Financial EngineeringFinancial Engineering

By CA. Pradeep Kumar GuptaBy CA. Pradeep Kumar Gupta

(CA., CS., B.com)(CA., CS., B.com)

Financial MarketFinancial Market

Capital Market (SEBI)Capital Market (SEBI) Money Market (RBI) Money Market (RBI)

Capital MarketCapital Market

Primary Market (IPO)Primary Market (IPO) Secondary Market (FPO)Secondary Market (FPO)

Secondary MarketSecondary Market

Cash MarketCash Market Derivative MarketDerivative Market

Stock Exchanges of IndiaStock Exchanges of India(under SEBI)(under SEBI)

BSE (Bombay Stock Exchange)BSE (Bombay Stock Exchange) NSE (National Stock Exchange)NSE (National Stock Exchange)

Commodity Exchange of IndiaCommodity Exchange of India( under Forward Market Commission)( under Forward Market Commission)

NCDEX (National Commodity & NCDEX (National Commodity & Derivatives Exchange) (Agriculture Derivatives Exchange) (Agriculture Products)Products)

(Index-Dhanya)(Index-Dhanya) MCX (Multi Commodity Exchange) MCX (Multi Commodity Exchange)

(Metals)(Metals) 0nly future trading is permitted in 0nly future trading is permitted in

Indian commodity exchanges.Indian commodity exchanges. (Index Comdex)(Index Comdex)

What is derivativesWhat is derivatives

The word derivatives originates from The word derivatives originates from mathematics and refers to a variable, mathematics and refers to a variable, which has been derived from another which has been derived from another variable. Derivatives are so called variable. Derivatives are so called because they have no value of an because they have no value of an underlying assets. The underlying underlying assets. The underlying assets can be equity, commodity, or assets can be equity, commodity, or any other assets. any other assets.

Types of DerivativesTypes of Derivatives

ForwardForward FutureFuture OptionOption

Forward ContractForward Contract

Forward contract is a agreement to Forward contract is a agreement to buy or sell an assets at a certain buy or sell an assets at a certain future time for a certain price.future time for a certain price.

Parties of Forward ContractParties of Forward Contract

Buyer-One of the parties to a forward Buyer-One of the parties to a forward Contract assumes a Buying Position Contract assumes a Buying Position (Long Position) and agrees to buy the (Long Position) and agrees to buy the underlying assets on a certain underlying assets on a certain specified future date for a certain specified future date for a certain specified price.specified price.

Seller-Other parties to contract Seller-Other parties to contract i.e.the seller assumes a short i.e.the seller assumes a short position and agrees to sale the position and agrees to sale the assets on the same date for the assets on the same date for the same price.same price.

Example-on a 01/08/2011 ABC Ltd. Example-on a 01/08/2011 ABC Ltd. enters into a forward contract with enters into a forward contract with PQR.Ltd for buying USD 1 crore at PQR.Ltd for buying USD 1 crore at Rs.45 per USD on 30/09/2011.Rs.45 per USD on 30/09/2011.

Features of the forward Features of the forward contractcontract

Quantity of the Commodity to be Quantity of the Commodity to be delivereddelivered

Quality of the commodity to be Quality of the commodity to be delivereddelivered

Price which the buyer would payPrice which the buyer would pay Counter parties risk involvedCounter parties risk involved Over the counter agreementOver the counter agreement

Future ContractFuture Contract

Future contract is standardized Future contract is standardized Forward contract .In future trading Forward contract .In future trading there is usually a contract which is there is usually a contract which is essentially an agreement between essentially an agreement between two parties to buy or sell an two parties to buy or sell an underlying assets at a certain time in underlying assets at a certain time in the future at a certain price. the future at a certain price.

Feature of future contractFeature of future contract

A future contract usually has a A future contract usually has a standardized date and month of standardized date and month of delivery quantity and price.delivery quantity and price.

Future trading are traded on Future trading are traded on exchange.exchange.

Three series of future contract are Three series of future contract are always available and have one-month, always available and have one-month, two month, and three month expiry two month, and three month expiry cycles. cycles.

Example-on a 3rd August Example-on a 3rd August 2011,Arvind enters into a August 2011,Arvind enters into a August 2011 Future contract for buying 1000 2011 Future contract for buying 1000 shares of Wipro Ltd.shares of Wipro Ltd.

Comparison of forward and futures contractComparison of forward and futures contract

ForwardForward FutureFuture

Private Contract between two Private Contract between two partiesparties Traded on an exchangeTraded on an exchange

Not standardized Not standardized Standardized ContractStandardized Contract

Usually one specified delivery dateUsually one specified delivery date Range of delivery datesRange of delivery dates

Settled at the end of contractSettled at the end of contract Settled dailySettled daily

Delivery or final cash settlement Delivery or final cash settlement usually takes placeusually takes place

Contract is usually closed out Contract is usually closed out prior to maturityprior to maturity

Some credit riskSome credit risk Virtually no credit riskVirtually no credit risk

Index FutureIndex Future

Index future are the future contract Index future are the future contract which underlying assets is a market which underlying assets is a market index. For a example future contract index. For a example future contract on “Senesx” and “Nifty” are called on “Senesx” and “Nifty” are called index future. index future.

OptionOption

Option is a derivatives instrument Option is a derivatives instrument that gives the holder a right, without that gives the holder a right, without any obligation to perform.any obligation to perform.

Option are basically contracts which Option are basically contracts which give to the buyer a facility which is give to the buyer a facility which is similar to buy or sell certain asset similar to buy or sell certain asset (underlying) but the buyer of an (underlying) but the buyer of an option has limited risk & unlimited option has limited risk & unlimited profit.profit.

Types of optionTypes of option(Based on Nature of Activity)(Based on Nature of Activity)

Call OptionCall Option Put OptionPut Option

Call OptionCall Option A call option gives the buyer the right to A call option gives the buyer the right to

buy in the underlying assets at the strike buy in the underlying assets at the strike price specified in the option.price specified in the option.

The profit /loss that the buyer makes on the The profit /loss that the buyer makes on the option depend upon the spot price of the option depend upon the spot price of the underlying. If upon expiration the spot price underlying. If upon expiration the spot price exceeds the strike price he makes a profit.if exceeds the strike price he makes a profit.if the spot price of the underlying assets is the spot price of the underlying assets is less than the strike price the premium of less than the strike price the premium of that option will become zero & maximum that option will become zero & maximum loss in this case is the premium he paid for loss in this case is the premium he paid for buying the option. buying the option.

Put OptionPut Option A put option gives the buyer the right to sell A put option gives the buyer the right to sell

in the underlying assets at the strike price in the underlying assets at the strike price specified in the option.specified in the option.

The profit /loss that the buyer makes on the The profit /loss that the buyer makes on the option depend upon the spot price of the option depend upon the spot price of the underlying. If upon expiration the spot price underlying. If upon expiration the spot price below the strike price he makes a profit. if below the strike price he makes a profit. if the spot price of the underlying assets is the spot price of the underlying assets is exceeds than the strike price the premium exceeds than the strike price the premium of that option will become zero & maximum of that option will become zero & maximum loss in this case is the premium he paid for loss in this case is the premium he paid for buying the option. buying the option.

Comparison between Call Option & Put OptionComparison between Call Option & Put Option

Call OptionCall Option Put OptionPut Option

Option which gives the holder right Option which gives the holder right to BUY an assets but not an to BUY an assets but not an obligation to buy.obligation to buy.

Option which gives the holder Option which gives the holder right to SELL an assets but right to SELL an assets but not an obligation to SELL.not an obligation to SELL.

Call option will be exercise only Call option will be exercise only when the exercise price is lower when the exercise price is lower than the market price.than the market price.

Put option will be exercise only Put option will be exercise only when the exercise price is when the exercise price is Higher than the market Higher than the market price.price.

Seller/writer is under obligation to Seller/writer is under obligation to sell the underlying assets if the sell the underlying assets if the buyer exercise his option to buy buyer exercise his option to buy the shares .the shares .

Seller/writer is under obligation Seller/writer is under obligation to sell the underlying assets to sell the underlying assets if the buyer exercise his if the buyer exercise his option to sell the shares .option to sell the shares .

Types of the OptionTypes of the Option((Based on the Exercising the Option)Based on the Exercising the Option)

American OptionAmerican Option European OptionEuropean Option

American OptionAmerican Option

Option under which holder can Option under which holder can exercise his right at any time before exercise his right at any time before expiry date.expiry date.

European OptionEuropean Option

Option under which holder can Option under which holder can exercise his right only on the expiry exercise his right only on the expiry date.date.

Types of Players/TraderTypes of Players/Trader

HedgersHedgers SpeculatorsSpeculators ArbitrageursArbitrageurs

Example of hedging using Example of hedging using forward contractforward contract

Payment $100000Payment $100000

Received $100000Received $100000

SpeculatorsSpeculators

Whereas hedgers want to avoid Whereas hedgers want to avoid exposure to adverse moment in the exposure to adverse moment in the price of an assets, speculators wish price of an assets, speculators wish to take a position in the market.to take a position in the market.

Either they are betting that the price Either they are betting that the price of the assets will go up or they are of the assets will go up or they are betting that it will go down.betting that it will go down.

Example:-future and option bothExample:-future and option both

ArbitrageursArbitrageurs

Arbitrageurs are a careful lot who keep Arbitrageurs are a careful lot who keep constant vigil on the market, across constant vigil on the market, across products and locations to identify products and locations to identify temporary imperfection and convert such temporary imperfection and convert such opportunities into risk less profit. In the opportunities into risk less profit. In the pure form of arbitraging, the operator:pure form of arbitraging, the operator:

1-has no investment; and1-has no investment; and2-simultaneously buys and sells in different 2-simultaneously buys and sells in different

markets and /or different period which markets and /or different period which ensure risk less profit to him. (example $ ensure risk less profit to him. (example $ in diff. mkt)in diff. mkt)

Types of OrderTypes of Order

Market Order-Buy or sell the rate Market Order-Buy or sell the rate prevailing in the market at the time of prevailing in the market at the time of placing the order.placing the order.

Limit Order-Buy/Sell order at specified Limit Order-Buy/Sell order at specified time limit irrespective of the rate time limit irrespective of the rate prevailing in the market at the time of prevailing in the market at the time of placing order.placing order.

Stop loss order-Order where the trader Stop loss order-Order where the trader wants to restrict his loss by specifying the wants to restrict his loss by specifying the limit for closing his deal. limit for closing his deal.

Market-if-Touched order: These are Market-if-Touched order: These are similar to stop loss order.This will similar to stop loss order.This will become market order if certain price become market order if certain price is reached. Example:sell when Wipro is reached. Example:sell when Wipro Future reaches Rs.2500.Future reaches Rs.2500.

Spread order-when customer order Spread order-when customer order to buy future in one delivery month to buy future in one delivery month and sell in another delivery month, and sell in another delivery month, they are termed as spread order. they are termed as spread order.

Scale Order-when customer wishes Scale Order-when customer wishes to make a gradual entry or exit from to make a gradual entry or exit from the market rather than execute the the market rather than execute the trade at just one price.trade at just one price.

Strike Price/Exercise Price: It is the Strike Price/Exercise Price: It is the price at which the contract is entered price at which the contract is entered into. There can be several strike into. There can be several strike prices at which one can enter into in prices at which one can enter into in contract in the option market.contract in the option market.

Spot price: The spot price of the Spot price: The spot price of the underlying asset in the cash market..underlying asset in the cash market..

Types of MarginTypes of Margin

Initial MarginInitial Margin Mark to Market MarginMark to Market Margin Maintenance MarginMaintenance Margin Additional MarginAdditional Margin Cross MarginCross Margin

Initial MarginInitial Margin

Whenever a client (both buyer & Whenever a client (both buyer & seller) books future contract he is seller) books future contract he is required to deposit a certain % of required to deposit a certain % of contract price(Ex-20%) as margin contract price(Ex-20%) as margin money which is called initial margin. money which is called initial margin.

Variation/Mark to market Variation/Mark to market marginmargin

It is paid to/received from the client It is paid to/received from the client daily and is calculated on the basis of daily and is calculated on the basis of daily settlement price.daily settlement price.

Maintenance MarginMaintenance Margin

Some exchange in the world work on Some exchange in the world work on the system of maintenance margin, the system of maintenance margin, which is set at a level slightly less which is set at a level slightly less than initial margin. The margin is than initial margin. The margin is required to be replenished to the required to be replenished to the level of initial margin, only if the level of initial margin, only if the margin level drops below the margin margin level drops below the margin limit. limit.

For example if the initial margin is For example if the initial margin is fixed at 100 and maintenance fixed at 100 and maintenance margin is 80 then the broker is margin is 80 then the broker is permitted to trade till such time limit permitted to trade till such time limit that the balance in this initial margin that the balance in this initial margin account 80 or more. If it drops below account 80 or more. If it drops below 80 say it drops to 70 then a margin 80 say it drops to 70 then a margin of 30(and not 10) is to be paid to of 30(and not 10) is to be paid to replenish the levels of initial margin. replenish the levels of initial margin.

Additional MarginAdditional Margin

In case of sudden higher than In case of sudden higher than expected volatility ,additional margin expected volatility ,additional margin may be called by the exchange. This may be called by the exchange. This is generally imposed when the is generally imposed when the exchange fears that the market have exchange fears that the market have become too volatile and may result become too volatile and may result in some crises, like payment crisis.in some crises, like payment crisis.

Cross MarginCross Margin

This is a method of calculating This is a method of calculating margin money account balance and margin money account balance and this takes into account combined this takes into account combined position in future, Option, Cash position in future, Option, Cash market etc. Hence the total margin market etc. Hence the total margin requirement reduces due to cross requirement reduces due to cross hedges. hedges. It is also not use in India.It is also not use in India.

Comparison of Stock Market and commodity marketComparison of Stock Market and commodity market

Stock MarketStock Market Commodity MarketCommodity Market

Future trading Settlement at Every Last Future trading Settlement at Every Last Month of ThursdayMonth of Thursday

Different dates (As.Metal 5Different dates (As.Metal 5thth of the of the next month, Agriculture Product next month, Agriculture Product 2020thth of the month, Electricity 15 of the month, Electricity 15thth of the month)of the month)

Time 9.30 to 3.30Time 9.30 to 3.30 10am to 11.55pm10am to 11.55pm

Monday to FridayMonday to Friday Monday to SaturdayMonday to Saturday

Future trading available only upto 3 Future trading available only upto 3 monthsmonths

Future trading available only upto Future trading available only upto 10-12 months10-12 months

Delivery not possibleDelivery not possible Delivery also possible.Delivery also possible.

Top cities-Ahemdabad,Mumbai,Delhi.Top cities-Ahemdabad,Mumbai,Delhi.Top cities-Ahemdabad, Top cities-Ahemdabad,

Rajkoat,IndoreRajkoat,Indore

Controlled by SEBIControlled by SEBIControlled by FMC (forward Market Controlled by FMC (forward Market

Commission)Commission)