introduction to deivatives

8/13/2019 Introduction to Deivatives

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Introduction to derivatives


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Introduction to derivatives

The emergence of the market for derivativeproducts, most notably forwards, futures andoptions, can be traced back to the willingness ofrisk-averse economic agents to guard themselves

against uncertainties arising out of fluctuations inasset prices. Through the use of derivative products, it is possible

to partially or fully transfer price risksby lockingin asset prices.

As instruments of risk management, these generallydo not influence the fluctuations in the underlyingasset prices.


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Derivatives defined

Derivative is a product whose value isderived from the value of one or morebasic variables, called bases (underlyingasset, index, or reference rate), in acontractual manner.

The underlying asset can be equity, forex,

commodity or any other asset.


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Arbitrage

Arbitrage is an important concept invaluing (pricing ) derivative securities.

If a return greater than risk free returncan be earned by holding a portfolio ofassets that produce a certain (risk less)return, then arbitrage opportunity exists.

Arbitrage opportunity arises whensecurities are mis priced


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Principals of Derivatives

There are 2 types of arbitrage argumentsthat are useful in study and use ofderivative

-law of one price, 2securities that haveidentical cash flow in the future,regardless of the future events, shouldhave the same price. If A & B have theidentical future payoffs and A is priced islower than B, buy A and sell B


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Principals of Derivatives

The second type of arbitrage is used when 2securities with uncertain returns can becombined in a portfolio that have a certain

payoff. If a portfolio consisting of A and B has a

certain pay off, the portfolio should yield therisk free rate. If this no arbitrage condition is

violated in that the certain return of A and Btogether is higher than the risk free rate, anarbitrage opportunity exists.


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Products, participants and

functions

Derivative contracts have several variants.The most common variants are forwards,futures, options and swaps.

The following three broad categories ofparticipants - hedgers, speculators, andarbitrageurs trade in the derivatives market.


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Need for Derivatives Market.

The derivative market helps to transfer the risksfrom those who have them but may not like themto those who appetite for them.

Market Risk

Credit Risk Price Discovery.

Increased integration of national financial markets

with the international markets. Derivative market helps to increase savings andinvestment in the long run.


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Types of derivatives

Forwards

Futures

Swaps Warrants


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DERIVATIVES WORLD


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Types of markets Cash: Payment is made as soon as the deal is struck

Tom:Price is decided today whereas the transactionwill be settled on the next business day

Spot: Price is decided today whereas the transaction issettled two (or More) business days later

Forward/future: Price is decided today whereas thetransaction takes place on a future date (few months)


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Exchange-traded vs. OTC

derivatives markets

The management of counter-party (credit) risk isdecentralized and located within individual institutions,

There are no formal centralized limits on individualpositions, 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

The OTC contracts are generally not regulated by aregulatory authority and the exchangesself regulatory

organization, although they are affected indirectly bynational legal systems, banking supervision and marketsurveillance


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Derivatives market in India

The derivatives trading on the exchange commenced withS&P CNX Nifty Index futures on June 12, 2000.

The trading in index options commenced on June 4, 2001and trading in options on individual securities commenced

on July 2, 2001. Single stock futures were launched onNovember 9, 2001.

The index futures and options contract on NSE are basedon S&P CNX Nifty Index. Currently, the futures contractshave a maximum of 3-month expiration cycles. Three

contracts are available for trading, with 1 month, 2 monthsand 3 months expiry. A new contract is introduced on thenext trading day following the expiry of the near monthcontract.


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CLEARING AND SETTLEMENT


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Understanding volume

They benchmark the degree of activity

Volume is the velocity of trading ornumber of contracts traded in a day (andnot the sum of buyers & sellers) .

To determine volume, simply add either allbuyers or all sellers.

Number of contract traded includescreation of new contract, transfer orliquidation of a contract.


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Understanding Open Interest

Open Interest (OI) measures the number ofcontracts held at the conclusion of a tradingsession

It is a description of participation -tradersshow their conviction to the marketparticipation by taking their positions homewith them, at least overnight.

Important as many transactions may takeplace during the day without initiating newcontracts


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An example

Day 1 Trader A buys one contractTrader B sells one contractTrader C buys one contractTrader D sells one contract

OI - 4 contractsVol. - 2 contract

Day 2 Trader E buys one contractTrader A sells to offset

OI - 4 contractsVol. - 1 contract

Day 3 Trader F buys one contractTrader G sells one contractTrader B buys to offsetTrader C sells to offsetTrader E sells to offsetTrader D buys to offset

OI - 2 contracts

Vol. - 3 contracts


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SETTLEMENT MECHANISM Final Settlement: On expiry of the Futures market , all

positions of a CM , as existing at the close of tradinghours on the expiry day, are marked to market at thefinal settlement price of the contract , and theresulting profit/loss shall be settled in cash. The

loss/profit amount shall be debited /credited to therelevant CMson T+1 Day.

Final settlement price shall be the closing price of theunderlying security in the capital market segment of

the NSE/BSE, on the expiration day of the futurescontract.


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SETTLEMENT MECHANISM

Premium Settlement: Buyers of option contracts areliable to pay the premium amount to the sellers. Thepay-in and pay-out of the premium settlement is onT+1 days.

Exercise Settlement: Interim Exercise Settlement: Aninvestor can exercise his in-the-money options atany time during trading hours. It shall be effectedat the close of the trading hours ,on the day ofexercise.


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The investor who has exercised the option willreceive the exercised settlement value per unitof the option from the investor who has beenassigned the option contract. Exercise settlementvalue is the difference between the strike priceand the exercise price. Exercise settlement priceis the closing price of the security on which theoption was purchased

The settlement is on T+1 days.


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Exercise Settlement : Final Exercise settlementshall be effected for all open long in-the-moneystrike price options existing at the close oftrading hours, on the expiration day of an optioncontract.

All such long positions shall be exercised andautomatically assigned to short positions inoption contracts with the same series, on arandom basis.

Final Settlement on T+1 days.


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Trading mechanism

The futures and options trading system of NSE,called NEAT-F&O trading system, provides afully automated screenbased trading for Niftyfutures & options and stock futures & options ona nationwide basis and an online monitoringand surveillance mechanism.

It supports an anonymous order driven marketwhich provides complete transparency oftrading operations and operates on strict pricetime priority. It is similar to that of trading ofequities in the Cash Market (CM) segment.


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Clearing and settlement

NSCCL undertakes clearing and settlementof all deals executed on the NSEs F&Osegment.

It acts as legal counterparty to all deals on theF&O segment and guarantees settlement.


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Clearing

The first step in clearing process is workingout open positions or obligations ofmembers.

Positions are calculated on net basis (buy-sell) for each contract. Clients positions arearrived at by summing together net (buy-sell)

positions of each individual


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Settlement

All futures and options contracts are cashsettled, i.e. through exchange of cash. Theunderlying for index futures/options of the

Nifty index cannot be delivered. Futures and options on individual securitiescan be delivered as in the spot market.However, it has been currently mandated

that stock options and futures would also becash settled.

Risk management system


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Risk management systemThe salient features of risk containment

measures on the F&O segment are:

NSCCL charges an upfront initial margin forall the open positions of a CM up to clientlevel.

It follows the VaR based margining systemNSCCL computes the initial marginpercentage for each Nifty index futures

contract on a daily basis


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Market Index

What are some major uses of security-market indicator series (indexes)?

Factors in Constructing Market Indexes?

What are the major stock-market indexesseries

Bond-market indexes


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Uses of Security Market

For calculating benchmark returns tojudge portfolio performance

For development of an index portfolio

For technical analysis, to predict futureprice movements

To compute a securitys systematic riskbyexamining how its return responds tochanges in the market index


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Factors in Constructing MarketIndexes

The sample of firms to include

What is the intended population that thesample is to represent? How large a sample is

needed for the index to be representative?

Weighting system for sample members

Should the weighting system be based on

price, total firm value, or equally weighted?


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Stock-Market Indicator Series

Price-Weighted Series

Dow Jones Industrial Average (DJIA)

Value-Weighted Series

NYSE Composite

S&P 500 Index

BSE Sensex


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Price weighted Index(DJIA)

Best-known, oldest, most popular index

Price-weighted average of thirty largewell-known industrial stocks, leaders intheir industry and listed.

Total the current price of the 30 stocks anddivide by a divisor


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Criticism of the Price weightedIndex

Sample used is limited

30 non-randomly selected blue-chip stocks are notrepresentative of the all listed stocks

Price-weighted series(emphasis on price ratherthan value)

Places more weight on higher-priced stocks rather than

those with higher market values Introduces a downward bias in DJIA by reducing

weight of growing companies whose stock splits


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Although the price weighted index is a popularindex, the most popular type is value-weighted.

Derive the initial total market value of all stocksused in the series

Market Value = Number of Shares Outstanding

x Current Market Price

Beginning index value is usually 100, new marketvalues change the value of the index

Automatic adjustment for splits

Weighting depends on market value


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ValueIndexBeginningIndex t

bb

tt

QP

QP

where:

Indext= index value on day t

Pt= ending prices for stocks on day t

Qt= number of outstanding shares on dayt

Pb = ending price for stocks on base dayQb = number of outstanding shares on base day


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Date Price O/s Shares ProductJanuary 1, 2000 300 10000 3000000

January 1, 2004 360 150000 54000000

Value of Index 1800


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Bond-Market Indicator Series

Relatively new and not widely published

Growth in fixed-income mutual fundsincrease need for reliable benchmarks forevaluating performance

Increasing interest in bond index funds,which requires an index to emulate

Many managers have not matched aggregatebond market return


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Difficulties in Creating a Bond-Market Index

Range of bond quality varies from Treasurysecurities to bonds in default

Bond market changes constantly with newissues, maturities, calls, and sinking funds

Bond prices are affected differently by changinginterest rates dependent on maturity, coupon,and market yield

Correctly pricing individual bond issues can be achallenge without current and continuoustransaction prices available


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Index

Total

ReturnsIndex

Principal

Returnsindex

Avg.

Coupon

Avg.

ResidualMaturity

Portfolio

YTM

Portfolio

Duration

Portfolio

ModifiedDuration

ALL 234.82 127.37 8.93 9.092 7.293 5.751 5.548

1 yr -3 yr 191.8 98.46 10.514 1.913 7.578 1.736 1.673

3-8 yr 229.39 115.92 9.652 5.54 7.064 4.367 4.218

8+ 286.5 145.87 8.235 14.427 7.324 8.427 8.129TB 195.39 195.39 0 0.401 6.043 0.397 0.385

GS 239.28 119.95 8.93 9.778 7.299 6.123 5.908


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Introduction to futures

and options


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Forward contracts

A forward contract is an agreement to buy or sell an asseton a specified date for a specified price.

One of the parties to the contract assumes a long positionand agrees to buy the underlying asset on a certain specified

future date for a certain specified price. The other partyassumes a short position and agrees to sell the asset on thesame date for the same price.

Other contract details like delivery date, price and quantityare negotiated bilaterally by the parties to the contract. The

forward contracts are normally traded outside theexchanges.


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The salient features of forward

contracts are: Bilateral Contracts Custom Designed

Contract price is not availble in publicdomain

Can be off set with the same counterparty


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Limitations of forward markets

Forward markets world-wide are afflictedby several problems:

Lack of centralisation of trading

Counterparty risk

Illiquidity


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Introduction to futures

v

Futures markets were designed to solve the problems that

exist in forward markets.

A futures contract is an agreement between two parties tobuy or sell an asset at a certain time in the future at a certain

price. But unlike forward contracts, the futures contracts are

standardized and exchange traded. To facilitate liquidity in

the futures contracts, the exchange specifies certain

standard features of the contract.

It is a standardized contract with standard underlying

instrument, a standard quantity and quality of the underlying

instrument that can be delivered,(or which can be used for

reference purposes in settlement) and a standard timing ofsuch settlement.

A futures contract may be offset prior to maturity by

entering into an equal and opposite transaction. More than

99% of futures transactions are offset this way.


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Introduction to options

Options are fundamentally different from forwardand futures contracts. An option gives the

holder of the option the right to do something. Theholder does not have to exercise this right.

In contrast, in a forward or futures contract, the twoparties have committed themselves to doing

something. Whereas it costs nothing (except marginrequirements) to enter into a futures contract,

the purchase of an option requires an upfrontpayment.

introduction to deivatives

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