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DERIVATIVES (Instrument for risk reduction)
WHAT IS A DERIVATIVE?
Derivatives is a product contract# which does not have an$ value on its
own i"e" it# derives its value from some underl$ing" Derivatives or derivatives
securities are contracts which are written etween two parties (counter
parties) and whose values is derived from underl$ing widel$ held and easil$
marketale assets such as agricultural and other ph$sical (tangile)
commodities or currencies or short term and long term financial instruments
tangile things like commodities price inde% (inflation rate)# euit$ price inde%
or ond price inde%" The counter parties to such contract are those other than
the original issuer (holder ) of the underl$ing assets " The e%change*traded
derivatives are uit liuid and have low transaction cost" It is possile to
comine them to match specific reuirements"
The value of derivatives and those of their underl$ing assets are
closel$ related" +suall$ in trading derivatives# the taking or making of deliver$
of underl$ing assets is not involved & the transactions are mostl$ settled $
taking offsetting positions in the derivatives themselves" There is therefore# no
effective limit on the claims# which can e traded in respect of underl$ing
assets" Derivatives are ,off alance- instruments# a fact is said to e oscure
the leverage and financial might give to the part$" The$ are mostl$ secondar$
market instruments and have little usefulness in moili!ing fresh capital $ the
companies" Although the standardi!ed# general e%change traded derivatives
are eing increasingl$ evolved# still there are man$ privatel$ negotiated#
customi!ed# .T/* traded financial contracts which are in vogue and which
e%pose the uses to operational risk" There is also and uncertaint$ aout the
regulator$ status of such derivatives"
Derivatives are used to facilitate hedging of price risk of inventor$
holding or a financial commercial transaction over a certain period" In
practice# ever$ derivatives 0contract1 has a fi%ed e%piration date # mostl$ in the
range of 2 to 23 months from the date of commencement of the contract"
(4resentl$ 2#3#5# month-s contracts are availale in India)
Example: A ver$ simple e%ample of derivatives is curd# which is
derivative of milk" The price of curd depends upon the price of milk which inturn depends upon the demand 6 suppl$ of milk"
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DERIVATIVES (Instrument for risk reduction)
HISTORY OF DERIVATIVES
The first centrali!ed commodities market in 9ritain was founded in
the 2:; the =ondon /ommodit$ E%change in the Virginian
and 9altic coffee house the =ondon ?etal E%change in @erusalem and the
=ondon Stock E%change in @onathans" At the same time there was an
options market in olland at the Amsterdam Trade /enter ased on tulips"
+nfortunatel$ the speculative use of these options rought aout the
collapse of the Dutch econom$
.rgani!ed futures markets# as we know them toda$ reall$ developed in
the last centur$# primaril$ in the +S# when the /hicago 9oard of Trade
(/9.T) was estalished in 2BCB" At that time /hicago was not onl$ at the
center of the railroads& it was also an important port on the 8reat =akes and
close to the ?idwest farmlands" ith /hicago eing such an important center
for agricultural markets the /9.T was estalished to provide farmers with a
central market place to guarantee the prices for their livestock and grain"
THE NEED FOR A DERIVATIVES MARKET
The derivatives market performs a numer of economic functions>
2" The$ help in transferring risks from risk averse people to risk oriented
people
3" The$ help in the discover$ of future as well as current prices
5" The$ catal$!e entrepreneurial activit$
C" The$ increase the volume traded in markets ecause of participation of risk
averse people in greater numers
:" The$ increase savings and investment in the long run
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DERIVATIVES (Instrument for risk reduction)
FACTORS DRIVING THE GROWTH OF FINANCIAL
DERIVATIVES:
2" Increased volatilit$ in asset prices in financial markets#
3" Increased integration of national financial markets with the international
markets#
5" ?arked improvement in communication facilities and sharp decline in their
costs#
C" Development of more sophisticated risk management tools# providing
economic agents a wider choice of risk management strategies# and
:" Innovations in the derivatives markets# which optimall$ comine the risks
and returns over a large numer of financial assets leading to higher returns#
reduced risk as well as transactions costs as compared to individual financial
assets"
WHAT KINDS OF RISKS DO PARTICIPANTS IN THEDERIVATIVES MARKETS FACE?
Some example o! "#$ a"e p"o%#&e& 'elo(>Co)*+e"pa"+, -o" &e!a)l+. "#$ ver$ low or almost !ero ecause
the e%change takes on the responsiilit$
Ope"a+#o*al "#$ risk that operational s$stems might fail
Le/al "#$ risk that legal oFections might e raised# regulator$
framework might disallow some activities
Ma"$e+ "#$ risk that market prices ma$ move ups or down
L#0)#+, "#$ risk that unwinding of transactions might e
difficult if the market is illiuid"
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DERIVATIVES (Instrument for risk reduction)
DERIVATIVES MEM1ERSHIP
The Derivatives Segment memership is open to the e%isting memers
of the /ash Segment as well as non*memers provided the$ fulfill the
memership reuired as laid down from time to time" The following are the
different t$pes of memership presentl$ availale for the Derivatives Segment>
2) P"o!e#o*al Clea"#*/ Mem'e" -PCM.: 4/? means a /learing
?emer# who is permitted to clear and settle trades on his own account# on
account of his clients and or on account of trading memers and their clients"
3) C)+oa* Clea"#*/ Mem'e" -CCM.: //? means /ustodian
registered as /learing ?emer# who ma$ clear and settle trades on his own
account# on account of his clients and or on account of trading memers and
their clients"
5) T"a*/ C)m Clea"#*/ Mem'e" -TCM.: A T/? means a Trading
?emer who is also a /learing ?emer and can clear and settle trades on his
own account# on account of his clients and on account of associated Trading
?emers and their clients"
C) Sel! Clea"#*/ Mem'e" -SCL)> A S/? means a Trading ?emer who is
also a /learing ?emer and can clear and settle trades on his own account and
on account of his clients"
:) T"a*/ Mem'e" -TM.:AT? is a memer of the E%change who has
onl$ trading rights and whose trades are cleared and settled $ the /learing
?emer with whom he is associated"
;) L#m#+e& T"a*/ Mem'e" -LTM.:A =T? is a memer# who is not the
memers of the /ash Segment of the E%change# and would like to e a Trading?emer in the Derivatives Segment at 9SE" An =T? has onl$ the trading rights
and his trades are cleared and settled $ the clearing memer with whom he
is associated"
As on @anuar$ 2# 3
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E8AMPLE
Imagine $ou are a farmer" Jou grow 2#
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DERIVATIVES (Instrument for risk reduction)
T2)9 +2e +(o mao" l#m#+a+#o* o! !o"(a"& a"e:
K /ounter part$ risk
K 4rice not eing transparent
/ounter part$ risk is also referred to as ,default- risk or ,credit- risk"
FUTURE CONTRACT
7utures trading was started in the mid western part of +SA during
2HG
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DERIVATIVES (Instrument for risk reduction)
FEATURES OF FUTURES
K /ontract etween two parties through an e%change
K E%change is the legal counter part$ to oth partiesK 4rice decided toda$
K Luantit$ decided toda$ (uantities have to e in standard denominations
specified $ the e%change)
K Lualit$ decided toda$ (ualit$ should e as per the specifications decided $
the e%change)
K Tick si!e (i"e" the minimum amount $ which the price uoted can change) is
decided $ the e%change
K Deliver$ will take place sometime in future (e%pir$ date is specified $ the
e%change)
K ?argins are pa$ale $ oth the parties to the e%change
K In some cases# the price limits (or circuit filters) can e decided $ the
e%change"
LIMITATION OF FUTURE:
7utures suffer from lack of fle%iilit$"
Suppose $ou want to u$ 2
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DERIVATIVES (Instrument for risk reduction)
Mea*#*/ o! exp#", o! F)+)"e
7utures contracts will e%pire on a certain pre*specified date" In India# futures
contracts e%pire on the last Thursda$ of ever$ month"
7or e%ample# a 7eruar$ 7utures contract will e%pire on the last Thursda$ of
7eruar$" In this case# 7eruar$ is referred to as the /ontract month"
If the last Thursda$ is a holida$# 7utures and .ptions will e%pire on the
previous working da$" .n e%pir$# all contracts will e compulsoril$ settled"
Settlement can e effected in cash or through deliver$"
Co*%e"/e*3e a+ Exp#"a+#o*
7utures pricing have e%pectations and a time value uilt into them" This
is the reason as time period e%pires the e%pectation value and the time value
deca$s and the futures price converges into the cash market price" This
process of convergence results in price discover$ of cash inde% at a given
point in time" /onvergence also forces the respective market participants to
suare off their respective e%posures or rollover their e%posures to the ne%t
contract month" /onvergence also reiterates the fact that derivatives
instruments have limited life"
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DERIVATIVES (Instrument for risk reduction)
WHAT TYPE OF MARGINS ARE PAYA1LE ON
FUTURES?
9oth u$ers and sellers of 7utures should pa$ an Initial ?argin to the
e%change at the point of entering into 7utures contracts" This Initial ?argin is
retained $ the e%change till these transactions are suared up"
7urther# ?ark to ?arket ?argins are pa$ale ased on closing prices at the
end of each trading da$" These ?argins will e paid $ the part$ who suffered
losses and will e received $ the part$ who made profits"
The e%change thus collects these margins from the losers and pa$s them to
the winners on a dail$ asis"
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DERIVATIVES (Instrument for risk reduction)
MARK = TO< MARKET
Ever$ da$ all the open positions in 7utures contracts are marked to the
closing price and the variation# if an$# is collected paid to the memers $
deiting crediting their settlement ank accounts with the respective clearing
anks on T O 2 morning" Also# where the positions are closed# profit loss on
such positions is also credited deited to the memer-s ank accounts"
Me+2o&olo/, !o" 3al3)la+#*/ 3lo#*/ p"#3e !o" &a#l, ma"$ +o
ma"$e+:
The dail$ closing price of the futures contract for calculating mark*to*market
margin is arrived at using following algorithm>*
eighted average price of all the trades in last half an hour of the continuous
trading session"
If there are no trades during last half an hour# then the theoretical price would
e taken as the official closing price" The theoretical price is arrived at $
using the following algorithm>*
T2eo"e+#3al p"#3e > Clo#*/ %al)e o! )*&e"l,#*/ - 3lo#*/
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DERIVATIVES (Instrument for risk reduction)
%al)e o! )*&e"l,#*/ @ No5 o! &a, +o exp#", @ "#$ !"ee #*+e"e+
"a+e - a+ p"ee*+ 5B . B .5
HOW CAN I S7UARE UP A FUTURES CONTRACT?
If $ou have ought a 7utures contract# $ou can sell it and thus suare up" If
$ou sold a 7utures contract# $ou can u$ it ack and suare up"
If $ou do not suare up till the da$ of e%pir$# it will e automaticall$ suared up
$ the e%change"
HOW TO 1ENEFIT FROM STOCK FUTURES
Jou are ullish on a stock sa$ Sat$am# which is currentl$ uoting at Rs 3B It touches Rs 55< as $ou predicted $ou made a profit of Rs :< on an
investment of Rs 3B< i"e" a Return of 2B in one month 7antastic PP
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DERIVATIVES (Instrument for risk reduction)
Wa#+> /an it get an$ etter M
Ye
7)e+#o*> hat should $ou do M
A*(e"> 9u$ Sat$am 7utures instead"
E!!e3+> .n u$ing Sat$am 7utures# $ou get the same position as Sat$am in
the cash market# ut $ou pa$ a margin and not the entire amount" 7or
e%ample# if the margin is 3
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even if $ou do not have an$ shares of Sat$am" Thus# $ou can enefit from a
downturn as well as from an upturn"
If $ou predict an upturn# $ou should u$ 7utures and if $ou predict a downturn#
$ou can alwa$s sell 7utures thus $ou can make mone$ in a falling market as
well as in a rising one an opportunit$ that till recentl$ was availale onl$ to
rokersoperators and not easil$ to retail investors"
Jou should look for opportunities where futures prices are higher than cash
prices" 7or e%ample# if Sat$am is uoting at Rs 3:< in the cash market and
one month Sat$am futures are uoting at Rs 3:5 in the futures market# $ou
can earn Rs 5 as difference" Jou will then u$ Sat$am in the cash market andat the same time# sell Sat$am one month futures"
.n or around the e%pir$ da$ (last Thursda$ of each month)# $ou will suare up
oth the positions# i"e" $ou will sell Sat$am in the cash market and u$
futures" The two prices will e the same (or ver$ nearl$ the same) as cash
and futures prices will converge on e%pir$" It does not matter to $ou what the
price is" Jou will make $our profit of Rs 5 an$wa$"
Fo" example# if the price is Rs 3G
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In this manner# $ou will generate returns whenever the futures prices are
aove cash market prices"
TRADERS PARTICIPANTS OPERATORS OF
FUTURE MARKETS
HEDGER
SPECULATOR
AR1ITRAGEURS
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SPREADERS
7uture contracts are ought and sold u$ large numer of individuals#
usiness organi!ations# governments and others for variet$ of purposes"The trader in the future market can e categori!ed on the asis of the
purposes for which the$ deal in the market"
U)all, !#*a*3#al &e"#%a+#%e a++"a3+ !ollo(#*/ +,pe o! +"a&e" a
)*&e":
HEDGERA edging is a position taken in futures or other markets for the purpose of
reducing e%posure to one or more t$pes of risk" A person who undertakes
such position is called as 0edger1" In other words# a hedger uses future
markets to reduce risk caused $ the movement in prices of securities#
commodities# e%change rate# interest rate# indices# etc" as such# a hedger
will take an opposite position to a perceived risk is called (hedging strateg$
in future markets1" The essence of hedging strateg$ is the adoption of future
position that# on average# generates profits when the market value of the
commitment is higher than the e%pected value"
SPECULATOR
A Speculator ma$ e defined as investors who are willing to take a risk
$ taking future position with the e%pectation to earn profits" The
speculators forecast the future economic condition and decide which
position (long and short) to e taken that will $ield a profit if the forecast
is reali!ed" In other words# Speculators are those who do not have an$
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position on which the$ enter in futures and options market" The$ onl$
have a particular view on the market# stock# commodit$# etc" In short#
speculators put their mone$ at risk in the hope of profiting from an
anticipated price change" The$ consider various factors such as demand#
suppl$# market positions# open interests# economic fundamentals and
other data to take their positions"
Ill)+"a+#o*:
Speculators usuall$ trade in the future markets to earn profits on
the asis of difference in spot and future prices of the underl$ing asset"
Ram is a trader ut has no time to track and anal$!e the stocks"owever# he fancies his chances in predicting the market trend" So
instead of u$ing different stocks# he u$s SE'SEN futures"
.n ?a$ 2# 3
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An aritrageur is asicall$ risk averse" e enters into those contracts
were he can earn risk less profits" hen markets are imperfect# u$ing in
one market and simultaneousl$ selling in other market gives risk less
profit" Aritrageurs are alwa$s in the look out for such imperfections"
In the futures market one can take advantages of aritrage opportunities
$ u$ing from lower priced market and selling at the higher priced
market" In Inde% futures aritrage is possile etween the spot market
and the futures market ('SE has provided a special software for u$ing
all :< 'ift$ stocks in the spot market)"
Take the case of the 'SE 'ift$"
Assume that 'ift$ is at 23
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factor which causes changes in the spreads" In a profitale spread
position# normall$# there is a large gain on one side of the spread in
comparison to the loss on the other side of the spread" In this wa$# a
spread reduces the risks even if the forecast is incorrect" .n the other
hand# the pure speculators would make mone$ $ taking onl$ the
profitale side of the market ut at ver$ high risk"
TYPES OF FUTURES
F)+)"e 3o*+"a3+ a"e '"oa&l, %#&e& #*+o +(o +,pe:
COMMODITY FUTURES
FINANCIAL FUTURES
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DERIVATIVES (Instrument for risk reduction)
COMMODITY FUTURES
A commodit$ futures is a contract in commodit$ like agricultural products#
metals 6 minerals etc" in organi!ed commodit$ futures markets#
contractscontracts are standardi!ed with standard uantities" .f course this
standard varies from commodit$ to commodit$ "the$ also have fi%ed deliver$
dates in each month or a few months on a $ear"
I* I*a 3ommo+, !)+)"e #* a/"#3)l+)"al p"o&)3+ a"e pop)la"5
Some o! +2e (ell e+a'l#2e& 3ommo+, !)+)"e a"e a
!ollo(:
2" =ondon metal stock e%change (=?E) to deal in gold
3" /hicago oard of trade (/9T) to deal in so$aean oil
5" 'ew Jork cotton e%change (/T') to deal in cotton
C" /ommodit$ e%change# 'E Jork (/.?EN) to deal in agricultural
products
:" International petroleum e%change of =ondon (I4E) to deal in crude oil
FINANCIAL FUTURES
The standardi!ed features or specification make 7utures tradale like a
contract" And since 7utures are derivatives# the 7utures contracts are ased
on an underl$ing" It is the movement of the underl$ing that decides how the
7utures price will move"
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There are onl$ two possile trades with a futures contract 9u$ or Sell" If
investor-s e%pectations for the underl$ing asset are ullish the$ should u$
futures" If the e%pectations prove to e correct# the futures contract will rise in
value allowing them to close out the position at a profit" If# on the other hand#
investors view the underl$ing asset as earish# then the$ should sell the
futures contract" If the view is correct# the$ will e ale to u$ ack the futures
at a lower price than the$ were sold for# the difference eing the profit the$
have made" Inde% 7utures contracts can e used to take a view on the
directions of the overall market with the added advantage of gearing"
7or e%ample# lets take the underl$ing asset on SE'SEN" If $ou elieve the
SE'SEN will rise $ou can u$ the futures contract ($ going long on the
SE'SEN futures) or if $ou elieve the SE'SEN will fall# $ou can sell the
SE'SEN futures ($ going short on the SE'SEN futures)"
7inancial Derivatives like futures do not generall$ terminate in deliver$" ?ost
positions are closed out efore e%pir$" So if investor# 0A1 had ought two
SE'SEN futures contracts giving them a long position# then he is reuired to
sell two SE'SEN futures# which will result in the investor having a short
position" This will mean that as far as the /learing ouse is concerned the
investor is oth long and short of two contracts"
Sell it ack into the market (If he is long)
9u$ it ack from the market (If he is short)
These two positions are then filed awa$ together netting one off with the
other" 'ot onl$ this will result in the investors having no outstanding position
in the futures# ut will also enale investors either to reali!e their profits or
reduce their losses"
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TYPES OF FINANCIAL FUTURE
4. INTEREST RATE FUTURE CONTRACT:
It is one of the important financial future instruments in the world" 7uture
trading on interest earing securities started onl$ in 2HG:# ut growth in the
market has een tremendous" Important interest earing securities are like
treasur$ ills# notes# onds# deenture# euro dollar time deposits and
municipal onds" In this market almost entire ranges of maturities earing
securities are traded"
Fo" e/> Three month maturit$ instruments like treasur$ ills 6 # including
foreign det instruments at /?E# 9ritish govt" ond at =ondon International "
financial future e%change (=I77E)# @apanese govt" ond at /9.T etc" are
traded"
6. FOREIGN CURRENCY FUTURE CONTRACT:
This financial future # as the name indicates# trade in 7oreign currencies # thusknown as e%change rate futures " active future trading in certain currencies
started in the earl$ 2HG
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which is to e delivered to fulfill the oligations as inde% futures are cash
settled" As other derivatives# the contract derives its value from the
underl$ing inde%" The underl$ing indices in this case will e the various
eligile indices and as permitted $ the Regulator from time to"
CONTRACT SPECIFICATIONS OF SENSE8 FUTURES
Fea+)"e SENSE8 F)+)"e
+nderl$ing inde% 9SE sensitive inde% (SE'SEN)
/ontract ?ultiplier :