It provides guarantee that all the trades in future market will honor their obligations All the buying & selling futures contracts require daily collections & payment of funds to parties of future transactions. Clearing House monitors this Members of exchange provide daily reports to the clearing house regarding future trades The Clearing House does not hold any long or short positions but act as an intermediary If all the outstanding long & short positions are added the total is zero

The concept of Margin

The basic objective of margin is to provide a financial safeguard for ensuring that the investors will perform their contract obligations An investor who enters into a future contract is required to deposit funds with the broker is called margin The exchange may set the minimum margin but the brokers may require long margin

The concept of Margin

The amount of margin may vary from the contract to contract and broker to broker The margin may be deposited in the different forms like cash, banks, letter of credit and treasury securities No interest is paid on margin in money This loss of interest is the cost of margin requirement

The types of Margin

1. 2. 3.

Initial Margin Maintenance Margin Clearing Margin

Initial Margin

It is original amount that must be deposited into account to establish future position it varies from stock to stock The initial margin may be 5% or 10% of the value of the contract To determine the initial margin the exchange considers the degree of volatility of price movements of the underlying asset in the past Example

Initial Margin - Advantages

It enables the clearing house to cover the losses on the position even in the most adverse situation It approximately equals the maximum daily price fluctuations permitted by the exchange

Maintenance Margin

It is the minimum amount which may be kept in the margin account It is normally 75% of the initial margin If the future prices move against the investor resulting in the fall in the margin account below maintenance margin the broker will make a call i.e. the demand for additional funds

Maintenance Margin

The function of a maintenance margin is prevent catastrophic losses due to the overextension of credit to investors When a given position declines in value to a point where a margin call is issued, the investor is given the choice to add funds to the account to maintain the position or to close the position at a loss and eliminate the risk of further margin calls

Margin Call

a margin call on futures contracts is triggered when the value of your account drops below the maintenance level For example, you hold five futures contracts that have an initial margin of 10,000 and a maintenance margin of 7,000. The value of your account falls to 6,500. You will get a margin call requiring you to add 3,500 to your account to bring it back to the initial margin You also have the option of closing your positions to eliminate the margin call

Maintenance Margin Illustration

Trading Day Future Price Daily Gain (Loss) Cummulative Gain (Loss) Margin Account Balance

01-Aug

5000

02-Aug
03-Aug 04-Aug 05-Aug 08-Aug

4000
3500 3700 2200 1900

Clearing Margin

A margin which a clearing house member is required to maintain with the clearing house There is no maintenance margin The margin is calculated on the gross basis & net basis Gross margin All the long positions are added to all the short positions and margin is provided Net margin The long positions are netted against the short positions and the margins for net positions are determined