Derivatives

Derivatives &

Derivatives MarketSession 11

• 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.

Commodity derivative – Underlying is wheat, cotton, pepper, corn,

oats, soyabean, crude oil, natural gas, gold, silver, turmeric etc.

Financial derivatives – Underlying is stocks, bonds, indexes, foreign

exchange, Eurodollar etc.

• Derivative minimises the risk of owning things that are subject to unexpected price fluctuations like foreign currencies, bulk of wheat, stocks & bonds.

Under lying Price

Change

Derivative Price

Change

Change in Spot or

Cash Market Price of

Underlying

Change in Prices in

Derivatives market

Two Purposes

HEDGINGSPECULATI

ON

• Forwards • Futures• Options• Swaps

FORWARDS

• It is a contract between two parties to buy or sell an underlying asset at today’s 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.

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 49.03*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.

FUTURES

Futures are financial contracts to eliminate the risk of change in price in the future date. 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.

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 Contract Exchange Traded Contract

Customised Terms Standardized Terms

Substantial Credit Risk No risk

Unregulated Regulated

Transparency Information Asymmetry

Overleveraged positions

Less leveraged

A farmer supplies Barley to a Breakfast cereal manufacturer, he fears fall in future prices of Barley, so he can enter 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 b’coz 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 market –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 investor’s 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.

(a) Margin available  100*100*35% Rs.3500

(b) Less : MTM Loss (100-75)*100 Rs.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

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:

NEAT F & O system is used.The minimum contract size in

derivative market is 2 lakhs & it changes based upon the prices of stock.

In 2005 the lot size in infosys shares was pruned from 200 to 100.

Now lot size is 50 for most of the shares.

NSCCL settles all deals on NSE’s derivative segment.

It acts as a legal counter party to all deals on derivative segment & guarantees settlement.

Members are required to settle the mark to market losses by T + 1 day.

Major Derivatives Exchanges in the World

• Chicago Board of Trade• Chicago Mercantile Exchange• Australian Options Market• Commodity Exchange, New York• London Commodity Exchange• London Securities and Derivatives Exchange• London Metal Exchange• Singapore International Financial Futures Exchange• Sydney Futures Exchange• Tokyo International Financial Futures Exchange• National Stock Exchange, India

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.

• Trading in index options commenced in June 2001, options on individual securities in July 2001 and Futures on individual stocks in November 2001.

Types of Futures• Commodity futures (Wheat, corn, etc.) and

• Financial futuresFinancial futures include:

– Foreign currencies– Interest rate– Market index futures (Market index futures are

directly related with the stock market)– Individual stock.

Open Interest

It is the number of outstanding futures contracts. In other words, the number of futures contracts that have to be settled on or before maturity date.

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 Options

On 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 and

• Put 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 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 September 2010. 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.

• 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 Options

On the basis of maturity pattern of options, option contracts are categorized in to two. They are:

• European Style Options

• American 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 Options

Options 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 Options

Based on the mode of trading options are classified in to two:

• Over-the-counter Options

• Exchange Traded Options

Moneyness of Options

Moneyness of an option describes the relationship between the strike price of the option and the current stock price. This takes three forms:

1. In the Money

2. At the Money

3. Out of the Money

1. In the Money Options

When 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.

Strike Price (Rs.) Call Option Put Option

420

In the Money Out of the Money430

440

450 At the Money At the Money

460

Out of the Money In the Money470

480

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

1991 Liberalization process initiated

14-Dec-95 NSE asked SEBI for permission to trade index futures.

18-Nov-96SEBI setup L.C.Gupta Committee to draft a policy framework for index futures.

11-May-98 L.C.Gupta Committee submitted report.

07-Jul-99RBI gave permission for OTC forward rate agreements (FRAs) and interest rate swaps.

24-May-00SIMEX chose Nifty for trading futures and options on an Indian index.

25-May-00SEBI gave permission to NSE and BSE to do index futures trading.

09-Jun-00 Trading of BSE Sensex futures commenced at BSE.

12-Jun-00 Trading of Nifty futures commenced at NSE.

25-Sep-00 Nifty futures trading commenced at SGX.

02-Jun-01 Individual Stock Options & Derivatives