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Derivatives

Derivatives

Financial markets are, by nature, extremely volatile and hence the risk factor is an important concern for financial agents. To reduce this rick, the concept of derivatives comes into the picture.
Derivatives have probably been around for as long as people have been trading with one another. Forward contracting dates back at least to the 12th century, and may well have been around before then. Merchants entered into contracts with one another for future delivery of specified amount of commodities at specified pric. A primary motivation for pre-arranging a buyer or seller for a stock of commodities in early forward contracts was to lessen the possibility that large swings would inhibit marketing the commodity after a harvest.
In short, derivative is not an asset in itself but an agreement or a contract to transfer the real asset in future whenever exercised. The date and price of execution is mentioned in the contract as per agreement between the parties. There are varieties of derivatives available at present like futures, options and swaps; futures and options being the most common ones. They yield better returns with lower capital investment as compared to the amount that will be invested to buy the shares directly form the spot market.
It is governed by the Securities Contract Regulation Act or SCRA 1956.

Development of exchange – traded derivatives

Derivatives have probably been around for as long as people have been trading with one another. Forward contracting dates back at least to the 12th century, and may well have been around before then. Merchants entered into contracts with one another for future delivery of specified amount of commodities at specified price. A primary motivation for pre-arranging a buyer or seller for a stock of commodities in early forward contracts was to lessen the possibility that large swings would inhibit marketing the commodity after a harvest.

The need for a derivatives market

The derivatives market performs a number of economic functions.
1. They help in transferring risks from risk averse people to risk oriented people
2. They help in the discovery of future as well as current prices
3. They catalyze entrepreneurial activity
4. They increase the volume traded in markets because of participation of risk averse people in greater number
5. They increase savings and investment in the long run.
Holder: Holder is the buyer of derivative agreement. By buying an agreement, the buyer may agree to buy or sell the underlying asset.
Seller: One who sells the contract to holder.

Types of derivatives products
Forwards

A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at today’s pre- agreed price.

Futures

A future contract is an agreement between two parties to buy or sell an asset a certain time in the future at a certain price. They are different from futures contract as they are standardized by the exchange .

Options

Options are of two types call and put. Call gives the buyer the right but not the obligation to buy a given quantity of the underlying asset at a future date at a pre determined price. Put give the seller the right but not an obligation to sell at a given price at a future date.

Warrants

Options generally have lives upto 1 year, majority of the options trade on the stock market have a maturity of up to 9 months. Longer traded options are called warrants and are generally traded over the counter.

Leaps

These are options having a maturity of up to 3 years.

Basket

Basket options are options on portfolios of underlying assets. The underlying asset is usually a basket of asset.

Swaps

swaps are private agreement between two parties to share cash flows in the future on the basis of a pre determined formula. The two commonly used swaps are:
1. Interest rate swaps: These entail only swapping the interest related cash flows between two parties.
2. Currency swaps: these entail swapping both the principal and the interest rate between the two parties with cash flows in one direction being in a different currency than those in the opposite direction.

Swaptions

Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating.

able 1 The global derivatives industry : outstanding contracts, (in $ billion)
1995    1996     1997    1998    1999    2000
Exchange traded instruments 9283   10018  12403  13932  13522  14302
Interest rate futures and options 8618  9257  11221  12643  11669  12626
Currency futures and options 154  171  161  81  59  96
Stock index futures and options 511  591  1021  1208  1793  1580
Some OTC instruments 17713  25453  29035  80317  88201  95199
Interest rate swaps and options 16515  23894  27211  44259  53316  58244
Currency swaps and options 1197  1560  1824  5948  4751  5532
Other instruments –  –  –  30110  30134  31423
Total 26996  35471  41438  94249  101723  109501

Source: Bank for International Settlements
(OTC: Over The Counter traded instruments, discussed later.)

Factors driving the growth of financial derivatives 

1. Increased volatility in asset prices in financial markets,
2. Increased integration of national financial markets with the international markets,
3. Marked improvement in communication facilities and sharp decline in their costs,
4. Development of more sophisticated risk management tools, providing economic agents a wider choice of risk management strategies, and
5. Innovations in the derivatives markets, which optimally combine the risks and returns over a large number of financial assets leading to higher returns, reduced risk as well as transaction costs as compared to individual financial assets.

Table 2 Turnover in derivatives contracts traded on exchanges, (in US$ trillion)
1993  1993  1995  1996  1997  1998  1999  2000
Interest rate futures 177.3  271.9  266.4  253.6  247.8  296.6
Interest rate futures and options 8618  9257  11221  12643  11669  12626
Currency futures and options 154  171  161  81  59  96
Stock index futures and options 511  591  1021  1208  1793  1580
Some OTC instruments 17713  25453  29035  80317  88201  95199
Interest rate swaps and options 16515  23894  27211  44259  53316  58244
Currency swaps and options 1197  1560  1824  5948  4751  5532
Other instruments –  –  –  30110  30134  31423
Total 26996  35471  41438  94249  101723  109501

Basics of futures & options

What are futures and options?
A contract to make or take delivery of a product in the future, at a price set in the present
In formalized futures and options trading on exchanges, standardized agreements specify price, quantity, and month of delivery
Started in agriculture, but have expanded to a wide range of products.

Futures

In futures contract the buyer and seller enter into an obligatory agreement to exercise the contract at maturity. It is not equity in a stock or commodity. It is a contract – a contract to make or take delivery of a product in the future, at a price set in the present.In formalized trading of futures contracts on exchanges, standardized agreements specify price, quantity and the month of delivery.
Both the buyer and seller have the obligation to exercise the contract which means on maturity, seller will transfer the underlying securities and buyer will make the cash payment as per agreed price.
The buyer does not have to pay any amount for buying a futures contract because it is an enforceable agreement which will get settled on maturity date.

Example of future trading

A person bought a futures contract to buy security A at a price of Rs 500 on a specific future date. On the expiry date, the price went up to Rs 600. So the deal is good for buyer who will get the securities at Rs 100 lesser than the actual market price. On other side, it is devastating for the seller who is obliged to sell them at lower price which has been agreed upon.

Features

Future is again a contract to buy or sell an underlying of a certain qty at a certain future time at a certain price

Timings for trading in this product is 10.00 Am to 3.30 Pm
Futures can be bought in both Stock and Index.
In this only 3 month contracts are available (Near, Middle, Far)
It gives far more leverage than any product in other words you have more opportunities to earn money though immense loss cannot also be ignored
Like margin here also you need to keep some deposit/margin with us in order for to trade
Need to pay a small IM(initial margin) and keep a (MM) minimum margin
The contract expires on the last Thursday of every month means it wont be allowed for trading anymore from the expiry day onwards

Futures terminology

SPOT PRICE : The price at which an asset is traded in the spot market
FUTURES PRICE : The price at which a futures contract takes place in the futures market.
CONTRACT CYCLE: The period over which a contract trades. Contracts on NSE have a 1 month, 2 month and 3 month expiry cycles which expire on the last Thursday of the month. On the Friday following the last Thursday a new 3month expiry contract is issued.
EXPIRY DATE : The last date till which the contract can be executed beyond which the contract ceases to exist.
CONTRACT SIZE: The amount of assets that can be delivered under one contract.
BASIS:In the context of future basis can be defined as the difference between futures price and spot price.
INITIAL MARGIN: The amount that must be deposited into the margin account at the time when a futures contract is entered into is called initial margin.
MARKING TO MARKET: In the futures market at the end of each trading day the margin account is adjusted to see the days gain or loss depending on the futures closing price this is called marking to margin.
SQUARE OFF:Taking an opposite or close position of the initial position.
OPEN POSITIONS:The position is open and has not been squared off.
LIMIT:The purchasing power in each product. In other words how much you have allocated in that particular product for trading purpose.
LTP :It is the last traded price of the contract
MAINTAINENCE MARGIN:This is somewhat lower than the initial margin this is to ensure that the balance in the margin account never becomes negative. If the margin account falls below the maintenance margin then the investor receives a margin call and is expected to top up the A/c till the initial margin before the trading begins the next day.

Options

In options contract the buyer is given an option to decide whether or not he wants to exercise the contract at maturity.
Buyer of the contract has the option to exercise it anytime on or before expiry but seller has the obligation to exercise it. If buyer demands to buy the asset, seller will have to sell it.

Options are two types

CALL
PUT

Call option

It gives the buyer, the right to buy the asset at a strike price. A call option is an option to buy a stock at a specific price on or before a Certain date. The seller or writer however has the obligation to sell the asset if the buyer of the call option decides to exercise his option to buy.

Put Option

It gives the buyer a right to sell the asset at the ‘strike price’ to the buyer. Put options are options to sell a stock at a specific price on or before a certain date.The seller or writer however has the obligation to buy the asset if the buyer of the put Option decides to exercise his option to sell. These are like insurance policies. If you buy a new car and they auto insurance on the car, you pay a premium and are hence, protected if the asset is damaged in an accident. If this happens you use your policy to regain the value of the asset. So put options gains in value if the value of the asset decreases. With put option, you can insure a stock by fixing a selling price. If something happens which causes the asset price to fall and thus get damaged, you can exercise your option and sell it at its insured price level.
The buyer has to pay an amount called as Premium for acquiring an additional right of having an option to exercise the contract or not.

Example of option trading

A person bought a call option at a strike price of Rs 100. On maturity the price falls to Rs 80. He will not exercise the contract because he can buy the same asset from the market at Rs 80. However if price rises, he will exercise the contract. Similarly, a person bought a put option at a strike price of Rs 100. On maturity the price shoots up to Rs 150. He will not exercise the contract because he can sell the same asset in the market at Rs 150, rather than giving it to the seller at agreed upon price of Rs 100.

Options terminology

INDEX OPTION: Options which have index as the underlying.
STOCK OPTION: stock option are option on individual stocks. The contract gives the holder the right to buy or sell the stocks at a specified price.
BUYER OF AN OPTION: The buyer of the option is one who by paying the option premium buys the right but not the obligation to exercise his option on the seller/writer.
WRITER OF AN OPTION: The writer of a call or put option is one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him.
CALL OPTION: This gives the holder the right to buy but not an obligation to buy a certain asset at a certain time at a certain price.
PUT OPTION: This gives the holder a right but not an obligation to sell at a fixed price at a future date.
OPTION PRICE/ PREMIUM: The price that the option buyer pays the option seller.
STRIKE PRICE: The price specified in the options contract is the strike price or the exercise price.
AMERICAN OPTIONS: Options that can be exercised any time up to the expiry date.
EUROPEAN OPTIONS: European options are options that can be exercised at the expiry date only.
ITM (In the Money) OPTION:An ITM option is one that would lead to positive cash flows to the holder if it were exercised immediately. A call option on the index is said to be ITM if Strike price < Spot price. A put option is said to be ITM if the Strike price > Spot price.
AT THE MONEY (ATM) OPTION: The option that would lead to zero cash flows if exercised immediately.
i.e. spot price = strike price
OUT OF MONEY (OTM) OPTION : An option that would lead to –ve cash flows if exercised immediately.
COST OF CARRY: The relationship between futures price and spot price can be summarized as what is known as cost of carry. This measures the storage cost plus the interest that is paid to finance the asset less the income earned on it.

Option payoffs

Payoff profile for buyer of a call option:
The profit or loss he makes depends on the spot price of the underlying. If upon expiration the spot price exceeds the strike price he makes a profit. If the strike price is more than the spot price he makes a loss to the amount of premium he has paid.
Payoff profile of a writer of the call option:
For selling an option the writer of the option charges a premium. If spot price exceeds the strike price the writer starts making losses whereas if the spot price is less than the strike price the option is not exercised and the writer gets a profit of the amount of premium.
Payoff profile of the buyer of put option :
If the spot price is below the strike price he makes a profit. If the spot price is more than the strike price he leaves his option unexercised and his loss is the amount of premium he has paid.
Payoff profile of a writer of put options:
By selling the option the writer of the option gets a premium. The profit or loss that the buyer makes depends on the spot price of the underlying. Whatever is the buyers loss is the sellers gain.

Why do futures and options markets exist?

Risk Transfer
Price Discovery

Professionals such as grain merchants, energy firms and portfolio managers use futures and options to reduce the risk to their business associated with volatile prices. For example, a flour miller might use a futures contract to set a price now for wheat that he knows he will need to purchase in the future, rather than face the chance that prices could be even higher when he buys the wheat. Similarly, a natural gas producer might use a futures contract to set a price now for gas he will sell in the future, locking in a profit rather than being exposed to the possibility of lower prices. These types of futures and options users are known as hedgers, and are in the market specifically to reduce risk.People who assume risk take it on in exchange for the opportunity for profit. Thus the futures and options markets serve the important function of risk transfer.
Futures and options markets also provide the economy with price discovery. Futures prices are determined by supply and demand. An exchange itself does not set prices; it simply provides a place where buyers and sellers can negotiate. If there are more buyers than sellers, the price goes up. If there are more sellers than buyers, the price goes down. The prices discovered through futures markets offer valuable economic information about supply and demand in a competitive business environment.

How does trading futures and options work?

Similar to stocks, gains and losses are the result of price changes
An added economic benefit of using futures and options markets for many investors is lowered transaction costs. Similar to stocks, gains and losses in futures trading are the result of price changes. If you have sold a futures contract, your trade will show a profit if prices fall. If you have bought, higher prices will produce a profit. To make a profit on a futures trade you can first buy low and then sell high, or reverse the order and sell high, then buy low.

Futures can be highly leveraged
Options risks differ depending on position

It is important to understand futures may be highly leveraged. This means that if the price moves in the direction you anticipated you could realize large profits in relation to your initial investment. Conversely, if prices move in the opposite direction of what you anticipated, you could realize large losses in relation to your initial investment.
Options on futures are different from futures themselves in that the most a buyer can lose is the cost of purchasing the option, known as the premium, along with transaction costs. An option seller, however, has unlimited risk.

A number of factors to consider including account type, trading style
Traded through a registered broker

Commodity1

Commodity3

Commodity Derivatives

Futures contracts in pepper, turmeric,gur(jaggery), hessian (jute fabric), jute sacking, castor seed, potato, coffee, cotton, and soybean and its derivatives are traded in 18 commodity exchanges located in various parts of the country. Futures trading in other edible oils, oilseeds and oil cakes have been permitted. Trading in futures in the new commodities, especially in edible oils, is expected to commence in the near future. The sugar industry is exploring the merits of trading sugar futures contracts. The policy initiatives and the modernisation programme include extensive training, structuring a reliable clearinghouse, establishment of a system of warehouse receipts, and the thrust towards the establishment of a national commodity exchange. The Government of India has constituted a committee to explore and evaluate issues pertinent to the establishment and funding of the proposed national commodity exchange for the nationwide trading of commodity futures contracts, and the other institutions and institutional processes such as warehousing and clearinghouses. With commodity futures, delivery is best effected using warehouse receipts(which are like dematerialised securities). Warehousing functions have enabled viable exchanges to augment their strengths in contract design and trading. The viability of the national commodity exchange is predicated on the reliability of the warehousing functions. The programme for establishing a system of warehouse receipts is in progress. The Coffee Futures Exchange India(COFEI) has operated as system of warehouse receipts since 1998.

Exchange-traded vs.OTC(Over The Counter) derivatives markets

The OTC derivatives markets have witnessed rather sharp growth over the last few years, which has accompanied the modernization of commercial and investment banking and globalisation of financial activities. The recent developments in information technology have contributed to a great extent to these developments. While both exchange-traded and OTC derivative contracts offer many benefits, the former have rigid structures compared to the later. It has been widely discussed that the highly leveraged institutions and their OTC derivative positions were the main cause of turbulence in financial markets in 1998. These episodes of turbulence revealed the risks posed to market stability originating in features of OTC derivative instruments and markets.

The OTC derivatives markets have the following features compared to exchange-traded derivatives

The management of counter-party (credit) risk is decentralized and located within individual institutions,
There are no formal centralized limits on individual positions, leverage, or margining,
There are no formal rules for risk and burden-sharing,
There are no formal rules or mechanisms for ensuring market stability and integrity, and for safeguarding the collective interests of market participants,and
5. The OTC contracts are generally not regulated by a gegulatory authority and the exchange’s self-regulatory organization, although they are affected indirectly by national legal systems, banking supervision and market surveillance.

Paricipants in derivatives market

Hedgers :Face risk associated with the price of an asset.
Speculators :People who wish to bet on the future price movements.
Arbitrageurs :Take advantage of the price discrepancy between two markets.

Hedging

Making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract. An example of a hedge would be if you owned a stock, then sold a futures contract stating that you will sell your stock at a set price, therefore avoiding market fluctuations. Investors use this strategy when they are unsure of what the market will do. A perfect hedge reduces your risk to nothing (except for the cost of the hedge).
The best way to understand hedging is to think of it as insurance. When people decide to hedge, they are insuring themselves against a negative event. This doesn’t prevent a negative event from happening, but if it does happen and you’re properly hedged, the impact of the event is reduced. So, hedging occurs almost everywhere, and we see it everyday. For example, if you buy house insurance, you are hedging yourself against fires, break-ins or other unforeseen disasters. Portfolio managers, individual investors and corporations use hedging techniques to reduce their exposure to various risks.
In financial markets,hedging against investment risk means strategically using instruments in the market to offset the risk of any adverse price movements. In other words, investors hedge one investment by making another. Technically, to hedge you would invest in two securities with negative correlations.
Hedging cannot help to escape the risk-return tradeoff. A reduction in risk will always mean a reduction in potential profits. Hedging is a technique not to make money but to reduce potential loss. If the investment hedged against makes money, then the profit would be reduced but if the investment loses money and the hedge is successful, it will reduce the loss.

Speculation

Speculation usually involves making assumptions that a particular stock price is going to change.

Investors enter into a trade with the intention of ending it in the same settlement cycle;
When they use the existing mechanisms of lending and borrowing to carry-forward their obligations to subsequent settlements.
Having described it thus, it may be mentioned that speculation through borrowing and lending mechanisms is present in most markets.

Anything can lead to speculation. It can be based on some news or some global reaction. If a company reports consistent growth in net sales the stock price will be worth more and market reaction can drive it more. People may not know each and every product being sold but a close study of a company can give an estimate of where the companies sales are headed. The share value can increase or decrease on a given day due to thousands of reasons.

Why is it present? 

Speculation exists because it enhances the functioning of the stock market. The market for stocks itself exists because different people have different views on the same stock. To explain, if all investors had the same view on every company, then everybody would want to buy at the same time or conversely, sell at the same time. The implication is that a market cannot exist because there is simply no one with a different view.
Unlike bank deposits, investing in stocks is, relatively, a risky business. There can be short, sharp fluctuations that result in big gains or losses. One way of looking at speculators is that they are a class of investors who are willing to take more risks on an average. And the thumb rule is that greater the variety (categories of investors), greater the likelihood of trades taking place.

Importance of volume in a market 

The biggest advantage of speculation is that it increases the volume of the stocks traded. And volume is absolutely essential in creating a marketplace that functions smoothly.
Higher volume means that investors can enter and exit any moment. Equities are more actively traded than corporate debt in India, thus, providing investors with a handy investment avenue that yield cash at short notice.
Volume also plays an important role in price formation. If there arises a sudden huge sale in any market, the prices will crash. In a stock market that sees sporadic trades, orders for slightly bigger quantities will create huge swings in price. Thus, the price formation will be jerky.
On the other hand, when the market is liquid in terms of frequent trades taking place, the change in price is relatively smooth. Even if big orders come in, the depth in market results in relatively smooth changes taking place.

The downsides 

The biggest fear with speculation is that it can accentuate sharp movements. By definition, speculators are the ones who are willing to take bigger risks and are also likely to be first to panic in case of adverse developments.

Arbitraging 

“Arbitrage” trading is simply the trading of securities when the opportunity exists during the trading day, to take advantage of differences in value between the markets the trades are made within. Arbitrage trading takes place all day long on most days that the markets are active.
Arbritrage is legally allowed. In fact arbitrage is responsible for a large part of the daily volumes on the NSE & BSE exchanges. What mainly takes place in India is called Market Arbitrage. Market Arbitrage involves purchasing and selling the same security at the same time in different markets (BSE & NSE) to take advantage of a price difference between the two separate markets. In perfect securities markets there would never be any arbitrage traders or trades. Since the securities markets are not perfect when news or other information moves a security or index they can and often do become unequal in price temporally. If the markets were perfect all identical securities would trade at the same value or price on each market they were traded on.A market arbitrageur would short sell the higher priced stock and buy the lower priced one. The profit is the spread between the two assets.

Here is a simple example 

Suppose you own 500 shares of RPL. One trading day you notice that RPL is trading at 150 on the BSE and 140 on the NSE. You sell your 600 shares on the BSE at 150 and simultaneously buy back the 600 shares on the NSE at 145.
You profit in this case is 500*10.00 = 5000.00 less brokerages if any.
One of the most popular Arbitrage trading opportunities is played with the S&P futures and the S&P 500 stocks. During most trading days these two will develop disparity in the pricing between the two of them. This happens when the price of the stocks which are mostly traded on the NYSE and NASDAQ markets either get ahead or behind the S&P Futures which are traded in the CME market. Lets say the stocks get ahead of the futures in price. Arbitrage traders will sell the stock and buy the futures. They end up with the same or closely related investment but have just made money by taking the difference in the prices from the two separate markets.

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