Derivatives

Definition
• A derivative is a financial security with a value
that is derived from, an underlying asset or
group of assets—a benchmark.
• The derivative itself is a contract between two
or more parties, and the derivative derives its
price from fluctuations in the underlying asset.
• The most common underlying assets for
derivatives are stocks, bonds, commodities,
currencies, interest rates, and market indexes.
Derivatives can trade OTC or on an
exchange
• OTC-traded derivatives, generally have a greater
possibility of counterparty risk. Counterparty risk
is the danger that one of the parties involved in
the transaction might default. These parties
trade between two private parties and are
unregulated.
• Conversely, derivatives that are exchange-traded
are standardized and more heavily regulated.
Over-the-counter (OTC)
• Over-the-counter (OTC) or off-exchange trading is done
directly between two parties, without the supervision of an
exchange.
• OTC is a decentralized market, without a central physical
location, where market participants trade with one another
through various communication modes such as the telephone,
email and proprietary electronic trading systems.
• An investor can choose from either a discount broker or a full-
service broker to invest. However, investors should be aware
that not all brokers allow trading in OTC securities.
 Exchange-traded derivative
• An exchange traded derivative is a financial instrument that trades on a
regulated exchange and whose value is based on the value of another asset.
• Exchange-traded derivative contracts are standardized derivative contracts
such as futures and options contracts that are transacted on an organized
futures exchange. These derivatives can be used to hedge exposure or
speculate on a wide range of financial assets like commodities, equities,
currencies and even interest rates.
• They are standardized and require payment of an initial deposit or margin
settled through a clearing house.
• Two big advantages
• Standardization: The exchange has standardized terms and specifications for each
derivative contract, making it easy for the investor to determine how many
contracts can be bought or sold. Each individual contract is also of a size that is not
daunting for the small investor.
• Elimination of default risk: The derivatives exchange itself acts as
the counterparty for each transaction involving an exchange traded derivative,
effectively becoming the seller for every buyer, and the buyer for every seller. This
eliminates the risk that the counterparty to the derivative transaction may default
on its obligations
Hedgers
• These are investors with a present or anticipated exposure to the
underlying asset which is subject to price risks. Hedgers use the
derivatives markets primarily for price risk management of assets and
portfolios.
• Let's assume part of your investment portfolio includes 100 shares of
Company XYZ, which manufactures autos. Because the auto industry is
cyclical (meaning Company XYZ usually sells more cars and is more
profitable during economic booms and sells fewer cars and is less
profitable during economic slumps), Company XYZ shares will probably
be worth less if the economy starts to deteriorate.
• How do you protect your investment?
• One way is to buy defensive stocks. These stocks might be from the food,
utility, or other industries that sell products that consumers consider basic
necessities. During economic slumps, these stocks tend to gain or at least
hold their value. Thus, these stocks may gain when your XYZ shares lose.
Speculators
• These are individuals who take a view on the future direction of the
markets. They take a view whether prices would rise or fall in future and
accordingly buy or sell futures and options to try and make a profit from
the future price movements of the underlying asset.
• Speculators hypothesize expected price movements and take accordant
positions that maximize profit. Speculators are extremely high risk takers
who are in the Derivative markets merely for the purpose of making
profits. They need to effectively forecast market trends to take positions
that don’t in any way guarantee safely of invested capital or returns.
• Speculators rely on fast moving trends to forecast possible market moves –
these could range from changing consumer tastes to fluctuating rates of
interest, economic growth indicators coinciding with market timing etc.
• Speculators can make huge profits or an equally huge loss and are typically
high net investors looking to diversify holding with a view to maximize
profits in a short period of time.
Arbitrageurs
• They take positions in financial markets to earn riskless profits.
The arbitrageurs take short and long positions in the same or
different contracts at the same time to create a position which
can generate a riskless profit.
• They play in an extremely fast paced environment with
decisions being made at a moment’s notice. Sometimes the
price of a stock in the cash market is lower or higher than it
should be, in comparison to its price in the derivatives market.
Arbitrageurs exploit these imperfections and inefficiencies to
their advantage.
• They also play an important role in increasing liquidity in the
market thus making it more fluid.
Regulatory framework of
Derivatives markets in India
• With the amendment in the definition of 'securities' under SC(R)A
(to include derivative contracts in the definition of securities),
derivatives trading takes place under the provisions of the
Securities Contracts (Regulation) Act, 1956 and the Securities and
Exchange Board of India Act, 1992.
• Foreign Exchange Management (Foreign Exchange Derivative
Contracts) Regulations, 2000 dated 3/5/2000 as amended from
time to time, permitted persons resident in India and persons
resident outside India viz., foreign portfolio investors (FPIs) to
participate in the currency futures and exchange traded currency
options market in India subject to the terms and conditions
mentioned therein.
Derivatives market at NSE
• The derivatives trading on the exchange commenced with S&P
CNX Nifty Index futures on June 12, 2000.
• The trading in index options commenced on June 4, 2001 and
trading in options on individual securities commenced on July
2, 2001.
• Single stock futures were launched on November 9, 2001.
• The index futures and options contract on NSE are based on S&P
CNX Nifty Index.
• Currently, the futures contracts have a maximum of 3-month
expiration cycles. Three contracts are available for trading,
with 1 month, 2 months and 3 months expiry.
• A new contract is introduced on the next trading day following
the expiry of the near month contract.
 Trading mechanism
• The futures and options trading system of NSE, called NEAT-F&O
trading system, provides a fully automated screen—based
trading for Nifty futures & options and stock futures & options on
a nationwide basis and an online monitoring and surveillance
mechanism.
• The NEAT-F&O trading system is accessed by two types of users.
• The Trading Members (TM) have access to functions such as order
entry, order matching, order and trade management. Various
conditions like Good-till-Day, Good-till Cancelled, Good-till-Date,
Immediate or Cancel, Limit/Market price, Stop loss, etc. can be built
into an order.
• The Clearing Members (CM) use the trader workstation for the
purpose of monitoring the trading member(s) for whom they clear
the trades.
Membership criteria
• NSE admits members on its derivatives segment in accordance with the
rules and regulations of the exchange and the norms specified by SEBI.
• NSE follows 2—tier membership structure stipulated by SEBI to enable
wider participation.
• Those interested in taking membership on F&O segment are required
to take membership of CM and F&O segment or CM, WDM and F&O
segment.
• There are three types of CMs:
• Self Clearing Member: A SCM clears and settles trades executed by him
only either on his own account or on account of his clients.
• Trading Member Clearing Member: TM—CM is a CM who is also a TM. TM
— CM may clear and settle his own proprietary trades and client's trades as
well as clear and settle for other TMs.
• Professional Clearing Member: PCM is a CM who is not a TM. Typically,
banks or custodians could become a PCM and clear and settle for TMs.
Advantages of Derivatives
• Derivatives can be a useful tool for
businesses and investors alike.
• They provide a way to lock in prices, hedge
against unfavorable movements in rates,
and mitigate risks—often for a limited
cost.
• derivatives can often be purchased on
margin
Downside of Derivatives
• Derivatives are difficult to value because they are based on the
price of another asset.
• The risks for OTC derivatives include counter-party risks that are
difficult to predict or value as well.
• Most derivatives are also sensitive to changes in the amount of
time to expiration, the cost of holding the underlying asset and
interest rates. These variables make it difficult to perfectly match
the value of a derivative with the underlying asset.
• Since the derivative itself has no intrinsic value (its value comes
only from the underlying asset) it is vulnerable to market
sentiment and market risk.
• It is possible for supply and demand factors to cause a
derivative's price and its liquidity to rise and fall, regardless of
what is happening with the price of the underlying asset.
Pros & cons
PROS CONS
• Lock in prices • Hard to value
• Hedge against risk • Subject to
• Can be leveraged counterparty default
• Diversify portfolio (if OTC)
• Complex to
understand
• Sensitive to supply
and demand factors
TYPES OF DERIVATIVES
• 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 futures contract is an agreement between two parties
to buy or sell an asset at a certain time in the future at a certain
price. Futures contracts are special types of forward contracts in
the sense that the former are standardized exchange-traded
contracts.
• Options: Options are of two types - calls and puts.
• Calls give the buyer the right but not the obligation to buy a given
quantity of the underlying asset, at a given price on or before a
given future date.
• Puts give the buyer the right, but not the obligation to sell a given
quantity of the underlying asset at a given price on or before a given
date.
Cont.,
• Warrants: Options generally have lives of up to one year, the
majority of options traded on options exchanges having a maximum
maturity of nine months.
• Longer-dated options are called warrants and are generally traded
over-the-counter.
• LEAPS: Long-Term Equity Anticipation Securities.
• These are options having a maturity of up to three years.
• Baskets: Basket options are options on portfolios of underlying
assets. Equity index options are a form of basket options.
• 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.
• 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.
Cont.,
• Swaps: Swaps are private agreements between two parties to
exchange cash flows in the future according to a prearranged
formula. They can be regarded as portfolios of forward
contracts.
• The two commonly used swaps are :
• Interest rate swaps: These entail swapping only the interest
related cash flows between the parties in the same currency.
• Currency swaps: These entail swapping both principal and
interest between the parties, with the cash flows in one direction
being in a different currency than those in the opposite direction.
Salient features of forward
contracts
• They are bilateral contracts and hence exposed to
counter—party risk.
• Each contract is custom designed and hence is unique in
terms of contract size, expiration date and the asset type
and quality.
• The contract price is generally not available in public
domain.
• On the expiration date, the contract has to be settled by
delivery of the asset.
Standardized items in a futures
contract
• Quantity of the underlying
• Quality of the underlying
• The date and the month of delivery
• The units of price quotation and minimum price
change
• Location of settlement
Terminology
• Contract size – The amount of the asset that has to be
delivered under one contract. All futures are sold in multiples
of lots which is decided by the exchange board.
• Eg. If the lot size of Tata steel is 500 shares, then one futures
contract is necessarily 500 shares.
• Contract cycle – The period for which a contract trades. The
futures on the NSE have one (near) month, two (next) months,
three (far) months expiry cycles.
• Expiry date – usually last Thursday of every month or previous
day if Thursday is public holiday.
• Strike price – The agreed price of the deal is called the strike
price.
• Cost of carry – Difference between strike price and current
price.
Margins
• A margin is an amount of a money that must be deposited with the clearing house
by both buyers and sellers in a margin account in order to open a futures contract.
• It ensures performance of the terms of the contract.
• It’s aim is to minimize the risk of default by either counterparty.
• Initial Margin - Deposit that a trader must make before trading any futures. Usually,
10% of the contract size.
• Maintenance Margin - When margin reaches a minimum maintenance level, the
trader is required to bring the margin back to its initial level. The maintenance
margin is generally about 75% of the initial margin.
• Variation Margin - Additional margin required to bring an account up to the required
level.
• Margin call – If amount in the margin A/C falls below the maintenance level, a
margin call is made to fill the gap.
• Marking to Market
• This is the practice of periodically adjusting the margin account by adding or subtracting
funds based on changes in market value to reflect the investor’s gain or loss.
• This leads to changes in margin amounts daily.
• This ensures that there are no defaults by the parties.
Introduction to options
• The next derivative product traded on the NSE, namely
options.
• Options are fundamentally different from forward and
futures contracts.
• An option gives the holder of the option the right
to do something. The holder does not have to
exercise this right.
• In contrast, in a forward or futures contract, the two
parties have committed themselves to doing something.
Whereas it costs nothing (except margin requirements)
to enter into a futures contract, the purchase of an
option requires an up—front payment.
Options Terminology
• Underlying: Specific security or asset.
• Option premium: Price paid.
• Strike price: Pre-decided price.
• Expiration date: Date on which option expires.
• Exercise date: Option is exercised.
• Open interest: Total numbers of option contracts that have not yet
been expired.
• Option holder: One who buys option.
• Option writer: One who sells option.
• Option class: All listed options of a type on a particular instrument.
• Option series: A series that consists of all the options of a given
class with the same expiry date and strike price.
• Put-call ratio: The ratio of puts to the calls traded in the market.
What is a Currency Swap?
• It is a swap that includes exchange of principal and interest
rates in one currency for the same in another currency.
• It is considered to be a foreign exchange transaction.
• It is not required by law to be shown in the balance sheets.
• The principal may be exchanged either at the beginning or at
the end of the tenure.
• However, if it is exchanged at the end of the life of the swap,
the principal value may be very different.
• It is generally used to hedge against exchange rate
fluctuations.