DERIVATIVE MARKETS

S.Y.B.F.M

DIVYA BAJAJ(3) SOHIL GANDHI(17) NIKITA JAIN(22) KASHNI KADAKIA(27) BHAGYESH SHAH(50) POOJA SHAH(52)

TABLE OF CONTENTS

I. II. III. IV. V. VI. VII.

WHAT ARE DERIVATIVES? WHAT IS A DERIVATIVE MARKET? CURRENCY FUTURES STRUCTURE OF DERIVSTIVES IN INDIA SIZE OF DERIVATIVE CONTRACTS SYSTEMS IN DEBT MARKETS MEASURES SPECIFIED BY SEBI TO PROTECT

INVESTOER RIGHTS

VIII. IX.

ACKNOWLEDGEMENT BIBLIOGRAPHY

What are Derivatives?

A. The term "Derivative" indicates that it has no independent value, i.e. its value is entirely "derived" from the value of the underlying asset. The underlying asset can be securities,

commodities, bullion, currency, live stock or anything else. In other words, Derivative means a forward, future, option or any other hybrid contract of pre determined fixed duration, linked for the purpose of contract fulfillment to the value of a specified real or financial asset or to an index of securities.

With

Securities

Laws

(Second

Amendment)

Act,1999,

Derivatives has been included in the definition of Securities. The term Derivative has been defined in Securities Contracts

(Regulations) Act, as:A Derivative includes: a. 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; b. a contract which derives its value from the prices, or index of prices, of underlying securities;

What is derivative markets?

The derivatives markets are the financial markets for derivatives, financial instruments like futures contracts or options, which are derived from other forms of assets. The market can be divided into two, that for 1. exchange traded derivatives and that for 2. over-the-counter derivatives. The legal nature of these products is very different as well as the way they are traded, though many market participants are active in both

Exchange rated derivative Futures exchanges, such as [Link] and the Chicago Mercantile Exchange, trade in standardized derivative contracts. These are options contracts and futures contracts on a whole range of

underlying products. The members of the exchange hold positions in these contracts with the exchange, who acts as central counterparty. When one party goes long (buys) a futures contract, another goes short (sells). When a new contract is introduced, the total position in the contract is zero. Therefore, the sum of all the long positions must be equal to the sum of all the short positions. In other words, risk is transferred from one party to another. The total notional amount of all the outstanding positions at the end of June 2004 stood at $53 trillion.

Over the counter derivatives Tailor-made derivatives not traded on a futures exchange are traded on over-the-counter markets, also known as the OTC market. These consist of investment banks who have traders who make markets in these derivatives, and clients such as hedge funds, commercial banks, government sponsored enterprises, etc. Products that are always traded over-the-counter are swaps, forward rate agreements, forward contracts, credit derivatives, etc. The total notional amount of all the outstanding positions at the end of the end of 2007 this figure had risen to $596 trillion.

What are Currency Futures?

A. Currency futures are contracts to buy or sell a specific

underlying currency at a specific time in the future, for a specific price. Currency futures are exchange-traded contracts and they are standardized in terms of delivery date, amount and contract terms. Currency future contracts allow investors to hedge against foreign exchange risk. Since these contracts are marked-tomarket daily, investors can--by closing out their position--exit from their obligation to buy or sell the currency prior to the contract's delivery date.

CREDIT DERIVATIVE In finance, a credit derivative is a derivative whose value is derived from the credit risk on an underlying bond, loan or other financial asset. In this way, the credit risk is on an entity other than the counterparties to the transaction itself.[1] This entity is known as the reference entity and may be a corporate, a sovereign or any other form of legal entity which has incurred debt.[2] Credit derivatives are bilateral contracts between a buyer and seller under which the seller sells protection against the credit risk of the reference entity. The parties will select which credit events apply to a transaction and these usually consist of one or more of the following: bankruptcy (the risk that the reference entity will become bankrupt) failure to pay (the risk that the reference entity will default on one of its obligations such as a bond or loan) obligation default (the risk that the reference entity will default on any of its obligations) obligation acceleration (the risk that an obligation of the reference entity will be accelerated e.g. a bond will be declared immediately due and payable following a default) repudiation/moratorium (the risk that the reference entity or a government will declare a moratorium over the reference entity's obligations) restructuring (the risk that obligations of the reference entity will be restructured). Where credit protection is bought and sold between bilateral counterparties this is known as an unfunded credit derivative. If the credit derivative is entered into by a financial institution or a special purpose vehicle (SPV) and

payments under the credit derivative are funded using securitization techniques, such that a debt obligation is issued by the financial institution or SPV to support these obligations, this is known as a funded credit derivative.

HYBRID SECURITIES "Hybrid securities", often referred as "hybrids", are a broad group of securities that combine the elements of the two broader groups of securities Debt and Equity. Hybrid securities pay a predictable (fixed or floating) rate of return or dividend until a certain date, at which point the holder has a number of options including converting the securities into the underlying share. Therefore, unlike a share of stock (equity) the holder has a 'known' cash flow, and, unlike a fixed interest security (debt) there is an option to convert to the underlying equity. More common examples include

convertible and converting preference shares. A hybrid security is structured differently and while the price of some securities behave more like fixed interest securities, others behave more like the underlying shares into which they convert.

OPTIONS CONTRACTS In finance, an option is a contract between a buyer and a seller that gives the buyer the right, but not the obligation, to buy or to sell a particular asset (the underlying asset) on or before the option's expiration time, at an agreed price, the strike price. In return for granting the option, the seller

collects a payment (the premium) from the buyer. A call option gives the buyer the right to buy the underlying asset and a put option gives the buyer of the option the right to sell the underlying asset. If the buyer chooses to exercise this right, the seller is obliged to sell or buy the asset at the agreed price.[1][2] The buyer may choose not to exercise the right and let it expire. The underlying asset can be a piece of property, a security (stock or bond), or a derivative instrument, such as a futures contract. The theoretical value of an option is evaluated according to several models. These models, which are developed by quantitative analysts, attempt to predict how the value of an option changes in response to changing conditions. Hence, the risks associated with granting, owning, or trading options may be quantified and managed with a greater degree of precision, perhaps, than with some other investments. Exchange-traded options form an important class of options which have standardized contract features and trade on public exchanges, facilitating trading among independent parties. Over-the-counter options are traded between private parties, often well-capitalized institutions that have negotiated separate trading and clearing arrangements with each other.

FUTURES CONTRACTS A futures contract is a standardized contract to buy or sell a specified commodity of standardized quality at a certain date in the future and at a market determined price (the futures price ). The contracts are traded on a futures exchange. Futures contracts are not "direct" securities like stocks, bonds, rights or warrants. They are still securities, however, though they are a type of derivative contract.

The price is determined by the instantaneous equilibrium between the forces of supply and demand among competing buy and sell orders on the exchange at the time of the purchase or sale of the contract. In many cases, the underlying asset to a futures contract may not be traditional "commodities" at all - that is, item can be currencies, securities or financial instruments and intangible assets or referenced items such as stock indexes and interest rates. The future date is called the delivery date or final settlement date . The official price of the futures contract at the end of a day's trading session on the exchange is called the settlement price for that day of business on the exchange[1]. A futures contract gives the holder the obligation to make or take delivery under the terms of the contract, whereas an option grants the buyer the

right, but not the obligation, to establish a position previously held by the
seller of the option. In other words, the owner of an options contract may exercise the contract, but both parties of a "futures contract" must fulfill the contract on the settlement date. The seller delivers the underlying asset to the buyer, or, if it is a cash-settled futures contract, then cash is transferred from the futures trader who sustained a loss to the one who made a profit. To exit the commitment prior to the settlement date, the holder of a futures position has to offset his/her position by either selling a long position or buying back (covering) a short position, effectively closing out the futures position and its contract obligations. Futures contracts, or simply futures, (but not future or future contract ) are exchange traded derivatives. The exchange's clearinghouse acts as

counterparty on all contracts, sets margin requirements, and crucially also provides a mechanism for settlement.

FORWARD CONTRACT A forward contract or simply a forward is an agreement between two parties to buy or sell an asset at a certain future time for a certain price agreed today. [1] This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a forward contract. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price, which is equal to the forward price at the time the contract is entered into. The price of the underlying instrument, in whatever form, is paid before control of the instrument changes. This is one of the many forms of buy/sell orders where the time of trade is not the time where the securities themselves are exchanged. The forward price of such a contract is commonly contrasted with the spot price, which is the price at which the asset changes hands on the spot date. The difference between the spot and the forward price is the forward premium or forward discount, generally considered in the form of a profit, or loss, by the purchasing party. Forwards, like other derivative securities, can be used to hedge risk (typically currency or exchange rate risk), as a means of speculation, or to allow a party to take advantage of a quality of the underlying instrument which is timesensitive. A closely related contract is a futures contract; they differ in certain respects. Forward contracts are very similar to futures contracts, except they are not marked to market, exchange traded, or defined on

standardized assets. [2] Forwards also typically have no interim partial

settlements or "true-ups" in margin requirements like futures - such that the parties do not exchange additional property securing the party at gain and the entire unrealized gain or loss builds up while the contract is open. A forward contract arrangement might call for the loss party to pledge collateral or additional collateral to better secure the party at gain.

SWAPS In finance, a swap is a derivative in which two counterparties exchange certain benefits of one party's financial instrument for those of the other party's financial instrument. The benefits in question depend on the type of financial instruments involved. Specifically, the two counterparties agree to

exchange one stream of cash flows against another stream. These streams are called the legs of the swap. The swap agreement defines the dates when the cash flows are to be paid and the way they are calculated. [1] Usually at the time when the contract is initiated at least one of these series of cash flows is determined by a random or uncertain variable such as an interest rate, foreign exchange rate, equity price or commodity [Link] cash flows

are calculated over a notional principal amount, which is usually not exchanged between counterparties. Consequently, swaps can be used to create unfunded exposures to an underlying asset, since counterparties can earn the profit or loss from movements in price without having to post the notional amount in cash or collateral. Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on changes in the expected direction of underlying prices. The first swaps were negotiated in the early 1980s. [1] David Swensen, a Yale Ph.D. at Salomon Brothers, engineered the first swap transaction according to "When Genius Failed: The Rise and Fall of Long-Term Capital Management" by Roger Lowenstein. Today, swaps are among the most heavily traded financial contracts in the world.

What is the structure of Derivative Markets in India?

A. Derivative trading in India takes can place either on a separate and independent Derivative Exchange or on a separate segment of an existing Stock Exchange. Derivative Exchange/Segment function as a Self-Regulatory Organisation (SRO) and SEBI acts as the oversight regulator. The clearing & settlement of all trades on the Derivative Exchange/Segment would have to be through a Clearing Corporation/House, which is independent in governance and membership from the Derivative

Exchange/Segment. Throughtout the world derivatives markets have become more important and popular.

What is the lot size of contract in the equity derivatives market?

A. Lot size refers to number of underlying securities in one contract. The lot size is determined keeping in mind the minimum contract size requirement at the time of introduction of derivative contracts on a particular underlying. For example, if shares of XYZ Ltd are quoted at Rs.1000 each and the minimum contract size is Rs.2 lacs, then the lot size for that particular scrips stands to be 200000/1000 = 200 shares i.e. one contract in XYZ Ltd. covers 200 shares.

What is the margining system in the equity derivatives market?

A. Two type of margins have been specified i.

Initial Margin - Based on 99% VaR and worst case loss over a specified horizon, which depends on the time in which Mark to Market margin is collected. Gupta Committee had

recommended that the level of initial margin required on a position should be related to the risk of loss on the position. The concept of value-at-risk should be used in calculating required level of initial margins. The initial margins should be large enough to cover the one day loss that can be encountered on the position on 99% of the days
ii.

Mark to Market Margin (MTM) - collected in cash for all Futures contracts and adjusted against the available Liquid Networth for option positions. In the case of Futures

Contracts MTM may be considered as Mark to Market Settlement.

Q What measures have been specified by SEBI to protect the rights of investor in Derivatives Market?
A. The measures specified by SEBI include: a. Investor's money has to be kept separate at all levels and is permitted to be used only against the liability of the Investor and is not available to the trading member or clearing member or even any other investor. b. The Trading Member is required to provide every investor with a risk disclosure document which will disclose the risks associated with the derivatives trading so that investors can take a conscious decision to trade in derivatives. c. Investor would get the contract note duly time stamped for receipt of the order and execution of the order. The order will be executed with the identity of the client and without client ID order will not be accepted by the system. The investor could also demand the trade confirmation slip with his ID in support of the contract note. This will protect him from the risk of price favour, if any, extended by the Member.

d. In the derivative markets all money paid by the Investor towards margins on all open positions is kept in trust with the Clearing House/Clearing corporation and in the event of default of the Trading or Clearing Member the amounts paid by the client towards margins are segregated and not utilized towards the default of the member. However, in the event of a default of a member, losses suffered by the Investor, if any, on settled / closed out position are

compensated from the Investor Protection Fund, as per the rules, bye-laws and regulations of the derivative segment of the exchanges. e. The Exchanges are required to set up arbitration and investor grievances redressal mechanism operative from all the four areas / regions of the country.

ACKNOWLEDGEMENT

FIRSTLY I WOULD LIKE TO THANK OUR SECURITY ANALYSIS PROFESSOR, [Link] FOR GIVING US SUCH AN INTERESTING TOPIC TO WORK ON. IT WAS A GREAT EXPERIENCE TO WORK ON THIS BOOK REPORT AND THIS HAS HELPED US TO GAIN A LOT OF INFORMATION AND KNOWLEDGE.

BIBLIOGRAPHY

[Link] [Link] [Link] [Link] [Link]