Derivatives & Derivatives Market

Derivative comes from the word to derive

A derivative is a contract whose value is derived from the value of another asset called underlying asset

If the price of underlying asset/security changes the price of derivative security also changes.

Financial derivatives Underlying is stocks, bonds, indexes, foreign exchange, Eurodollar etc.

Commodity derivative Underlying is wheat, cotton, pepper, corn, oats, soyabean, crude oil, natural gas, gold, silver, turmeric etc.

Derivative minimizes the risk of owning things that are subject to unexpected price fluctuations like stocks & bonds, foreign currencies, commodities like wheat, minerals, etc.

Under lying Price ChangeDerivative Price ChangeChange in Spot or Cash Market Price of Underlying Change in Prices in Derivatives market

Three PurposesHEDGINGSPECULATIONPROFIT THROUGH ARBITRAGE

Forwards FuturesOptionsSwaps

Over the counter derivativesExchange traded derivatives

Over the counter derivatives are the ones that are traded directly between 2 parties, without the intermediation of stock exchanges

Exchange-traded derivatives are those that are traded via derivative exchanges.

In case of OTC derivatives, the management of counterparty risk is decentralised and rests with the individual partiesBut in case of exchange traded derivatives the counter party risk lies with the exchange concerned

There are no formal centralised limits on individual positions, leverage or marginingIn the case of exchange traded derivative, such regulations would be there

In case of OTC derivatives, the contracts are custom designedIn the case of exchange traded derivatives, they are highly standardised regarding the size, price and time duration

In case of OTC derivatives, there are not formal rules for risk and burden sharingBut in case of exchange traded derivatives such rules exist. Hence the element of risk is relatively less here.

In case of OTC derivatives, there are no rules or mechanisms to ensure market stability and integrity and for safeguarding the interests of market participants But in case of exchange traded derivatives there are elaborate rules and institutional mechanisms in these matters

In India, two exchanges offer derivatives trading: the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). OTC derivative trading are considered as illegal in Indian Law.

OTC ContractExchange Traded ContractCustomized TermsStandardized TermsSubstantial Credit RiskNo riskUnregulatedRegulatedTransparencyInformation AsymmetryOverleveraged positionsLess leveraged

FORWARDSIt is a contract between two parties to buy or sell an underlying asset at todays pre-agreed price (known as Forward Price) on a specified date in the future. This forward price is set at the inception of contract

It is the most basic form of derivative contract.

These contracts are not standardized, the end users can tailor make the contracts to fit their very specific needs. Traded at Over The Counter exchange.

It is a bilateral contractIt is exposed to counterparty riskEach contract is customer designed and hence is uniqueContract price is not generally available in public domainOn the expiration date the contract has to be settled through delivery of the asset

Forward contracts are very useful in hedging, speculation and arbitrage

Suppose the present value of share is 45 and Mr X expects it to go up to 75 in 3 months. Mr X can make a good profit by buying 10,000 shares at, say, 50 per share through a forward contract today.

After 3 months, the investor can take a reversing transaction to book profits. If the actual price in 3 months is 75, Mr X will be making a profit of 25 per share and a total profit of 2,50,000.

But the risk is that price can decrease also. If price drops to 25, then Mr X will incur a loss of 2,50,000

An Indian Company has ordered machinery from USA. The price of $ 5,00,000 is payable after six months. The current exchange rate is 49.08 as on 28th Feb 2012. At the current rate the company needs 49.08*5,00,000 = 2,45,40,000 If the company anticipates depreciation of Indian rupee over time. The company can enter into a forward contract & forget about any exchange rate fluctuations. Suppose the exchange rate becomes 50, then also the company has to pay Rs. 2,45,40,000 for buying $ 5,00,000 though the value is 2,50,00,000.

Lack of centralisation of tradingInadequate liquidityPresence of huge counterparty risk

FUTURESFutures are financial contracts that help to lock-in the price at which one wishes to buy or sell an asset in the future. Futures are highly standardized, exchange traded contracts to buy or sell specified quantity of financial instruments/commodity in a designated future month at a future price.

Futures Price: The price agreed by the two traders on the floor of exchange.

Futures are standardised contracts.For e.g. an exchange may offer 4 different types of future contracts on a given security likeMarch 31/110, June 30/115, September 30/120, December 31/125That means, the buyer/seller of a March 31/110 futures contract in effect undertakes to buy/sell the security at Rs 110 on March 31, and so forth

A farmer supplies Barley to a Breakfast cereal manufacturer. He fears fall in future prices of Barley. so he thinks of entering into a futures contract for selling 20 metric ton of barley.If he wants to sell less than 20 metric ton he has to enter into a forward agreement & not futures.This is bcoz standard contract size for barley in barley international exchange is 20 metric ton or its multiples.

Futures vs Forwards

It is the initial deposit required to open a trading account in a futures trading exchange. The initial margin is fixed by the broker, but has to satisfy an exchange minimum. The variation margin i.e. the change in the amount of an account on a given day in response to a marked to - market process, is settled on daily basis.

The exchange requires both parties to put up an initial amount of cash, the margin. Additionally, since the futures price will generally change daily, the difference in the prior agreed-upon price and the daily futures price is settled daily The exchange will draw money out of one party's margin account and put it into the other's so that each party has the appropriate daily loss or profit. If the margin account goes below a certain value, then a margin call is made and the account owner must replenish the margin account. This process is known as marking to market.

Initial Margin The amount that must be deposited in the margin account when establishing a position. The margin requirement is about 12% futures & 8% for options.Marking to Market In the futures market at the end of each trading day, the margin account is adjusted to reflect the investors gain or loss depending upon the futures closing account.Maintenance Margin This is set to ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin, the investor is expected to top up the initial level before trading commences on the next day.

For example, say, you have bought 100 shares of XYZ at Rs.100 and Threshold MTM Loss is 20% and the applicable margin % is 35%. You would be having a margin of Rs.3500 blocked on this position. The current market price is now say Rs.75. This means the MTM loss is 25% which is more than the threshold MTM loss % of 20% and hence additional margin to be called in for. Additional margin to be calculated as follows:

(a) Margin available100*100*35%Rs.3500(b) Less : MTM Loss(100-75)*100Rs.2500(c) Effective available margin(a-b)Rs.1000(d) Required Margin 75*100*35%Rs.2625(e) Additional Margin required(d-c)Rs.1625

Types of FuturesCommodity futures (Wheat, corn, etc.) andFinancial futuresFinancial futures include:Foreign currenciesInterest rateMarket index futures (Market index futures are directly related with the stock market)Individual stock.

OPTIONS An option is a contract between two parties in which one party has the right but not the obligation to buy or sell some underlying asset on a specified date at a specified price.The option buyer has the right not an obligation to buy or sell.If the buyer decides to exercise his right the seller of the option has an obligation to deliver or take delivery of the underlying asset at the price agreed upon.

Types of OptionsOn the basis of the nature of the rights and obligations in the option contract, options are classified in to two categories. They are:Call Options andPut Options.

CALL OPTIONS A call option is a contract that gives the option holder the right to buy some underlying asset from the option seller at a specified price on or before a specified date. Eg. The current market price of Ashok Leyland is Rs.69. An option contract is created and traded on this share. A call option on the share would give the right to buy the share at a specified price (Rs.70) during June 2014. This call option would be traded between two parties P (the purchaser and S ( the seller). The purchaser P would be prepared to pay a small price known as option premium (Rs.2) to S, the seller of the option.

PUT OPTIONS A put option is a contract which gives its owner the right to sell some underlying asset at a specified price on or before a specified date. The seller of the put option has the obligation to take delivery of the underlying asset, if the owner of the option decides to exercise the option.

A Call OptionIf an investor buys one option to buy one Infosys share at Rs 730 by paying a premium of Rs 10, his total cost is Rs 740At any time before or on the expiration date, the investor can exercise the right to buy the option, if the price goes above Rs 740 in the cash market.If it does not, then he will not do anything and will allow the option to expire.

A Put OptionIf an investor buys one option to sell one Infosys share at Rs 730 by paying a premium of Rs 10, again his total cost is Rs 740At any time before or on the expiration date, the investor can exercise the right to sell the option, if the price goes below Rs 740 in the cash market.If it does not, then he will not do anything and will allow the option to expire.

Option Writer or Option Grantor: The seller of option.Strike price or Exercise price : The price at which the option holder may purchase the underlying asset from the option seller. Time to Expiration or Time to Expiry : The period of time specified for exercising the option.Expiration Date : The precise date on which the option right expires.

Types of OptionsOn the basis of maturity pattern of options, option contracts are categorized in to two. They are:European Style OptionsAmerican Style Options

European Style Options Options which can be exercised only on the maturity date of the option or on the expiry date.American Style OptionsOptions which can be exercised at any time up to and including the expiry date.Most of the exchange traded options are American style. In India stock options are American style while index options are European style.

Types of OptionsBased on the mode of trading options are classified in to two:Over-the-counter OptionsExchange Traded Options

Moneyness of OptionsMoneyness of an option describes the relationship between the strike price of the option and the current stock price. This takes three forms: In the Money (advantageous to option holder) At the Money (neutral) Out of the Money (not advantageous to option holder)

In the Money OptionsWhen the strike price of a call option is lower than the current stock price, the option is said to be in the money. This is because the owner of the option has the right to buy the stock at a price which is lower than the price which he has to pay if he had to buy it from the open market. Similarly in the case of put option, when the strike price is greater than the stock price, the option is said to be in the money.If an in the money option is exercised, there will be an immediate cash inflow.

When the strike price of a call option is equal to the current stock price, the option is said to be at the money option.In the case of a put option if the strike price of the option is equal to the stock price, the put option is said to be at the money.

When the strike price of a call option is more than the stock price, the option is termed as out of the money option. In the case of put option, if the strike price is less than the stock price, the option is said to be out of the money option.

When the Shares of A Ltd. is Trading at Rs.450

Difference between Futures & Options

An Option gives the buyer the right but not the obligation while the seller has an obligation to comply with the contract. In the case of a futures contract, there is an obligation on the part of both the buyer and the seller. When you purchase call or put Options you have the right to let your Option lapse but if you choose to exercise it, the counter-party (seller) must comply. A futures contract, on the other hand, is binding on both counter-parties as both parties have to settle on or before the expiry date.

Purchasing a futures contract requires an up front margin and normally involves a larger outflow of cash than in the case of Options, which require only the payment of premium.

A futures contract carries unlimited profit and loss potential whereas the buyer of a Call or Put Option's loss is limited but the profit potential is unlimited.

Futures are a favourite with speculators and arbitrageurs whereas Options are widely used by hedgers.

When you buy an option, you pay the seller a non-refundable amount, known as the option premium, for the right to exercise that option before it expires.If you sell an option, you receive a premium from the buyer. In fact, collecting the premium is often one motive for selling options, including those you anticipate will expire without being exercised.Factors such as the price and volatility of the underlying instrument, current interest rates, and so on affect the premium price.

No big investmentNo margin as in futuresNo obligation (for buyer)No mark to marketMore gain than risk

Involves premium paymentLess liquidity

On December 1999, the Securities Contract Regulation Act was amended to include derivatives within the sphere of securities.Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2000 on the recommendation of L. C Gupta committee. Securities and Exchange Board of India (SEBI) permitted the derivative segments of two stock exchanges, NSE and BSE, and their clearing house/corporation to commence trading and settlement in approved derivatives contracts.