Derivatives – Indian Scenario - 1 - Visit mbafin.blogspot.com for more 1.0 Introduction to derivatives The emergence of the market for derivative products, most notably forwards, futures and options, can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets are marked by a very high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer price risks by locking-in asset prices. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices. However, by locking-in asset prices, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors. Derivative products initially emerged, as hedging devices against fluctuations in commodity prices and commodity- linked derivatives remained the sole form of such products
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Derivatives – Indian Scenario - 1 -
Visit mbafin.blogspot.com for more
1.0 Introduction to derivativesThe emergence of the market for derivative products, most notably forwards, futures and
options, can be traced back to the willingness of risk-averse economic agents to guard
themselves against uncertainties arising out of fluctuations in asset prices. By their very
nature, the financial markets are marked by a very high degree of volatility. Through the
use of derivative products, it is possible to partially or fully transfer price risks by
locking-in asset prices. As instruments of risk management, these generally do not
influence the fluctuations in the underlying asset prices. However, by locking-in asset
prices, derivative products minimize the impact of fluctuations in asset prices on the
profitability and cash flow situation of risk-averse investors.
Derivative products initially emerged, as hedging devices against fluctuations in
commodity prices and commodity-linked derivatives remained the sole form of such
products for almost three hundred years. The financial derivatives came into spotlight in
post-1970 period due to growing instability in the financial markets. However, since their
emergence, these products have become very popular and by 1990s, they accounted for
about two-thirds of total transactions in derivative products. In recent years, the market
for financial derivatives has grown tremendously both in terms of variety of instruments
available, their complexity and also turnover. In the class of equity derivatives, futures
and options on stock indices have gained more popularity than on individual stocks,
especially among institutional investors, who are major users of index-linked derivatives.
Even small investors find these useful due to high correlation of the popular indices with
various portfolios and ease of use. The lower costs associated with index derivatives vis-
vis derivative products based on individual securities is another reason for their growing
use.
Derivatives – Indian Scenario - 2 -
The following factors have been driving the growth of financial derivatives:
1. Increased volatility in asset prices in financial markets,
2. Increased integration of national financial markets with the international markets,
3. Marked improvement in communication facilities and sharp decline in their costs,
4. Development of more sophisticated risk management tools, providing economic
agents a wider choice of risk management strategies, and
5. Innovations in the derivatives markets, which optimally combine the risks and
returns over a large number of financial assets, leading to higher returns, reduced
risk as well as trans-actions costs as compared to individual financial assets.
1.1 Derivatives defined
Derivative is a product whose value is derived from the value of one or more basic
variables, called bases (underlying asset, index, or reference rate), in a contractual
manner. The underlying asset can be equity, forex, commodity or any other asset. For
example, wheat farmers may wish to sell their harvest at a future date to eliminate the
risk of a change in prices by that date. Such a transaction is an example of a derivative.
The price of this derivative is driven by the spot price of wheat which is the “underlying”.
In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R) A) defines
“equity derivative” to include –
1. 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.
2. A contract, which derives its value from the prices, or index of prices, of
underlying securities.
The derivatives are securities under the SC(R) A and hence the trading of derivatives is
governed by the regulatory framework under the SC(R) A.1
1.2 Types of derivatives
The most commonly used derivatives contracts are forwards, futures and options which
we shall discuss in detail later. Here we take a brief look at various derivatives contracts
that have come to be used.
1 Source: www.nse-india.com
Derivatives – Indian Scenario - 3 -
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.
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.
Warrants: Options generally have lives of upto 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: The acronym LEAPS means Long-Term Equity Anticipation Securities. These
are options having a maturity of upto three years.
Baskets: Basket options are options on portfolios of underlying assets. The underlying
asset is usually a moving average or a basket of assets. Equity index options are a form of
basket options.
Derivatives – Indian Scenario - 4 -
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. Rather than have
calls and puts, 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.2
1.3 Participants and Functions
Three broad categories of participants - hedgers, speculators, and arbitrageurs - trade in
the derivatives market. Hedgers face risk associated with the price of an asset. They use
futures or options markets to reduce or eliminate this risk. Speculators wish to bet on
future movements in the price of an asset. Futures and options contracts can give them an
extra leverage; that is, they can increase both the potential gains and potential losses in a
speculative venture. Arbitrageurs are in business to take advantage of a discrepancy
between prices in two different markets. If, for example, they see the futures price of an
asset getting out of line with the cash price, they will take offsetting positions in the two
markets to lock in a profit.
The derivative market performs a number of economic functions. First, prices in an
organized derivatives market reflect the perception of market participants about the future
and lead the prices of underlying to the perceived future level. The prices of derivatives
converge with the prices of the underlying at the expiration of derivative contract. Thus
derivatives help in discovery of future as well as current prices. Second, the derivatives
market helps to transfer risks from those who have them but may not like them to those
who have appetite for them. Third, derivatives, due to their inherent nature, are linked to
the underlying cash markets. With the introduction of derivatives, the underlying market
witnesses higher trading volumes because of participation by more players who would
not otherwise participate for lack of an arrangement to transfer risk. Fourth, speculative
trades shift to a more controlled environment of derivatives market. In the absence of an
organized derivatives market, speculators trade in the underlying cash markets.
Margining, monitoring and surveillance of the activities of various participants become
2 Source: Options Futures & Other Derivatives John C Hull
Derivatives – Indian Scenario - 5 -
extremely difficult in these kind of mixed markets. Fifth, an important incidental benefit
that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial
activity. The derivatives have a history of attracting many bright, creative, well-educated
people with an entrepreneurial attitude. They often energize others to create new
businesses, new products and new employment opportunities, the benefit of which are
immense. Sixth, derivatives markets help increase savings and investment in the long run.
Transfer of risk enables market participants to expand their volume of activity.
Derivatives thus promote economic development to the extent the later depends on the
rate of savings and investment.
1.4 Development of exchange-traded derivatives
Derivatives have probably been around for as long as people have been trading with one
another. Forward contracting dates back at least to the 12th century, and may well have
been around before then. Merchants entered into contracts with one another for future
delivery of specified amount of commodities at specified price. A primary motivation for
prearranging a buyer or seller for a stock of commodities in early forward contracts was
to lessen the possibility that large swings would inhibit marketing the commodity after a
harvest.
Although early forward contracts in the US addressed merchants’ concerns about
ensuring that there were buyers and sellers for commodities, “credit risk” remained a
serious problem. To deal with this problem, a group of Chicago businessmen formed the
Chicago Board of Trade (CBOT) in 1848. The primary intention of the CBOT was to
provide a centralized location known in advance for buyers and sellers to negotiate
forward contracts. In 1865, the CBOT went one step further and listed the first “exchange
traded” derivatives contract in the US; these contracts were called “futures contracts”. In
1919, Chicago Butter and Egg Board, a spin-off of CBOT, was reorganized to allow
futures trading. Its name was changed to Chicago Mercantile Exchange (CME). The
CBOT and the CME remain the two largest organized futures exchanges, indeed the two
largest “financial” exchanges of any kind in the world today.
Derivatives – Indian Scenario - 6 -
The first stock index futures contract was traded at Kansas City Board of Trade.
Currently the most popular index futures contract in the world is based on S&P 500
index, traded on Chicago Mercantile Exchange. During the mid eighties, financial futures
became the most active derivative instruments generating volumes many times more than
the commodity futures. Index futures, futures on T-bills and Euro-Dollar futures are the
three most popular futures contracts traded today. Other popular international exchanges
that trade derivatives are LIFFE in England, DTB in Germany, SGX in Singapore, TIFFE
in Japan, MATIF in France, etc.3
Table 1.1 The global derivatives industry: Outstanding contracts, (in $ billion)
Table 1.2 Chronology of instruments1874 Commodity futures
1972 Foreign currency futures
1973 Equity options
1975 Treasury bond futures
1981 Currency swaps
1982 Interest rate swaps, T note futures, Eurodollar futures, Equity index futures,
Options on T bond futures, Exchange listed currency options
1983 Options on equity index, Options on T-note futures, Options on currency futures,
Options on equity index futures, interest rate caps and floors
1985 Eurodollar options, Swap options
1987 OTC compound options, OTC average options
1989 Futures on interest rate swaps, Quanto options
3 Source: Derivatives in India FAQ Ajay Shah & Susan Thomas
Derivatives – Indian Scenario - 7 -
1990 Equity index swaps
1991 Differential swaps
1993 Captions, exchange listed FLEX options
1994 Credit default options
1.5 Exchange-traded vs. OTC derivatives markets
The OTC derivatives markets have witnessed rather sharp growth over the last few years,
which has accompanied the modernization of commercial and investment banking and
globalisation of financial activities. The recent developments in information technology
have contributed to a great extent to these developments. While both exchange-traded
and OTC derivative contracts offer many benefits, the former have rigid structures
compared to the latter. It has been widely discussed that the highly leveraged institutions
and their OTC derivative positions were the main cause of turbulence in financial
markets in 1998. These episodes of turbulence revealed the risks posed to market stability
originating in features of OTC derivative instruments and markets.
The OTC derivatives markets have the following features compared to exchange-traded
derivatives:
1. The management of counter-party (credit) risk is decentralized and located within
individual institutions,
2. There are no formal centralized limits on individual positions, leverage, or
margining,
3. There are no formal rules for risk and burden-sharing,
4. There are no formal rules or mechanisms for ensuring market stability and
integrity, and for safeguarding the collective interests of market participants, and
5. The OTC contracts are generally not regulated by a regulatory authority and the
exchange’s self-regulatory organization, although they are affected indirectly by
national legal systems, banking supervision and market surveillance.
Derivatives – Indian Scenario - 8 -
Some of the features of OTC derivatives markets embody risks to financial market
stability.
The following features of OTC derivatives markets can give rise to instability in
institutions, markets, and the international financial system: (i) the dynamic nature of
gross credit exposures; (ii) information asymmetries; (iii) the effects of OTC derivative
activities on available aggregate credit; (iv) the high concentration of OTC derivative
activities in major institutions; and (v) the central role of OTC derivatives markets in the
global financial system. Instability arises when shocks, such as counter-party credit
events and sharp movements in asset prices that underlie derivative contracts, occur
which significantly alter the perceptions of current and potential future credit exposures.
When asset prices change rapidly, the size and configuration of counter-party exposures
can become unsustainably large and provoke a rapid unwinding of positions.
There has been some progress in addressing these risks and perceptions. However, the
progress has been limited in implementing reforms in risk management, including
counter-party, liquidity and operational risks, and OTC derivatives markets continue to
pose a threat to international financial stability. The problem is more acute as heavy
reliance on OTC derivatives creates the possibility of systemic financial events, which
fall outside the more formal clearing house structures. Moreover, those who provide OTC
derivative products, hedge their risks through the use of exchange traded derivatives. In
view of the inherent risks associated with OTC derivatives, and their dependence on
exchange traded derivatives, Indian law considers them illegal.
Derivatives – Indian Scenario - 9 -
2.0 Indian Derivatives MarketStarting from a controlled economy, India has moved towards a world where prices
fluctuate every day. The introduction of risk management instruments in India gained
momentum in the last few years due to liberalisation process and Reserve Bank of India’s
(RBI) efforts in creating currency forward market. Derivatives are an integral part of
liberalisation process to manage risk. NSE gauging the market requirements initiated the
process of setting up derivative markets in India. In July 1999, derivatives trading
commenced in India
Table 2.1 Chronology of instruments1991 Liberalisation process initiated
14 December 1995 NSE asked SEBI for permission to trade index futures.
18 November 1996 SEBI setup L.C.Gupta Committee to draft a policy framework for
index futures.
11 May 1998 L.C.Gupta Committee submitted report.
7 July 1999 RBI gave permission for OTC forward rate agreements (FRAs) and
interest rate swaps.
24 May 2000 SIMEX chose Nifty for trading futures and options on an Indian
index.
25 May 2000 SEBI gave permission to NSE and BSE to do index futures trading.
9 June 2000 Trading of BSE Sensex futures commenced at BSE.
12 June 2000 Trading of Nifty futures commenced at NSE.
25 September 2000 Nifty futures trading commenced at SGX.
2 June 2001 Individual Stock Options & Derivatives
2.1 Need for derivatives in India today
In less than three decades of their coming into vogue, derivatives markets have become
the most important markets in the world. Today, derivatives have become part and parcel
of the day-to-day life for ordinary people in major part of the world.
Until the advent of NSE, the Indian capital market had no access to the latest trading
Derivatives – Indian Scenario - 10 -
methods and was using traditional out-dated methods of trading. There was a huge gap
between the investors’ aspirations of the markets and the available means of trading. The
opening of Indian economy has precipitated the process of integration of India’s financial
markets with the international financial markets. Introduction of risk management
instruments in India has gained momentum in last few years thanks to Reserve Bank of
India’s efforts in allowing forward contracts, cross currency options etc. which have
developed into a very large market.
2.2 Myths and realities about derivatives
In less than three decades of their coming into vogue, derivatives markets have become
the most important markets in the world. Financial derivatives came into the spotlight
along with the rise in uncertainty of post-1970, when US announced an end to the Bretton
Woods System of fixed exchange rates leading to introduction of currency derivatives
followed by other innovations including stock index futures. Today, derivatives have
become part and parcel of the day-to-day life for ordinary people in major parts of the
world. While this is true for many countries, there are still apprehensions about the
introduction of derivatives. There are many myths about derivatives but the realities that
are different especially for Exchange traded derivatives, which are well regulated with all
the safety mechanisms in place.
What are these myths behind derivatives?
Derivatives increase speculation and do not serve any economic purpose
Indian Market is not ready for derivative trading
Disasters prove that derivatives are very risky and highly leveraged
instruments
Derivatives are complex and exotic instruments that Indian investors will find
difficulty in understanding
Is the existing capital market safer than Derivatives?
2.2.1 Derivatives increase speculation and do not serve any economic purpose
While the fact is...
Derivatives – Indian Scenario - 11 -
Numerous studies of derivatives activity have led to a broad consensus, both in the
private and public sectors that derivatives provide numerous and substantial benefits to
the users. Derivatives are a low-cost, effective method for users to hedge and manage
their exposures to interest rates, commodity prices, or exchange rates.
The need for derivatives as hedging tool was felt first in the commodities market.
Agricultural futures and options helped farmers and processors hedge against commodity
price risk. After the fallout of Bretton wood agreement, the financial markets in the world
started undergoing radical changes. This period is marked by remarkable innovations in
the financial markets such as introduction of floating rates for the currencies, increased
trading in variety of derivatives instruments, on-line trading in the capital markets, etc.
As the complexity of instruments increased many folds, the accompanying risk factors
grew in gigantic proportions. This situation led to development derivatives as effective
risk management tools for the market participants.
Looking at the equity market, derivatives allow corporations and institutional investors to
effectively manage their portfolios of assets and liabilities through instruments like stock
index futures and options. An equity fund, for example, can reduce its exposure to the
stock market quickly and at a relatively low cost without selling off part of its equity
assets by using stock index futures or index options.
By providing investors and issuers with a wider array of tools for managing risks and
raising capital, derivatives improve the allocation of credit and the sharing of risk in the
global economy, lowering the cost of capital formation and stimulating economic growth.
Now that world markets for trade and finance have become more integrated, derivatives
have strengthened these important linkages between global markets, increasing market
liquidity and efficiency and facilitating the flow of trade and finance.4
2.2.2 Indian Market is not ready for derivative trading
While the fact is...
4 Source: www.nse-india .com
Derivatives – Indian Scenario - 12 -
Often the argument put forth against derivatives trading is that the Indian capital market
is not ready for derivatives trading. Here, we look into the pre-requisites, which are
needed for the introduction of derivatives and how Indian market fares:
Table 2.2
PRE-REQUISITES INDIAN SCENARIOLarge market Capitalisation India is one of the largest market-capitalised countries in
Asia with a market capitalisation of more than Rs.765000 crores.
High Liquidity in the underlying
The daily average traded volume in Indian capital market today is around 7500 crores. Which means on an average every month 14% of the country’s Market capitalisation gets traded. These are clear indicators of high liquidity in the underlying.
Trade guarantee The first clearing corporation guaranteeing trades has become fully functional from July 1996 in the form of National Securities Clearing Corporation (NSCCL). NSCCL is responsible for guaranteeing all open positions on the National Stock Exchange (NSE) for which it does the clearing.
A Strong Depository National Securities Depositories Limited (NSDL) which started functioning in the year 1997 has revolutionalised the security settlement in our country.
A Good legal guardian In the Institution of SEBI (Securities and Exchange Board of India) today the Indian capital market enjoys a strong, independent, and innovative legal guardian who is helping the market to evolve to a healthier place for trade practices.
2.2.3 Disasters prove that derivatives are very risky and highly leveraged
instruments
While the fact is...
Disasters can take place in any system. The 1992 Security scam is a case in point.
Disasters are not necessarily due to dealing in derivatives, but derivatives make
Derivatives – Indian Scenario - 13 -
headlines... Here I have tried to explain some of the important issues involved in disasters
related to derivatives. Careful observation will tell us that these disasters have occurred
due to lack of internal controls and/or outright fraud either by the employees or
promoters.
Barings Collapse
1. 233 year old British bank goes bankrupt on 26th February 1995
2. Downfall attributed to a single trader, 28 year old Nicholas Leeson
3. Loss arose due to large exposure to the Japanese futures market
4. Leeson, chief trader for Barings futures in Singapore, takes huge position in index
futures of Nikkei 225
5. Market falls by more than 15% in the first two months of ’95 and Barings suffers
huge losses
6. Bank looses $1.3 billion from derivative trading
7. Loss wipes out the entire equity capital of Barings
The reasons for the collapse:
Leeson was supposed to be arbitraging between Osaka Securities Exchange and
SIMEX -- a risk less strategy, while in truth it was an unhedged position.
Leeson was heading both settlement and trading desk -- at most other banks the
functions are segregated, this helped Leeson to cover his losses -- Leeson was
unsupervised.
Lack of independent risk management unit, again a deviation from prudential norms.
There were no proper internal control mechanisms leading to the discrepancies going
unnoticed – Internal audit report which warned of "excessive concentration of power
in Leeson’s hands" was ignored by the top management.
The conclusion as summarised by Wall Street Journal article
" Bank of England officials said they did not regard the problem in this case as one
peculiar to derivatives. In a case where a trader is taking unauthorised positions, they
said, the real question is the strength of an investment houses’ internal controls and the
external monitoring done by Exchanges and Regulators. "
Metallgesellschaft
Derivatives – Indian Scenario - 14 -
1. Metallgesellshaft (MG) -- a hedge that went bad to the tune of $1.3 billion
Germany’s 14th largest industrial group nearly goes bankrupt from losses suffered
through its American subsidiary - MGRM
2. MGRM offered long term contracts to supply 180 million barrels of oil products
to its clients -- commitments were quite large, equivalent to 85 days of Kuwait’s
oil output
3. MGRM created a hedge position for these long term contracts with short term
futures market through rolling hedge --, As there was no viable long term
contracts available
4. Company was exposed to basis risk -- risk of short term oil prices temporarily
deviating from long term prices.
5. In 1993, oil prices crashed, leading to billion dollars of margin call to be met in
cash. The Company was faced with temporary funds crunch.
6. New management team decides to liquidate the remaining contracts, leading to a
loss of 1.3 billion.
7. Liquidation has been criticised, as the losses could have decreased over time.
Auditors’ report claims that the losses were caused by the size of the trading
exposure.
Reasons for the losses:
The transactions carried out by the company were mainly OTC in nature and hence
lacked transparency and risk management system employed by a derivative exchange
Large exposure
Temporary funds crunch
Lack of matching long-term contracts, which necessitated the company to use rolling
short term hedge -- problem arising from the hedging strategy
Basis risk leading to short term loss
2.2.4 Derivatives are complex and exotic instruments that Indian investors will have
difficulty in understanding
While the fact is...
Derivatives – Indian Scenario - 15 -
Trading in standard derivatives such as forwards, futures and options is already prevalent
in India and has a long history. Reserve Bank of India allows forward trading in Rupee-
Dollar forward contracts, which has become a liquid market. Reserve Bank of India also
allows Cross Currency options trading.
Forward Markets Commission has allowed trading in Commodity Forwards on
Commodities Exchanges, which are, called Futures in international markets.
Commodities futures in India are available in turmeric, black pepper, coffee, Gur
(jaggery), hessian, castor seed oil etc. There are plans to set up commodities futures
exchanges in Soya bean oil as also in Cotton. International markets have also been
allowed (dollar denominated contracts) in certain commodities. Reserve Bank of India
also allows, the users to hedge their portfolios through derivatives exchanges abroad.
Detailed guidelines have been prescribed by the RBI for the purpose of getting approvals
to hedge the user’s exposure in international markets.
Derivatives in commodities markets have a long history. The first commodity futures
exchange was set up in 1875 in Mumbai under the aegis of Bombay Cotton Traders
Association (Dr.A.S.Naik, 1968, Chairman, Forwards Markets Commission, India, 1963-
68). A clearinghouse for clearing and settlement of these trades was set up in 1918. In
oilseeds, a futures market was established in 1900. Wheat futures market began in Hapur
in 1913. Futures market in raw jute was set up in Calcutta in 1912. Bullion futures market
was set up in Mumbai in 1920.
History and existence of markets along with setting up of new markets prove that the
concept of derivatives is not alien to India. In commodity markets, there is no resistance
from the users or market participants to trade in commodity futures or foreign exchange
markets. Government of India has also been facilitating the setting up and operations of
these markets in India by providing approvals and defining appropriate regulatory
frameworks for their operations.
Derivatives – Indian Scenario - 16 -
Approval for new exchanges in last six months by the Government of India also indicates
that Government of India does not consider this type of trading to be harmful albeit
within proper regulatory framework.
This amply proves that the concept of options and futures has been well ingrained in the
Indian equities market for a long time and is not alien as it is made out to be. Even today,
complex strategies of options are being traded in many exchanges which are called teji-
mandi, jota-phatak, bhav-bhav at different places in India (Vohra and Bagari,1998)
In that sense, the derivatives are not new to India and are also currently prevalent in
various markets including equities markets.
2.2.5 Is the existing capital market more safer than Derivatives?
While the fact is...
World over, the spot markets in equities are operated on a principle of rolling settlement.
In this kind of trading, if you trade on a particular day (T), you have to settle these trades
on the third working day from the date of trading (T+3).
Futures market allow you to trade for a period of say 1 month or 3 months and allow you
to net the transaction taken place during the period for the settlement at the end of the
period. In India, most of the stock exchanges allow the participants to trade during one-
week period for settlement in the following week. The trades are netted for the settlement
for the entire one-week period. In that sense, the Indian markets are already operating the
futures style settlement rather than cash markets prevalent internationally.
In this system, additionally, many exchanges also allow the forward trading called badla
in Gujarati and Contango in English, which was prevalent in UK. This system is
prevalent currently in France in their monthly settlement markets. It allowed one to even
further increase the time to settle for almost 3 months under the earlier regulations. This
way, a curious mix of futures style settlement with facility to carry the settlement
obligations forward creates discrepancies.
Derivatives – Indian Scenario - 17 -
The more efficient way from the regulatory perspective will be to separate out the
derivatives from the cash market i.e. introduce rolling settlement in all exchanges and at
the same time allow futures and options to trade. This way, the regulators will also be
able to regulate both the markets easily and it will provide more flexibility to the market
participants.
In addition, the existing system although futures style, does not ask for any margins from
the clients. Given the volatility of the equities market in India, this system has become
quite prone to systemic collapse. This was evident in the MS Shoes scandal. At the time
of default taking place on the BSE, the defaulting member of the BSE Mr.Zaveri had a
position close to Rs.18 crores. However, due to the default, BSE had to stop trading for a
period of three days. At the same time, the Barings Bank failed on Singapore Monetary
Exchange (SIMEX) for the exposure of more than US $ 20 billion (more than Rs.84,000
crore) with a loss of approximately US $ 900 million ( around Rs.3,800 crore). Although,
the exposure was so high and even the loss was also very big compared to the total
exposure on MS Shoes for BSE of Rs.18 crores, the SIMEX had taken so much margins
that they did not stop trading for a single minute.
2.3 Comparision of New System with Existing System5
Many people and brokers in India think that the new system of Futures & Options and
banning of Badla is disadvantageous and introduced early, but I feel that this new system
is very useful especially to retail investors. It increases the no of options investors for
investment. In fact it should have been introduced much before and NSE had approved it
but was not active because of politicization in SEBI.
The figure 2.1 –2.4 6shows how advantages of new system (implemented from June
20001) v/s the old system i.e.before June 2001
5 Source: Mr. Rajesh Gajra Senior writer- Intelligent Investor ([email protected])6 Source: Invest Monitor (Magazine) July 2001
Derivatives – Indian Scenario - 18 -
New System Vs Existing System for Market Players
Figure 2.1
Speculators
Existing SYSTEM New
Approach Peril &Prize Approach Peril &Prize 1) Deliver based 1) Both profit & 1)Buy &Sell stocks 1)MaximumTrading, margin loss to extent of on delivery basis loss possibletrading& carry price change. 2) Buy Call &Put to premiumforward transactions. by paying paid2) Buy Index Futures premium hold till expiry.
Advantages Greater Leverage as to pay only the premium.
Greater variety of strike price options at a given time.
Figure 2.2
Arbitrageurs
Existing SYSTEM New
Approach Peril &Prize Approach Peril &Prize 1) Buying Stocks in 1) Make money 1) B Group more 1) Risk freeone and selling in whichever way the promising as still game. another exchange. Market moves. in weekly settlement forward transactions. 2) Cash &Carry
Derivatives – Indian Scenario - 19 -
2) If Future Contract arbitrage continuesmore or less than Fair price
Fair Price = Cash Price + Cost of Carry.
Figure 2.3
Hedgers
Existing SYSTEM New
Approach Peril &Prize Approach Peril &Prize 1) Difficult to 1) No Leverage 1)Fix price today to buy 1) Additionaloffload holding available risk latter by paying premium. cost is onlyduring adverse reward dependant 2)For Long, buy ATM Put premium.market conditions on market prices Option. If market goes up,as circuit filters long position benefit elselimit to curtail losses. exercise the option. 3)Sell deep OTM call option with underlying shares, earn premium + profit with increase prcie
Advantages Availability of Leverage
Figure 2.4
Small Investors
Existing SYSTEM New
Approach Peril &Prize Approach Peril &Prize 1) If Bullish buy 1) Plain Buy/Sell 1) Buy Call/Put options 1) Downsidestocks else sell it. implies unlimited based on market outlook remains profit/loss. 2) Hedge position if protected & holding underlying upside stock unlimited.
Derivatives – Indian Scenario - 20 -
Advantages Losses Protected.
3.0 SWAPSA contract between two parties, referred to as counter parties, to exchange two streams of
payments for agreed period of time. The payments, commonly called legs or sides, are
calculated based on the underlying notional using applicable rates. Swaps contracts also
include other provisional specified by the counter parties. Swaps are not debt instrument
to raise capital, but a tool used for financial management. Swaps are arranged in many
different currencies and different periods of time. US$ swaps are most common followed
by Japanese yen, sterling and Deutsche marks. The length of past swaps transacted has
ranged from 2 to 25 years.
3.1 Why did swaps emerge?
In the late 1970's, the first currency swap was engineered to circumvent the currency
control imposed in the UK. A tax was levied on overseas investments to discourage
capital outflows. Therefore, a British company could not transfer funds overseas in order
to expand its foreign operations without paying sizeable penalty. Moreover, this British
company had to take an additional currency risks arising from servicing a sterling debt
with foreign currency cash flows. To overcome such a predicament, back-to-back loans
were used to exchange debts in different currencies. For example, a British company
wanting to raise capital in the France would raise the capital in the UK and exchange its
obligations with a French company, which was in a reciprocal position. Though this type
of arrangement was providing relief from existing protections, one could imagine, the
task of locating companies with matching needs was quite difficult in as much as the cost
of such transactions was high. In addition, back-to-back loans required drafting multiple
loan agreements to state respective loan obligations with clarity. However this type of
arrangement lead to development of more sophisticated swap market of today.
Facilitators
The problem of locating potential counter parties was solved through dealers and brokers.
A swap dealer takes on one side of the transaction as counterparty. Dealers work for
investment, commercial or merchant banks. "By positioning the swap", dealers earn bid-
Derivatives – Indian Scenario - 21 -
ask spread for the service. In other words, the swap dealer earns the difference between
the amount received from a party and the amount paid to the other party. In an ideal
situation, the dealer would offset his risks by matching one step with another to
streamline his payments. If the dealer is a counterparty paying fixed rate payments and
receiving floating rate payments, he would prefer to be a counterparty receiving fixed
payments and paying floating rate payments in another swap. A perfectly netted position
as just described is not necessary. Dealers have the flexibility to cover their exposure by
matching multiple parties and by using other tools such as futures to cover an exposed
position until the book is complete.
Swap brokers, unlike a dealer do not take on a swap position themselves but simply
locate counter parties with matching needs. Therefore, brokers are free of any risks
involved with the transactions. After the counter parties are located, the brokers negotiate
on behalf of the counter parties to keep the anonymity of the parties involved. By doing
so, if the swap transaction falls through, counter parties are free of any risks associated
with releasing their financial information. Brokers receive commissions for their services.
3.2 Swaps Pricing:
There are four major components of a swap price.
Benchmark price
Liquidity (availability of counter parties to offset the swap).
Transaction cost
Credit risk 7
Swap rates are based on a series of benchmark instruments. They may be quoted as a
spread over the yield on these benchmark instruments or on an absolute interest rate
basis. In the Indian markets the common benchmarks are MIBOR, 14, 91, 182 & 364 day
T-bills, CP rates and PLR rates.
7 Source: www.appliederivatives.com
Derivatives – Indian Scenario - 22 -
Liquidity, which is function of supply and demand, plays an important role in swaps
pricing. This is also affected by the swap duration. It may be difficult to have counter
parties for long duration swaps, specially so in India Transaction costs include the cost of
hedging a swap. Say in case of a bank, which has a floating obligation of 91 day T. Bill.
Now in order to hedge the bank would go long on a 91 day T. Bill. For doing so the bank
must obtain funds. The transaction cost would thus involve such a difference.
Yield on 91 day T. Bill - 9.5%
Cost of fund (e.g.- Repo rate) – 10%
The transaction cost in this case would involve 0.5%
Credit risk must also be built into the swap pricing. Based upon the credit rating of the
counterparty a spread would have to be incorporated. Say for e.g. it would be 0.5% for an
AAA rating.
Swap Market Participation’s
Since swaps are privately negotiated products, there is no restriction on who can use the
market. However, parties with low credit quality have difficulty entering the market. This
is due to fact that they cannot be matched with counter parties who are willing to take on
their risks. In the U.S. many parties require their counter parties to have minimum assets
of $10 million. This requirement has become a standardized representation of "eligible
swap participants".
3.3 Introduction of Forward Rate Agreements and Interest
Rate Swaps
The Indian scene 8
Objective
To further deepen the money markets
To enable banks, primary dealers and all India financial institutions to hedge interest
rate risks.
These guidelines are intended to form the basis for development of Rupee derivative
products such as FRAs/IRS in the country. They have been formulated in consultation
8 Source: RBI Guidelines
Derivatives – Indian Scenario - 23 -
with market participants. The guidelines are subject to review, on the basis of
development of FRAs/IRS market.
Accordingly, it has been decided to allow scheduled commercial banks (excluding
Regional Rural Banks), primary dealers and all -India financial institutions to undertake
FRAs/IRS as a product for their own balance sheet management and for market making
purposes.
Prerequisites
Participants are to ensure that appropriate infrastructure and risk management systems are
put in place. Further, participants should also set up sound internal control system
whereby a clear functional separation of trading, settlement, monitoring and control and
accounting activities is provided.
3.4 Description of the product
A Forward Rate Agreement (FRA) is a financial contract between two parties
exchanging or swapping a stream of interest payments for a notional principal amount on
settlement date, for a specified period from start date to maturity date. Accordingly, on
the settlement date, cash payments based on contract (fixed) and the settlement rate, are
made by the parties to one another. The settlement rate is the agreed benchmark/reference
rate prevailing on the settlement date.
An Interest Rate Swap (IRS) is a financial contract between two parties exchanging or
swapping a stream of interest payments for a notional principal amount of multiple
occasions on specified periods. Accordingly, on each payment date that occurs during the
swap period-Cash payments based on fixed/floating and floating rates are made by the
parties to one another.
Currency swaps can be defined as a legal agreement between two or more parties to
exchange interest obligation or interest receipts between two different currencies. It
involves three steps:
Initial exchange of principal between the counter parties at an agreed upon rate of
exchange which is usually based on spot exchange rate. This exchange is optional and
its sole objective is to establish the quantum of the respective principal amounts for
Derivatives – Indian Scenario - 24 -
the purpose for calculating the ongoing payments of interest and to establish the
principal amount to be re-exchanged at the maturity of the swap.
Ongoing exchange of interest at the rates agreed upon at the outset of the transaction.
Re-exchange of principal amount on maturity at the initial rate of exchange.
This straight forward, three step process results in the effective transformation of the debt
raised in one currency into a fully hedged liability in other currency.
Participants
Schedule commercial banks.
Primary dealers
All India financial institutions
3.5 Currency Swaps in India
RBI in its slack season credit policy '97 allowed the authorized dealers to arrange
currency swap without its prior approval. This was to enable those requiring long-term
forward cover to hedge themselves without altering the external liability of the country.
Prior to this policy RBI had been approving rupee foreign currency swaps between
corporates on a case basis, but no such swaps were taking place.
RBI in its process of making the Indian corporates globally competitive has simplified
their access to this instrument by making changes in its credit policy. But despite an
easing regulation, swaps have not hit the market in a big way.
India has a strong dollar-rupee forward market with contracts being traded for one, two,
six-month expiration. Daily trading volume on this forward market is around $500
million a day. Indian users of hedging services are also allowed to buy derivatives
involving other currencies on foreign markets. Outside India, there is a small market for
cash –settled forward contracts on the dollar –rupee exchange rate.
While studying swaps in the Indian context, the counter parties involved are Indian
corporates and the swap dealers are the Authorized dealers of foreign exchange, i.e., the
banks allowed by RBI to carry out the swaps. These banks form the counterparty to the
Derivatives – Indian Scenario - 25 -
corporates on both sides of the swap and keep a spread between the interest rates to be
received and offered. One of the currencies involved is the Indian rupee and the other
could be any foreign currency. The interest rate on the rupee is most likely to be fixed,
and on foreign currency it could be either fixed or floating.
3.5.1 The Players
Swaps are instruments, which allow the user to hedge - that are to offset risk or to take
risk deliberately in the expectation of making profit. The user in this case would be any
corporate having a foreign exchange exposure/ a risk. A foreign exchange exposure will
arise out of the mismatch between the currency of inflow and outflow. The outflow being
considered here is the interest and the principal payment on the borrowings of the
corporates. Corporates having such currency mismatches would be of the following types
3.5.2Corporates with rupee loan and forex revenue
Mainly the exporters would fall in this category. Corporates with foreign subsidiaries
would also be having forex revenues but due to cheaper availability of funds abroad, it is
unlikely that these subsidiaries would be funded by a rupee loan. Thus the main players
meeting this criterion would be the exporters. The main players in the Indian market are
Tata Exports, Hindustan Levers Ltd., ITC Ltd., and Nestle Indian Ltd. among the others.
3.5.3 Corporates with forex loan and rupee revenue
The corporates having foreign currency loan could further be classified into two groups.
One which have net imports and thus may have raised loans to meet their import
requirements, for example Bharat Heavy Electricals Ltd., Apollo Tyres Ltd., Tata Power
Co. Ltd.
Two, which do not have net imports but have raised foreign currency loan for funding
requirements, for example Arvind Mills Ltd., Ballarpur Industries etc.
3.5.4 Corporates with no foreign exposure
There may be corporates with no existing exposure but willing to take up an exposure in
an expectation of making profit out of this transaction. Thus they would be willing to
swap their rupee loan with forex loan and book in forward cover or make the payments
Derivatives – Indian Scenario - 26 -
on spot basis on the day of disbursements. These corporates may also consider the option
of raising new loans in foreign currency and swap a rupee loan if it turns out to be
cheaper option. Thus many corporates would fall under this category.
3.5.5 Banks
Banks act as the authorized dealers and are instrumental in arranging swaps. They have to
take the swaps on their books. A bank would enter into swap with a party and then try to
find another with opposite requirement to hedge itself against any fluctuation in exchange
rates. They would normally keep a spread between the offer and bid rate thus make profit
from transaction. They also take up the credit risk of counterparties.
3.6 The needs of the players and how currency swaps help meet
these needs
3.6.1 To manage the exchange rate risk
Since the international trade implies returns and payments in a variety of currencies
whose relative values may fluctuate it involves taking foreign exchange risk. The players
mentioned above are facing this risk. A key question facing the players then is whether
these exchange risks are so large as to affect their business. A related question is what, if
any, special strategies should be followed to reduce the impact of foreign exchange risk.
One-way to minimize the long-term risk of one currency being worth more or less in the
future is to offset the particular cash flow stream with an opposite flow in the same
currency. The currency swap helps to achieve this without raising new funds; instead it
changes existing cash flows.
3.6.2 To lower financing cost
Currency swaps can be used to reduce the cost of loan. The following example deals with
such a case.
Consider two Indian corporates A & B. Corporate A is an exporter with a rupee loan at
14% fixed rate. B has a dollar loan at LIBOR + 0.25% floating rate. Due to difference in
the credit rating of the two companies, the rates at which the loans are available to them
are different. A has access to 14% rupee loan and dollar loan at LIBOR + 0.25%.
A would like to convert its rupee loan into a dollar loan, to reverse its revenue in dollars
and B would like to convert the dollar loan into a fixed rupee loan thus crystallizing its
Derivatives – Indian Scenario - 27 -
cost of borrowing. They can enter into a swap and reduce the cost compared to what it
would have been if they had taken a direct loan in the desired currencies.
- Comparative advantage
Company A Exporter Company B
Options: Options:
Borrow ruppe at 13% Borrow ruppe at 14.5%
Borrow dollars at LIBOR +100 bps Borrow dollars at LIBOR +200 bps
Company A has an absolute advantage over B in both the markets/ rates. The advantage
in terms of rupee funds is 150 bps while it is 100 bps in case of dollar rates. Thus B has a
comparative advantage in terms of dollar rates.
Now as A is an exporter he would be more interested in a dollar denominated loan to
offset his future receivables.
Therefore it would be advantageous if A would borrow at rupee rates and B borrows at
LIBOR rates. Then they may go in for a currency swap. The net gain arising out of such a
swap will be 50 bps, which may be shared between the parties.
The swap will thus result in A paying B a floating rate of LIBOR + 75 bps in return for a
13% fixed rupee rate. The swap will take place on a notional principal basis.
The effective cost for A is LIBOR + 75 bps and for B it is 14.25%. The effective cost for
A is 12.75%. This results into a net saving of 25 bps for both the parties.
Figure 3.1
LIBOR +75 bps
Company A Company B12.75% in INR
13% in INR Libor +200 bps
- To access restricted markets
Many countries have restrictions on the type of borrowers that can raise funds in their
bond markets. Foe example an Indian firm exporting goods to Japan may wish to issue
bonds in yen to form a natural hedge by reversing their cash flows. To issue a yen bond,
Derivatives – Indian Scenario - 28 -
the borrower must qualify for a single A credit rating. If the company does not qualify in
this regard it would fail to issue yen denominated bond.
By issuing bonds in the rupee market and then entering into a currency swap, the firm can
meet its expectation of raising a yen denominated loan.
3.6.3 Swaps for reducing the cost of borrowing
With the introduction of rupee derivatives the Indian corporates can attempt to reduce
their cost of borrowing and thereby add value. A typical Indian case would be a corporate
with a high fixed rate obligation.
Eg.
Mehta Ltd. an AAA rated corporate, 3 years back had raised 4-year funds at a fixed rate
of 18.5%. Today a 364-day T. bill is yielding 10.25%, as the interest rates have come
down. The 3-month MIBOR is quoting at 10%.
Fixed to floating 1 year swaps are trading at 50 bps over the 364-day T. bill vs 6-month
MIBOR.
The treasurer is of the view that the average MIBOR shall remain below 18.5% for the
next one year.
The firm can thus benefit by entering into an interest rate fixed for floating swap,
whereby it makes floating payments at MIBOR and receives fixed payments at 50 bps
over a 364 day treasury yield i.e. 10.25 + 0.50 = 10.75 %.
Figure 3.2
Fixed 10.75 Mehta Ltd Counter Party
3 Months MIBOR
18.75%s MIBOR
Derivatives – Indian Scenario - 29 -
The effective cost for Mehta Ltd. = 18.5 + MIBOR - 10.75
= 7.75 + MIBOR
At the present 3m MIBOR at 10%, the effective cost is = 10 + 7.75 = 17.75%
The gain for the firm is (18.5 - 17.75) = 0.75 %
The risks involved for the firm are
- Default/ credit risk of counterparty. This may be ignored, as the counterparty is a bank.
This risk involves losses to the extent of the interest rate differential between fixed and
floating rate payments.
- The firm is faced with the risk that the MIBOR goes beyond 10.75%. Any rise beyond
10.75% will raise the cost of funds for the firm. Therefore it is very essential that the firm
hold a strong view that MIBOR shall remain below 10.75%. This will require continuous
monitoring on the path of the firm.
How does the bank benefit out of this transaction?
The bank either goes for another swap to offset this obligation and in the process earn a
spread. The bank may also use this swap as an opportunity to hedge its own floating
liability. The bank may also leave this position uncovered if it is of the view that MIBOR
shall rise beyond 10.75%.
Taking advantage of future views/ speculation
If a bank holds a view that interest rate is likely to increase and in such a case the return
on fixed rate assets will not increase, it will prefer to swap it with a floating rate interest.
It may also swap floating rate liabilities with a fixed rate.
3.7 Factors to be looked at while doing a swap
Though swaps can be used in the above conditions effectively, corporates need to look at
a few factors before deciding to swap.
The estimated net exposure
Derivatives – Indian Scenario - 30 -
They need to estimate the net exposure that they are likely to have in the future.
Projecting the growth in exports/ imports, taking into account the changes in management
and government policies can do this.
Expected range of exchange rates
This can be determined by a fundamental and technical analysis. For fundamental
analysis one needs to keep track of the balance of payment condition, GDP growth rate,
etc. of the country. The technical factors look at past trends and expected demand-supply
position. Other factors like political stability also needs to be considered.
Expected interest rates
Since currency swaps include exchange of interest payments, the interest rates also need
to be traced. By keeping an eye on the yield curve of long term bonds and the macro
economic variables of different countries, the interest rates can be estimated.
Amount of cover to be taken
Having estimated the amount of exposure, the expected exchange rates and the interest
rates, the parties can determine the risks involved and can decide upon the amount of
cover to be taken. This shall depend on the management policy whether they believe in
minimizing the risk for a given level of return or maximizing the gain for a given level of
risk. The risk taking capability of a corporate will depend upon the financial backup to
absorb the losses, if any, the availability of time and resources to monitor the forex
market.
3.8 Market Report- Issues of Concern
Unfortunately, money markets as a whole are not developed. The biggest problem
continues to be the structure of the money market. Two-way quotes are a fundamental
necessity for a proper yield curve to develop and a reference rate to be established. The
RBI does not encourage lend/borrow transaction on the same day. While foreign banks
and some of the new banks are perennial borrowers in the inter-bank market, several
nationalised banks and institutions are perennial lenders. This leaves the primary dealers
to do the trading. But their limited funds do not enable them to become large players.
This gives rise to uni-directional players who are averse to two-way quotes. This deters
the development of a benchmark around which a term market can evolve.
Derivatives – Indian Scenario - 31 -
Right now, whatever trading is done is through the fixed rate. For IRS to happen there
should be swaps in maturities. A benchmarking has to be done and for that we need a
correct reference rate, which will have to evolve beyond the overnight rate (MIBOR).
That can happen only if a term money market is in place.
In India fixed rates are aplenty with banks and institutions borrowing and lending at fixed
rates. They also adopt floating rates (Prime Lending Rate or PLR) while lending. But the
PLR has two crucial deficiencies compared to rates like LIBOR: PLR is not a market
related rate, but determined, somewhat arbitrarily, on the basis of the bank rate. Besides
there are no two-way quotes in PLR, in the absence of which swap deals virtually become
infructuous. Rates like LIBOR, Fed Funds Rate/ T.Bill Rate are those at which banks are
prepared to lend and borrow in any currency.
In India too, such a market does exist for the rupee- the call money market. Banks
borrow/lend at market determined rates. But where the Indian money market differs from
other major financial centers is that, in the latter money is available for periods ranging
from 1 or 7 days to 3, 6 and 12 months, whereas in India, rupee is available for a day or
two, up to a maximum period of 13 days, as a general rule. The reason being the
fortnightly reserve requirements.
Another deficiency is the lack of integration with the foreign exchange (FX) markets. In
order to protect and control the exchange rate of the rupee, strong silos have been created.
Forward premium between the rupee and another foreign currency does not reflect the
interest rate differential. If anything, it reflects the estimated risk of depreciation of the
local unit against the dollar. This gives rise to significant arbitrage opportunities between
the two markets, which are protected through the RBI diktat. At present, the tenors
available in the IRS market are short and the benchmark limited to only one, the Mumbai
Inter-bank Offer Rate (MIBOR).
3.9 Some swaps in near future9
March 10 2001
9 Source: www.economictimes.com
Derivatives – Indian Scenario - 32 -
ICICI inks 5-year rupee IRS with Citibank
ICICI has entered into a five-year rupee interest rate swap with Citibank. This is the
fourth long-term swap deal in the IRS market during the fortnight.
The ICICI-Citibank swap deal has a notional amount of Rs 50 crore. The fixed portion of
the swap is based on the yield on the four-year government security, while the floating
rate is based on the one-year G-sec yield. “The floating rate will be reset on an annual
basis, for which five securities have been identified to provide a perfect residual
maturity,” said an ICICI official.
11 MAY 2001
Vysya Bank, L&T in Rs 10-cr overnight index swap deal
VYSYA Bank and Larsen & Toubro have entered into an overnight index swap (OIS)
transaction for Rs 10 crore. The one-year swap has Vysya Bank paying 8.75 per cent
against the compounded NSE Mibor to L&T. The deal, brokered by eMecklai, was done
over the internet. The verification of the swap differences will be carried out quarterly
with settlement at maturity.
17 FEBRUARY Jet swaps $340-m floating loan with Credit LyonnaisGeorge Cherian
CREDIT Lyonnais and Jet Airways have concluded the largest interest rate swap in the
country. A total of $340m of the air tax operator’s outstanding foreign currency floating
rate loans has been swapped to fixed/ floating via a structured interest rate swap spread
over four years.
It will insulate Jet Airways against rising interest rates. It will also give Jet Airways the
opportunity to take advantage of falling interest rates in later years. The swap, which has
been executed in two tranches of $200m and $140m, is the largest ever derivatives
transaction in the domestic market
4.0 Forward contracts & Futures & OptionsA forward contract is an agreement to buy or sell an asset on a specified date for a
specified price. One of the parties to the contract assumes a long position and agrees to
buy the underlying asset on a certain specified future date for a certain specified price.
The other party assumes a short position and agrees to sell the asset on the same date for
Derivatives – Indian Scenario - 33 -
the same price. Other contract details like delivery date, price and quantity are negotiated
bilaterally by the parties to the contract. The forward contracts are normally traded
outside the exchanges.
The salient features of forward contracts are:
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.
If the party wishes to reverse the contract, it has to compulsorily go to the same
counter-party, which often results in high prices being charged.
However forward contracts in certain markets have become very standardized, as in the
case of foreign exchange, thereby reducing transaction costs and increasing transactions
volume. This process of standardization reaches its limit in the organized futures market.
Forward contracts are very useful in hedging and speculation. The classic hedging
application would be that of an exporter who expects to receive payment in dollars three
months later. He is exposed to the risk of exchange rate fluctuations. By using the
currency forward market to sell dollars forward, he can lock on to a rate today and reduce
his uncertainty. Similarly an importer who is required to make a payment in dollars two
months hence can reduce his exposure to exchange rate fluctuations by buying dollars
forward.
If a speculator has information or analysis, which forecasts an upturn in a price, then he
can go long on the forward market instead of the cash market. The speculator would go
long on the forward, wait for the price to rise, and then take a reversing transaction to
book profits. Speculators may well be required to deposit a margin upfront. However, this
is generally a relatively small proportion of the value of the assets underlying the forward
contract. The use of forward markets here supplies leverage to the speculator.
4.1 Limitations of forward markets
Derivatives – Indian Scenario - 34 -
Forward markets world-wide are afflicted by several problems:
Lack of centralization of trading
Illiquidity, and Counter party risk
In the first two of these, the basic problem is that of too much flexibility and generality.
The forward market is like a real estate market in that any two consenting adults can form
contracts against each other. This often makes them design terms of the deal, which are
very convenient in that specific situation, but makes the contracts non-tradable.
Counterparty risk arises from the possibility of default by any one party to the
transaction. When one of the two sides to the transaction declares bankruptcy, the other
suffers. Even when for-ward markets trade standardized contracts, and hence avoid the
problem of illiquidity, still the counterparty risk remains a very serious issue.
4.2 Introduction to futures
Futures markets were designed to solve the problems that exist in forward markets. 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. 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 of such 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.
The standardized items in a futures contract are: -
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
Derivatives – Indian Scenario - 35 -
4.3 Distinction between futures and forwards contracts
Forward contracts are often confused with futures contracts. The confusion is primarily
because both serve essentially the same economic functions of allocating risk in the
presence of future price uncertainty. However futures are a significant improvement over
the forward contracts as they eliminate counter party risk and offer more liquidity. Table
3.1 lists the distinction between the two.
Table 4.1 Distinction between futures and forwards 10
4.4 Futures Terminology
Spot price: The price at which an asset trades in the spot market.
Futures price: The price at which the futures contract trades in the futures market.
Contract cycle: The period over which a contract trades. The index futures contracts
on the NSE have one-month, two-months and three-months expiry cycles, which
expire on the last Thursday of the month. Thus a January expiration contract expires
on the last Thursday of January and a February expiration contract ceases trading on
the last Thursday of February. On the Friday following the last Thursday, a new
contract having a three-month expiry is introduced for trading.
Expiry date: It is the date specified in the futures contract. This is the last day on
which the contract will be traded, at the end of which it will cease to exist.
Contract size: The amount of asset that has to be delivered under one contract. For
in-stance, the contract size on NSE’s futures market is 200 Nifties.
Basis: In the context of financial futures, basis can be defined as the futures price
minus the spot price. There will be a different basis for each delivery month for each
10 Source: Derivatives in India FAQ’s by Ajay Shah & Susan Thomas
contract. In a normal market, basis will be positive. This reflects that futures prices
normally exceed spot prices.
Cost of carry: The relationship between futures prices and spot prices can be
summarized in terms of what is known as the cost of carry. This measures the storage
cost plus the interest that is paid to finance the asset less the income earned on the
asset.
Initial margin: The amount that must be deposited in the margin account at the time
a futures contract is first entered into is known as initial margin.
Marking-to-market: In the futures market, at the end of each trading day, the margin
ac-count is adjusted to reflect the investor’s gain or loss depending upon the futures
closing price. This is called marking–to–market.
Maintenance margin: This is somewhat lower than the initial 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 receives a
margin call and is expected to top up the margin account to the initial margin level
before trading commences on the next day.
4.5 Introduction to options
In this section, we look at the next derivative product to be 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.
4.5.1 History of options
Although options have existed for a long time, they were traded OTC, without much
knowledge of valuation. Today exchange-traded options are actively traded on stocks,
stock indexes, foreign currencies and futures contracts. The first trading in options began
Derivatives – Indian Scenario - 37 -
in Europe and the US as early as the eighteenth century. It was only in the early 1900s
that a group of firms set up what was known as the put and call Brokers and Dealers
Association with the aim of providing a mechanism for bringing buyers and sellers
together. If someone wanted to buy an option, he or she would contact one of the member
firms.
The firm would then attempt to find a seller or writer of the option either from its own
clients or those of other member firms. If no seller could be found, the firm would
undertake to write the option itself in return for a price. This market however suffered
from two deficiencies. First, there was no secondary market and second, there was no
mechanism to guarantee that the writer of the option would honor the contract. It was in
1973, that Black, Merton and Scholes invented the famed Black Scholes formula. In
April 1973, CBOE was set up specifically for the purpose of trading options. The market
for options developed so rapidly that by early ’80s, the number of shares underlying the
option contract sold each day exceeded the daily volume of shares traded on the NYSE.
Since then, there has been no looking back.
4.6 Option Terminology
Index options: These options have the index as the underlying. Some options are
European while others are American. Like index futures contracts, index options
contracts are also cash settled.
Stock options: Stock options are options on individual stocks. Options currently
trade on over 500 stocks in the United States. A contract gives the holder the right to
buy or sell shares at the specified price.
Buyer of an option: The buyer of an option is the one who by paying the option
premium buys the right but not the obligation to exercise his option on the
seller/writer.
Writer of an option: The writer of a call/put option is the one who receives the
option premium and is thereby obliged to sell/buy the asset if the buyer exercises on
him. There are two basic types of options, call options and put options. Call option: A
call option gives the holder the right but not the obligation to buy an asset by a certain
Derivatives – Indian Scenario - 38 -
date for a certain price. Put option: A put option gives the holder the right but not the
obligation to sell an asset by a certain date for a certain price.
Option price: Option price is the price which the option buyer pays to the option
seller.
Expiration date: The date specified in the options contract is known as the
expiration date, the exercise date, the strike date or the maturity.
Strike price: The price specified in the options contract is known as the strike price
or the exercise price.
American options: American options are options that can be exercised at any time
upto the expiration date. Most exchange-traded options are American.
European options: European options are options that can be exercised only on the
expiration date itself. European options are easier to analyze than American options,
and properties of an American option are frequently deduced from those of its
European counterpart.
In-the-money option: An in-the-money (ITM) option is an option that would lead to
a positive cashflow to the holder if it were exercised immediately. A call option on
the index is said to be in-the-money when the current index stands at a level higher
than the strike price (i.e. spot price > strike price). If the index is much higher than the
strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the
index is below the strike price.
At-the-money option: An at-the-money (ATM) option is an option that would lead
to zero cashflow if it were exercised immediately. An option on the index is at-the-
money when the current index equals the strike price (i.e. spot price = strike price)._
Out-of-the-money option: An out-of-the-money (OTM) option is an option that
would lead to a negative cashflow it it were exercised immediately. A call option on
the index is out-of- the-money when the current index stands at a level which is less
than the strike price (i.e. spot price < strike price). If the index is much lower than the
strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if
the index is above the strike price.
Intrinsic value of an option: The option premium can be broken down into two
components - intrinsic value and time value. The intrinsic value of a call is the
amount the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero.
Derivatives – Indian Scenario - 39 -
Putting it another way, the intrinsic value of a call isN½P which means the intrinsic
value of a call is Max [0, (St – K)] which means the intrinsic value of a call is the (St –
K). Similarly, the intrinsic value of a put is Max [0, (K -St )] ,i.e. the greater of 0 or
(K - St ). K is the strike price and St is the spot price.
Time value of an option: The time value of an option is the difference between its
premium and its intrinsic value. A call that is OTM or ATM has only time value.
Usually, the maximum time value exists when the option is ATM. The longer the
time to expiration, the greater is a call’s time value, all else equal. At expiration, a call
should have no time value. 11
Table 4.2 Distinction between futures and options
Futures Options
Exchange traded, with novation Same as futures.
Exchange defines the product Same as futures.
Price is zero, strike price moves Strike price is fixed, price moves.
Price is zero Price is always positive.
Linear payoff Nonlinear payoff.
Both long and short at risk Only short at risk.
4.7 Futures and options
An interesting question to ask at this stage is - when would one use options instead of
futures? Options are different from futures in several interesting senses.
At a practical level, the option buyer faces an interesting situation. He pays for the option
in full at the time it is purchased. After this, he only has an upside. There is no possibility
of the options position generating any further losses to him (other than the funds already
paid for the option). This is different from futures, which is free to enter into, but can
11 Source: www.derivativesindia.com
Derivatives – Indian Scenario - 40 -
generate very large losses. This characteristic makes options attractive to many
occasional market participants, who cannot put in the time to closely monitor their futures
positions.
Buying put options is buying insurance. To buy a put option on Nifty is to buy insurance,
which reimburses the full extent to which Nifty drops below the strike price of the put
option. This is attractive to many people, and to mutual funds creating “guaranteed return
products”. The Nifty index fund industry will find it very useful to make a bundle of a
Nifty index fund and a Nifty put option to create a new kind of a Nifty index fund, which
gives the investor protection against extreme drops in Nifty.
4.8 Index derivatives
Index derivatives are derivative contracts, which derive their value from an underlying
index. The two most popular index derivatives are index futures and index options. Index
derivatives have become very popular worldwide. In his report, Dr.L.C.Gupta attributes
the popularity of index derivatives to the advantages they offer.
Institutional and large equity-holders need portfolio-hedging facility. Index–
derivatives are more suited to them and more cost–effective than derivatives based on
individual stocks. Pension funds in the US are known to use stock index futures for
risk hedging purposes.
Index derivatives offer ease of use for hedging any portfolio irrespective of its
composition.
Stock index is difficult to manipulate as compared to individual stock prices, more so
in India, and the possibility of cornering is reduced. This is partly because an
individual stock has a limited supply, which can be cornered.
Stock index, being an average, is much less volatile than individual stock prices. This
implies much lower capital adequacy and margin requirements.
Index derivatives are cash settled, and hence do not suffer from settlement delays and
problems related to bad delivery, forged/fake certificates.
Derivatives – Indian Scenario - 41 -
The L.C.Gupta committee which was setup for developing a regulatory framework for
derivatives trading in India had suggested a phased introduction of derivative products in
the following order:
1. Index futures
2. Index options
3. Options on individual stocks
With all the above infrastructure in place, trading of index futures and index options
commenced at NSE in June 2000 and June 2001 respectively.
5.0 Payoff & Pricing of Futures and
OptionsA payoff is the likely profit/loss that would accrue to a market participant with change in
the price of the underlying asset. This is generally depicted in the form of payoff
diagrams which show the price of the underlying asset on the X–axis and the
profits/losses on the Y–axis. In this section we shall take a look at the payoffs for buyers
and sellers of futures and options.
5.1 Payoff for futures
Futures contracts have linear payoffs. In simple words, it means that the losses as well as
profits for the buyer and the seller of a futures contract are unlimited.
These linear payoffs are fascinating as they can be combined with options and the
underlying to generate various complex payoffs.
5.1.1 Payoff for buyer of futures: Long futures
The payoff for a person who buys a futures contract is similar to the payoff for a person
who holds an asset. He has a potentially unlimited upside as well as a potentially
unlimited downside.
Take the case of a speculator who buys a two-month Nifty index futures contract when
the Nifty stands at 1220. The underlying asset in this case is the Nifty portfolio. When the
Derivatives – Indian Scenario - 42 -
index moves up, the long futures position starts making profits, and when the index
moves down it starts making losses. Figure 5.1 shows the payoff diagram for the buyer of
a futures contract.
5.1.2 Payoff for seller of futures: Short futures
The payoff for a person who sells a futures contract is similar to the payoff for a person
who shorts an asset. He has a potentially unlimited upside as well as a potentially
unlimited downside. Take the case of a speculator who sells a two-month Nifty index
futures contract when the Nifty stands at 1220. The underlying asset in this case is the
Nifty portfolio. When the index moves down, the short futures position starts making
profits, and when the index moves up, it starts making losses. Figure 5.2 shows the
payoff diagram for the seller of a futures contract.
Figure 5.1 Payoff for a buyer of Nifty futures
The figure shows the profits/losses for a long futures position. The investor bought futures when the index was at 1220. If the index goes up, his futures position starts making profit. If the index falls, his futures position starts showing losses.
Profit
1220 0 Nifty
Loss
Figure 5.2 Payoff for a seller of Nifty futures
The figure shows the profits/losses for a short futures position. The investor sold futures when the index was at 1220. If the index goes down, his futures position starts making profit. If the index rises, his futures position starts showing losses.
Profit
1220 0 Nifty
Derivatives – Indian Scenario - 43 -
Loss
5.2 Options payoffs
The optionality characteristic of options results in a non-linear payoff for options. In
simple words, it means that the losses for the buyer of an option are limited, however the
profits are potentially unlimited. For a writer, the payoff is exactly the opposite. His
profits are limited to the option premium, however his losses are potentially unlimited.
These non-linear payoffs are fascinating as they lend themselves to be used to generate
various payoffs by using combinations of options and the underlying. We look here at the
six basic payoffs.
5.2.1 Payoff profile of buyer of asset: Long asset
In this basic position, an investor buys the underlying asset, Nifty for instance, for 1220,
and sells it at a future date at an unknown price,S4 it is purchased, the investor is said to
be “long” the asset. Figure 5.3 shows the payoff for a long position on the Nifty.12
Figure 5.3 Payoff for investor who went Long Nifty at 1220
The figure shows the profits/losses from a long position on the index. The investor bought the index at 1220. If the index goes up, he profits. If the index falls he looses.
Profit +60
0 1160 1220 1280 Nifty
-60
Loss
5.2.2 Payoff profile for seller of asset: Short asset
12 Source: NSE Derivatives Core Module
Derivatives – Indian Scenario - 44 -
In this basic position, an investor shorts the underlying asset, Nifty for instance, for 1220,
and buys it back at a future date at an unknown price S4 Once it is sold, the investor is
said to be “short” the asset. Figure 5.4 shows the payoff for a short position on the Nifty.
Figure 5.4 Payoff for investor who went Short Nifty at 1220
The figure shows the profits/losses from a short position on the index. The investor sold the index at 1220. If the index falls, he profits. If the index rises, he looses.
Profit
+60
0 1160 1220 1280 Nifty
-60
Loss
5.2.3 Payoff profile for buyer of call options: Long call
A call option gives the buyer the right to buy the underlying asset at the strike price
specified in the option. The profit/loss that the buyer makes on the option depends on the
spot price of the underlying. If upon expiration, the spot price exceeds the strike price, he
makes a profit. Higher the spot price, more is the profit he makes. If the spot price of the
underlying is less than the strike price, he lets his option expire un-exercised. His loss in
this case is the premium he paid for buying the option. Figure 5.5 gives the payoff for the
buyer of a three month call option (often referred to as long call) with a strike of 1250
bought at a premium of 86.60.
5.2.4 Payoff profile for writer of call options: Short call
A call option gives the buyer the right to buy the underlying asset at the strike price
specified in the option. For selling the option, the writer of the option charges a premium.
The profit/loss that the buyer makes on the option depends on the spot price of the
underlying. Whatever is the buyer’s profit is the seller’s loss. If upon expiration, the spot
Derivatives – Indian Scenario - 45 -
price exceeds the strike price, the buyer will exercise the option on the writer. Hence as
the spot price increases the writer of the option starts making losses. Higher the spot
price, more is the loss he makes. If upon expiration the spot price of the underlying is less
than the strike price, the buyer lets his option expire un-exercised and the writer gets to
keep the premium. Figure 5.6 gives the payoff for the writer of a three month call option
(often referred to as short call) with a strike of 1250 sold at a premium of 86.60.
Figure 5.5 Payoff for buyer of call option
The figure shows the profits/losses for the buyer of a three-month Nifty 1250 call option. As can be seen, as the spot Nifty rises, the call option is in-the-money. If upon expiration, Nifty closes above the strike of 1250, the buyer would exercise his option and profit to the extent of the difference between the Nifty-close and the strike price. The profits possible on this option are potentially unlimited. However if Nifty falls below the strike of 1250, he lets the option expire. His losses are limited to the extent of the premium he paid for buying the option.
Profit
1250 0 Nifty
86.60
Loss
Figure 5.6 Payoff for writer of call option
The figure shows the profits/losses for the seller of a three-month Nifty 1250 call option. As the spot Nifty rises, the call option is in-the-money and the writer starts making losses. If upon expiration, Nifty closes above the strike of 1250, the buyer would exercise his option on the writer who would suffer a loss to the extent of the difference between the Nifty-close and the strike price. The loss that can be incurred by the writer of the option is potentially unlimited, whereas the maximum profit is limited to the extent of the up-front option premium of Rs.86.60 charged by him.
Profit
86.60 1250 0 Nifty
Derivatives – Indian Scenario - 46 -
Loss
5.2.5 Payoff profile for buyer of put options: Long put
A put option gives the buyer the right to sell the underlying asset at the strike price
specified in the option. The profit/loss that the buyer makes on the option depends on the
spot price of the underlying. If upon expiration, the spot price is below the strike price, he
makes a profit. Lower the spot price, more is the profit he makes. If the spot price of the
underlying is higher than the strike price, he lets his option expire un-exercised. His loss
in this case is the premium he paid for buying the option. Figure 5.7 gives the payoff for
the buyer of a three month put option (often referred to as long put) with a strike of 1250
bought at a premium of 61.70.
Figure 5.7 Payoff for buyer of put option
The figure shows the profits/losses for the buyer of a three-month Nifty 1250 put option. As can be seen, as the spot Nifty falls, the put option is in-the-money. If upon expiration, Nifty closes below the strike of 1250, the buyer would exercise his option and profit to the extent of the difference between the strike price and Nifty-close. The profits possible on this option can be as high as the strike price. However if Nifty rises above the strike of 1250, he lets the option expire. His losses are limited to the extent of the premium he paid for buying the option.
Profit
1250 0 Nifty61.70
Loss
5.2.6 Payoff profile for writer of put options: Short put
Derivatives – Indian Scenario - 47 -
A put option gives the buyer the right to sell the underlying asset at the strike price
specified in the option. For selling the option, the writer of the option charges a premium.
The profit/loss that the buyer makes on the option depends on the spot price of the
underlying. Whatever is the buyer’s profit is the seller’s loss. If upon expiration, the spot
price happens to be below the strike price, the buyer will exercise the option on the
writer. If upon expiration the spot price of the underlying is more than the strike price, the
buyer lets his option expire un-exercised and the writer gets to keep the premium. Figure
5.8 gives the payoff for the writer of a three-month put option (often referred to as short
put) with a strike of 1250 sold at a premium of 61.70.
Figure 5.8 Payoff for writer of put optionThe figure shows the profits/losses for the seller of a three-month Nifty 1250 put option. As the spot Nifty falls, the put option is in-the-money and the writer starts making losses . If upon expiration, Nifty closes below the strike of 1250, the buyer would exercise his option on the writer who would suffer a loss to the extent of the difference between the strike price and Nifty-close. The loss that can be incurred by the writer of the option is a maximum extent of the strike price(Since the worst that can happen is that the asset price can fall to zero) whereas the maximum profit is limited to the extent of the up-front option premium of Rs.61.70 charged by him.
Profit
61.70 1250 0 Nifty
Loss
5.3 Pricing Index FuturesStock index futures began trading on NSE on the 12th June 2000. Ever since, the
volumes and open interest has been steadily growing. Looking at the futures prices on
NSE’s market, have you ever felt the need to know whether the quoted prices are a true
reflection of the underlying index’s price? Have you wondered whether you could make
risk-less profits by arbitraging between the underlying and futures markets? If so, you
Derivatives – Indian Scenario - 48 -
need to know the cost-of-carry to understand the dynamics of pricing that constitute the
estimation of fair value of futures.
5.3.1 The cost of carry model
We use fair value calculation of futures to decide the no-arbitrage limits on the price of a
futures contract. This is the basis for the cost-of-carry model where the price of the
contract is defined as:
F=S+C
Where:
F: Futures price
S: Spot price
C: Holding costs or carry costs
This can also be expressed as:
F=s (1+r) T
Where:
r: Cost of financing
T: Time till expiration
If F < s (1+r) T or F > s (1+r) T, arbitrage opportunities would exist i.e. whenever the
futures price moves away from the fair value, there would be chances for arbitrage. We
know what the spot and future prices are, but what are the components of holding cost?
The components of holding cost vary with contracts on different assets. At times the
holding cost may even be negative. In the case of commodity futures, the holding cost is
the cost of financing plus cost of storage and insurance purchased etc. In the case of
equity futures, the holding cost is the cost of financing minus the dividends returns.
Note: In the futures pricing examples worked out in this book, we are using the concept
of discrete compounding, where interest rates are compounded at discrete intervals, for
example, annually or semiannually. Pricing of options and other complex derivative
securities requires the use of continuously compounded interest rates. Most books on
derivatives use continuous compounding for pricing futures too. However, we have used
Derivatives – Indian Scenario - 49 -
discrete compounding as it is more intuitive and simpler to work with. Had we to use the
concept of continuous compounding, the above equation would have been expressed as:
F= Se rT
Where:
r: Cost of financing (using continuously compounded interest rate)
T: Time till expiration
e: 2.71828
5.3.2 Pricing futures contracts on commodities
Let us take an example of a futures contract on a commodity and work out the price of
the contract. The spot price of silver is Rs.7000/kg. If the cost of financing is 15%
annually, what should be the futures price of 100 gms of silver one month down the line ?
Let us assume that we’re on 1st January 2001. How would we compute the price of a
silver futures contract expiring on 30th January? From the discussion above we know that
the futures price is nothing but the spot price plus the cost-of-carry. Let us first try to
work out the components of the cost-of-carry model.
1. What is the spot price of silver? The spot price of silver, S= Rs.7000/kg.
2. What is the cost of financing for a month? (1+0.15) 30/365
3. What are the holding costs? Let us assume that the storage cost = 0.
In this case the fair value of the futures price, works out to be = Rs.708.
F=s (1+r) T + C = 700(1.15) 30/365 =Rs. 708
If the contract was for 3 month period i.e. expiring 30th March the cost of financing would
increase the futures price. Therefore, the futures price would be C = 700(1.15) 90/365 =
Rs.724.5. On the other hand, if the one-month contract was for 10,000 kg. Of silver
instead of 100 gms, then it would involve a non-zero storage cost, and the price of the
future contract would be Rs. 708 +the cost of storage.
5.3.3 Pricing futures contracts on equity index
A futures contract on the stock market index gives its owner the right and obligation to
buy or sell the portfolio of stocks characterized by the index. Stock index futures are cash
settled; there is no delivery of the underlying stocks.
Derivatives – Indian Scenario - 50 -
In their short history of trading, index futures have had a great impact on the world’s
securities markets. Indeed, index futures trading has been accused of making the world’s
stock markets more volatile than ever before. The critics claim that individual investors
have been driven out to the equity markets because the actions of institutional traders in
both the spot and futures markets cause stock values to gyrate with no links to their
fundamental values. Whether stock index futures trading is a blessing or a curse is
debatable. It is certainly true, however, that its existence has revolutionized the art and
science of institutional equity portfolio management.
The main differences between commodity and equity index futures are that: _
There are no costs of storage involved in holding equity.
Equity comes with a dividend stream, which is a negative cost if you are long the
stock and a positive cost if you are short the stock.
Therefore, Cost of carry = Financing cost - Dividends
Thus, a crucial aspect of dealing with equity futures as opposed to commodity futures is
an accurate forecasting of dividends. The better the forecast of dividend offered by a
security, the better is the estimate of the futures price.
5.3.4 Pricing index futures given expected dividend amount
The pricing of index futures is also based on the cost-of-carry model, where the carrying
cost is the cost of financing the purchase of the portfolio underlying the index, minus the
present value of dividends obtained from the stocks in the index portfolio.
Example
Nifty futures trade on NSE as one,two and three-month contracts. What will be the price
of a new two-month futures contract on Nifty?
1. Let us assume that M & M will be declaring a dividend of Rs. 10 per share after 15
days of purchasing the contract.
2. Current value of Nifty is 1200 and Nifty trades with a multiplier of 200.
3. Since Nifty is traded in multiples of 200, value of the contract is 200*1200 =
Rs.240,000.
Derivatives – Indian Scenario - 51 -
4. If M & M has a weight of 7% in Nifty, its value in Nifty is Rs.16,800 i.e.(240,000 *
0.07).
5. If the market price of M & M is Rs.140, then a traded unit of Nifty involves 120 shares
of M & M i.e.(16,800/140).
6. To calculate the futures price, we need to reduce the cost-of-carry to the extent of
dividend received. The amount of dividend received is Rs.1200 i.e.(120 * 10). The
dividend is received 15 days later and hence compounded only for the remainder of 45
days. To calculate the futures price we need to compute the amount of dividend received
per unit of Nifty. Hence we divide the compounded dividend figure by 200.
Do you sometimes think that the market index is going to rise? That you could make a
profit by adopting a position on the index? How does one implement a trading strategy to
benefit from an upward movement in the index? Today, using options you have two
choices:
Derivatives – Indian Scenario - 75 -
1. Buy call options on the index; or,
2. Sell put options on the index
We have already seen the payoff of a call option. The downside to the buyer of the call
option is limited to the option premium he pays for buying the option. His upside
however is potentially unlimited.
Having decided to buy a call, which one should you buy? Table 7.1 gives the premia for
one-month calls and puts with different strikes. Given that there are a number of one–
month calls trading, each with a different strike price, the obvious question is: which
strike should you choose? Let us take a look at call options with different strike prices.
Assume that the current index level is 1250, risk-free rate is 12% per year and index
volatility is 30%. The following options are available:
1. A one month call on the Nifty with a strike of 1200.
2. A one month call on the Nifty with a strike of 1225.
3. A one month call on the Nifty with a strike of 1250.
4. A one month call on the Nifty with a strike of 1275.
5. A one month call on the Nifty with a strike of 1300.
Which of these options you choose largely depends on how strongly you feel about the
likelihood of the upward movement in the market index, and how much you are willing
to lose should this upward movement not come about. There are five one–month calls
and five one–month puts trading in the market.
Table 7.1 One-month calls and puts trading at different strikes
The spot Nifty level is 1250. There are five one-month calls and five one-month puts
trading in the market. Figure 7.1 shows the payoffs from buying calls at different strikes.
Figure 7.2 shows the payoffs from writing puts at different strikes.
Nifty Strike price of option Call Premium (Rs.) Put Premium (Rs.)
1250 1200 80.10 18.15
1250 1225 63.65 26.50
1250 1250 49.45 37.00
Derivatives – Indian Scenario - 76 -
1250 1275 37.50 49.80
1250 1300 27.50 64.80
As a person who wants to speculate on the hunch that the market index may rise, you can
also do so by selling or writing puts. As the writer of puts, you face a limited upside and
an unlimited downside.
Having decided to write a put, which one should you write? Given that there are a
number of one-month puts trading, each with a different strike price, the obvious question
is: which strike should you choose ? This largely depends on how strongly you feel about
the likelihood of the upward movement in the market index. In the example in Figure 7.2,
at a Nifty level of 1250, one option is in–the–money and one is out–of–the–money. As
expected, the in–the–money option fetches the highest premium of Rs.64.80 whereas the
out–of–the–money option has the lowest premium of Rs.18.15.
Figure 7.1 Payoff for buyer of call options at various strikesThe figure shows the profits/losses for a buyer of Nifty calls at various strikes. The in–the–money option with a strike of 1200 has the highest premium of Rs.80.10 whereas the out–of–the–money option with a strike of 1300 has the lowest premium of Rs.27.50.
Figure 7.2 Payoff for writer of put options at various strikesThe figure shows the profits/losses for a writer of Nifty puts at various strikes. The in–the–money option with a strike of 1300 fetches the highest premium of Rs.64.80 whereas the out–of–the–money option with a strike of 1200 has the lowest premium of Rs.18.15.
Do you sometimes think that the market index is going to drop? That you could make a
profit by adopting a position on the index? How does one implement a trading strategy to
benefit from a downward movement in the index? Today, using options, you have two
choices:
1. Sell call options on the index; or,
2. Buy put options on the index
We have already seen the payoff of a call option. The upside to the writer of the call
option is limited to the option premium he receives upright for writing the option. His
downside however is potentially unlimited. Having decided to write a call, which one
should you write? Table 7.2 gives the premiums for one month calls and puts with
different strikes. Given that there are a number of one-month calls trading, each with a
different strike price, the obvious question is: which strike should you choose ? Let us
take a look at call options with different strike prices. Assume that the current index level
is 1250, risk-free rate is 12% per year and index volatility is 30%. You could write the
following options :
1. A one month call on the Nifty with a strike of 1200.
Derivatives – Indian Scenario - 78 -
2. A one month call on the Nifty with a strike of 1225.
3. A one month call on the Nifty with a strike of 1250.
4. A one month call on the Nifty with a strike of 1275.
5. A one month call on the Nifty with a strike of 1300.
Which of this options you write largely depends on how strongly you feel about the
likelihood of the downward movement in the market index and how much you are willing
to lose should this downward movement not come about.
Table 7.2 One month calls and puts trading at different strikes
The spot Nifty level is 1250. There are five one-month calls and five one-
month puts trading in the market. Figure 7.3 shows payoff for seller of
various calls at different strikes. Figure 7.4 shows the payoffs from buying
puts at different strikes.
Nifty Strike price of option Call Premium (Rs.) Put Premium (Rs.)
1250 1200 80.10 18.15
1250 1225 63.65 26.50
1250 1250 49.45 37.00
1250 1275 37.50 49.80
1250 1300 27.50 64.80
As a person who wants to speculate on the hunch that the market index may fall, you can
also buy puts. As the buyer of puts you face an unlimited upside but a limited downside.
If the index does fall, you profit to the extent the index falls below the strike of the put
purchased by you. Having decided to buy a put, which one should you buy? Given that
there are a number of one-month puts trading, each with a different strike price, the
obvious question is: which strike should you choose? This largely depends on how
strongly you feel about the likelihood of the downward movement in the market index.
Figure 7.3 Payoff for seller of call option at various strikes
The figure shows the profits/losses for a seller of Nifty calls at various strike prices. The in–the–money option has the highest premium of Rs.80.10 whereas the at–the–money option has the lowest premium of Rs.27.50.
Derivatives – Indian Scenario - 79 -
Profit 80.10
1327.5 49.45
27.50
1200 1250 1300 Nifty
Loss 1280.10 1299.45
Figure 7.4 Payoff for buyer of put options at various strikes
The figure shows the profits/losses for a buyer of Nifty puts at various strike prices. The in–the–money option has the highest premium of Rs.64.80 whereas the at–the–money option has the lowest premium of Rs.18.50.
7.4 S5: Anticipate volatility; buy a call and a put
Do you sometimes think that the market index is going to go through large swings in a
given period, but have no opinion on the direction of the swing? This strategy is useful in
times of uncertainty (e.g. recently during the WTC attacks). How does one implement a
Derivatives – Indian Scenario - 80 -
trading strategy to benefit from market volatility? Combinations of call and put options
provide an excellent way to trade on volatility. Here is what you would have to do:
1. Buy call options on the index at a strike K and maturity T, and
2. Buy put options on the index at the same strike K and of maturity T.
This combination of options is often referred to as a Straddle and is an appropriate
strategy for an investor who expects a large move in the index but does not know in
which direction the move will be.
Consider an investor who feels that the index which currently stands at 1252 could move
significantly in three months. The investor could create a straddle by buying both a put
and a call with a strike close to 1252 and an expiration date in three months. Suppose a
three month call at a strike of 1250 costs Rs.95.00 and a three month put at the same
strike cost Rs.57.00. To enter into this positions, the investor faces a cost of Rs.152.00. If
at the end of three months, the index remains at 1252, the strategy costs the investor
Rs.150. (An up-front payment of Rs.152, the put expires worthless and the call expires
worth Rs.2). If at expiration the index settles around 1252, the investor incurs losses.
However, if as expected by the investors, the index jumps or falls significantly, he profits.
For a straddle to be an effective strategy, the investor’s beliefs about the market
movement must be different from those of most other market participants. If the general
view is that there will be a large jump in the index, this will reflect in the prices of the
options.
Figure 7.5 Payoff for buyer of three-month call and put options at strikes of 1250
The figure shows the profits/losses for a combination of a long call and a long put at the same strike and expiration. The investor has bought both a call and a put on the Nifty index. If on the expiration date, the index closes between 1098 and 1402, he losses a maximum of Rs.152. If however, his expectation of high volatility does come true, his profits are potentially unlimited. If for instance the index jumps to 1420, he makes a neat profit of Rs.18 i.e. (1420-1250)-152. The effectiveness of this combination depends how different is the investors belief about market movement from that of most other participants. The higher the cost of setting up this combination, the more the index would have to move for it to be profitable.
Derivatives – Indian Scenario - 81 -
Profit
1098 1193 1250 1345 1402 | | | | |
57.00
95.00
152.00
Loss
Table 7.3 Three-month calls and puts trading at different strikes
Given below are the three-month call and put option premia on the S&P CNX Nifty. An
investor who decides to play on the volatility of the market must decide at what strike to
generate the straddle. In this case he has three three-month option contracts to choose
from.
Nifty Strike price of option Call Premium (Rs.) Put Premium (Rs.)
1248 1250 48 38.30
1248 1245 50.65 35.95
1248 1230 59.05 29.50
7.5 S6: Bull spreads - Buy a call and sell another
There are times when you think the market is going to rise over the next two months,
however in the event that the market does not rise, you would like to limit your downside.
Derivatives – Indian Scenario - 82 -
One way you could do this is by entering into a spread. A spread trading strategy
involves taking a position in two or more options of the same type, that is, two or more
calls or two or more puts. A spread that is designed to profit if the price goes up is called
a bull spread.
The cost of the bull spread is the cost of the option that is purchased, less the cost of the
option that is sold. Table 7.4 gives the profit/loss incurred on a spread position as the
index changes.
Figure 7.6 shows the payoff from the bull spread.
Broadly, we can have three types of bull spreads:
1. Both calls initially out-of-the-money,
2. One call initially in-the-money and one call initially out-of-the-money, and
3. Both calls initially in-the-money.
The decision about which of the three spreads to undertake depends upon how much risk
the investor is willing to take. The most aggressive bull spreads are of type 1. They cost
very little to set up, but have a very small probability of giving a high payoff.
Table 7.4 Expiration day cash flows for a Bull spread using two-month calls
The table shows possible expiration day profit for a bull spread created by buying one market lot of calls at a strike of 1260 and selling a market lot of calls at a strike of 1350. The cost of setting up the spread is the call premium paid (Rs.76.50) minus the call premium received (Rs.37.85), which is Rs.38.65. This is the maximum loss that the position will make. On the other hand, the maximum profit on the spread is limited to Rs.51.35. Beyond an index level of 1350, any profits made on the long call position will be cancelled by losses made on the short call position, effectively limiting the profit on the combination.
Figure 7.6 Payoff for a bull spread created using call options
The figure shows the profits/losses for a bull spread.As the index moves above 1260, the position starts making profits (cutting losses) until the spot reaches 1350. Beyond 1350, the profits made on the long call position get offset by the losses made on the short call position and hence the maximum profit on this spread is made if the index on the expiration day closes at 1350. Hence the payoff on this spread lies between 38.85 to 51.35.
Profit
51.35
37.85
1260 1298.65 1336.50 1350 1387.85 | | | | | Loss
38.65
76.50
7.6 S7: Bear spreads - sell a call and buy another
There are times when you think the market is going to fall over the next two months,
however in the event that the market does not fall, you would like to limit your downside.
One way you could do this is by entering into a spread. A spread trading strategy
involves taking a position in two or more options of the same type, that is, two or more
Derivatives – Indian Scenario - 84 -
calls or two or more puts. A spread that is designed to profit if the price goes down is
called a bear spread.
A bear spread created using calls involves initial cash inflow since the price of the call
sold is greater than the price of the call purchased. Table 7.5 gives the profit/loss incurred
on a spread position as the index changes. Figure 7.7 shows the payoff from the bull
spread.
Broadly we can have three types of bear spreads:
1. Both calls initially out-of-the-money,
2. One call initially in-the-money and one call initially out-of-the-money, and
3. Both calls initially in-the-money.
The decision about which of the three spreads to undertake depends upon how much risk
the investor is willing to take. The most aggressive bear spreads are of type 1. They cost
very little to set up, but have a very small probability of giving a high payoff. As we
move from type 1 to type 2 and from type 2 to type 3, the spreads become more
conservative and cost higher to set up. Bear spreads can also be created by buying a put
with a high strike price and selling a put with a low strike price.
Figure 7.7 Payoff for a bear spread created using call optionsThe figure shows the profits/losses for a bear spread. As can be seen, the payoff obtained is the sum of the payoffs of the two calls, one sold at Rs.76.50 and the other bought at Rs.37.85. The maximum gain from setting up the spread is Rs.38.65 which is the difference between the call premium received and the call premium paid. The upside on the position is limited to this amount. Hence the payoff on this spread lies between +38.85 to -51.35.
Profit
76.50
38.65
Derivatives – Indian Scenario - 85 -
1260 1298.65 1336.50 1350 1387.85 | | | | |
37.85
51.35
Loss
Table 7.5 Expiration day cash flows for a Bear spread using two-month calls
The table shows possible expiration day profit for a bear spread created by selling one market lot of calls at
a strike of 1260 and buying a market lot of calls at a strike of 1350.