derivative series

“Hi ! this week I am taking this

opportunityto give you an in-depth

understanding on Futures trading

MarketsMarkets

SPOT/ CASH MARKET

FUTURES OPTIONS

DERIVATIVES

FINANCIAL MARKETS

Derivatives DefinedIt is a product whose value is derived from the value of one or more variables –bases \underlying asset which could be equity,commodity,forex,other asset.

For e.g A farmer may wish to sell his harvest at a future date to eliminate risk of a change in price by that date.This is a derivative type of transaction in which the price is driven by the spot price of wheat which is the “underlying asset”.

Basics of Futures tradingA 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.

Index futures are all futures contracts where the underlying is the stock index (Nifty or Sensex) and helps a trader to take a view on the market as a whole.

In India we have index futures contracts based on S&P CNX Nifty and the BSE Sensex and near 3 months duration contracts are available at all times.

Each contract expires on the last Thursday of the expiry month and simultaneously a new contract is introduced for trading after expiry of a contract.

Example of Future ContractIf the Current price of Tata Steel is Rs. 200 per stock. You are interested in buying 500 shares of Tata Steel. You find someone, say John, who has 500 shares you tell John that you will buy 500 shares at Rs. 200, but not now, at a later point oftime,say on the last Thursday of this month.

This agreed date will be called the Expiry date of your agreement or contract. John more or less agrees but the following points come up in your agreement.

John will have to go through the trouble of keeping the shares with him until the end of this month. Moreover, the economy is doing well, so it is likely that the price of the stock at the end of the month will be not Rs. 200, but something more. So he says lets strike a deal not at the current price of Rs 200 but Rs. 202/-. The agreed price of the deal will be called the Strike price of the futures contract.

Example of Future Contract (contd.)He says you can think of the Rs. 2 per share as his charge for keeping the shares for you until the expiry date. This difference between the strike price and the current price is also called as Cost of Carry.

The total contract size is now Rs. 202 for 500 shares, which means Rs 101000.However both you and John realize that each of you is taking a risk.

For e.g.If tomorrow the price of the stock falls from Rs. 200 to Rs. 190, in that case it is much more profitable for you buy shares from the market than from John. What if you decide not to honors the contract or agreement? it will be a loss for John.

Similarly if the price rises you are at a risk if John doesn't honors the futures contract. So both of you decide that you will find a common friend and keep Rs.25000 each with this friend in order to take care of price fluctuations. This money paid by both of you is called Margin paid for the futures contract.

Example of Future Contract (contd.)Finally you decide that the futures contract will cash settled. Which means at the expiry date of the contract, instead of actually handing over 500 shares -John will pay you the money if the price rises, or if the price falls you will pay John the balance amount.

For example at the end of the expiry date if you find out that the price of the share is Rs. 230, then the difference

Rs. 230 - Rs. 202 = Rs. 28

will be paid to you by John. You can then purchase the shares from the Stock Market at Rs. 230. Since you will get Rs. 28 per share from John, you will effectively be able to buy the shares at Rs. 202 , the agreed strike price of the futures contract. Similarly John can directly sell his 500 shares in the market at Rs. 230 and give you Rs 28 (per share) which means he effectively sold each share at Rs.202, the agreed price.

Future Contract in NIFTYFutures contracts in Nifty in July 2009

On 27th July 2009

Contract month Expiry/settlementJuly 2009 July 30August 2009 August 27 September 2009 September 24

Contract month Expiry/settlementAugust 2009 August 27September 2009 September 24October 2009 October 29

Example of Future Contract in NIFTY - continued

The permitted min lot size is 50 or multiples thereof for the Nifty. That is you buy one Nifty contract the total deal value will be :

50*4500 (Nifty value)= Rs 9,00,000.

In the case of BSE Sensex the market lot is 50. That is you buy one Sensex futures the total value will be

50*14600 (Sensex value)= Rs 7,30,000.

The index futures symbols are represented as follows:

BSE NSE

BSXJUN2009 (June contract) FUTDXNIFTY 28-JUN2009

BSXJUL2009 (July contract) FUTDXNIFTY 28-JUL2009

BSXAUG200 (Aug contract) FUTDXNIFTY 28-AUG2009

HedgingFutures can be used as a effective risk management tool. When an investors exposure to movements of Nifty is not as per their anticipated price they offset it by investing accordingly in the Futures market .Index futures in particular can be very effectively used to get red of market risks of a portfolio.

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The other benefit of trading in index futures is to hedge your portfolio against the risk of trading. In order to understand how one can protect his portfolio from value erosion. Let us take an example.

Ram enters into a contract with Shyam that six months from now he will sell to Shyam 10 dresses for Rs 4000. The cost of manufacturing for Ram is only Rs 1000 and he will make a profit of Rs 3000 if the sale is completed.

However, Ram fears that Shyam may not honors his contract six months from now.So he inserts a new clause in the contract that if Shyam fails to honors the contract he will have to pay a penalty of Rs 1000. And if Shyam honors the contract Ram will offer a discount of Rs 1000 as incentive.

Cost (Rs) Selling price Profit

1000 4000 3000

Hedging a Future

Hedging a Future Contract – contd.Shyam defaults Shyam honors

1000 (Initial Investment) 3000 (Initial profit)

1000 (penalty from Shyam) (-1000) discount given to Shyam

- (No gain/loss) 2000 (Net gain)

As we see above if Shyam defaults Ram will get a penalty of Rs 1000 but he will recover his initial investment. If Shyam honors the contract, Ram will still make a profit of Rs 2000. Thus, Ram has hedged his risk against default and protected his initial investment.

Hedging involves protecting an existing asset position from future adverse price movements. In order to hedge a position, a market player needs to take an equal and opposite position in the futures market to the one held in the cash market.

ArbitrageThey involve a sequence of trades on the spot and on the index futures market. Yet, they are completely risk less. The trader is simultaneously buying at the present and selling off in the future, or vice versa. Regardless of what happens to Nifty, the returns on arbitrage are the same. Since there is no risk involved, it is called Arbitrage.

Daily marginingDaily margining is of two types:

1. Initial margins : The initial margin amount is large enough to cover a one-day loss that can be encountered on 99% of the days.

2. Mark-to-market profit/loss : The daily settlement process called "mark-to-market" provides for collection of losses that have already occurred (historic losses) whereas initial margin seeks to safeguard against potential losses on outstanding positions. The mark-to-market settlement is done in cash.

Let us take a hypothetical trading activity of a client of a NSE futures division to demonstrate the margins payments that would occur.A client purchases 200 units of FUTIDX NIFTY 29JUN2009 at Rs 4500. The initial margin payable as calculated by VaR is 15%.Total long position = Rs 9,00,000 (200*4500)Initial margin (15%) = Rs 1,35,000

Daily margining - continuedAssuming that the contract will close on Day + 3 the mark-to-market position will look as follows:Position on Day 1

New position on Day 2Value of new position = 4,400*200= 8,80,000 Margin = 1,32,000

Close Price Loss Margin released Net cash outflow

4400*200 =8,80,000

20,000 (9,00,000-8,80,000) 3,000 (1,35,000-1,32,000)

17,000 (20,000-3000)

Payment to be made

(17,000)

Close Price Gain Addn Margin Net cash inflow

4510*200 =9,02,000

22,000 (9,02,000-8,80,000)

3,300 (1,35,300-1,32,000)

18,700 (22,000-3300)

Payment to be received

18,700

Daily margining - continued

Position on Day 3

Value of new position = 4510*200 = Rs 9,02,000Margin = Rs 1,35,300

* Margin Account

Close Price Gain Net cash inflow

4600*200 =9,20,000 18,000 (9,20,000-9,02,000) 18,000 + 1,35,300 * = 153,300

Payment to be recd 153,300

Margin AccountMargin account*

Initial margin = Rs 135,000Margin released (Day 1) = (-) Rs 3,000Position on Day 2 Rs 132,000Addn margin = (+) Rs 3,300Total margin in a/c Rs 135,300*

Net gain/lossDay 1 (loss) = (Rs 17,000)Day 2 Gain = Rs 18,700Day 3 Gain = Rs 18,000Total Gain = Rs 19,700

The client has made a profit of Rs 19,700 at the end of Day 3 and the total cash inflow at the close of trade is Rs 63,300.

Open interest (OI)Open interest indicates the total gross outstanding open positions in the market for that particular series.

The most useful measure of market activity is Open interest, which is also published by exchanges and used for technical analysis. Open interest indicates the liquidity of a market and is the total number of contracts, which are still outstanding in a futures market for a specified futures contract.

Open interest is therefore a measure of contracts that have not been matched and closed out. The number of open long contracts must equal exactly the number of open short contracts.

Open interest (OI) contd.Action Resulting open interest

New buyer (long) and new seller (short) Trade to form a new contract.

Rise

Existing buyer sells and existing seller buys –The old contract is closed.

Fall

New buyer buys from existing buyer. The Existing buyer closes his position by selling to new buyer.

No change – there is no increase in long contracts being held

Existing seller buys from new seller. The Existing seller closes his position by buying from new seller.

No change – there is no increase in short contracts being held

Price Open interest MarketStrong

Warning signalWeak

Warning signal

Futures TerminologiesOpen Interest - Is the difference in the rate invested in the Futures market and the daily fluctuating rate of the stock.Roll Over -If a stock invested in doesn't reach the Speculated rate in Futures market,then the deal is closed by the investor/exchange at the end of the series after which one can re-invest/rollover for the next series.Cost Of Carrying-Relation between futures prices and spot prices.Initial Margin-Amount deposited in the margin account at the time a futures contract is first entered intoMarking to Market-In the futures market the margin account is adjusted at the end of each day to reflect investors gain/loss depending on the futures closing price.

Futures TerminologiesIn the money - Option leading to a positive cash flow to the investor.A call option is ITM if current index is higher than the strike price.

At the money - An call option at the index is ATM if current index equals strike price.It would lead to a zero cash flow.

Out of the money options- An call option at the index is OTM if current index stands at a level less then strike price.

Intrinsic value-Difference between spot price and strike price.

Time value-Is the difference between its premium and intrinsic value.

Hope this series has given you understanding & clarity before you

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