F&o Cbse

MBA
(DISTANCE MODE)
DBA 1754
FINANCIAL DERIVATIVES
IV SEMESTER
COURSE MATERIAL
Centre for Distance Education
Anna University Chennai
Chennai 600 025
Author
Dr Dr Dr Dr Dr. J . J . J . J . J. Gopu . Gopu . Gopu . Gopu . Gopu
Assistant Professor
Department of Management Studies
BSA Crescent Engineering College
Chennai - 600 048
Reviewer
Ms Ms Ms Ms Ms. Y . Y . Y . Y . Yasmeen Haider asmeen Haider asmeen Haider asmeen Haider asmeen Haider
Senior Lecturer
BSA Crescent Engineering College
Chennai - 600 048
Dr Dr Dr Dr Dr. T . T . T . T . T.V .V .V .V .V.Geetha .Geetha .Geetha .Geetha .Geetha
Professor
Department of Computer Science and Engineering
Chennai - 600 025
Dr Dr Dr Dr Dr.H.P .H.P .H.P .H.P .H.Peer eer eer eer eeru Mohamed u Mohamed u Mohamed u Mohamed u Mohamed
Professor
Chennai - 600 025
Dr Dr Dr Dr Dr.C .C .C .C .C. Chella . Chella . Chella . Chella . Chellappan ppan ppan ppan ppan
Professor
Chennai - 600 025
Dr Dr Dr Dr Dr. A. K . A. K . A. K . A. K . A. Kannan annan annan annan annan
Professor
Chennai - 600 025
Copyrights Reserved
(For Private Circulation only)
Editorial Board
ii
iii
ACKNOWLEDGEMENT
The author has drawn inputs from several sources for the preparation of this course material, to meet the
requirements of the syllabus. The author gratefully acknowledges the following sources:
N.D.Vohra and B.R.Bagri, Futures and Options II Edition; Tata McGraw Hill Ltd.
S.L.Gupta, Financial derivatives, theory, concepts and problems, Prentice Hall India, 2006.
www.nseindia.com
www.theponytail.com
http://www.emecklai.com
http://www.geocities.com
www.indiainfoline.com
http://sasmit.blogspot.com
Inspite of at most care taken to prepare the list of references any omission in the list is only accidental and not
purposeful.
Dr. J. Gopu
Author
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vii
DBA 1754 FINANCIAL DERIVATIVES
UNIT I - INTRODUCTION
Financial derivatives an introduction; Futures market and contracting; Forward market pricing and trading
mechanism; Futures pricing theories and characteristics.
UNIT II - REGULATIONS
Financial derivatives market in India; Regulation of financial derivatives in India.
UNIT III - STRATEGIES
Hedging strategy using futures; Stock index futures; Short-term interest rate futures; Long-term interest rate
futures; Foreign currency futures; Foreign currency forwards.
UNIT IV - OPTIONS
Options basics; Option pricing models; trading with options; Hedging with options; currency options; Financial
Swaps and Options; Swap markets.
UNIT V - ACCOUNTING
Accounting treatment of derivative transactions; Management of derivatives exposure; Advanced financial
derivatives; Credit derivatives.
REFERENCES
1. N.D.Vohra and B.R.Bagri, Futures and Options II Edition; Tata McGraw Hill Ltd.
2. S.L.Gupta, Financial derivatives, theory, concepts and problems, Prentice Hall India, 2006.
ix
CONTENTS
UNIT I
CHAPTER I
FINANCIAL DERIVATIES AN INTRODUCTION
1.1 INTRODUCTION 1
1.2 THE SIGNIFICANCE OF DERIVATIVES 3
1.3 TYPES OF DERIVATIVES 3
1.3.1 Forward Contracts 3
1.3.2 Future Contracts 4
1.3.3 Options Contracts 4
1.3.4 Swap 4
1.4 FUTURES MARKET AND CONTRACTING 4
1.4.1 Contract Specifications 5
1.4.2 Trading Parameters 5
1.5 FORWARDS VS FUTURES 7
1.6 DIFFERENCES BETWEEN FORWARDS AND
FUTURES CONTRACTS 8
1.7 FUTURES PRICES AND FUTURE SPOT PRICES
UNIT II
CHAPTER I
FINANCIAL DERIVATIVES MARKET IN INDIA
2.1.1 Introduction 11
2.1.2 Derivatives Market in India 11
2.1.3 Development of exchange-traded derivatives 16
2.1.4 The need for a derivatives market 16
CHAPTER II
REGULATIONS OF FINANCIAL DERIVATIVES IN INDIA
2.2.2 Regulations by National Stock Exchange 18
2.2.3 Black-Scholes Option Price calculation model 26
2.2.4 Payment of Margins 27
2.2.5 Violations 27
2.2.6 Market Wide Position Limits for derivative contracts
on underlying stocks 28
2.2.7 Price Scan Range 29
2.2.8 Position Limits 29
2.2.9 Scheme for FIIs and MFs trading in Exchange traded derivatives 30
UNIT III
CHAPTER I
HEDGING STRATEGIES USING INDEX FUTURES
3.1.2 S&P CNX Nifty 35
3.1.3 Trading in Nifty 36
3.1.4 S&P CNX Nifty Futures 36
3.1.5 CNX Nifty Junior Futures 41
3.1.6 Cnxit Futures 43
3.1.7 CNX 100 Futures 44
3.1.8 BANK Nifty Futures 46
3.1.9 Nifty Midcap 50 Futures 48
3.1.10 Futures on Individual Securities 50
CHAPTER II
INTEREST RATE FUTURES
3.2.2 Security descriptor 54
3.2.3 Underlying Instrument 54
3.2.4 Trading cycle 55
3.2.5 Expiry day 55
3.2.6 Product Characteristics 55
3.2.7 Trading Parameters 55
3.2.8 Clearing and Settlement 57
3.2.9 Interest Rate Derivatives - Risk Containment 59
CHAPTER III
CUURENCY FUTURES
3.3.2 To Hedge or Not to Hedge? 61
3.3.3 Uncorrelated risks 61
3.3.4 Expected returns are zero 62
3.3.5 a) How long is the long-run? 62
3.3.5 b) Risk-return trade-off 62
3.3.6 Instruments for Hedging Currency Risk 62
3.3.7 Exchange-Traded Currency Futures 63
3.3.8 Accessible to All Market Participants 63
x
xI
3.3.9 Illustrating the Use of Currency Futures 64
3.3.10 Summary 65
UNIT IV
CHAPTER I
OPTION MARKET
4.1.2 The main characteristics of a option contract 67
4.1.3 The market participants 68
4.1.4 Mini Option contracts on S&P CNX Nifty index 69
4.1.5 CNXIT Options 69
4.1.6 CNX 100 Options 73
4.1.7 BANKNIFTY OPTIONS 76
4.1.8 NIFTY MIDCAP 50 OPTIONS 79
4.1.9 Options on Individual Securities 82
CHAPTER II
FINANCIAL SWAPS MARKET
4.2.2 There are Three Basic Motivations for Swaps: 96
4.2.3 Firms use Swaps to Reduce Financing Costs 96
4.2.4 Parallel Loans 96
4.2.5 Back-to-Back Loans 97
4.2.6 Drawbacks of parallel and back to back loans 97
4.2.7 Swap Banks 98
4.2.8 Types of Swaps 98
4.2.9 Swaptions, Caps, Floor and Collars 99
4.2.10 Motivation for Swaps 99
4.2.11 Closing Thoughts 99
4.2.12 Interest Rate Swaps 100
4.2.13 Currency Swaps 101
4.2.14 Flexibility 102
4.2.15 Exposure 105
4.2.16 Hedging Swaps 103
4.2.17 Identifying the risk of the swaps portfolio 104
4.2.18 Constructing the Hedge Portfolio 104
4.2.19 Why will the Dealer only Partially Hedge the Swaps Portfolio? 105
4.2.20 Floating Rate Cash Flow Management 105
4.2.21 Mismatches in the Timing of Short-Term Cash Flows. 105
4.2.22 Mmismatches in the Type of Index used to Hedge. 105
4.2.23 Interest Rate Swaps 106
4.2.24 Valuation of swaps 106
4.2.25 Equity Swaps 107
4.2.26 Equity swaps make the index trading strategy even easier. 107
UNIT V
CHAPTER I
ACCOUNTING TREATMENT FOR
DERIVATIVE TRANSACTIONS
5.1.2 Getting Ready 111
5.1.3 Hedge Accounting 112
5.1.4 Embedded Derivatives 113
5.1.5 Recent Announcement 113
5.1.6 Fair value hedges are accounted for as follows: 114
5.1.7 Cash flow hedges are accounted for as follows: 114
5.1.8 New Accounting Rules for Derivatives and Hedging Activity 115
5.1.9 Fair Value Hedges 115
5.1.10 Cash Flow Hedges 116
5.1.11 Hedges for Net Investment in Foreign Operations 116
5.1.12 Derivatives and Income Statement Volatility 117
5.1.13 Increased Derivatives Disclosure 117
5.1.14 Derivatives Management Systems 117
CHAPTER II
CREDIT DERIVATIVES
5.2.2 Credit Swaps management. 122
5.2.3 Credit Default Swaps 123
5.2.4 Options on Credit Risky Bonds 124
xii
NOTES
1 ANNA UNIVERSITY CHENNAI
UNIT I
INTRODUCTION
CHAPTER I
FINANCIAL DERIVATIES AN INTRODUCTION
1.1 INTRODUCTION
In finance, a security whose price is dependent upon or derived from one or more
underlying assets. The derivative itself is merely a contract between two or more parties.
Its value is determined by fluctuations in the underlying asset. The most common underlying
assets include stocks, bonds, commodities, currencies, interest rates and market indexes.
Most derivatives are characterized by high leverage.
Futures contracts, forward contracts, options and swaps are the most common types
of derivatives. Because derivatives are just contracts, just about anything can be used as
an underlying asset. There are even derivatives based on weather data, such as the amount
of rain or the number of sunny days in a particular region.
Derivatives are generally used to hedge risk, but can also be used for speculative
purposes. For example, a European investor purchasing shares of an American
company off of an American exchange (using American dollars to do so) would be exposed
to exchange-rate risk while holding that stock. To hedge this risk, the investor could purchase
currency futures to lock in a specified exchange rate for the future stock sale and currency
conversion back into euros.
Derivative is any financial instrument, whose payoffs depend in a direct way on the
value of an underlying variable at a time in the future. This underlying variable is also called
the underlying asset, or just the underlying.
Usually, derivatives are contracts to buy or sell the underlying asset at a future time,
with the price, quantity and other specifications defined today. Contracts can be binding
for both parties or for one party only, with the other party reserving the option to exercise
or not. If the underlying asset is not traded, for example if the underlying is an index, some
kind of cash settlement has to take place. Derivatives are traded in organized exchanges as
well as over the counter [OTC derivatives]. Examples of derivatives include forwards,
futures, options, caps, floors, swaps, collars, and many others.
DBA 1754
NOTES
Derivative contracts in general and options in particular are not novel securities. It has
been nearly 25 centuries since the above abstract appeared in Aristotles Politics, describing
the purchase of a call option on oil-presses. More recently, De La Vega (1688), in his
account of the operation of the Amsterdam Exchange, describes traded contracts that
exhibit striking similarities to the modern traded options.
Nevertheless, the modern treatment of derivative contracts has its roots in the inspired
work of the Frenchman Louis Bachelier in 1900. This was the first attempt of a rigorous
mathematical representation of an asset price evolution through time. Bachelier used the
concepts of random walk in order to model the fluctuations of the stock prices, and developed
a mathematical model in order to evaluate the price of options on bond futures. Although
the above model was incomplete and based on assumptions that are virtually unacceptable
in recent studies, its importance lies on the novelty of its ideas, both from an economists
and a mathematicians point of view. Unfortunately, this work was not developed further,
despite the publication of the Einstein paper on Brownian motion in 1905, which would
shed light on the properties of the model and perhaps highlight its misspecifications.
The above treatment of security prices was long forgotten until the 70s, when Professor
Samuelson and his co-workers at MIT rediscovered Bacheliers work and questioned its
underlying assumptions. By construction, the payoff of a call option on the expiration day
will depend on the price of the underlying asset on that day, relative to the options exercise
price. Common reasoning declares that therefore, the price of the call option today has to
depend on the probability of the stock price exceeding the exercise price. One could then
argue that a mathematical model that can satisfactory explain the underlying assets price is
sufficient in order to price the call option today, just by constructing the probabilistic model
of the price on the expiration day. Professors Black, Merton and Scholes recognized that
the above reasoning is incorrect: Since todays price incorporates the probabilistic model
of the future behavior of the asset price, the option can (and has to) be priced relative to
todays price alone. They realized that a levered position, using the stock and the riskless
bond that replicates the payoff of the option is feasible, and therefore the option can be
priced using no-arbitrage restrictions. Equivalently, they observed that the true probability
distribution for the stock price return can be transformed into one which has an expected
value equal to the risk free rate, the so called risk adjusted or risk neutral distribution; the
pricing of the derivative can be carried out using the risk neutral distribution when
expectations are taken.
The classic papers produced by this work, namely Black and Scholes (1973) and
Merton (1976), triggered an avalanche of papers on option pricing, and resulted in the
1997 Nobel Prize in economics for the pioneers of contingent claims pricing. Even today,
nearly thirty years after its publication, the original Black and Scholes paper is one of the
most heavily cited in finance?
NOTES
1.2 THE SIGNIFICANCE OF DERIVATIVES
Every candidate underlying asset will have a value that is affected by a variety of
factors, therefore inheriting risk. Derivative contracts, due to the leverage that they offer
may seem to multiply the exposure to such risks. However, derivatives are rarely used in
isolation. By forming portfolios utilizing a variety of derivatives and underlying assets, one
can substantially reduce her risk exposure, when an appropriate strategy is considered.
Derivative contracts provide an easy and straightforward way to both reduce risk -
hedging, and to bear extra risk -speculating. As noted above, in any market conditions
every security bears some risk. Using active derivative management involves isolating the
factors that serve as the sources of risk, and attacking them in turn. In general, derivatives
can be used to
hedge risks;
reflect a view on the future behavior of the market, speculate;
lock in an arbitrage profit;
change the nature of a liability;
change the nature of an investment;
1.3 TYPES OF DERIVATIVES
Derivative contracts have several variants. The most common variants are forwards,
futures, options and swap.
1.3.1 Forward Contracts
A forward contract is an agreement between two parties a buyer and a seller to
purchase or sell something at a later date at a price agreed upon today. Forward contracts,
sometimes called forward commitments, are very common in everyone life. For example,
an apartment lease is a forward commitment. By signing a one-year lease, the tenant agrees
to purchase the service use of the apartment each month for the next twelve months at
a predetermined rate. Like-wise, the landlord agrees to provide the service each month
for the next twelve months at the agreed-upon rate. Now suppose that six months later the
tenant finds a better apartment and decides to move out. The forward commitment remains
in effect, and the only way the tenant can get out of the contract is to sublease the apartment.
Because there is usually a market for subleases, the lease is even more like a futures
contract than a forward contract.
Any type of contractual agreement that calls for the future purchase of a good or
service at a price agreed upon today and without the right of cancellation is a forward
contract.
DBA 1754
NOTES
1.3.2 Future Contracts
A futures contract is an agreement between two parties a buyer and a seller to
buy or sell something at a future date. The contact trades on a futures exchange and is
subject to a daily settlement procedure. Future contracts evolved out of forward contracts
and possess many of the same characteristics. In essence, they are like liquid forward
contracts. Unlike forward contracts, however, futures contracts trade on organized
exchanges, called future markets. For example, the buyer of a future contact, who has the
obligation to buy the good at the later date, can sell the contact in the future market, which
relieves him or her of the obligation to purchase the good. Likewise, the seller of the
futures contract, who is obligated to sell the good at the later date, can buy the contact
back in the future market, relieving him or her of the obligation to sell the good. Future
contacts also differ from forward contacts in that they are subject to a daily settlement
procedure. In the daily settlement, investors who incur losses pay them every day to investors
who make profits.
1.3.3 Options Contracts
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.
1.3.4 Swap
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 and currency swaps.
Interest rate swaps: These involve 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.
1.4 FUTURES MARKET AND CONTRACTING
This contract is an agreement to buy or sell an asset at a certain time in the future for
a certain price. Futures are traded in exchanges and the delivery price is always such that
todays value of the contract is zero. Therefore in principle, one can always engage into
future without the need of an initial capital: the speculators heaven
A futures contract is a forward contract, which is traded on an Exchange. NSE
commenced trading in index futures on June 12, 2000. The index futures contracts are
based on the popular market benchmark S & P CNX Nifty index.
NOTES
NSE defines the characteristics of the futures contract such as the underlying index,
market lot, and the maturity date of the contract. The futures contracts are available for
trading from introduction to the expiry date.
1.4.1 Contract Specifications
Security descriptor
The security descriptor for the S&P CNX Nifty futures contracts is:
Market type : N
Instrument Type : UTIDX
Underlying : NIFTY
Expiry date : Date of contract expiry
Instrument type represents the instrument i.e. Futures on Index. Underlying symbol
denotes the underlying index which is S&P CNX Nifty Expiry date identifies the date of
expiry of the contract
Underlying Instrument
The underlying index is S&P CNX Nifty.
Trading cycle
S&P CNX Nifty futures contracts have a maximum of 3-month trading cycle - the
near month (one), the next month (two) and the far month (three). A new contract is
introduced on the trading day following the expiry of the near month contract. The new
contract will be introduced for a three month duration. This way, at any point in time, there
will be 3 contracts available for trading in the market i.e., one near month, one mid month
and one far month duration respectively.
Expiry day
S&P CNX Nifty futures contracts expire on the last Thursday of the expiry month. If
the last Thursday is a trading holiday, the contracts expire on the previous trading day.
1.4.2 Trading Parameters
Contract size
The value of the futures contracts on Nifty may not be less than Rs. 2 lakhs at the time
of introduction. The permitted lot size for futures contracts & options contracts shall be the
same for a given underlying or such lot size as may be stipulated by the Exchange from time
to time.
Price steps
The price step in respect of S&P CNX Nifty futures contracts is Re.0.05.
DBA 1754
NOTES
Base Prices
Base price of S&P CNX Nifty futures contracts on the first day of trading would be
theoretical futures price.. The base price of the contracts on subsequent trading days would
be the daily settlement price of the futures contracts.
Price bands
There are no day minimum/maximum price ranges applicable for S&P CNX Nifty
futures contracts. However, in order to prevent erroneous order entry by trading members,
operating ranges are kept at +/- 10 %. In respect of orders which have come under price
freeze, members would be required to confirm to the Exchange that there is no inadvertent
error in the order entry and that the order is genuine. On such confirmation the Exchange
may approve such order.
Quantity freeze
Orders which may come to the exchange as Quantity freeze shall be such that have a
quantity of more than 15000. In respect of orders which have come under quantity freeze,
members would be required to confirm to the Exchange that there is no inadvertent error
in the order entry and that the order is genuine. On such confirmation, the Exchange may
approve such order. However, in exceptional cases, the Exchange may, at its discretion,
not allow the orders that have come under quantity freeze for execution for any reason
whatsoever including non-availability of turnover / exposure limit. In all other cases, quantity
freeze orders shall be cancelled by the Exchange.
Order type/Order book/Order attribute
Regular lot order
Stop loss order
Immediate or cancel
Spread order
The forward contract
The forward contract is an over-the-counter [OTC] agreement between two parties,
to buy or sell an asset at a certain time in the future for a certain price.
The party that has agreed to buy has a long position.
The party that has agreed to sell has a short position.
Usually, the delivery price is such that the initial value of the contract is zero. The
contract is settled at maturity. For example, a long forward position with delivery price will
K have the payoffs shown in figure
NOTES
Forward contract payoffs
1.5 FORWARDS VS FUTURES
It can be shown that when interest rates are constant and the same for all maturities,
then the futures and forward prices are the same. If the interest rates are stochastic, this
relationship does not hold. Whether the forward price is lower than the futures price or
higher will depend on the correlation of the underlying asset with the interest rates. This
situation arises from the daily settlement procedure that takes place in the futures market.
Remember that there is no secondary market for the forward contracts.
Suppose that the interest rates and the underlying asset are negatively correlated.
That is to say that on average, when the interest rates fall the price of the underlying asset
increases, something that is true in the stock markets. Consider an investor that holds a
long futures position. When the asset price increases, because of the marking-the-market
procedure, the investor is making an immediate gain the basis increases. This extra gain
will be invested at an interest rate which is lower than average, due to the negative
correlation. In a similar fashion, when the price of the underlying falls, the immediate loss
will have to be financed at a rate which is above the average. Forwards are not subject to
daily settlements, and therefore not affected by the spot-interest correlation. This makes
forward contracts more attractive; in an efficient market when the spot-interest correlation
is negative we expect forward prices to be higher than the futures ones.
Obviously the inverse will also hold, that is to say when the spot-interest correlation is
positive we expect forward prices to be lower than the futures ones.
These differences have only a theoretical value, in practice these differences are ignored.
Usually the maturity of futures contracts is quite short, and the spot-interest correlation is
not that high in absolute terms to imply significant differences. Therefore handbooks and
practitioners make the assumption that futures and forwards have the same price, even
when interest rates are uncertain. Of course one has to be careful when dealing with longer
maturity futures, since then the differences might become quite significant.
DBA 1754
NOTES
In the remaining of these notes we will use the same notation F(t, r) for both forwards
and futures, recognizing the pitfalls.
Although similar in nature, these two instruments exhibit some fundamental differences
in the organization and the contract characteristics.
1.6 DIFFERENCES BETWEEN FORWARDS AND FUTURES
CONTRACTS
In the example a futures contract was not available for the investor to hedge against
the interest rate risk. One can now see that she could alternative go to some investment
company seeking for a forward contract that would suit her needs.
1.7 FUTURES PRICES AND FUTURE SPOT PRICES
One very important question that one can ask is: Is the futures price an unbiased
estimator of the future spot price? The answer is no in general. Remember the relation
between risk and return as stated by the CAPM: there are two types of risk in the economy,
namely the systematic and the nonsystematic risk. The nonsystematic risk can be eliminated
by holding a well diversified portfolio, which is perfectly correlated with the market. The
systematic risk cannot be eliminated, since it is the risk of the portfolio that is inherited from
the market as a whole and it cannot be diversified away. The CAPM formula dictates that
r
p
r = p (r
M
r)
We have already seen that a futures contract, when seen as a riskless investment will
grow in value with the risk free rate of return.
Example 10 (Futures risk) Suppose that an investor takes a long futures position.
She puts the present value of the futures position into a risk free investment, to meet the
requirements when the contract matures, in order to buy the asset on the delivery date.
Forwards Futures
Primary market Dealers Organized Exchange
Secondary market None the Primary market
Contracts Negotiated Standardized
Delivery Contracts expire Rare delivery
Collateral None
Initial margin, mark-the-
market
Credit risk Depends on parties None [Clearing House]
Market participants Large firms Wide variety

NOTES
The cash flows of the speculator are
. time at ) ( S
and , t time at e ) , t ( F
) t ( r

The present value of this investment is
) t ( 1 r
t
) t ( r
e )] ( S [ E e ) , t ( F

+
where E
t
is the conditional expectations operator, and r
1
is the discount rate appropriate
for the investment meaning the expected return required from investors in order to
compensate for the risks that are beard. The fact that the present value of all investment
opportunities is equal to zero will give
) t ( ) 1 r r (
t
e )] ( S [ E ) , t ( F

=
.
It is straightforward to observe that the relationship of the futures with the expected
spot price will depend on the relationship between the two returns, which in turn depends
on the correlation of the investment with the market due to the CAPM.
Example 11 (cont. Futures risk) Consider the case that S
T
is positively correlated
with the market as is the usual case. Then, from the definition of
) rm ( var
) r , r ( cov
M 1
I
=
it is
implied that
I
is positive. The CAPM dictates that an investment with positive will have
required return higher than the risk free rate. This in turn will give F(t,r) < E
t
[S(r)].The
inverse will also hold: If S
T
is negatively correlated with the market, then F(t,r) > E
t
[S(r)]..
What is the case where the futures price is an unbiased estimator of the future spot price?
This happens only when the investment is not correlated with the market, or equivalently
when the investment does not exhibit systematic risk. If fact in this cases the above feature
is more of an accident: it is not the case that the futures price became an unbiased estimator,
it is more that the asset price happens to grow at the risk free rate of return.
Summary
Usually, derivatives are contracts to buy or sell the underlying asset at a future time,
with the price, quantity and other specifications defined today. Contracts can be binding
for both parties or for one party only, with the other party reserving the option to exercise
or not. If the underlying asset is not traded, for example if the underlying is an index, some
kind of cash settlement has to take place. Derivatives are traded in organized exchanges as
well as over the counter [OTC derivatives]. Examples of derivatives include forwards,
futures, options, caps, floors, swaps, collars, and many others.
DBA 1754
NOTES
Derivative contracts in general and options in particular are not novel securities. It has
been nearly 25 centuries since the above abstract appeared in Aristotles Politics, describing
the purchase of a call option on oil-presses. More recently, De La Vega (1688), in his
account of the operation of the Amsterdam Exchange, describes traded contracts that
exhibit striking similarities to the modern traded options.
Nevertheless, the modern treatment of derivative contracts has its roots in the inspired
work of the Frenchman Louis Bachelier in 1900. This was the first attempt of a rigorous
mathematical representation of an asset price evolution through time. Bachelier used the
concepts of random walk in order to model the fluctuations of the stock prices, and developed
a mathematical model in order to evaluate the price of options on bond futures. Although
the above model was incomplete and based on assumptions that are virtually unacceptable
in recent studies, its importance lies on the novelty of its ideas, both from an economists
and a mathematicians point of view. Unfortunately, this work was not developed further,
despite the publication of the Einstein paper on Brownian motion in 1905, which would
shed light on the properties of the model and perhaps highlight its misspecifications.
Questions
1. What do you mean by Derivatives? Explain its importance
2. Discuss the various types of Derivatives
3. Explain the differences between Forwards and Futures contracts
4. Define Option contract
5. Is the futures price an unbiased estimator of the future spot price? Explain
NOTES
UNIT II
REGULATIONS
CHAPTER - I
FINANCIAL DERIVATIVES MARKET IN INDIA
2.1.1 Introduction
Derivatives are financial contracts whose values are derived from the value of an
underlying primary financial instrument, commodity or index, such as: interest rates, exchange
rates, commodities, and equities. Derivatives include a wide assortment of financial contracts,
including forwards, futures, swaps, and options. The International Monetary Fund defines
derivatives as financial instruments that are linked to a specific financial instrument or
indicator or commodity and through which specific financial risks can be traded in financial
markets in their own right. The value of financial derivatives derives from the price of an
underlying item, such as asset or index. Unlike debt securities, no principal is advanced to
be repaid and no investment income accrues. While some derivatives instruments may
have very complex structures, all of them can be divided into basic building blocks of
options, forward contracts or some combination thereof. Derivatives allow financial
institutions and other participants to identify, isolate and manage separately the market
risks in financial instruments and commodities for the purpose of hedging, speculating,
arbitraging price differences and adjusting portfolio risks.
2.1.2 Derivatives Market in India
Derivatives markets have had a slow start in India. The first step towards introduction
of derivatives trading in India was the promulgation of the Securities Laws (Amendments)
Ordinance, 1995, which withdrew the prohibition on options in securities. The market for
derivatives, however, did not take off, as there was no regulatory framework to govern
trading of derivatives. SEBI set up a 24-member committee under the Chairmanship of
Dr. L.C. Gupta on 18th November 1996 to develop appropriate regulatory framework
for derivatives trading in India. The committee recommended that derivatives should be
declared as securities so that regulatory framework applicable to trading of securities
could also govern trading of securities. SEBI was given more powers and it starts regulating
the stock exchanges in a professional manner by gradually introducing reforms in trading.
DBA 1754
NOTES
Derivatives trading commenced in India in June 2000 after SEBI granted the final approval
in May 2000. SEBI permitted the derivative segments of two stock exchanges, viz NSE
and BSE, and their clearing house/corporation to commence trading and settlement in
approved derivative contracts.
Introduction of derivatives was made in a phase manner allowing investors and traders
sufficient time to get used to the new financial instruments. Index futures on CNX Nifty and
BSE Sensex were introduced during 2000. The trading in index options commenced in
June 2001 and trading in options on individual securities commenced in July 2001. Futures
contracts on individual stock were launched in November 2001. In June 2003, SEBI/RBI
approved the trading in interest rate derivatives instruments and NSE introduced trading in
futures contract on June 24, 2003 on 91 day Notional T-bills. Derivatives contracts are
traded and settled in accordance with the rules, bylaws, and regulations of the respective
exchanges and their clearing house/corporation duly approved by SEBI and notified in the
official gazette.
The emergence of the market for derivatives products, most notable forwards, futures,
options and swaps 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 can be subject to 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, derivatives products generally
do not influence the fluctuations in the underlying asset prices. However, by locking-in
asset prices, derivatives products minimize the impact of fluctuations in asset prices on the
profitability and cash flow situation of risk-averse investors.
Factors generally attributed as the major driving force behind growth of financial
derivatives are:
i. Increased Volatility in asset prices in financial markets,
ii. Increased integration of national financial markets with the international markets,
iii. Marked improvement in communication facilities and sharp decline in their costs,
iv. Development of more sophisticated risk management tools, providing economic
agents a wider choice of risk management strategies, and
v. 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 transaction costs as compared to individual financial assets
Financial markets are, by nature, extremely volatile and hence the risk factor is an
important concern for financial agents. To reduce this risk, the concept of derivatives comes
into the picture. Derivatives are products whose values are derived from one or more
basic variables called bases. These bases can be underlying assets (for example forex,
NOTES
equity, etc), bases or reference rates. 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. The transaction
in this case would be the derivative, while the spot price of wheat would be the underlying
asset. Development of exchange-traded derivatives has 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 pre-arranging 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. The need for a derivatives market. The derivatives
market performs a number of economic functions:
i. They help in transferring risks from risk averse people to risk oriented people
ii. They help in the discovery of future as well as current prices
iii. They catalyze entrepreneurial activity
iv. They increase the volume traded in markets because of participation of risk averse
people in greater numbers
v. They increase savings and investment in the long run The participants in a derivatives
market
Hedgers use futures or options markets to reduce or eliminate the risk associated
with price of an asset. Speculators use futures and options contracts to get extra leverage
in betting on future movements in the price of an asset. They can increase both the potential
gains and potential losses by usage of derivatives 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. Types of Derivatives
Forwards: A forward contract is a customized contract between two entities, where
settlement takes place on a specific date in the future at todays 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. 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.
DBA 1754
NOTES
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. 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
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.
Factors driving the growth of financial derivatives
a. Increased volatility in asset prices in financial markets,
b. Increased integration of national financial markets with the international markets,
c. Marked improvement in communication facilities and sharp decline in their costs,
d. Development of more sophisticated risk management tools, providing economic
agents a wider choice of risk management strategies, and
d. 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 transactions costs as compared to individual financial assets.
Derivatives trading commenced in India in June 2000 after SEBI granted the final
approval to this effect in May 2001. SEBI permitted the derivative segments of two stock
exchanges, NSE and BSE, and their clearing house/corporation to commence trading and
settlement in approved derivatives contracts. To begin with, SEBI approved trading in
index futures contracts based on S&P CNX Nifty and BSE30(Sensex) index. This was
followed by approval for trading in options based on these two indexes and options on
individual securities. The trading in BSE Sensex options commenced on June 4, 2001
and the trading in options on individual securities commenced in July 2001. Futures contracts
on individual stocks were launched in November 2001. The derivatives trading on NSE
commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in index
options commenced on June 4, 2001 and trading in options on individual securities
commenced on July 2, 2001. Single stock futures were launched on Nov. 9, 2001. The
index futures and options contract on NSE are based on S&P CNX Trading and settlement
in derivative contracts is done in accordance with the rules, byelaws, and regulations of the
respective exchanges and their clearing house/corporation duly approved by SEBI and
NOTES
notified in the official gazette. Foreign Institutional Investors (FIIs) are permitted to trade in
all Exchange traded derivative products.
The following are some observations based on the trading statistics provided in the
NSE report on the futures and options (F&O):
Single-stock futures continue to account for a sizable proportion of the F&O
segment. It constituted 70 per cent of the total turnover during June 2002. A
primary reason attributed to this phenomenon is that traders are comfortable with
single-stock futures than equity options, as the former closely resembles the erstwhile
badla system.
On relative terms, volumes in the index options segment continue to remain poor.
This may be due to the low volatility of the spot index. Typically, options are
considered more valuable when the volatility of the underlying (in this case, the
index) is high. A related issue is that brokers do not earn high commissions by
recommending index options to their clients, because low volatility leads to higher
waiting time for round-trips.
Put volumes in the index options and equity options segment have increased since
January 2002. The call-put volumes in index options have decreased from 2.86 in
January 2002 to 1.32 in June. The fall in call-put volumes ratio suggests that the
traders are increasingly becoming pessimistic on the market.
Farther month futures contracts are still not actively traded. Trading in equity options
on most stocks for even the next month was non-existent.
Daily option price variations suggest that traders use the F&O segment as a less risky
alternative (read substitute) to generate profits from the stock price movements. The fact
that the option premiums tail intra-day stock prices is evidence to this. Calls on Satyam
fall, while puts rise when Satyam falls intra-day. If calls and puts are not looked as just
substitutes for spot trading, the intra-day stock price variations should not have a one-to-
one impact on the option premiums.
Commodity Derivatives Futures contracts in pepper, turmeric, gur (jaggery), hessian
(jute fabric), jute sacking, castor seed, potato, coffee, cotton, and soybean and its derivatives
are traded in 18 commodity exchanges located in various parts of the country. Futures
trading in other edible oils, oilseeds and oil cakes have been permitted. Trading in futures
in the new commodities, especially in edible oils, is expected to commence in the near
future. The sugar industry is exploring the merits of trading sugar futures contracts. The
policy initiatives and the modernisation programme include extensive training, structuring a
reliable clearinghouse, establishment of a system of warehouse receipts, and the thrust
towards the establishment of a national commodity exchange. The Government of India
has constituted a committee to explore and evaluate issues pertinent to the establishment
and funding of the proposed national commodity exchange for the nationwide trading of
commodity futures contracts, and the other institutions and institutional processes such as
warehousing and clearinghouses. With commodity futures, delivery is best effected using
DBA 1754
NOTES
warehouse receipts (which are like dematerialised securities). Warehousing functions have
enabled viable exchanges to augment their strengths in contract design and trading. The
viability of the national commodity exchange is predicated on the reliability of the
warehousing functions. The programme for establishing a system of warehouse receipts is
in progress. The Coffee Futures Exchange India (COFEI) has operated a system of
warehouse receipts since 1998 Exchange-traded vs. OTC (Over The Counter) 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
exchanges self-regulatory organization, although they are affected indirectly by
national legal systems, banking supervision and market surveillance.
2.1.3 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 12
th
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 pre-arranging 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.
2.1.4 The need for a derivatives market
The derivatives market performs a number of economic functions:
They help in transferring risks from risk adverse people to risk oriented people
They help in the discovery of future as well as current prices
NOTES
They catalyze entrepreneurial activity
They increase the volume traded in markets because of participation of risk adverse
people in greater numbers
They increase savings and investment in the long run
Summary
Derivatives are financial contracts whose values are derived from the value of an
underlying primary financial instrument, commodity or index, such as: interest rates, exchange
rates, commodities, and equities
Derivatives markets have had a slow start in India. The first step towards introduction
of derivatives trading in India was the promulgation of the Securities Laws (Amendments)
Ordinance, 1995, which withdrew the prohibition on options in securities. The market for
derivatives, however, did not take off, as there was no regulatory framework to govern
trading of derivatives
Financial markets are, by nature, extremely volatile and hence the risk factor is an
important concern for financial agents. To reduce this risk, the concept of derivatives comes
into the picture. Derivatives are products whose values are derived from one or more
basic variables called bases. These bases can be underlying assets (for example forex,
equity, etc), bases or reference rates. 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. The transaction
in this case would be the derivative, while the spot price of wheat would be the underlying
asset
Commodity Derivatives Futures contracts in pepper, turmeric, gur (jaggery), hessian
(jute fabric), jute sacking, castor seed, potato, coffee, cotton, and soybean and its derivatives
are traded in 18 commodity exchanges located in various parts of the country. Futures
trading in other edible oils, oilseeds and oil cakes have been permitted. Trading in futures
in the new commodities, especially in edible oils, is expected to commence in the near
future. The sugar industry is exploring the merits of trading sugar futures contracts. The
policy initiatives and the modernisation programme include extensive training, structuring a
reliable clearinghouse, establishment of a system of warehouse receipts, and the thrust
towards the establishment of a national commodity exchange.
Questions
The derivatives market performs a number of economic functions, Discuss
What is the feature of OTC derivatives markets?
Explain the development of Derivatives Market in India
What are the factors generally attributed as the major driving force behind
growth of financial derivatives in India?
What do you understand by Swaps?
DBA 1754
NOTES
CHAPTER II
REGULATIONS OF FINANCIAL
DERIVATIVES IN INDIA
2.2.1 Introduction
The first step towards introduction of derivatives trading in India was the promulgation
of the Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on
options in securities. The market for derivatives, however, did not take off, as there was no
regulatory framework to govern trading of derivatives. SEBI set up a 24member committee
under the Chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop appropriate
regulatory framework for derivatives trading in India. The committee submitted its report
on March 17, 1998 prescribing necessary preconditions for introduction of derivatives
trading in India. The committee recommended that derivatives should be declared as
securities so that regulatory framework applicable to trading of securities could also
govern trading of securities. SEBI also set up a group in June 1998 under the Chairmanship
of Prof.J.R.Varma, to recommend measures for risk containment in derivatives market in
India. The report, which was submitted in October 1998, worked out the operational
details of margining system, methodology for charging initial margins, broker net worth,
deposit requirement and realtime monitoring requirements. The Securities Contract
Regulation Act (SCRA) was amended in December 1999 to include derivatives within the
ambit of securities and the regulatory framework was developed for governing derivatives
trading. The act also made it clear that derivatives shall be legal and valid only if such
contracts are traded on a recognized stock exchange, thus precluding OTC derivatives.
The government also rescinded in March 2000, the threedecade old notification, which
prohibited forward trading in securities.
2.2.2 Regulations by National Stock Exchange
2.2.2.1 Minimum Base Capital
A Clearing Member (CM) is required to meet with the Base Minimum Capital (BMC)
requirements prescribed by NSCCL before activation. The CM has also to ensure that
BMC is maintained in accordance with the requirements of NSCCL at all points of time,
after activation. Every CM is required to maintain BMC of Rs.50 lakhs with NSCCL in
the following manner:
1. Rs.25 lakhs in the form of cash.
2. Rs.25 lakhs in any one form or combination of the below forms:
NOTES
i. Cash
ii. Fixed Deposit Receipts (FDRs) issued by approved banks and deposited with
approved Custodians or NSCCL
iii. Bank Guarantee in favour of NSCCL from approved banks in the specified format.
iv. Approved securities in demat form deposited with approved Custodians.
In addition to the above MBC requirements, every CM is required to maintain BMC
of Rs.10 lakhs, in respect of every trading member(TM) whose deals such CM undertakes
to clear and settle, in the following manner:
1. Rs.2 lakhs in the form of cash.
2. Rs.8 lakhs in a one form or combination of the following:
Cash
Fixed Deposit Receipts (FDRs) issued by approved banks and deposited
with approved Custodians or NSCCL
Bank Guarantee in favour of NSCCL from approved banks in the specified format.
Approved securities in demat form deposited with approved Custodians.
Any failure on the part of a CM to meet with the BMC requirements at any point of
time, will be treated as a violation of the Rules, Bye-Laws and Regulations of NSCCL and
would attract disciplinary action inter-alia including, withdrawal of trading facility and/ore
clearing facility, closing out of outstanding positions etc.
2.2.2.2 Additional Base Capital
Clearing members may provide additional margin/collateral deposit (additional base
capital) to NSCCL and/or may wish to retain deposits and/or such amounts which are
receivable from NSCCL, over and above their minimum deposit requirements, towards
initial margin and/ or other obligations.
Clearing members may submit such deposits in any one form or combination of the
following forms:
Cash
Fixed Deposit Receipts (FDRs) issued by approved banks and deposited with
approved Custodians or NSCCL
Bank Guarantee in favour of NSCCL from approved banks in the specified format.
Approved securities in demat form deposited with approved custodians
2.2.2.3 Effective Deposits / Liquid Networth
Effective deposits
All collateral deposits made by CMs are segregated into cash component and non-
cash component.
DBA 1754
NOTES
For Additional Base Capital, cash component means cash, bank guarantee, fixed
deposit receipts, T-bills and dated government securities. Non-cash component shall mean
all other forms of collateral deposits like deposit of approved demat securities.
At least 50% of the Effective Deposits should be in the form of cash.
2.2.2.4 Liquid Networth
Liquid Networth is computed by reducing the initial margin payable at any point in
time from the effective deposits.
The Liquid Networth maintained by CMs at any point in time should not be less than
Rs.50 lakhs (referred to as Minimum Liquid Net Worth).
2.2.2.5 Margins
NSCCL has developed a comprehensive risk containment mechanism for the Futures
& Options segment. The most critical component of a risk containment mechanism for
NSCCL is the online position monitoring and margining system. The actual margining and
position monitoring is done on-line, on an intra-day basis. NSCCL uses the SPAN
(Standard Portfolio Analysis of Risk) system for the purpose of margining, which is a
portfolio based system
2.2.2.6 Initial Margin
NSCCL collects initial margin up-front for all the open positions of a CM based on
the margins computed by NSCCL - SPAN. A CM is in turn required to collect the initial
margin from the TMs and his respective clients. Similarly, a TM should collect upfront
margins from his clients.
Initial margin requirements are based on 99% value at risk over a one day time horizon.
However, in the case of futures contracts (on index or individual securities), where it may
not be possible to collect mark to market settlement value, before the commencement of
trading on the next day, the initial margin may be computed over a two-day time horizon,
applying the appropriate statistical formula. The methodology for computation of Value at
Risk percentage is as per the recommendations of SEBI from time to time.
2.2.2.7 Initial margin requirement for a member
For client positions - shall be netted at the level of individual client and grossed
across all clients, at the Trading/ Clearing Member level, without any setoffs between
clients.
For proprietary positions - shall be netted at Trading/ Clearing Member level without
any setoffs between client and proprietary positions.
For the purpose of SPAN Margin, various parameters are specified from time to
time.
NOTES
In case a trading member wishes to take additional trading positions his CM is required
to provide Additional Base Capital (ABC) to NSCCL. ABC can be provided by the
members in the form of Cash Bank Guarantee, Fixed Deposit Receipts and approved
securities.
2.2.2.8 Premium Margin
In addition to Initial Margin, Premium Margin would be charged to members. The
premium margin is the client wise margin amount payable for the day and will be required
to be paid by the buyer till the premium settlement is complete.
2.2.2.9 Assignment Margin
Assignment Margin is levied on a CM in addition to SPAN margin and Premium
Margin. It is required to be paid on assigned positions of CMs towards Interim and Final
Exercise Settlement obligations for option contracts on individual securities, till such
obligations are fulfilled.
The margin is charged on the Net Exercise Settlement Value payable by a Clearing
Member towards Interim and Final Exercise Settlement and is deductible from the effective
deposits of the Clearing Member available towards margins. Assignment margin is released
to the CMs for exercise settlement pay-in.
2.2.2.10 Margin Reports
The following margin reports are downloaded to members on a daily basis:
1. Margin Statement of Clearing Members : MG-09
2. Margin Statement of Trading Member/ Custodial Participant : MG-10
3. Margin Payable Statement of Clearing Member : MG-11
4. Detail Margin File of Clearing Members : MG - 12
5. Client Level Margin File of Trading Members : MG-13 Details of Margin Reports
2.2.2.11 NSCCL SPAN
The objective of SPAN is to identify overall risk in a portfolio of futures and options
contracts for each member. The system treats futures and options contracts uniformly,
while at the same time recognizing the unique exposures associated with options portfolios
like extremely deep out-of-the-money short positions, inter-month risk and inter-commodity
risk.
Because SPAN is used to determine performance bond requirements (margin
requirements), its overriding objective is to determine the largest loss that a portfolio might
reasonably be expected to suffer from one day to the next day.
DBA 1754
NOTES
In standard pricing models, three factors most directly affect the value of an option at
a given point in time:
1. Underlying market price
2. Volatility (variability) of underlying instrument
3. Time to expiration
As these factors change, so too will the value of futures and options maintained within
a portfolio. SPAN constructs scenarios of probable changes in underlying prices and
volatilities in order to identify the largest loss a portfolio might suffer from one day to the
next. It then sets the margin requirement at a level sufficient to cover this one-day loss.
i. Mechanics of SPAN
ii. Risk Arrays
iii. Composite Delta
iv. Calendar spread or Intra commodity or Inter month Risk Charge
v. Short option Minimum Charge
vi. Net Buy Premium (only for option contracts)
vii. Computation of Initial Margin Overall Portfolio Margin Requirement
viii. Black Scholes Option Price calculation model.
2.2.2.12 Mechanics of SPAN
The complex calculations (e.g. the pricing of options) in SPAN are executed by the
Clearing Corporation. The results of these calculations are called Risk arrays. Risk arrays,
and other necessary data inputs for margin calculation are then provided to members in a
file called the SPAN Risk Parameter file. This file will be provided to members on a daily
basis.
Members can apply the data contained in the Risk parameter files, to their specific
portfolios of futures and options contracts, to determine their SPAN margin requirements.
Hence members need not execute complex option pricing calculations, which would
be performed by NSCCL. SPAN has the ability to estimate risk for combined futures and
options portfolios, and re-value the same under various scenarios of changing market
conditions.
2.2.2.13 Risk Arrays
The SPAN risk array represents how a specific derivative instrument (for example,
an option on NIFTY index at a specific strike price) will gain or lose value, from the
current point in time to a specific point in time in the near future (typically it calculates risk
over a one day period called the look ahead time), for a specific set of market conditions
which may occur over this time duration.
NOTES
The specific set of market conditions evaluated, are called the risk scenarios, and
these are defined in terms of :
1. how much the price of the underlying instrument is expected to change over one
trading day, and
2. how much the volatility of that underlying price is expected to change over one
trading day.
The results of the calculation for each risk scenario i.e. the amount by which the
futures and options contracts will gain or lose value over the look-ahead time under that
risk scenario - is called the risk array value for that scenario. The set of risk array values
for each futures and options contract under the full set of risk scenarios, constitutes the
Risk Array for that contract.
In the Risk Array, losses are represented as positive values, and gains as negative
values. Risk array values are typically represented in the currency (Indian Rupees) in which
the futures or options contract is denominated.
SPAN further uses a standardized definition of the risk scenarios, defined in terms of
i. the underlying price scan range or probable price change over a one day period,
ii. and the underlying price volatility scan range or probable volatility change of the
underlying over a one day period.
These two values are often simply referred to as the price scan range and the volatility
scan range. There are sixteen risk scenarios in the standard definition. These scenarios are
listed as under:
a. Underlying unchanged; volatility up
b. Underlying unchanged; volatility down
c. Underlying up by 1/3 of price scanning range; volatility up
d. Underlying up by 1/3 of price scanning range; volatility down
e. Underlying down by 1/3 of price scanning range; volatility up
f. Underlying down by 1/3 of price scanning range; volatility down
g. Underlying up by 2/3 of price scanning range; volatility up
h. Underlying up by 2/3 of price scanning range; volatility down
i. Underlying down by 2/3 of price scanning range; volatility up
j. Underlying down by 2/3 of price scanning range; volatility down
k. Underlying up by 3/3 of price scanning range; volatility up
l. Underlying up by 3/3 of price scanning range; volatility down
m. Underlying down by 3/3 of price scanning range; volatility up
n. Underlying down by 3/3 of price scanning range; volatility down
DBA 1754
NOTES
o. Underlying up extreme move, double the price scanning range (cover 35% of
loss)
p. Underlying down extreme move, double the price scanning range (cover 35% of
loss)
SPAN uses the risk arrays to scan probable underlying market price changes and
probable volatility changes for all contracts in a portfolio, in order to determine value gains
and losses at the portfolio level. This is the single most important calculation executed by
the system.
As shown above in the sixteen standard risk scenarios, SPAN starts at the last underlying
market settlement price and scans up and down three even intervals of price changes
(price scan range).
At each price scan point, the program also scans up and down a range of probable
volatility from the underlying markets current volatility (volatility scan range). SPAN
calculates the probable premium value at each price scan point for volatility up and volatility
down scenario. It then compares this probable premium value to the theoretical premium
value (based on last closing value of the underlying) to determine profit or loss.
Deep-out-of-the-money short options positions pose a special risk identification
problem. As they move towards expiration, they may not be significantly exposed to normal
price moves in the underlying. However, unusually large underlying price changes may
cause these options to move into-the-money, thus creating large losses to the holders of
short option positions. In order to account for this possibility, two of the standard risk
scenarios in the Risk Array (sr. no. 15 and 16) reflect an extreme underlying price movement,
currently defined as double the maximum price scan range for a given underlying. However,
because price changes of these magnitudes are rare, the system only covers 35% of the
resulting losses.
After SPAN has scanned the 16 different scenarios of underlying market price and
volatility changes, it selects the largest loss from among these 16 observations. This largest
reasonable loss is the Scanning Risk Charge for the portfolio - in other words, for all
futures and options contracts.
2.2.2.14 Composite Delta
SPAN uses delta information to form spreads between futures and options contracts.
Delta values measure the manner in which a futures or options value will change in relation
to changes in the value of the underlying instrument. Futures deltas are always 1.0; options
deltas range from -1.0 to +1.0. Moreover, options deltas are dynamic: a change in value of
the underlying instrument will affect not only the options price, but also its delta.
NOTES
In the interest of simplicity, SPAN employs only one delta value per contract, called
the Composite Delta. It is the weighted average of the deltas associated with each
underlying price scan point. The weights associated with each price scan point are
based upon the probability of the associated price movement, with more likely price changes
receiving higher weights and less likely price changes receiving lower weights. Please note
that Composite Delta for an options contract is an estimate of the contracts delta after the
lookahead - in other words, after one trading day has passed.
2.2.2.15 Calendar Spread or Intra-commodity or Inter-month Risk Charge
As SPAN scans futures prices within a single underlying instrument, it assumes that
price moves correlate perfectly across contract months. Since price moves across contract
months do not generally exhibit perfect correlation, SPAN adds an Calendar Spread Charge
(also called the Inter-month Spread Charge) to the Scanning Risk Charge associated with
each futures and options contract. To put it in a different way, the Calendar Spread Charge
covers the calendar (inter-month etc.) basis risk that may exist for portfolios containing
futures and options with different expirations.
For each futures and options contract, SPAN identifies the delta associated each
futures and option position, for a contract month. It then forms spreads using these deltas
across contract months. For each spread formed, SPAN assesses a specific charge per
spread which constitutes the Calendar Spread Charge.
The margin for calendar spread shall be calculated on the basis of delta of the portfolio
in each month. Thus a portfolio consisting of a near month option with a delta of 100 and
a far month option with a delta of 100 would bear a spread charge equivalent to the
calendar spread charge for a portfolio which is long 100 near month futures contract and
short 100 far month futures contract.
A calendar spread would be treated as a naked position in the far month contract
three trading days before the near month contract expires.
2.2.2.16 Short Option Minimum Charge
Short options positions in extremely deep-out-of-the-money strikes may appear to
have little or no risk across the entire scanning range. However, in the event that underlying
market conditions change sufficiently, these options may move into-the-money, thereby
generating large losses for the short positions in these options. To cover the risks associated
with deep-out-of-the-money short options positions, SPAN assesses a minimum margin
for each short option position in the portfolio called the Short Option Minimum charge,
which is set by the NSCCL. The Short Option Minimum charge serves as a minimum
charge towards margin requirements for each short position in an option contract.
DBA 1754
NOTES
For example, suppose that the Short Option Minimum charge is Rs. 50 per short
position. A portfolio containing 20 short options will have a margin requirement of at least
Rs. 1,000, even if the scanning risk charge plus the inter month spread charge on the
position is only Rs. 500.
2.2.2.17 Net Buy Premium (only for option contracts)
In the above scenario only sell positions are margined and offsetting benefits for buy
positions are given to the extent of long positions in the portfolio by computing the net
option value.
To cover the one day risk on long option positions (for which premium shall be payable
on T+1 day), net buy premium to the extent of the net long options position value is
deducted from the Liquid Networth of the member on a real time basis. This would be
applicable only for trades done on a given day. The Net Buy Premium margin shall be
released towards the Liquid Networth of the member on T+1 day after the completion of
pay-in towards premium settlement.
2.2.2.18 Computation of Initial Margin - Overall Portfolio Margin
Requirement
The total margin requirements for a member for a portfolio of futures and options
contract would be computed as follows:
i. SPAN will add up the Scanning Risk Charges and the Intracommodity Spread
Charges.
ii. SPAN will compares this figure (as per i above) to the Short Option Minimum
charge
iii. It will select the larger of the two values between (i) and (ii)
iv. Total SPAN Margin requirement is equal to SPAN Risk Requirement (as per
above), less the net option value, which is mark to market value of difference in
long option positions and short option positions.
v. Initial Margin requirement = Total SPAN Margin Requirement + Net Buy Premium
2.2.3 Black-Scholes Option Price calculation model
The options price for a Call, computed as per the following Black Scholes formula:
C = S * N (d
1
) - X * e
- rt
* N (d
2
)
and the price for a Put is : P = X * e
- rt
* N (-d
2
) - S * N (-d
1
)
where :
d
1
= [ln (S / X) + (r +
2
/ 2) * t] / * sqrt(t)
NOTES
d
2
= [ln (S / X) + (r -
2
/ 2) * t] / * sqrt(t)
= d
1
- * sqrt(t)
C = price of a call option
P = price of a put option
S price of the underlying asset
X = Strike price of the option
r = rate of interest
t = time to expiration
= volatility of the underlying
N represents a standard normal distribution with mean =0 and standard deviation = 1
ln represents the natural logarithm of a number. Natural logarithms are based on the
constant e (2.71828182845904).
Rate of interest may be the relevant MIBOR rate or such other rate as may be specified.
SPAN is a registered trademark of the Chicago Mercantile Exchange, used herein
under License. The Chicago Mercantile Exchange assumes no liability in connection with
the use of SPAN by any person or entity.
2.2.4 Payment of Margins
The initial margin is payable upfront by Clearing Members. Initial margins can be paid
by members in the form of Cash, Guarantee, Fixed Deposit Receipts and approved securities
Non-fulfillment of either the whole or part of the margin obligations will be treated as
a violation of the Rules, Bye-Laws and Regulations of NSCCL and will attract penal
charges at 0.7 percent per day of the amount not paid throughout the period of non-
payment. In addition NSCCL may at its discretion and without any further notice to the
clearing member, initiate other disciplinary action, inter-alia including, withdrawal of trading
facilities and/ or clearing facility, close out of outstanding positions, imposing penalties,
collecting appropriate deposits, invoking bank guarantees/ fixed deposit receipts, etc.
2.2.5 Violations
PRISM (Parallel Risk Management System) is the real-time position monitoring and
risk management system for the Futures and Options market segment at NSCCL. The
risk of each trading and clearing member is monitored on a real-time basis and alerts/
disablement messages are generated if the member crosses the set limits.
DBA 1754
NOTES
Initial Margin Violation
Exposure Limit Violation
Trading Memberwise Position Limit Violation
Client Level Position Limit Violation
Market Wide Position Limit Violation
Violation arising out of misutilisation of trading member/constituent collaterals and/
or deposits
Violation of Exercised Positions
Clearing members, who have violated any requirement and / or limits, may submit a
written request to NSCCL to either reduce their open position or, bring in additional cash
deposit by way of cash or bank guarantee or FDR or securities.
A penalty of Rs. 5000/- is levied for each violation and is debited to the clearing
account of clearing member on the next business day. In respect of violation on more than
one occasion on the same day, penalty in case of second and subsequent violation during
the day will be increased by Rs.5000/- for each such instance. (For example in case of
second violation for the day the penalty leviable will be Rs.10000/-, Rs.15000 for third
instance and so on). The penalty is charged to the clearing member irrespective of whether
the clearing member brings in margin deposits subsequently.
Where the penalty levied on a clearing member/ trading member relates to a violation
of Client-wise Position Limit, the clearing member/ trading member may in turn, recover
such amount of penalty from the concerned clients who committed the violation
2.2.6 Market Wide Position Limits for derivative contracts on underlying
stocks
At the end of each day the Exchange shall test whether the market wide open interest
for any scrip exceeds 95% of the market wide position limit for that scrip. If so, the
Exchange shall take note of open position of all client/ TMs as at the end of that day in that
scrip, and from next day onwards the client/ TMs shall trade only to decrease their positions
through offsetting positions till the normal trading in the scrip is resumed.
The normal trading in the scrip shall be resumed only after the open outstanding
position comes down to 80% or below of the market wide position limit.
A facility is available on the trading system to display an alert once the open interest in
the futures and options contract in a security exceeds 60% of the market wide position
limits specified for such security. Such alerts are presently displayed at time intervals of 10
minutes.
NOTES
At the end of each day during which the ban on fresh positions is in force for any
scrip, when any member or client has increased his existing positions or has created a new
position in that scrip the client/ TMs shall be subject to a penalty of 1% of the value of
increased position subject to a minimum of Rs.5000 and maximum of Rs.1, 00,000. The
positions, for this purpose, will be valued at the underlying close price.
The penalty shall be recovered from the clearing member affiliated with such trading
members/clients on a T+1 day basis along with pay-in. The amount of penalty shall be
informed to the clearing member at the end of the day.
2.2.7 Price Scan Range
To compute worst scenario loss on a portfolio, the price scan range for option on
individual securities and futures on individual securities would also be linked to liquidity,
measured in terms of impact cost for an order size of Rs 5 lakh calculated on the basis of
order book snapshots in the previous six months. Accordingly if the mean value of the
impact cost exceeds 1%, the price scanning range would be scaled up by square root of
three. This would be in addition to the requirement on account of look ahead period as
may be applicable.
The mean impact cost as stipulated by SEBI is calculated on the 15th of each month
on a rolling basis considering the order book snap shots of previous six months. If the
mean impact cost of a security moves from less than or equal to 1% to more than 1%, the
price scan range in such underlying shall be scaled by square root of three and scaling shall
be dropped when the impact cost drops to 1% or less. Such changes shall be applicable
on all existing open position from the third working day from the 15th of each month. The
detail of impact cost on the list of underlyings on which derivative contracts are available
and the methodology of computation of the same are available at our website.
2.2.8 Position Limits
Clearing Members are subject to the following exposure / position limits in addition to
initial margins requirements
i. Exposure Limits
ii. Trading Member wise Position Limit
iii. Client Level Position Limit
iv. Market Wide Position Limits (for Derivative Contracts on Underlying Stocks)
v. Collateral limit for Trading Members
DBA 1754
NOTES
2.2.9 Scheme for FIIs and MFs trading in Exchange traded derivatives
2.2.9.1 Position Limits
The position limits for FII, Mutual Funds , FII sub-accounts & MF schemes shall be
as under:
2.2.9.2 At the level of the FII and MF
i. FII & MF Position limits in Index options contracts:
FII and MF position limit in all index options contracts on a particular underlying
index shall be Rs.500 crores or 15 % of the total open interest of the market in index
options, whichever is higher. This limit would be applicable on open positions in all options
contracts on a particular underlying index.
ii. FII & MF Position limits in Index futures contracts:
FII and MF position limit in all index futures contracts on a particular underlying index
shall be Rs.500 crores or 15 % of the total open interest of the market in index futures,
whichever is higher. This limit would be applicable on open positions in all futures contracts
on a particular underlying index.
In addition to the above, FIIs & MFs shall take exposure in equity index derivatives
subject to the following limits:
Short positions in index derivatives (short futures, short calls and long puts) not
exceeding (in notional value) the FIIs / MFs holding of stocks.
Long positions in index derivatives (long futures, long calls and short puts) not
exceeding (in notional value) the FIIs / MFs holding of cash, government securities,
T-Bills and similar instruments.
In this regard, if the open positions of an FII / MF exceeds the limits as stated in item
no a or b, such surplus would be deemed to comprise of short and long positions in the
same proportion of the total open positions individually. Such short and long positions in
excess of the said limits shall be compared with the FIIs / MFs holding in stocks, cash etc
as stated above.
iii. Stock Futures & Options
For stocks having applicable market-wise position limit (MWPL) of Rs. 500 crores
or more, the combined futures and options position limit shall be 20% of applicable
MWPL or Rs. 300 crores, whichever is lower and within which stock futures
position cannot exceed 10% of applicable MWPL or Rs. 150 crores, whichever
is lower.
NOTES
For stocks having applicable market-wise position limit (MWPL) less than Rs.
500 crores, the combined futures and options position limit would be 20% of
applicable MWPL and futures position cannot exceed 20% of applicable MWPL
or Rs. 50 crore which ever is lower.
2.2.9. 3 At the level of the sub-account a) Index Futures & Options
A disclosure is requirement from any person or persons acting in concert who together
own 15% or more of the open interest of all futures and options contracts on a particular
underlying index on the Exchange. A failure to do so shall be treated as a violation and shall
attract appropriate penal and disciplinary action in accordance with the Rules, Bye-Laws
and Regulations of NSE/NSCCL.
b) Stock Futures & Options
The gross open position across all futures and options contracts on a particular
underlying security, of a sub-account of an FII, should not exceed the higher of :
i. 1% of the free float market capitalisation (in terms of number of shares) or
ii. 5% of the open interest in the derivative contracts on a particular underlying stock (in
terms of number of contracts). These position limits shall be applicable on the combined
position in all futures and options contracts on an underlying security on the Exchange.
c) Procedures
The Clearing Corporation would monitor the FII position limits at the end of each
trading day. For this purpose, the following procedure is prescribed:
FIIs intending to trade in the F&O segment of the Exchange shall be required to
notify the following details of the Clearing Member/s, who shall clear and settle their trades
in the F&O segment, to Clearing Corporation.
1. Name of FII
2. SEBI Registration Number
3. Name of sub-account/s of FII (if any)
4. Name of the Clearing Member/s.
A unique code will be allotted by Clearing Corporation to each such FII prior to
commencement of trading by them. This will be utilized by Clearing Corporation for the
purpose of monitoring position limits at the level of the FII. For e.g. If the name of FII is
say XYZ and it has 2 sub accounts viz. scheme 1 and 2, the FII code allotted by NSCCL
may be XYZ (comprising 12 characters).
Each FII/ sub-account of the FII, as the case may be, intending to trade in the F&O
segment of the Exchange, shall further be required to obtain a unique Custodial Participant
(CP) code allotted from the Clearing Corporation, through their Clearing Member. CP
DBA 1754
NOTES
code normally comprises of 12 alphanumeric characters. Clearing Corporation will allot
CP codes to each such FII/ sub-account of the FII. he Clearing Member/s of the FII/ sub-
account of the FII, are required to furnish the following details to Clearing Corporation, to
obtain CP codes:
a) Name of FII
b) Unique code allotted to the FII by NSCCL (as detailed in 2 above)
c) Name of sub-account/s of FII
d) CP code/s allotted to the FII/ sub account/s of the FII, in the Capital Market
segment of Clearing Corporation
Eg. In the example given in 2 above the CP codes allotted by NSCCL may be
ABCDEFGH0001 and ABCDEFGH0002.
FIIs/ sub accounts of FIIs which have been allotted a unique CP code by Clearing
Corporation shall only be permitted to trade on the Exchange.
The FII/ sub-account of FII shall ensure that all orders placed by them on the Exchange
carry the relevant CP code allotted by Clearing Corporation as specified in point 3 above,
in the relevant field in NEATFO.
Clearing Member/s of the FII shall submit the details of all the trades confirmed by
FII to Clearing Corporation, by the end of each trading day, as per the mechanism specified.
Clearing Corporation will monitor the open positions of the FII/ sub-account of the
FII for each underlying security and index on which futures and option contracts are traded
on the Exchange, against the position limits specified at the level of FII/ sub-accounts of
FII respectively, at the end of each trading day.
The cumulative FII position may be disclosed to the market on a T + 1 basis, before
the commencement of trading on the next day.
In the event of an FII breaching the position limits on any underlying, Clearing
Corporation will advise the Exchange to withdraw the facility granted to such FII to take
any fresh positions in any derivative contracts. Such FII will be required to reduce their
open position in such underlying, in accordance with the mechanism provided by Clearing
Corporation from time to time. The facility withdrawn may be reinstated upon due
compliance of the position limits.
It shall also be obligatory on FIIs to report any breach of position limits by them / their
sub-account/s, to Clearing Corporation and ensure that such sub-account/s does not take
any fresh positions in any derivative contracts in such underlying. The sub-account of FII
shall be required to reduce open position in such underlying, in accordance with the
mechanism specified by Clearing Corporation. Only upon due compliance of the position
limits, the sub-accounts may permitted to take further positions.
NOTES
d) Computation of Position Limits
The position limits would be computed on a gross basis at the level of a FII and on a
net basis at the level of sub-accounts and proprietary positions.
The open position for all derivative contracts would be valued as the open interest
multiplied with the closing price of the respective underlying in the cash market.
E) Client Margin Reporting
Clearing Members (CMs) and Trading Members (TMs) are required to collect upfront
initial margins from all their Trading Members/ Constituents.
CMs are required to compulsorily report, on a daily basis, details in respect of such
margin amount due and collected, from the TMs/ Constituents clearing and settling through
them, with respect to the trades executed/ open positions of the TMs/ Constituents, which
the CMs have paid to NSCCL, for the purpose of meeting margin requirements.
Similarly, TMs are required to report on a daily basis details in respect of such margin
amount due and collected from the constituents clearing and settling through them, with
respect to the trades executed/ open positions of the constituents, which the trading members
have paid to the CMs, and on which the CMs have allowed initial margin limit to the TMs.
f) Due date for Margin Reporting
The cut off day upto which a member may report client margin details to NSCCL is
referred to as the sign off date. It shall be 2 working days after the trade day.
g) Non submission of Client Margin Reporting Files
A penalty of Rs.200/- is charged to the members for each day of wrong reporting/
partial reporting or non reporting of client margin in the prescribed format as specified
above, beyond 2 working days from the trade day.
h) Short reporting of margins in Client Margin Reporting Files
The following penalty shall be levied in case of short reporting by trading/clearing
member per instance. The amount of penalty shall vary as per the percentage of short
reporting done by members as indicated below :
Percentage of short reporting (In
terms of Value)
Penalty per instance
< 1% Nil
> 1% but less than or equal to 20% Reprimand Letter
>20 Rs. 1000 or 0.10% of the shortage
amount whichever is higher subject
to a maximum of Rs. 1,00,000/-

DBA 1754
NOTES
Summary
The first step towards introduction of derivatives trading in India was the promulgation
of the Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on
options in securities. The market for derivatives, however, did not take off, as there was no
regulatory framework to govern trading of derivatives. SEBI set up a 24member committee
under the Chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop appropriate
regulatory framework for derivatives trading in India. The committee submitted its report
on March 17, 1998 prescribing necessary preconditions for introduction of derivatives
trading in India.
Clearing members may provide additional margin/collateral deposit (additional base
capital) to NSCCL and/or may wish to retain deposits and/or such amounts which are
receivable from NSCCL, over and above their minimum deposit requirements, towards
initial margin and/ or other obligations.
NSCCL has developed a comprehensive risk containment mechanism for the Futures
& Options segment. The most critical component of a risk containment mechanism for
NSCCL is the online position monitoring and margining system. The actual margining and
position monitoring is done on-line, on an intra-day basis. NSCCL uses the SPAN
(Standard Portfolio Analysis of Risk) system for the purpose of margining, which is a
portfolio based system
The objective of SPAN is to identify overall risk in a portfolio of futures and options
contracts for each member. The system treats futures and options contracts uniformly,
while at the same time recognizing the unique exposures associated with options portfolios
like extremely deep out-of-the-money short positions, inter-month risk and inter-commodity
risk.
Because SPAN is used to determine performance bond requirements (margin
requirements), its overriding objective is to determine the largest loss that a portfolio might
reasonably be expected to suffer from one day to the next day
PRISM (Parallel Risk Management System) is the real-time position monitoring and
risk management system for the Futures and Options market segment at NSCCL. The
risk of each trading and clearing member is monitored on a real-time basis and alerts/
disablement messages are generated if the member crosses the set limits.
Questions
(a) Explain the NSE Regulation over Minimum Base Capital of Clearing Member
(b) What is the initial margin of Members for Derivative Trading?
(c) Explain the Mechanics of SPAN
(d) What is meant by Price Scan Range?
(e) What do you mean by Client Margin Reporting?
(f) How does the Clearing Corporation monitor the FII position limits at the end of
each trading day?
NOTES
UNIT III
STRATEGIES
CHAPTER I
HEDGING STRATEGIES USING INDEX FUTURES
3.1.1 Introduction
If a company knows that it has to sell a particular asset at a particular time in the
future, it can hedge by taking a short position, therefore locking in the price of delivery.
This is called a short hedge. Similarly, a company that knows that it will need an asset in the
future can take a long hedge, thus locking in the price of purchase. It is very important to
note that hedging does not necessarily improve the financial outcome, it just reduces the
uncertainty. In practice, hedging is not perfect, the basis risk arises due to a number of
reasons:
The asset being hedged might be different that the one underlying the futures contract,
i.e. using a 30y T-bill to hedge a 10y T-note;
The hedger might be uncertain about the exact time that the delivery has to take
place, i.e. a new oil ring that is expected to start extracting next summer, without
knowing exactly when; and
3.1.2 S&P CNX Nifty
S&P CNX Nifty is a well diversified 50 stock index accounting for 21 sectors of the
economy. It is used for a variety of purposes such as benchmarking fund portfolios, index
based derivatives and index funds.
S&P CNX Nifty is owned and managed by India Index Services and Products Ltd.
(IISL), hich is a joint venture between NSE and CRISIL. IISL is Indias first specialised
company focused upon the index as a core product. IISL has a Marketing and licensing
agreement with Standard & Poors (S&P), who are world leaders in index services.
The traded value for the last six months of all Nifty stocks is approximately 48.15%
of the traded value of all stocks on the NSE
Nifty stocks represent about 59.32% of the total market capitalization as on June 30,
2008.
DBA 1754
NOTES
Impact cost f the S&P CNX Nifty for a portfolio size of Rs.2 crore is 0.14%
S&P CNX Nifty is professionally maintained and is ideal for derivatives trading
3.1.3 Trading in Nifty
The National Stock Exchange of India Limited (NSE) commenced trading in derivatives
with index futures on June 12, 2000. The futures contracts on NSE are based on S&P
CNX Nifty. The Exchange later introduced trading on index options based on Nifty on
June 4, 2001.
The turnover in the derivatives segment has shown considerable growth in the last
year, with NSE turnover accounting for 60% of the total turnover in the year 2000-2001.
Further details on index based derivatives are available under the Derivatives (F&O) section
of the website.
3.1.4 S&P CNX Nifty Futures
based on the popular market benchmark S&P CNX Nifty index. (Selection criteria for
indices)
3.1.4.1 Eligibility Criteria for selection of Securities and Indices
The eligibility of a stock / index for trading in Derivatives segment is based upon the
criteria laid down by SEBI through various circulars issued from time to time.
A) Eligibility criteria of stocks
The stock shall be chosen from amongst the top 500 stocks in terms of average daily
market capitalisation and average daily traded value in the previous six months on a rolling
basis.
The stocks median quarter-sigma order size over the last six months shall be not less
than Rs. 0.10 million (Rs. 1 lac). For this purpose, a stocks quarter-sigma order size shall
mean the order size (in value terms) required to cause a change in the stock price equal to
one-quarter of a standard deviation.
The market wide position limit in the stock shall not be less than Rs. 500 million (Rs.
50 crores). The market wide position limit (number of shares) shall be valued taking the
closing prices of stocks in the underlying cash market on the date of expiry of contract in
NOTES
the month. The market wide position limit of open position (in terms of the number of
underlying stock) on futures and option contracts on a particular underlying stock shall be
20% of the number of shares held by non-promoters in the relevant underlying security i.e.
free-float holding.
B) Continued Eligibility
For an existing stock to become ineligible, the criteria for market wide position limit
shall be relaxed upto 10% of the criteria applicable for the stock to become eligible for
derivatives trading. To be dropped out of Derivatives segment, the stock will have to fail
the relaxed criteria for 3 consecutive months.
If an existing security fails to meet the eligibility criteria for three months consecutively,
then no fresh month contract shall be issued on that security.
However, the existing unexpired contracts may be permitted to trade till expiry and
new strikes may also be introduced in the existing contract months.
C) Re-introduction of dropped stocks
A stock which is dropped from derivatives trading may become eligible once again.
In such instances, the stock is required to fulfill the eligibility criteria for three consecutive
months to be re-introduced for derivatives trading.
D) Eligibility criteria of Indices
Futures & Options contracts on an index can be introduced only if 80% of the index
constituents are individually eligible for derivatives trading. However, no single ineligible
stock in the index shall have a weightage of more than 5% in the index. The index on which
futures and options contracts are permitted shall be required to comply with the eligibility
criteria on a continuous basis.
SEBI has subsequently modified the above criteria, vide its clarification issued to the
Exchange The Exchange may consider introducing derivative contracts on an index if the
stocks contributing to 80% weightage of the index are individually eligible for derivative
trading. However, no single ineligible stocks in the index shall have a weightage of more
than 5% in the index.
The above criteria is applied every month, if the index fails to meet the eligibility
criteria for three months consecutively, then no fresh month contract shall be issued on that
index, However, the existing unexpired contacts shall be permitted to trade till expiry and
new strikes may also be introduced in the existing contracts.
DBA 1754
NOTES
3.1.4.2 The following procedure is adopted for calculating the Quarter Sigma
Order Size
a) The applicable VAR (Value at Risk) is calculated for each security based on the
J.R. Varma Committee guidelines. (The formula suggested by J. R. Varma for
computation of VAR for margin calculation is statistically known as Exponentially
weighted moving average (EWMA) method. In comparison to the traditional
method, EWMA has the advantage of giving more weight to the recent price
movements and less weight to the historical price movements.)
b) Such computed VAR is a value (like 0.03), which is also called standard deviation
or Sigma. (The meaning of this figure is that the security has the probability to
move 3% to the lower side or 3% to the upper side on the next trading day from
the current closing price of the security).
c) Such arrived at standard deviation (one sigma), is multiplied by 0.25 to arrive at
the quarter sigma.
(For example, if one sigma is 0.09, then quarter sigma is 0.09 * 0.25 = 0.0225)
a) From the order snapshots (taken four times a day from NSEs Capital Market
Segment order book) the average of best buy price and best sell price is computed
which is called the average price.
b) The quarter sigma is then multiplied with the average price to arrive at quarter
sigma price. The following example explains the same :
a) Based on the order snapshot, the value of the order (order size in Rs.), which will
move the price of the security by quarter sigma price in buy and sell side is computed.
The value of such order size is called Quarter Sigma order size. (Based on the
above example, it will be required to compute the value of the order (Rs.) to move
the stock price to Rs. 306.00 in the buy side and Rs. 307.40 on the sell side. That
is Buy side = average price quarter sigma price and Sell side = average price +
quarter sigma price). Such an exercise is carried out for four order snapshots per
day for all stocks for the previous six months period
b) From the above determined quarter sigma order size (Rs.) for each order book
snap shot for each security, the median of the order sizes (Rs.) for buy side and sell
side separately, are computed for all the order snapshots taken together for the
last six months.
c) The average of the median order sizes for buy and sell side are taken as the median
quarter sigma order size for the security.
d) The securities whose median quarter sigma order size is equal to or greater than
Rs. 0.1 million (Rs. 1 Lac) qualify for inclusion in the F&O segment.
Futures & Options contracts may be introduced on new securities which meet the
above mentioned eligibility criteria, subject to approval by SEBI.
NOTES
New securities being introduced in the F&O segment are based on the eligibility
criteria which take into consideration average daily market capitalization, average daily
traded value, the market wide position limit in the security, the quarter sigma values and as
approved by SEBI. The average daily market capitalisation and the average daily traded
value would be computed on the 15th of each month, on a rolling basis, to arrive at the list
of top 500 securities. Similarly, the quarter sigma order size in a stock would also be
calculated on the 15th of each month, on a rolling basis, considering the order book
snapshots of securities in the previous six months and the market wide position limit (number
of shares) shall be valued taking the closing prices of stocks in the underlying cash market
on the date of expiry of contract in the month.
The number of eligible securities may vary from month to month depending upon the
changes in quarter sigma order sizes, average daily market capitalisation & average daily
traded value calculated every month on a rolling basis for the past six months and the
market wide position limit in that security. Consequently, the procedure for introducing and
dropping securities on which option and future contracts are traded will be as stipulated by
SEBI.
3.1.4.3 Selection criteria for mini derivative contracts:
Mini derivative contracts (Futures and options) shall be made available for trading on
such indices/securities as specified by SEBI from time to time.
3.1.4.4 Eligibility criteria for long term option contracts
SEBI has specifically permitted introduction of option contracts with longer tenure on
S&P CNX Nifty index.
3.1.4.5 Selection criteria for unlisted companies
For unlisted companies coming out with initial public offering, if the net public offer is
Rs. 500 crs. or more, then the Exchange may consider introducing stock options and
stock futures on such stocks at the time of its listing in the cash market.
3.1.4.6 Contract Specifications
Security descriptor The security descriptor for the S&P CNX Nifty futures contracts
is: Market type : N Instrument Type : FUTIDX Underlying : NIFTY Expiry date : Date of
contract expiry Instrument type represents the instrument i.e. Futures on Index. Underlying
symbol denotes the underlying index which is S&P CNX Nifty Expiry date identifies the
date of expiry of the contract
3.1.4.7 Underlying Instrument
The underlying index is S&P CNX NIFTY.
DBA 1754
NOTES
3.1.4.8 Trading cycle
S&P CNX Nifty futures contracts have a maximum of 3-month trading cycle - the
3.1.4.9 Expiry day
S&P CNX Nifty futures contracts expire on the last Thursday of the expiry month. If
3.1.4.10 Trading Parameters
a) Contract size
The value of the futures contracts on Nifty may not be less than Rs. 2 lakhs at the time
to time.
b) Price steps
The price step in respect of S&P CNX Nifty futures contracts is Re.0.05.
c) Base Prices
Base price of S&P CNX Nifty futures contracts on the first day of trading would be
theoretical futures price. The base price of the contracts on subsequent trading days would
d) Price bands
There are no day minimum/maximum price ranges applicable for S&P CNX Nifty
futures contracts. However, in order to prevent erroneous order entry by trading members,
e) Quantity freeze
Orders which may come to the exchange as quantity freeze shall be such that have a
NOTES
f) Order type/Order book/Order attribute
Regular lot order
Stop loss order
Immediate or cancel
Spread order
3.1.5 CNX Nifty Junior Futures
A futures contract is a forward contract, which is traded on an Exchange. JUNIOR
futures contracts would be based on the CNX Nifty Junior index. (Selection criteria for
indices)
3.1.5.1 Security descriptor
The security descriptor for the CNX Nifty Junior futures contracts is: Market type :
N Instrument Type : FUTIDX Underlying : JUNIOR Expiry date : Date of contract expiry
Instrument type represents the instrument i.e. Futures on Index. Underlying symbol denotes
the underlying index which is CNX Nifty Junior Expiry date identifies the date of expiry of
the contract
The underlying index is CNX NIFTY JUNIOR
JUNIOR futures contracts have a maximum of 3-month trading cycle - the near
month (one), the next month (two) and the far month (three). A new contract is introduced
on the trading day following the expiry of the near month contract. The new contract will
be introduced for a three month duration. This way, at any point in time, there will be 3
contracts available for trading in the market i.e., one near month, one mid month and one
far month duration respectively.
DBA 1754
NOTES
3.1.5.4 Expiry day
JUNIOR futures contracts expire on the last Thursday of the expiry month. If the last
Thursday is a trading holiday, the contracts expire on the previous trading day.
a) Contract size
The value of the futures contracts on JUNIOR may not be less than Rs. 2 lakhs at the
time of introduction. The permitted lot size for futures contracts & options contracts shall
be the same for a given underlying or such lot size as may be stipulated by the Exchange
from time to time.
b) Price steps
The price step in respect of JUNIOR futures contracts is Re.0.05.
c) Base Prices
Base price of JUNIOR futures contracts on the first day of trading would be theoretical
futures price.. The base price of the contracts on subsequent trading days would be the
daily settlement price of the futures contracts.
d) Price bands
Quantity freeze
e) Order type/Order book/Order attribute
Regular lot order
Stop loss order
Immediate or cancel
Spread order
NOTES
3.1.6 Cnxit Futures
A futures contract is a forward contract, which is traded on an Exchange. CNX IT
Futures Contract would be based on the index CNX IT index. (Selection criteria for
indices)
Contract Specifications
Trading Parameters
The security descriptor for the CNX IT futures contracts is: Market type : N Instrument
Type : FUTIDX Underlying : CNXIT Expiry date : Date of contract xpiry Instrument type
represents the instrument i.e. Futures on Index. Underlying ymbol denotes the underlying
index which is CNXIT Expiry date identifies the ate of expiry of the contract
The underlying index is CNX IT.
CNX IT futures contracts have a maximum of 3-month trading cycle - the near month
(one), the next month (two) and the far month (three). A new contract is introduced on the
trading day following the expiry of the near month contract. The new contract will be
introduced for a three month duration. This way, at any point in time, there will be 3
3.1.6.4 Expiry day
CNX IT futures contracts expire on the last Thursday of the expiry month. If the last
a) Contract size
The value of the futures contracts on CNXIT may not be less than Rs. 2 lakhs at the
from time to time.
DBA 1754
NOTES
b) Price steps
The price step in respect of CNX IT futures contracts is Re.0.05.
c) Base Prices
Base price of CNX IT futures Contracts on the first day of trading would be theoretical
d) Price bands
There are no day minimum/maximum price ranges applicable for CNX IT futures
contracts. However, in order to prevent erroneous order entry by trading members,
e) Quantity freeze
Regular lot order
Stop loss order
Immediate or cancel
Spread order
3.1.7 CNX 100 Futures
A futures contract is a forward contract, which is traded on an Exchange. CNX100
futures contracts would be based on the CNX 100 index. (Selection criteria for indices)
NOTES
Trading Parameters
The security descriptor for the CNX 100 futures contracts is: Market type : N
Instrument Type : FUTIDX Underlying : CNX100 Expiry date : Date of contract expiry
Instrument type represents the instrument i.e. Futures on Index. Underlying symbol denotes
the underlying index which is CNX 100 Expiry date identifies the date of expiry of the
contract
The underlying index is CNX 100
CNX100 futures contracts have a maximum of 3-month trading cycle - the near
be introduced for a three month duration. This way, at any point in time, there will be 3
3.1.7.4 Expiry day
CNX100 futures contracts expire on the last Thursday of the expiry month. If the last
a) Contract size
The value of the futures contracts on CNX100 may not be less than Rs. 2 lakhs at the
from time to time.
b) Price steps
The price step in respect of CNX100 futures contracts is Re.0.05.
c) Base Prices
Base price of CNX100 futures contracts on the first day of trading would be theoretical
DBA 1754
NOTES
d) Price bands
Quantity freeze
Order type/Order book/Order attribute
Regular lot order
Stop loss order
Immediate or cancel
Spread order
3.1.8 BANK Nifty Futures
A futures contract is a forward contract, which is traded on an Exchange. BANK
Nifty futures Contract would be based on the index CNX Bank index. (Selection criteria
for indices)
NSE defines the characteristics of the futures contract such as the underlying index, market
lot, and the maturity date of the contract. The futures contracts are available for trading
from introduction to the expiry date.
Trading Parameters
The security descriptor for the BANK Nifty futures contracts is:
Market type : N
Instrument Type : FUTIDX
Underlying : BANKNIFTY
Instrument type represents the instrument i.e. Futures on Index.
Underlying symbol denotes the underlying index which is BANK Nifty.
Expiry date identifies the date of expiry of the contract
NOTES
The underlying index is BANK NIFTY.
BANKNIFTY futures contracts have a maximum of 3-month trading cycle - the near
be introduced for three month duration. This way, at any point in time, there will be 3
3.1.8.4 Expiry day
BANKNIFTY futures contracts expire on the last Thursday of the expiry month. If
a) Contract size
The value of the futures contracts on BANKNIFTY may not be less than Rs. 2 lakhs
at the time of introduction. The permitted lot size for futures contracts & options contracts
shall be the same for a given underlying or such lot size as may be stipulated by the Exchange
from time to time.
b) Price steps
The price step in respect of BANKNIFTY futures contracts is Re.0.05.
c) Base Prices
Base price of BANKNIFTY futures Contracts on the first day of trading would be
theoretical futures price.. The base price of the contracts on subsequent trading days would
d) Price bands
There are no day minimum/maximum price ranges applicable for BANKNIFTY futures
contracts. However, in order to prevent erroneous order entry by trading members,
DBA 1754
NOTES
e) Quantity freeze
Regular lot order
Stop loss order
Immediate or cancel
Spread order
3.1.9 Nifty Midcap 50 Futures
A futures contract is a forward contract, which is traded on an Exchange.
NFTYMCAP50 futures contracts would be based on the Nifty Midcap 50 index.(Selection
criteria for indices)
Trading Parameters
The security descriptor for the Nifty Midcap 50 futures contracts is:
Market type : N
Instrument Type : FUTIDX
Underlying : NFTYMCAP50
Underlying symbol denotes the underlying index which is Nifty Midcap 50
NOTES
The underlying index is NIFTY MIDCAP 50.
NFTYMCAP50 futures contracts have a maximum of 3-month trading cycle - the
3.1.9.4 Expiry day
NFTYMCAP50 futures contracts expire on the last Thursday of the expiry month. If
a) Contract size
The value of the futures contracts on NFTYMCAP50 may not be less than Rs. 2
lakhs at the time of introduction. The permitted lot size for futures contracts & options
contracts shall be the same for a given underlying or such lot size as may be stipulated by
the Exchange from time to time.
b) Price steps
The price step in respect of NFTYMCAP50 futures contracts is Re.0.05.
c) Base Prices
Base price of NFTYMCAP50 futures contracts on the first day of trading would be
theoretical futures price. The base price of the contracts on subsequent trading days would
d) Price bands
e) Quantity freeze
DBA 1754
NOTES
Regular lot order
Stop loss order
Immediate or cancel
Spread order
3.1.10 Futures on Individual Securities
commenced trading in futures on individual securities on November 9, 2001. The futures
contracts are available on 267 securities stipulated by the Securities & Exchange Board of
India (SEBI). (Selection criteria for securities)
NSE defines the characteristics of the futures contract such as the underlying security,
Trading Parameters
The security descriptor for the futures contracts is:
Market type : N
Instrument Type : FUTSTK
Underlying : Symbol of underlying security
Underlying symbol denotes the underlying security in the Capital Market (equities) segment
of the Exchange
Futures contracts are available on 267 securities stipulated by the Securities &
Exchange Board of India (SEBI). These securities are traded in the Capital Market segment
of the Exchange.
NOTES
Futures contracts have a maximum of 3-month trading cycle - the near month (one),
the next month (two) and the far month (three). New contracts are introduced on the
trading day following the expiry of the near month contracts. The new contracts are
introduced for a three month duration. This way, at any point in time, there will be 3
contracts available for trading in the market (for each security) i.e., one near month, one
mid month and one far month duration respectively.
3.1.10.4 Expiry day
Futures contracts expire on the last Thursday of the expiry month. If the last Thursday
is a trading holiday, the contracts expire on the previous trading day.
a) Contract size
The value of the futures contracts on individual securities may not be less than Rs. 2
lakhs at the time of introduction for the first time at any exchange. The permitted lot size for
futures contracts & options contracts shall be the same for a given underlying or such lot
size as may be stipulated by the Exchange from time to time.
b) Price steps
The price step in respect of futures contracts is Re.0.05.
c) Base Prices
Base price of futures contracts on the first day of trading (i.e. on introduction) would
be the theoretical futures price. The base price of the contracts on subsequent trading days
would be the daily settlement price of the futures contracts.
d) Price bands
There are no day minimum/maximum price ranges applicable for futures contracts.
However, in order to prevent erroneous order entry by trading members, operating ranges
are kept at +/- 20 %. In respect of orders which have come under price freeze, members
would be required to confirm to the Exchange that there is no inadvertent error in the order
entry and that the order is genuine. On such confirmation the Exchange may approve such
order.
e) Quantity freeze
Orders which may come to the exchange as a quantity freeze shall be based on the
notional value of the contract of around Rs.5 crores. Quantity freeze is calculated for each
underlying on the last trading day of each calendar month and is applicable through the
DBA 1754
NOTES
next calendar month. In respect of orders which have come under quantity freeze, members
entry and that the order is genuine. On such confirmation, the Exchange may approve such
order. However, in exceptional cases, the Exchange may, at its discretion, not allow the
orders that have come under quantity freeze for execution for any reason whatsoever
including non-availability of turnover / exposure limits.
Regular lot order
Stop loss order
Immediate or cancel
Spread order
Summary
If a company knows that it has to sell a particular asset at a particular time in the
future, it can hedge by taking a short position, therefore locking in the price of delivery.
This is called a short hedge. Similarly, a company that knows that it will need an asset in the
future can take a long hedge, thus locking in the price of purchase. It is very important to
note that hedging does not necessarily improve the financial outcome, it just reduces the
uncertainty
S&P CNX Nifty is a well diversified 50 stock index accounting for 21 sectors of the
economy. It is used for a variety of purposes such as benchmarking fund portfolios, index
based derivatives and index funds.
based on the popular market benchmark S&P CNX Nifty index. (Selection criteria for
indices)
The stock shall be chosen from amongst the top 500 stocks in terms of average daily
market capitalisation and average daily traded value in the previous six months on a rolling
basis.
The stocks median quarter-sigma order size over the last six months shall be not less
than Rs. 0.10 million (Rs. 1 lac). For this purpose, a stocks quarter-sigma order size shall
mean the order size (in value terms) required to cause a change in the stock price equal to
one-quarter of a standard deviation.
A futures contract is a forward contract, which is traded on an Exchange. JUNIOR
futures contracts would be based on the CNX Nifty Junior index. (Selection criteria for
indices)
NOTES
Questions
1. Explain the eligibility criteria for selection of securities and Indices for Futures?
2. Explain the CNX Nifty Junior Futures
3. What do you understand about Nifty Midcap 50 Futures?
4. What are the Trading Parameters for FUTIDX?
5. What are the Contract Specifications for NIFTY MIDCAP 50?
DBA 1754
NOTES
CHAPTER II
INTEREST RATE FUTURES
3.2.1 Introduction
Interest Rate Futures Contracts are contracts based on the list of underlying as may
be specified by the Exchange and approved by SEBI from time to time. To begin with,
interest rate futures contracts on the following underlyings shall be available for trading on
the F&O Segment of the Exchange :
Notional T Bills
Notional 10 year bonds (coupon bearing and non-coupon bearing)
The list of securities on which Futures Contracts would be available and their symbols
for trading are as under :
3.2.2 Security Descriptor
The security descriptor for the interest rate future contracts is:
Market type : N
Instrument Type : FUTINT
Underlying : Notional T- bills and Notional 10 year bond (coupon bearing and non-coupon
bearing)
Expiry Date : Last Thursday of the Expiry month.
Instrument type represents the instrument i.e. Interest Rate Future Contract.
Underlying symbol denotes the underlying.
3.2.3 Underlying Instrument
Interest rate futures contracts are available on Notional T- bills , Notional 10 year
zero coupon bond and Notional 10 year coupon bearing bond stipulated by the Securities
& Exchange Board of India (SEBI).
S.No Symbol Description
1 NSETB91D Futures contract on National 91 days T bill
2 NSE10Y06 Futures contract on Notional 10 year coupon bearing bond
3 NSE10YZC Futures contract on Notional 10 year zero coupon bond

NOTES
3.2.4 Trading cycle
The interest rate future contract shall be for a period of maturity of one year with three
months continuous contracts for the first three months and fixed quarterly contracts for the
entire year. New contracts will be introduced on the trading day following the expiry of the
near month contract.
3.2.5 Expiry day
Interest rate future contracts shall expire on the last Thursday of the expiry month. If
the last Thursday is a trading holiday, the contracts shall expire on the previous trading day.
Further, where the last Thursday falls on the annual or half-yearly closing dates of the
bank, the expiry and last trading day in respect of these derivatives contracts would be
pre-poned to the previous trading day.
3.2.6 Product Characteristics
3.2.7 Trading Parameters
3.2.7.1 Contract size
The permitted lot size for the interest rate futures contracts shall be 2000. The minimum
value of a interest rate futures contract would be Rs. 2 lakhs at the time of introduction.
3.2.7.2 Price steps
The price steps in respect of all interest rate future contracts admitted to dealings on
the Exchange is Re.0.01.
Contract
underlying
Notional 10 year
bond (6 % coupon )
Notional 10 year
zero coupon bond
Notional 91 day
T-Bill
Contract
descriptor
N FUTINT
NSE10Y06
26JUN2003
N FUTINT
NSE10YZC
26JUN2003
N FUTINT
NSETB91D
26JUN2003
Contract
Value
Rs.2,00,000
Lot size 2000
Tick size Re.0.01
Expiry
date
Last Thursday of the month
Contract
months
The contracts shall be for a period of a maturity of one year
with three months continuous contracts for the first three
months and fixed quarterly contracts for the entire year.
Price
limits
Not applicable
Settlement
Price
As may be stipulated by NSCCL in this regard from time to
time.

DBA 1754
NOTES
The Futures contracts having face value of Rs 100 on notional ten year coupon bearing
bond and notional ten year zero coupon bond would be based on price quotation and
Futures contracts having face value of Rs. 100 on notional 91 days treasury bill would be
based on Rs. 100 minus (-) yield.
3.2.7.3 Base Price & operating ranges
Base price of the Interest rate future contracts on introduction of new contracts shall
be theoretical futures price computed based on previous days closing price of the notional
underlying security. The base price of the contracts on subsequent trading days will be the
closing price of the futures contracts. However, on such of those days when the contracts
were not traded, the base price will be the daily settlement price of futures contracts.
There will be no day minimum/maximum price ranges applicable for the futures
contracts. However, in order to prevent / take care of erroneous order entry, the operating
ranges for interest rate future contracts shall be kept at +/- 2% of the base price. In respect
of orders which have come under price freeze, the members would be required to confirm
to the Exchange that the order is genuine. On such confirmation, the Exchange at its discretion
may approve such order. If such a confirmation is not given by any member, such order
shall not be processed and as such shall lapse.
3.2.7.4 Quantity freeze
Orders which may come to the Exchange as a quantity freeze shall be 2500 contracts
amounting to 50,00,000 which works out on the day of introduction to approximately Rs
50 crores.
In respect of such orders which have come under quantity freeze, the member shall
be required to confirm to the Exchange that the order is genuine. On such confirmation, the
Exchange at its discretion may approve such order subject to availability of turnover/
exposure limits, etc. If such a confirmation is not given by any member, such order shall not
be processed and as such shall lapse.
3.2.7.5 Order type/Order book/Order attribute
Regular lot order
Stop loss order
Immediate or cancel
Good till day
Good till cancelled*
Good till date
Spread order
2L and 3L orders
NOTES
* Good till cancelled (GTC) orders shall be cancelled at the end of the period of 7
calendar days from the date of entering an order.
3.2.8 Clearing and Settlement
3.2.8.1 Settlement Procedure & Settlement Price
Daily Mark to Market Settlement and Final settlement for Interest Rate Futures
Contract
Daily Mark to Market settlement and Final Mark to Market settlement in respect
of admitted deals in Interest Rate Futures Contracts shall be cash settled by debiting/
crediting of the clearing accounts of Clearing Members with the respective Clearing
Bank.
All positions (brought forward, created during the day, closed out during the day)
of a F&O Clearing Member in Futures Contracts, at the close of trading hours on
a day, shall be marked to market at the Daily Settlement Price (for Daily Mark to
Market Settlement) and settled.
All positions (brought forward, created during the day, closed out during the day)
of a F&O Clearing Member in Futures Contracts, at the close of trading hours on
the last trading day, shall be marked to market at Final Settlement Price (for Final
Settlement) and settled.
Daily Settlement Price shall be the closing price of the relevant Futures contract
for the Trading day.
Final settlement price for an Interest rate Futures Contract shall be based on the
value of the notional bond determined using the zero coupon yield curve computed
by National Stock Exchange or by any other agency as may be nominated in this
regard.
Open positions in a Futures contract shall cease to exist after its expiration day.
3.2.8.2 Daily Settlement Price
Daily settlement price for an Interest Rate Futures Contract shall be the closing price
of such Interest Rate Futures Contract on the trading day. The closing price for an interest
rate futures contract shall be calculated on the basis of the last half an hour weighted
average price of such interest rate futures contract. In absence of trading in the last half an
hour, the theoretical price would be taken or such other price as may be decided by the
relevant authority from time to time. Theoretical daily settlement price for unexpired
futures contracts, shall be the futures prices computed using the (price of the notional
bond) spot prices arrived at from the applicable ZCYC Curve. The ZCYC shall be computed
by the Exchange or by any other agency as may be nominated in this regard from the
prices of Government securities traded on the Exchange or reported on the Negotiated
Dealing System of RBI or both taking trades of same day settlement(i.e. t = 0).
DBA 1754
NOTES
In respect of zero coupon notional bond, the price of the bond shall be the present
value of the principal payment discounted using discrete discounting for the specified period
at the respective zero coupon yield. In respect of the notional T-bill, the settlement price
shall be 100 minus the annualized yield for the specified period computed using the zero
coupon yield curve. In respect of coupon bearing notional bond, the present value shall be
obtained as the sum of present value of the principal payment discounted at the relevant
zero coupon yield and the present values of the coupons obtained by discounting each
notional coupon payment at the relevant zero coupon yield for that maturity. For this purpose
the notional coupon payment date shall be half yearly and commencing from the date of
expiry of the relevant futures contract.
For computation of futures prices from the price of the notional bond (spot prices)
thus arrived, the rate of interest may be the relevant MIBOR rate or such other rate as may
be specified from time to time.
3.2.8.3 Final Settlement Price for mark to market settlement of interest rate futures
contracts
Final settlement price for an Interest rate Futures Contract on zero coupon notional
bond and coupon bearing bond shall be based on the price of the notional bond determined
using the zero coupon yield curve computed as explained above. In respect of notional T-
bill it shall be 100 minus the annualised yield for the specified period computed using the
zero coupon yield curve.
3.2.8.4 Settlement value in respect of notional T-bill
Since the T-bills are priced at 100 minus the relevant annualised yield, the settlement
value shall be arrived at using the relevant multiplier factor. Currently it shall be 91/365
3.2.8.5 Settlement Schedule
NOTES
3.2.9 Interest Rate Derivatives - Risk Containment
3.2.9.1 Margins
Initial Margins
Computation of Initial Margin
Exposure Limits (2nd line of defense)
Trading Member wise/ Custodial Participant wise Position Limit
3.2.9.2 Initial Margins
Initial margin shall be payable on all open positions of Clearing Members, upto client
level, at any point of time, and shall be payable upfront by Clearing Members in accordance
with the margin computation mechanism and/ or system as may be adopted by Clearing
Corporation from time to time. Presently, the initial margins would be based on the zero
coupon yield curve computed at the end of the day as explained above with trades of same
day settlement (t =0). However, in case of large deviation between the yields generated
using only t = 0 trades and all trades, initial margins revised accordingly may be computed
and collected by the Clearing corporation from the members at its discretion.
Initial Margin shall include SPAN margins and such other additional margins, that
may be specified by Clearing Corporation from time to time.
3.2.9.3 Computation of Initial Margin
Clearing Corporation will adopt SPAN (Standard Portfolio Analysis of Risk) system or
any other system for the purpose of real time initial margin computation.
Initial margin requirements shall be based on 99% value at risk over a one day time
horizon. Provided, however, in the case of futures contracts, where it may not be possible
to collect mark to market settlement value, before the commencement of trading on the
next day, the initial margin may be computed over a two day time horizon, applying the
appropriate statistical formula.
The methodology for computation of Value at Risk percentage will be as per the
recommendations of SEBI from time to time.
3.2.9.4 Initial margin requirement for a member:
a) For client positions - shall be netted at the level of individual client and grossed
across all clients, at the Trading/ Clearing Member level, without any setoffs between
clients.
b) For proprietary positions - shall be netted at Trading/ Clearing Member level without
any set offs between client and proprietary positions.
DBA 1754
NOTES
For this purpose, various parameters shall be as specified hereunder or such other
parameters as may be specified by the relevant authority from time to time:
(a) Price scan range
In the case of Notional Bond Futures, the price scan range shall be 3.5 Standard
Deviation (3.5 sigma) and in no case the initial margin shall be less than 2% of the notional
value of the Futures Contracts, which shall be scaled up by look ahead period as may be
specified from time to time. For Notional T-Bill Futures, the price scan range shall be 3.5
Standard Deviation (3.5 sigma) and in no case the initial margin shall be less than 0.2% of
the notional value of the futures contract, which shall be scaled up by look ahead period as
may be specified from time to time.
(b) Calendar Spread Charge
The margin on calendar spread shall be calculated at a flat rate of 0.125% per month
of spread on the far month contract subject to a minimum margin of 0.25% and a maximum
margin of 0.75% on the far side of the spread with legs upto 1 year apart.
A Calendar spread positions will be treated as non-spread (naked) positions in the
far month contract, 3 trading days prior to expiration of the near month contract.
3.2.9.5 Exposure Limits (2nd line of defense)
Clearing Members shall be subject to Exposure limits in addition to initial margins.
Exposure Limit shall be 100 times the liquid net worth i.e. 1% of the notional value of the
gross open positions in Notional 10 year bond futures (both coupon bearing and zero
coupons) and shall be 1000 times the liquid net worth i.e. 0.1% of the gross open positions
in notional 91 day T-Bill futures.
Exposure limit for calendar spreads: the Calendar spread shall be regarded as an
open position of one third of the mark to market value of the far month contract. As the
near month contract approaches expiry, the spread shall be treated as a naked position in
the far month contract three days prior to the expiry of the near month contract
3.2.9.6 Trading Member wise/ Custodial Participant wise Position Limit
Each Trading Member/ Custodial Participant shall ensure that his clients do not exceed
the specified position limit. The position limits shall be at the client level and for near month
contracts and shall be 15% of the open interest or Rs. 100 crores, whichever is higher.
For futures contracts open interest shall be equivalent to the open positions in that
futures contract multiplied by its last available closing price.
NOTES
CHAPTER III
CUURENCY FUTURES
3.3.1 Introduction
A key difference between investing in domestic and foreign assets is that the latter
exposes the investor to a currency risk. Over the years, most investors have not been
careful in characterizing this risk to returns from unhedged portfolios. One simplistic view
was to measure the return in domestic currency terms and compare it with returns in local
currency terms, and characterize the difference as the currency effect. The reasoning
was that if the exchange rate remains constant from the time of purchase of the foreign
asset to its sale, then the currency risk has had zero impact. On the other hand, if the
domestic currency has weakened (strengthened) against the foreign currency, the exposure
would result in a gain (loss). In August 1998, the Association for Investment Management
Research (AIMR) argued that the use of changes in spot exchange rates (over the investment
period) as a measure of the influence of currency risk on foreign asset returns was misleading.
AIMR preferred an alternate approach, one that involved splitting the currency effect into
components: expected or known effect captured by forward premium or discount; and
unexpected or surprise effect.
In other words, currency surprise can be interpreted as the unexpected movement
of the foreign currency relative to its forward rate or market predicted rate. The assumption
here is that the forward premium or discount (expected currency effect) will be embedded
in the return from a fully hedged portfolio. This implies that Unhedged foreign asset return
(US$) = Currency surprise + Hedged foreign asset return (US$) Currency surprise is
essentially noise. So every investor in foreign assets must make an explicit decision on
whether or not he wants to take on exposure to this noise factor.
3.3.2 To Hedge or Not to Hedge?
Over the years, there has been considerable controversy on this question. As might
be expected, there are multiple view points regarding the relative merits of hedging away
currency risks. Here are a couple of classic arguments in favor of not hedging.
3.3.3 Uncorrelated risks
On a historical basis, changes in exchange rates (and hence currency returns) have
had very low correlations with foreign equity and bond returns. The belief is that this lack
of any systematic relationship could in theory lower portfolio risk.
DBA 1754
NOTES
3.3.4 Expected returns are zero
Viewed over a long investment horizon, currency movements cancel out each other
the mean-reversion argument. In other words, exchange rates have an expected return of
zero. So why bother hedging against currency surprise.
The arguments in favor of hedging are as follows:
3.3.5 a) How long is the long-run?
Financial planners advice their clients to pursue buy-and-hold strategies. If one trades
with the attitude of investing for the long-run, ignoring short-term dynamics of currency
returns could be a perfectly valid strategy. Folks who invest other peoples money, fund
managers, though tend to be compensated on their quarterly performances relative to
benchmark indices. In addition, there is sufficient evidence on the high turnover rates of
actively managed fund portfolios. In such instances, it behooves the fund manager to take
into account the impact of currency movements on the risk-return characteristics of his or
her portfolio. Realized versus expected returns Currency returns tend to be episodic. In
other words, there can be sufficient movement in exchange rates in the short run that in
theory could be exploited to generate positive returns. More important, these movements
also tend to exhibit some degree of persistence.
3.3.5 b) Risk-return trade-off
A study by Bob Doyen compares risk and return from hedged and unhedged equity
portfolios. It specifically looks at the MSCI EAFE Index for the period January 1980 to
June 1999. (Morgan Stanley Capital International Europe, Australia, Far East Index is the
most commonly cited international equity index.) Jan 1980 to Jun 1999 Annualized return
Volatility Unhedged EAFE return in US$ 13.48% 17.52% Hedged (US$) EAFE return
13.51% 15.29% It vividly illustrates the zero impact of currency movements on asset
returns over the long run. But it also presents sufficient evidence that hedging reduces the
volatility of the return. From an efficient portfolio perspective, hedging does seem to be an
attractive strategy. To conclude, whether foreign assets are being held for the short- or the
long-run, it is apparent that hedging can help improve a fund managers performance and
thus deliver value to investors.
3.3.6 Instruments for Hedging Currency Risk
Foreign currency markets are deep, highly liquid, and relatively inexpensive. Fund
managers seeking to manage their currency exposures can pursue one or more strategies:
trade over-the-counter (OTC) market currency forwards and options, exchange-traded
futures and options on futures, or hire the services of an overlay manager. Overlay managers
are essentially specialist currency trading firms that will actively manage a currency hedge
mandate, and in addition, attempt to generate a positive excess return. These firms too rely
on currency futures, forwards and options contracts.
NOTES
3.3.7 Exchange-Traded Currency Futures
Exchange-traded currency products offer at least three major advantages vis-vis the
inter-bank over-the-counter (OTC) market:
1. Price transparency and efficiency,
2. Elimination of counterparty credit risk, and
3. Accessibility for all
Types of market participants. Price Transparency and Efficiency Futures and options
exchanges bring together in one place divergent categories of buyers and sellers to determine
foreign exchange prices. This efficient price discovery process is further enhanced by
transparent trading arrangements. Whether the trading venue is open outcry or electronic,
the prices for exchangetraded foreign currency products are disseminated worldwide via
major quote vendors such as Reuters, Bloomberg, and others. Electronic trading on
computerized trading systems (e.g., GLOBEX at Chicago Mercantile Exchange (CME)
Inc.) takes place on a nearly 24-hour basis. Elimination of Counterparty Credit Risk
Exchange-traded currency contracts have the exchange clearing house as the counterparty
to every trade. For example, the CME Clearing House is the buyer to every seller and the
seller to every buyer of all its currency products. Market participants then need not evaluate
the credit worthiness of multiple counterparties. The CME Clearing House is their
counterparty. All clearing members of the CME Clearing House stand behind trades at the
exchange. Importantly, there has never been a single default in the 104-year history of the
exchange. The OTC inter-bank market operates on the basis of credit limits for every
potential counterparty. BIS requires banks to maintain adequate levels of capital to cover
forward-maturity currency transaction risk. These requirements are waived for foreign
exchange transactions booked on exchanges, where performance bonds are required and
daily mark to market of open positions is done.
3.3.8 Accessible to All Market Participants
The advent of financial futures began in the early 1970s because some inventive and
persistent commodity traders at Chicago Mercantile Exchange did not have access to the
inter-bank foreign exchange markets when they believed significant moves were about to
take place in currency prices. They established the International Monetary Market (now a
division of CME), which launched trading in seven currency futures contracts on May 16,
1972creating the worlds first financial futures. No longer was the arena of foreign
exchange trading limited to large commercial banks and their big corporate customers.
Individuals, small and medium-sized banks and corporations, investment funds and
governments can buy and sell currencies for future delivery or cash settlement. Universal
access to its markets is an important defining characteristic of exchange-traded foreign
currency futures and options.
DBA 1754
NOTES
3.3.9 Illustrating the Use of Currency Futures
Example 1: Hedging Mexican Peso Foreign Currency Risk
A U.S. hedge fund continues to find Mexican Treasury bill (CETES) yields attractive
and decides to rollover an investment in CETES, whose principal plus interest at maturity
in five months will be 850 million Mexican pesos (MP). Knowing that its all-in return is
subject to U.S. dollar versus Mexican peso exchange rate risk, the U.S. hedge fund wanted
to hedge its exposure of converting the CETES investment back into U.S. dollars. After
assessing the available alternatives, the U.S. hedge fund chose to hedge with exchange-
traded Mexican peso futures contracts. The trading unit of the Mexican peso futures is
500,000 MP. Therefore, on May 1st, the U.S. hedge fund sells 1,700 September 2003
Mexican peso futures at $0.08950 per MP (equivalent to 850 million MP). Over the
course of the next five months the U.S. dollar exchange rate for the Mexican peso falls to
$0.08600 per MP. As the Mexican peso futures price falls, the hedge funds trading account
at its clearing member firm is credited the gains on the position by the exchange clearing
house. The price move from US$0.08950 to US$0.08600 per Mexican peso on the short
Mexican peso futures position represents a gain of US$0.00350 per Mexican peso. This
is equal to a profit of US$1,750 per contract times 1,700 contracts for a net position gain
of US$2,975,000. (For the purpose of these examples, calculations do not include
brokerage or clearing fees that may be associated with exchange transactions.) This U.S.
dollar profit when added to the U.S. dollars resulting from conversion of the Mexican
pesodenominated CETES principal and interest into U.S. dollars at the lower dollar / peso
exchange rate (of US$0.08600 per Mexican peso), results in an effective rate equivalent
to the Mexican peso futures price at the start of the hedge.
Example 2: Hedging equity portfolio risk using CME$INDEX futures contracts In recent
months, CME has introduced a new dollar index futures contract. The CME$INDEX is a
geometric index of seven foreign currencies, weighted to reflect the relative competitiveness
of U.S. goods in foreign markets. It is designed to provide investors with a new instrument
for currency market participation and risk management. Here is an example illustrating the
use of CME$INDEX futures to hedge international equity portfolio risk. During the period
January to February of 2003, a large U.S. pension fund invested in various overseas
equity markets. Though the fund manager was comfortable with the near-term market risk
of these individual countries, given the recent weakness in the US dollar, plus the impending
war in Iraq, he sought to reduce portfolio risk by hedging a portion of the currency risk.
The foreign investment portfolio was valued at approximately $100 million, and the manager
believed that the U.S. dollar would not remain weak for an extended period of time. On
March 11, 2003, the June CME$INDEX futures contract traded at 103.45. At this price,
the notional value of each contract was $103,450. Since the fund manager wanted to
hedge half of his currency exposure, he bought 483 dollar index contracts, a number which
he derived by dividing $50 million by $103,450. In purchasing CME$INDEX futures
NOTES
contracts, the fund manager took on a position that was long the U.S. dollar and short a
basket of seven currencies, thereby hedging his exposure to the underlying currency risk.
Scenario A
Suppose that during mid-May 2003, the US dollar begins to reverse its course. By
early June, the U.S. dollar is up 3.5% on average, and the pension fund has cut back on its
exposure to overseas equity markets by 25%. The CME$INDEX June futures contract is
now trading at 107.20 and if he so desires, the fund manager can sell 121 contracts at this
price, or 25% of his 483 contract holdings, in order to book a gain of $453,750 on his
currency hedge. In this instance, the unhedged portion of the portfolio would result in a
loss due to the strengthening of the U.S. dollar. The remaining 362 ME$INDEX futures
contracts could then be rolled over to the next quarterly contract.
Scenario B
Referencing Scenario A above, assume that the U.S. dollar instead remains weak and
is down by 2% by early June. The fund manager can take physical delivery on 121 contracts,
whereby he would receive US dollars and would pay the appropriate amount of each of
the seven currencies in the index. (In a simple scenario, he would be using the foreign
currency proceeds from the sale of various stocks to make these payments.) This hedge
has simply reduced the potential gain from the US dollar weakness.
During periods of intense market risk, issues related to hedging different risk factors
become critical. This paper has focused on currency risks. We started with a complete
definition of currency effect on foreign portfolio returns, and argued in favor of protecting
against this risk. The main benefit of a full hedge would be in the form of a reduction in
portfolio volatility. Fund managers can choose from a range of instruments to hedge their
currency risks. The paper argues that exchange-traded futures contracts have certain
advantages that make them suitable for managing single currency as well as multiple currency
exposures, providing examples of hedging U.S. dollars versus Mexican pesos and hedging
equity portfolio risk using the new CME$INDEX.
3.3.10 Summary
A key difference between investing in domestic and foreign assets is that the latter
exposes the investor to a currency risk. Over the years, most investors have not been
careful in characterizing this risk to returns from unhedged portfolios. One simplistic view
was to measure the return in domestic currency terms and compare it with returns in local
currency terms, and characterize the difference as the currency effect. The reasoning
was that if the exchange rate remains constant from the time of purchase of the foreign
asset to its sale, then the currency risk has had zero impact. On the other hand, if the
domestic currency has weakened (strengthened) against the foreign currency, the exposure
would result in a gain (loss).
DBA 1754
NOTES
Over the years, there has been considerable controversy on this question. As
-might be expected, there are multiple view points regarding the relative merits of hedging
away currency risks. Here are a couple of classic arguments in favor of not hedging.
Financial planners advice their clients to pursue buy-and-hold strategies. If one trades
with the attitude of investing for the long-run, ignoring short-term dynamics of currency
returns could be a perfectly valid strategy. Folks who invest other peoples money, fund
managers, though tend to be compensated on their quarterly performances relative to
benchmark indices. In addition, there is sufficient evidence on the high turnover rates of
actively managed fund portfolios. In such instances, it behooves the fund manager to take
into account the impact of currency movements on the risk-return characteristics of his or
her portfolio
Questions
1 What do you understand by Currency Futures?
2 What is the need for Currency Futures?
3 Illustrate the use of Currency Futures
4 What do you understand by Exchange-Traded Currency Futures? State its
advantages
5 What is meant by Risk-return trade-off?
NOTES
UNIT IV
OPTIONS
CHAPTER I
OPTION MARKET
4.1.1 Introduction
Futures and Forwards share a very important characteristic: when the delivery date
arrives, the delivery must take place. The agreement is binding for both parties: the party
with the short position has to deliver the goods, and the party with the long position has to
pay the agreed price. Options give the party with the long position one extra degree of
freedom: she can exercise the contracts if she wants to do so; whereas the short party have
to meet the delivery if they are asked to do so. This makes options a very attractive way of
hedging an investment, since they can be used as to enforce lower bounds on the financial
losses. In addition, options offer a very high degree of gearing or leverage, which makes
them attractive for speculative purposes too.
4.1.2 The Main Characteristics of a Option Contract
a) The maturity : The time in the future, up to which the contract is valid;
b) The strike or exercise price : The delivery price. Remember that the long party
will assess whether or not this price is better than the current market price. If so,
then the option will be exercised. If not the option will be left to expire worthless;
c) Call or put: The call option gives the long party the right to buy the underlying
security at the strike price from the short party. The put option gives the long party
the right to sell the underlying security at the strike price to the short party. The
short party has to obey the long partys will;
d) American or European: The American option gives the right to the long party to
exercise the contract at any time they wish, up to the maturity date. If the option is
European, it can be exercised on the maturity date only; and
e) Details concerning the delivery.
Apart from the plain vanilla contracts which are American or European, a lot of other
exotic options have appeared recently, mostly as OTC contracts. These include Asian
options, digital options, lookback options, etc. Traders have been rather imaginative when
it comes to designing new derivative securities.
DBA 1754
NOTES
Unlike the forward or futures contracts, and because of the payoff asymmetries, the
initial value of an option, say, is not equal to zero. Apart from the above characteristics, the
option price is generally affected by:
a) The volatility [or uncertainty] of the underlying asset, from today up to the maturity
date. In fact, it is common in the literature for option markets to be described as
markets where volatility is traded;
b) The level of the interest rates, in fact the whole term structure, and the stochastic
behavior of them if they are unknown;
c) The dividends, coupon payments, costs of storage, and other cash flows that are
possible before the maturity date; and
d) Commissions and the way the margin is marked.
As an example of the payoff asymmetries, the profits from a long European call option
position look typically like the ones given in figure. A great deal of time will be dedicated
discussing how option contracts are priced.
European call option payoffs
4.1.3 The market participants
Three kinds of dealers engage in market activities: hedgers, speculators and
arbitrageurs. Each type of dealer has a different set of objectives, as discussed below.
a) Hedgers: Hedging includes all acts aimed to reduce uncertainty about future
[unknown] price movements in a commodity, financial security or foreign currency.
This can be done by undertaking forward or futures sales or purchases of the
commodity security or currency in the OTC forward or the organized futures market.
Alternatively, the hedger can take out an option which limits the holders exposure
to price fluctuations.
b) Speculators: Speculation involves betting on the movements of the market and
try to take advantage of the high gearing that derivative contracts offer, thus making
windfall profits. In general, speculation is common in markets that exhibit substantial
fluctuations over time. Normally, a speculator would take a bullish or bearish
NOTES
view on the market and engage in derivatives that will profit her if this view
materializes. Since in order to buy, say, a European call option one has to pay a
minute fraction of the possible payoffs, speculators can attempt to materialize
extensive profits.
c) Arbitrageurs: They lock riskless profits by taking positions in two or more
markets. They do not hedge nor speculate, since they are not exposed to any risks
in the very first place. For example if the price of the same product is different in
two markets, the arbitrageur will simultaneously buy in the lower priced market
and sell in the higher priced one. In other situations, more complicated arbitrage
opportunities might exist. Although hedging and [mainly] speculating are the reasons
that have made derivatives [im]famous, the analysis of pricing them fairly depends
solely on the actions of the arbitrageurs, since they ensure that price differences
between markets are eliminated, and that products are priced in a consisted way.
4.1.4 Mini Option contracts on S&P CNX Nifty index
A mini derivative option contract is similar to any other existing option contract except
for the minimum contract size. Currently SEBI has prescribed a minimum contract value of
not less than Rs 1 lac for mini derivative contracts as compared to Rs 2 lacs for normal
derivative contracts. MINIFTY option contracts would be based on the S&P CNX Nifty
index. (Selection criteria for mini derivative contracts)
NSE defines the characteristics of the mini derivative option contracts such as the
underlying index, market lot, and the maturity date of the contract. The option contracts
are available for trading from introduction to the expiry date. The mini option contracts are
European style and cash settled.
The contract specifications for Mini Option contracts on S&P CNX Nifty index are
exactly as applicable to the underlying S&P CNX Nifty index. The trading symbol for
these contracts is MINIFTY.
The trading specifications for Mini Option contracts on S&P CNX Nifty index are
exactly as applicable to the underlying S&P CNX Nifty index. The value of the option
contracts on MINIFTY may not be less than Rs. 1 lakhs at the time of introduction. The
permitted lot size for future & option contracts shall be the same for a given underlying or
such lot size as may be stipulated by the Exchange from time to time.
4.1.5 CNXIT OPTIONS
An option gives a person the right but not the obligation to buy or sell something. An
option is a contract between two parties wherein the buyer receives a privilege for which
DBA 1754
NOTES
he pays a fee (premium) and the seller accepts an obligation for which he receives a fee.
The premium is the price negotiated and set when the option is bought or sold. A person
who buys an option is said to be long in the option. A person who sells (or writes) an
option is said to be short in the option.
The options contracts are European style and cash settled and are based on the
CNX IT index. (Selection criteria for indices)
Trading Parameters
Security descriptor
The security descriptor for the CNX IT options contracts is:
Market type : N
Instrument Type : OPTIDX
Underlying : CNXIT
Option Type : CE/ PE
Strike Price: Strike price for the contract
Instrument type represents the instrument i.e. Options on Index.
Underlying symbol denotes the underlying index, which is CNXIT
Option type identifies whether it is a call or a put option., CE - Call European, PE
Put European.
The underlying index is CNXIT.
CNX IT options contracts have a maximum of 3-month trading cycle - the near
month (one), the next month (two) and the far month (three). On expiry of the near month
contract, new contracts are introduced at new strike prices for both call and put options,
on the trading day following the expiry of the near month contract. The new contracts are
introduced for three month duration.
NOTES
4.1.5.4 Expiry day
CNX IT options contracts expire on the last Thursday of the expiry month. If the last
4.1.5.5 Strike Price Intervals
The number of contracts provided in options on the index is related to the range in
which previous days closing value of the index falls as per the following table:
New contracts with new strike prices for existing expiration date are introduced for
trading on the next working day based on the previous days index close values, as and
when required. In order to decide upon the at-the-money strike price, the index closing
value is rounded off to the nearest applicable strike interval.
The in-the-money strike price and the out-of-the-money strike price are based on
the at-the-money strike price.
a) Contract size
The value of the option contracts on Nifty may not be less than Rs. 2 lakhs at the time
to time.
b) Price steps
The price step in respect of CNX IT options contracts is Re.0.05.
c) Base Prices
Base price of the options contracts, on introduction of new contracts, would be the
theoretical value of the options contract arrived at based on Black-Scholes model of
calculation of options premiums.
Index Level Strike Interval Scheme of strikes to be
introduced (ITM-ATM-
OTM)
upto 2000 25 4-1-4
>2001 upto 4000 50 4-1-4
>4001 upto 6000 50 5-1-5
>6000 50 6-1-6
DBA 1754
NOTES
C = S * N (d
1
) - X * e
- rt
* N (d
2
)
- rt
* N (-d
2
) - S * N (-d
1
)where :
d
1
= [ln (S / X) + (r +
2
/ 2) * t] / * sqrt(t)
d
2
= [ln (S / X) + (r -
2
/ 2) * t] / * sqrt(t)
= d
1
- * sqrt(t)
S = price of the underlying asset
N represents a standard normal distribution with mean = 0 and standard deviation = 1
constant e (2.71828182845904).
The base price of the contracts on subsequent trading days, will be the daily close
price of the options contracts. The closing price shall be calculated as follows:
If the contract is traded in the last half an hour, the closing price shall be the last half
an hour weighted average price.
If the contract is not traded in the last half an hour, but traded during any time of the
day, then the closing price will be the last traded price (LTP) of the contract.
If the contract is not traded for the day, the base price of the contract for the next
trading day shall be the theoretical price of the options contract arrived at based on Black-
Scholes model of calculation of options premiums.
d) Price bands
Quantity freeze
NOTES
e) Order type/Order book/Order attributes
Regular lot order
Stop loss order
Immediate or cancel
Spread order
4.1.6 CNX 100 Options
The premium is the price negotiated and set when the option is bought or sold. A person
who buys an option is said to be long in the option. A person who sells (or writes) an
option is said to be short in the option. The options contracts are European style and cash
settled and are based on the popular market CNX 100 index.
Security descriptor
The security descriptor for the CNX Nifty Junior options contracts is:
Market type : N
Underlying : CNX 100
Underlying symbol denotes the underlying index, which is CNX 100
Option type identifies whether it is a call or a put option., CE - Call European, PE
Put European.
The underlying index is CNX 100
DBA 1754
NOTES
CNX100 options contracts have a maximum of 3-month trading cycle - the near
month (one), the next month (two) and the far month (three). On expiry of the near month
contract, new contracts are introduced at new strike prices for both call and put options,
on the trading day following the expiry of the near month contract. The new contracts are
introduced for three month duration.
4.1.6.4 Expiry day
CNX100 options contracts expire on the last Thursday of the expiry month. If the last
a) Contract size
The value of the option contracts on CNX100 may not be less than Rs. 2 lakhs at the
from time to time.
b) Price steps
The price step in respect of CNX 100 options contracts is Re.0.05.
Index Level Strike
Interval
Scheme of strikes to be
introduced (ITM-ATM-
OTM)
upto 2000 25 4-1-4
>2001 upto 4000 50 4-1-4
>4001 upto 6000 50 5-1-5
>6000 50 6-1-6
NOTES
c) Base Prices
C = S * N (d
1
) - X * e
- rt
* N (d
2
)
- rt
* N (-d
2
) - S * N (-d
1
)
where :
d
1
= [ln (S / X) + (r +
2
/ 2) * t] / * sqrt(t)
d
2
= [ln (S / X) + (r -
2
/ 2) * t] / * sqrt(t)
= d
1
- * sqrt(t)
N represents a standard normal distribution with mean = 0 and standard deviation ln
represents the natural logarithm of a number. Natural logarithms are based on the constant
e (2.71828182845904).
DBA 1754
NOTES
d) Price bands
Quantity freeze
Regular lot order
Stop loss order
Immediate or cancel
Spread order
4.1.7 BANKNIFTY OPTIONS
An option gives a person the right but not the obligation to buy or sell something.
An option is a contract between two parties wherein the buyer receives a privilege
for which he pays a fee (premium) and the seller accepts an obligation for which
he receives a fee. The premium is the price negotiated and set when the option is
bought or sold. A person who buys an option is said to be long in the option. A
person who sells (or writes) an option is said to be short in the option.
BANK NIFTY index.
Security descriptor
The security descriptor for the BANKNIFTY options contracts is:
Market type : N
Instrument Type : OPTIDXUnderlying : BANKNIFTY
Underlying symbol denotes the underlying index, which is BANKNIFTY
NOTES
Option type identifies whether it is a call or a put option., CE - Call European, PE Put
European.
The underlying index is BANK NIFTY.
BANKNIFTY options contracts have a maximum of 3-month trading cycle - the
near month (one), the next month (two) and the far month (three). On expiry of the near
month contract, new contracts are introduced at new strike prices for both call and put
options, on the trading day following the expiry of the near month contract. The new
contracts are introduced for three month duration.
4.1.7.4 Expiry day
BANKNIFTY options contracts expire on the last Thursday of the expiry month. If
a) Contract size
The value of the option contracts on Nifty may not be less than Rs. 2 lakhs at the time
to time.
Index Level Strike Interval Scheme of strikes to be
introduced (ITM-ATM-OTM)
upto 2000 25 4-1-4
>2001 upto 4000 50 4-1-4
>4001 upto 6000 50 5-1-5
>6000 50 6-1-6
DBA 1754
NOTES
b) Price steps
The price step in respect of BANK Nifty options contracts is Re.0.05.
c) Base Prices
C = S * N (d
1
) - X * e
- rt
* N (d
2
)
- rt
* N (-d
2
) - S * N (-d
1
)
where :
d
1
= [ln (S / X) + (r +
2
/ 2) * t] / * sqrt(t)
d
2
= [ln (S / X) + (r -
2
/ 2) * t] / * sqrt(t)
= d
1
- * sqrt(t)
constant e (2.71828182845904).
NOTES
d) Price bands
Quantity freeze
Regular lot order
Stop loss order
Immediate or cancel
Spread order
4.1.8 NIFTY MIDCAP 50 OPTIONS
for which he pays a fee (premium) and the seller accepts an obligation for which he
receives a fee. The premium is the price negotiated and set when the option is
popular market Nifty Midcap 50 index.
Security descriptor
The security descriptor for the Nifty Midcap 50 options contracts is:
Market type : N
Underlying : NFTYMCAP50
DBA 1754
NOTES
Underlying symbol denotes the underlying index, which is Nifty Midcap 50
Option type identifies whether it is a call or a put option., CE - Call European, PE Put
European.
The underlying index is NIFTY MIDCAP 50
NFTYMCAP50 options contracts have a maximum of 3-month trading cycle - the
near month (one), the next month (two) and the far month (three). On expiry of the near
month contract, new contracts are introduced at new strike prices for both call and put
options, on the trading day following the expiry of the near month contract. The new
contracts are introduced for three month duration.
4.1.8.4 Expiry day
NFTYMCAP50 options contracts expire on the last Thursday of the expiry month.
If the last Thursday is a trading holiday, the contracts expire on the previous trading day.
Index Level Strike
Interval
Scheme of strikes to
be introduced (ITM-
ATM-OTM)
upto 2000 25 4-1-4
>2001 upto 4000 50 4-1-4
>4001 upto 6000 50 5-1-5
>6000 50 6-1-6
NOTES
a) Contract size
The value of the option contracts on NFTYMCAP50 may not be less than Rs.2
lakhs at the time of introduction. The permitted lot size for futures contracts & options
contracts shall be the same for a given underlying or such lot size as may be stipulated by
the Exchange from time to time.
b) Price steps
The price step in respect of NFTYMCAP50 options contracts is Re.0.05.
c) Base Prices
C = S * N (d
1
) - X * e
- rt
* N (d
2
)
- rt
* N (-d
2
) - S * N (-d
1
)
where :
d
1
= [ln (S / X) + (r +
2
/ 2) * t] / * sqrt(t)
d
2
= [ln (S / X) + (r -
2
/ 2) * t] / * sqrt(t)
= d
1
- * sqrt(t)
constant e (2.71828182845904).
DBA 1754
NOTES
d) Price bands
Quantity freeze
Regular lot order
Stop loss order
Immediate or cancel
Spread order
4.1.9 Options on Individual Securities
for which he pays a fee (premium) and the seller accepts an obligation for which
he receives a fee. The premium is the price negotiated and set when the option is
NSE became the first exchange to launch trading in options on individual securities.
Trading in options on individual securities commenced from July 2, 2001. Option contracts
are American style and cash settled and are available on 267 securities stipulated by the
Securities & Exchange Board of India (SEBI).
NOTES
Security descriptor
The security descriptor for the options contracts is:
Market type : N
Instrument Type : OPTSTK
Underlying : Symbol of underlying security
Option Type : CA / PA
Instrument type represents the instrument i.e. Options on individual securities.
Underlying symbol denotes the underlying security in the Capital Market (equities)
segment of the Exchange
Expiry date identifies the date of expiry of the contract Option type identifies whether
it is a call or a put option., CA - Call American, PA - Put American.
Option contracts are available on 267 securities stipulated by the Securities & Exchange
Board of India (SEBI). These securities are traded in the Capital Market segment of the
Exchange.
Options contracts have a maximum of 3-month trading cycle - the near month (one),
the next month (two) and the far month (three). On expiry of the near month contract, new
contracts are introduced at new strike prices for both call and put options, on the trading
day following the expiry of the near month contract. The new contracts are introduced for
three month duration.
4.1.9.4 Expiry day
Options contracts expire on the last Thursday of the expiry month. If the last Thursday
is a trading holiday, the contracts expire on the previous trading day.
The Exchange provides a minimum of seven strike prices for every option type (i.e
Call & Put) during the trading month. At any time, there are three contracts in-the-money
(ITM), three contracts out-of-the-money (OTM) and one contract at-the-money (ATM).
DBA 1754
NOTES
4.1.9.6 The Strike Price Interval
Price of Underlying Strike Price interval (Rs.)
Less than or equal to Rs. 50 2.50
> Rs.50 to less than or equal to Rs. 250 5
> Rs.2500 50
trading on the next working day based on the previous days underlying close values, as
and when required. In order to decide upon the at-the-money strike price, the underlying
closing value is rounded off to the nearest strike price interval.
the at-the-money strike price interval.
a) Contract size
The value of the option contracts on individual securities may not be less than Rs. 2
lakhs at the time of introduction for the first time at any exchange. The permitted lot size or
futures contracts & options contracts shall be the same for a given underlying or such lot
size as may be stipulated by the Exchange from time to time.
b) Price steps
The price step in respect of the options contracts is Re.0.05.
c) Base Prices
C = S * N (d
1
) - X * e
- rt
* N (d
2
)
- rt
* N (-d
2
) - S * N (-d
1
)
where :
d
1
= [ln (S / X) + (r +
2
/ 2) * t] / * sqrt(t)
d
2
= [ln (S / X) + (r -
2
/ 2) * t] / * sqrt(t)
= d
1
- * sqrt(t)
NOTES
constant e (2.71828182845904).
Rate of interest may be the relevant MIBOR rate or such other rate as may be
specified.
d) Price bands
Quantity freeze
entry and that the order is genuine. On such confirmation, the Exchange may approve such
order. However, in exceptional cases, the Exchange may, at its discretion, not allow the
orders that have come under quantity freeze for execution for any reason whatsoever
including non-availability of turnover / exposure limits.
DBA 1754
NOTES
Regular lot order
Stop loss order
Immediate or cancel
Spread order
OPTION Permitted lot size
Underlying Symbol Market Lot
BANK Nifty BANKNIFTY 25
CNX 100 CNX100 50
CNX IT CNXIT 50
CNX Nifty Junior JUNIOR 25
Nifty Midcap 50 NFTYMCAP50 75
S&P CNX Nifty NIFTY 50
S&P CNX Nifty MINIFTY 20
Derivatives on Individual Securities Symbol Market Lot
3I Infotech Ltd. 3IINFOTECH 2700
Aban Offshore Ltd. ABAN 50
Abb Ltd. ABB 250
Aditya Birla Nuvo Limited ABIRLANUVO 200
Adlabs Films Ltd ADLABSFILM 225
Aia Engineering Limited AIAENG 200
Allahabad Bank ALBK 2450
Alok Industries Ltd. ALOKTEXT 3350
Alstom Projects India Ltd APIL 200
Ambuja Cements Ltd. AMBUJACEM 2062
Amtek Auto Ltd. AMTEKAUTO 600
Andhra Bank ANDHRABANK 2300
Ansal Prop & Infra Ltd ANSALINFRA 1300
Aptech Limited APTECHT 650
Arvind Limited ARVIND 4300
Ashok Leyland Ltd ASHOKLEY 4775
Associated Cement Co. Ltd. ACC 188
NOTES
Aurobindo Pharma Ltd. AUROPHARMA 700
Axis Bank Ltd. AXISBANK 225
Bajaj Auto Limited BAJAJ-AUTO 200
Bajaj Hindustan Ltd. BAJAJHIND 950
Bajaj Holdings & Investment Ltd. BAJAJHLDNG 250
Ballarpur Industries Limited BALLARPUR 7300
Balrampur Chini Mills Ltd. BALRAMCHIN 2400
Bank Of Baroda BANKBARODA 700
Bank Of India BANKINDIA 950
Bata India Ltd. BATAINDIA 1050
Bharat Earth Movers Ltd. BEML 125
Bharat Electronics Ltd. BEL 138
Bharat Forge Co Ltd BHARATFORG 1000
Bharat Heavy Electricals Ltd. BHEL 75
Bharat Petroleum Corporation Ltd. BPCL 550
Bharti Airtel Ltd BHARTIARTL 250
Bhushan Steel & Strips Lt BHUSANSTL 250
Biocon Limited. BIOCON 450
Birla Corporation Ltd BIRLACORPN 850
Bombay Dyeing & Mfg. Co Ltd. BOMDYEING 300
Bombay Rayon Fashions Ltd BRFL 1150
Bongaigaon Refinery Ltd. BONGAIREFN 2250
Brigade Enterprises Ltd. BRIGADE 550
Cairn India Limited CAIRN 1250
Canara Bank CANBK 800
Central Bank Of India CENTRALBK 2000
Century Textiles Ltd CENTURYTEX 212
Cesc Ltd. CESC 550
Chambal Fertilizers Ltd. CHAMBLFERT 3450
Chennai Petroleum Corporation Ltd. CHENNPETRO 900
Cipla Ltd. CIPLA 1250
Cmc Ltd. CMC 200
DBA 1754
NOTES
Colgate Palmolive Ltd COLPAL 550
Corporation Bank CORPBANK 600
Crompton Greaves Ltd. CROMPGREAV 500
Cummins India Ltd CUMMINSIND 475
Dabur India Ltd. DABUR 2700
Deccan Aviation Limited AIRDECCAN 850
Dena Bank DENABANK 2625
Develop Credit Bank Ltd DCB 1400
Divi'S Laboratories Ltd. DIVISLAB 155
Dlf Limited DLF 400
Dr. Reddy'S Laboratories Ltd. DRREDDY 400
Edelweiss Capital Ltd EDELWEISS 250
Educomp Solutions Ltd EDUCOMP 75
Escorts India Ltd. ESCORTS 2400
Essar Oil Ltd. ESSAROIL 1412
Everest Kanto Cylinder Ltd EKC 1000
Federal Bank Ltd. FEDERALBNK 851
Financial Technologies (I) Ltd FINANTECH 150
Gail (India) Ltd. GAIL 750
Gateway Distriparks Ltd. GDL 2500
Gitanjali Gems Limited GITANJALI 500
Glaxosmithkline Pharma Ltd. GLAXO 300
Gmr Infrastructure Ltd. GMRINFRA 1250
Grasim Industries Ltd. GRASIM 88
Great Offshore Ltd GTOFFSHORE 250
Gtl Ltd. GTL 750
Gujarat Alkalies & Chem GUJALKALI 1400
Gujarat Narmada Fertilizer Co. Ltd. GNFC 1475
Havells India Limited HAVELLS 400
Hcl Technologies Ltd. HCLTECH 650
Hdfc Bank Ltd. HDFCBANK 200
Hero Honda Motors Ltd. HEROHONDA 400
NOTES
Underlying Symbol Market Lo
Hindalco Industries Ltd. HINDALCO 1759
Hinduja Ventures Ltd. HINDUJAVEN 500
Hindustan Construction Co HCC 1400
Hindustan Oil Exploration HINDOILEXP 1600
Hindustan Petroleum Corporation Ltd. HINDPETRO 1300
Hindustan Unilever Ltd HINDUNILVR 1000
Hindustan Zinc Limited HINDZINC 250
Hotel Leela Ventures Ltd HOTELEELA 3750
Housing Development And
Infrastructure Ltd. HDIL 516
Housing Development Finance
Corporation Ltd. HDFC 75
ibn18 Broadcast Limited IBN18 1250
Icici Bank Ltd. ICICIBANK 175
Idea Cellular Ltd. IDEA 2700
Ifci Ltd. IFCI 1970
I-Flex Solutions Ltd. I-FLEX 150
India Cements Ltd. INDIACEM 725
India Infoline Limited INDIAINFO 1250
Indian Bank INDIANB 1100
Indian Hotels Co. Ltd. INDHOTEL 1899
Indian Oil Corporation Ltd. IOC 600
Indian Overseas Bank IOB 1475
Indusind Bank Ltd. INDUSINDBK 1925
Industrial Development Bank Of India
Ltd. IDBI 1200
Info Edge (I) Ltd NAUKRI 150
Infosys Technologies Ltd. INFOSYSTCH 200
Infrastructure Development Finance
Company Ltd. IDFC 1475
DBA 1754
NOTES
NOTES
DBA 1754
NOTES
NOTES
DBA 1754
NOTES
NOTES
Summary
Futures and forwards share a very important characteristic: when the delivery date
arrives, the delivery must take place. The agreement is binding for both parties: the party
with the short position has to deliver the goods, and the party with the long position has to
pay the agreed price.
A mini derivative option contract is similar to any other existing option contract except
for the minimum contract size.
Options contracts have a maximum of 3-month trading cycle - the near month (one),
the next month (two) and the far month (three). On expiry of the near month contract, new
contracts are introduced at new strike prices for both call and put options, on the trading
day following the expiry of the near month contract.
entry and that the order is genuine.
Questions
1. What are the main characteristics of Option Contract? Explain
2. Who are the Market Participants in Option Market?
3. Explain the Mini Option contracts on S&P CNX Nifty index
4. What do you understand by Strike Price Intervals?
5. Explain the Options on Individual Securities
DBA 1754
NOTES
CHAPTER II
FINANCIAL SWAPS MARKET
4.2.1 Introduction
A Swap is an agreement between two parties, called Counterparties, who exchange
cash flows over a period of time in the future. When exchange rate and Interest rates
fluctuate, risks of forward and money market positions are so great that the forward market
& money market may not function properly. Currency futures and options are inflexible
and available only for selected currencies. In such cases, MNCs & governments may use
swap arrangements to protect the value of export sales, import orders and outstanding
loans dominated in foreign currencies.
4.2.2 There are Three Basic Motivations for Swaps:
Firms use swaps to provide protection against future changes in exchange rates and
interest rates.
Firms use swaps to eliminate interest-rate risks arising from normal commercial
operations
4.2.3 Firms use Swaps to Reduce Financing Costs
Financial swaps are now used by Multinational companies, commercial banks, world
organizations and sovereign governments to minimize currency and interest-rate risks. Thus
swaps have become another risk management tool along with currency forwards, futures
and options.
The origins of swap market can be traced back to 1970s when traders developed
currency swaps to evade British controls on movement of foreign currency. The market
has grown rapidly ever since and in year 2002 about $44 trillion was traded via swaps
4.2.4 Parallel Loans
A Parallel Loan refers to a loan which involves an exchange of currencies between 4
parties, with a promise to re-exchange the currencies at a predetermined exchange rate on
a specified future date. Typically, the parties consist of two pairs of affiliated companies.
Parallel loans are commonly arranged by two multinational parent companies in two different
countries.
The structure of a typical parallel loan is illustrated in the following example.
NOTES
IBM in USA with a subsidiary in Italy wants to obtain a one year Lira loan for its
subsidiary.
Olivetti in Italy wishes to invest in US via a loan to its US subsidiary. With a Parallel
loan, these loans can be arranged without currency crossing the national border. IBM
lends $10M to Olivettis US subsidiary at US interest rates. Olivetti in return lends $10M
in Lira to IBMs Italian subsidiary.
4.2.5 Back-to-Back Loans
Bank to back loan involves an exchange of currencies between two parties, with a
promise to re-exchange the currencies at a specified rate on a specified future date. Back
to back loans involve two companies domiciled in two different countries. For example,
IBM borrows money in US dollars and lends the borrowed funds to Olivetti in Italy, which
in return borrows funds in Italy and lends those funds to IBM in the United States. By this
simple arrangement, each firm has access to capital markets in foreign country and makes
use of their comparative advantage of borrowing in different capital markets.
4.2.6 Drawbacks of parallel and back to back loans
The difficulty in finding counterparties with matching needs. Firms must find firms with
mirror-image financing needs. Financing requirements include principals, types of interest
payments, frequency of interest payments, and length of the loan period. The search cost
for finding such counterparty is quite considerable.
One is still obligated to comply with the loan terms even when the other defaults. In the
above example, IBM is still liable for the loan even if Olivetti defaults. To avoid default
risks, a separate agreement defining the right of offset must be drafted.
The loans are carried on the accounting books of both the firms. This limits additional
borrowing and hence limits the leverage of these firms.
Swaps on the other hand overcome the above drawbacks by:
DBA 1754
NOTES
Making it easier to find counterparties via swap brokers.
Defining an offset agreement as a part of the swap.
Principal amounts in a swap do not appear on the accounting books. These off book
transactions help banks avoid increases in their capital requirements under applicable
regulations
As a result, Swaps are very popular financial instruments. In 2000, the size of world
swap market was greater than $25 billion
4.2.7 Swap Banks
Financial institutions which assist in the completion of a swap is called Swap Bank.
The swap bank makes profits from the bid-ask spread it imposes on the swap coupon. A
Swap broker is a swap bank who acts strictly as an agent without taking any financial
position in the swap transaction, i.e., mearly matches counterparties and does not assume
any risk of a swap. A Swap Dealer is a swap bank who actually transacts for its own
account to help complete the swap. In this capacity, the swap dealer assumes a position in
the swap and thus assumes certain risks.
4.2.8 Types of Swaps
4.2.8.1 Plain Vanilla Swaps
It is the simplest kind of swaps. Here two counterparties agree to make payments to
each other on the basis of some underlying assets. These payments include interest payments,
commissions and other service payments. The swap agreement contains specifications of
the assets to be exchanged, the rate of interest applicable to each, the timetable by which
the payments are to be made and other provisions.
The two parties may or may not exchange the underlying assets, which are called
Notional Principals, in order to distinguish them from physical exchanges in the cash markets.
4.2.8.2 Interest Rate Swaps
An interest rate swap is a swap in which counterparties exchange cash flows of a
floating rate for cash flows of a fixed rate or vice-versa. No notional principal changes
hands, but it is a reference amount against which interest is calculated. Interest swaps can
be international or purely domestic.
4.2.8.3 The Most Common Motive for Interest Rate Swaps are:
Changes in financial markets may cause interest rates to change
Borrowers may have different credit ratings in different countries
NOTES
Borrowers have different preferences for debt service payment schedule
Interest rate swaps are normally arranged by an international bank which serves as a swap
broker or a swap dealer. Through interest rate swaps, borrowers obtain a lower cost of
debt service payments and lenders obtain profit guarantees.
4.2.8.4 Currency Swaps
A Currency swap is a swap in which one party provides a certain principal in one currency
to its counterparty in exchange for an equivalent amount in a different currency. For example,
An US firm wants to exchange its Dollars for Italian Lira while an Italian firm want to
exchange Lira to US dollars. Given these two needs, the two may engage in a swap deal.
Currency swap is similar to parallel loans, but swaps are better due to:
Ease of finding counterparties
The right to offset the loan payments
Off books transactions.
4.2.9 Swaptions, Caps, Floor and Collars
A swaption is an option to enter into a plain vanilla swap. A Call swaption gives the
holder the right to receive fixed-interst payments. A put swaption gives the holder the right
to make fixed interest payments. Call swaptions are attractive when interest rates are
expected to fall. Put swaptions are attractive when interest rates are expected to rise.
Banks & investment firms usually act as dealers rather than as brokers.
An interest rate cap sets the maximum rate of interest on floating rate interest payments;
An interest rate floor set the minimum rate of interest on a floating rate interest payments;
and an interest rate collar combines a cap with a floor.
A buyer of these instruments pays a one time premium, which is a small percentage of
the notional capital.
4.2.10 Motivation for Swaps
There are three basic motivations for swaps. First, companies use swaps to provide
protection against future changes in exchange rates. Second, Companies use swaps to
eliminate interest rate risks arising from normal commercial operations. Third, companies
use swaps to reduce financing costs.
4.2.11 Closing Thoughts
Swap market has emerged largely because financial swaps escape many of the
limitations inherent in currency futures and options markets. Swaps are custom tailored to
the needs of two parties; swap agreements are more likely to meet the specific needs of
DBA 1754
NOTES
the counterparties than currency futures and options. Swap market is done via financial
institutions and offers privacy when compared to foreign exchange markets. Lastly swaps
are not as highly regulated as options and futures markets
4.2.12 Interest Rate Swaps
One of the largest components of the global derivatives markets and a natural adjunct
to the fixed income markets is the interest rate swaps market. Understanding the over-the-
counter swaps market can give a deeper insight into the capital flows that drive the bond
markets, the way in which the companies whose stock investor manage their exposure to
fluctuations in interest rates and the way banks and financial institutions make a great deal
of their income.
Simply put, it is the exchange of one set of cash flows for another. A pre-set index, notional
amount and set of dates of exchange determine each set of cash flows. The most common
type of interest rate swap is the exchange of fixed rate flows for floating rate flows.
Differences in the credit quality between entities borrowing money motivate the interest
rate swap market. Specifically, some agents may have a better borrowing profile in the
short maturities than they do in the long maturities. Other agents (with more creditworthy
status) have a comparative advantage raising money in the longer maturities.
A counter-partys creditworthiness is an assessment of their ability to repay money
lent to them over time. If a company has a good credit rating, they are more likely to be
able to pay back a loan over time than a company with a poor credit rating. This effect is
magnified with time. By making it easier for less creditworthy agents to borrow in the short
term than in the long term, lenders make sure that they are less exposed to this risk.
Therefore, we would expect that in fixed-floating interest rate swaps, the entity paying
fixed and receiving floating is usually the less creditworthy of the two counterparties.
The interest rate swap gives the less creditworthy entity a way of borrowing fixed rate
funds for a longer term at a cheaper rate than they could raise such funds in the capital
markets by taking advantage of the entitys relative advantage in raising funds in the shorter
maturity buckets.
As we shall see in a later article, this arbitrage opportunity is expanded when we
consider agents who can borrow money in a number of different currencies. In that case,
we can think of a matrix of currency and maturity to describe an entitys relative arbitrate
opportunities. This can be addressed using currency swaps.
Of course, fixed-floating interest rate swaps are not the only kinds of interest rate
swaps we can construct. Any kind of interest rate swap is possible, as long as the two
counter-parties can come up with differing indices. We could imagine a swap in which
there are two different kinds of floating indices or another in which there are two different
kinds of fixed indices.
NOTES
In subsequent articles, we shall also see how swaps can be constructed using equity
indices and commodity indices and the rationale for using these structures instead of outright
purchases of the underlying equities and commodities.
How do we value swaps? There are several steps:
a) Identify the cash flows. To simplify things, many people draw diagrams with inflows
and outflows of funds over time.
b) Construct the swap curve, obtained from the government yield curve and the swap
spread curve.
c) Construct a zero-coupon curve from the swap curve. (See the Fixed Income
section).
d) Present value the cash flows using the zero-coupon rates.
The swap spread is obtained from market makers. It is the market-determined
additional yield that compensates counter-parties who receive fixed payments in a swap
for the credit risk involved in the swap. The swap spread will differ with the creditworthiness
of the counter-party.
Just like an option, a swap can be at-the-money, in-the-money or out-of-the-money.
Most swaps are priced to be at-the-money at inception meaning that the value of the
floating rate cash flows is exactly the same as the value of the fixed rate cash flows at the
inception of the deal. Naturally, as interest rates change, the relative value may shift. Receiving
the fixed rate flow will become more valuable than receiving the floating rate flow if interest
rates drop or if credit spreads tighten.
Investment banks and commercial banks are the market makers for most of these
swaps. Most of them warehouse the risk in portfolios, managing the residual interest rate
risk of the cash flows. As you can imagine, the management of these risks can be very
complex with swaps maturing on a daily basis and the difficulties of managing a variety of
similar but not identically matched products.
4.2.13 Currency Swaps
In the case of a currency swap, principal exchange is not redundant. The exchange of
principal on the notional amounts is done at market rates, often using the same rate for the
transfer at inception as is employed at maturity.
For example, consider the US-based company (Acme Tool & Die) that has raised
money by issuing a Swiss Franc-denominated Eurobond with fixed semi-annual coupon
payments of 6% on 100 million Swiss Francs. Upfront, the company receives 100 million
Swiss Francs from the proceeds of the Eurobond issue (ignoring any transaction fees,
etc.). They are using the Swiss Francs to fund their US operations.
DBA 1754
NOTES
Why issue bonds in Swiss Francs? The only rationale for doing this is because there
are investors with Swiss Franc funds who are looking to diversify their portfolios with US
credits such as Acmes. They are willing to buy Acmes Eurobonds at a lower yield than
Acme can issue bonds in the US. A Eurobond is any bond issued outside of the country in
whose currency the bond is denominated.
Because this issue is funding US-based operations, we know two things straightaway.
Acme is going to have to convert the 100 million Swiss Francs into US dollars. And Acme
would prefer to pay its liability for the coupon payments in US dollars every six months.
Acme can convert this Swiss Franc-denominated debt into a US dollar-like debt by
entering into a currency swap with the First London Bank.
Acme agrees to exchange the 100 million Swiss Francs at inception into US dollars,
receive the Swiss Franc coupon payments on the same dates as the coupon payments are
due to Acmes Eurobond investors, pay US dollar coupon payments tied to a pre-set
index and re-exchange the US dollar notional into Swiss Francs at maturity.
Acmes US operations generate US dollar cash flows that pay the US-dollar index
payments.
Currency swaps are used to hedge or lock-in the value-added of issuing Eurobonds.
They are often negotiated as part of the whole issuance package with the main issuing
financial institution.
4.2.14 Flexibility
Currency swaps give companies extra flexibility to exploit their comparative advantage
in their respective borrowing markets.
Interest rate swaps allow companies to focus on their comparative advantage in
borrowing in a single currency in the short end of the maturity spectrum vs. the long-end of
the maturity spectrum.
Currency swaps allow companies to exploit advantages across a matrix of currencies
and maturities.
The success of the currency swap market and the success of the Eurobond market
are explicitly linked.
4.2.15 Exposure
Because of the exchange and re-exchange of notional principal amounts, the currency
swap generates a larger credit exposure than the interest rate swap.
NOTES
Companies have to come up with the funds to deliver the notional at the end of the
contract. They are obliged to exchange one currencys notional against the other currencys
notional at a fixed rate. The more actual market rates have deviated from this contracted
rate, the greater the potential loss or gain.
This potential exposure is magnified with time. Volatility increases with time. The
longer the contract, the more room for the currency to move to one side or other of the
agreed upon contracted rate of principal exchange.
This explains why currency swaps tie up greater credit lines than regular interest rate
swaps.
Currency swaps allow companies to exploit the global capital markets more efficiently.
They are an integral arbitrage link between the interest rates of different developed countries.
The future of banking lies in the securitization and diversification of loan portfolios.
The global currency swap market will play an integral role in this transformation. Banks
will come to resemble credit funds more than anything else, holding diversified portfolios of
global credit and global credit equivalents with derivative overlays used to manage the
variety of currency and interest rate risk.
4.2.16 Hedging Swaps
Dealers at commercial banks do most of the market making that is done in the interest
rate swap and currency swap markets. In addition to making markets to their customers,
these traders will also make prices to other financial institutions in the wholesale or interbank
market, often in transactions facilitated by interbank brokers. In any given day, the dealer
at the bank may engage in several transactions or several dozen transactions, all of which
are added to his general position. The combination of all of the different swaps and bond
trades and futures trades that the dealer has conducted constitutes a portfolio.
While it may be easier for us to understand intuitively the way in which the dealer
manages the risk of an individual swap transaction, in practice this is prohibitively difficult
and it does not take advantage of the natural hedges within the portfolio. Therefore, the
swaps dealer will manage the risks of his position using portfolio management techniques
that are similar to but more sophisticated than the portfolio management techniques used
for a simple cash position in fixed income or equities.
In portfolio hedging, the dealers objective is to construct a portfolio of hedges using
swaps, forward rate agreements (FRAs), futures and bonds the changes in value of which
offsets the change in value of the underlying swap portfolio for a given set of fluctuations in
interest rates, currency rates or basis between the futures and the bonds.
DBA 1754
NOTES
4.2.17 Identifying the risk of the swaps portfolio
The first necessary step in hedging the swaps portfolio is to measure the risk of the
swaps portfolio. Namely, the dealer must answer a series of questions. How much will the
portfolio lose on a mark-to-market basis if interest rates move up in a parallel fashion (i.e.
all interest rates increase by the same amount) by 50 basis points? How much will the
portfolio lose on a mark-to-market basis if interest rates fall in a parallel fashion by 50
basis points? How much will the portfolio lose if the spread between the 30-year government
bond and the 2-year government note increases by 25 basis points? How will the positions
sensitivity to interest rates change if the level of interest rates change?
Cash flows are grouped in maturity buckets (or intervals of consecutive maturity).
One example might be all of the cash flows from 1 year to 1 year and 3 months. Another
example might be all of the cash flows from 29 years to maturity to 30 years to maturity.
These grouped cash flows are then valued at market rates. Doing so enables the dealer to
get a true picture of the cash flows local sensitivity to market rates. The sensitivity of the
portfolio maturity bucket may be dependent on the level of interest rates because of the
convexity of fixed income flows.
One way of looking at the delta is just the fixed income instrument with a term to
maturity equal to the average maturity for the interval in question that is as sensitive in profit
and loss terms to small changes in the interest rate for that bucket as the swaps portfolio is
for that bucket.
Similarly, the gamma is an expression of the changes in the position size (i.e. the
changes in the delta) for changes in the level of interest rates.
Vega is the sensitivity of the portfolio to changes in implied volatilities for at-the-
money options associated with the maturity bucket in question. This may be important, for
example, if the portfolio contains swaptions.
In categorizing the risk of the swaps portfolio, the dealer must look at different types
of yield curve risk including parallel shifts in the yield curve, non-parallel shifts in the yield
curve and changes in swap spreads. Sophisticated dealers may incorporate some
assumptions about the correlation between swap spreads and interest rates in doing their
scenario analysis. It may be reasonable to believe that swap spreads will widen out if
interest rates back up because of degrading credit conditions, for example.
4.2.18 Constructing the Hedge Portfolio
The dealer will then take this analysis of the behavioural characteristics of the swap
portfolio and he will construct a hedging portfolio using one or more financial instruments in
order to offset those aspects of the risk that he is unhappy carrying. Note that the dealer
will not close out all of the aspects of the risk.
NOTES
4.2.19 Why will the Dealer only Partially Hedge the Swaps Portfolio?
Hedging costs money. The main benefit of hedging activity is to reduce the risk of the
portfolio. This benefit must be compared to the hedging cost. If the marginal benefit of
reducing the risk with an individual transaction is less than its marginal cost, it is not worthwhile
to hedge that risk.
Another reason for not completely hedging the swaps portfolio is the fact that the
dealer may carry a proprietary position in one or more aspects of the risk. If, for example,
he thinks that interest rates are going to fall in the 2-year to 3-year bucket, he may be
happy to continue received fixed interest payments for that period. If he is correct, he will
make money on a mark-to-market basis that he can realize by hedging the position at a
preferable level.
4.2.20 Floating Rate Cash Flow Management
One of the more difficult aspects of managing a swap portfolio is managing the short-
term cash flows or the floating rate cash flows. There are two problems that confront the
dealer.
4.2.21 Mismatches in the Timing of Short-Term Cash Flows.
Consider a hedge that was entered into two years ago to hedge a two year fixed-
floating plain vanilla interest rate swap where the hedge transaction took place a week
after the initial customer transaction. Unless the dealer matched the dates precisely at the
time he conducted the hedge transaction, there will be a one-week mismatch of flows.
Matching the dates may have cost extra money in terms of the market prices at the time of
transaction making it too expensive to match the timing of the cash flows. Some people
might argue that one week is not very much of a difference. That is no way to run a
business. To paraphrase an old saying, ten grand here and one hundred grand there and
pretty soon youre talking about some real money.
4.2.22 Mmismatches in the Type of Index used to Hedge.
Consider a swap in which the floating rate index is the 3-month US Bankers
Acceptance rate. If the best swap available at the time is the 3-month US LIBOR (London
Interbank Offered Rate for US dollars), then there is an index mismatch risk. If the
correlation between these two indices changes (and correlation between financial indices
is rarely stable), then the swap portfolio is exposed to refunding risk.
One way for the commercial bank to hedge its floating rate cash flows is to establish
a separate book dedicated to hedging such risks, one which participates actively in the
futures markets such as the IMM Eurodollar market and one which takes aggressive
positions in short-term interest rates.
DBA 1754
NOTES
An alternative might be to pay the hedging costs necessary for closing out the
mismatches. This can get expensive. With the increased commoditization of global derivatives
markets, dealers are losing much of their pricing edge, a phenomenon that makes paying
for outside hedging more difficult.
By giving an appreciation for the way swaps dealers manage their combined portfolio
risk, this article has identified some of the key types of risk in interest rate swaps and
interest rate products, generally.
4.2.23 Interest Rate Swaps
counter swaps market can give you a deeper insight into the capital flows that drive the
bond markets, the way in which the companies whose stock investor own manage their
exposure to fluctuations in interest rates and the way banks and financial institutions make
a great deal of their income.
What is an interest rate swap? Simply put, it is the exchange of one set of cash flows
for another. A pre-set index, notional amount and set of dates of exchange determine each
set of cash flows. The most common type of interest rate swap is the exchange of fixed
rate flows for floating rate flows.
The interest rate swap gives the less creditworthy entity a way of borrowing fixed rate
funds for a longer term at a cheaper rate than they could raise such funds in the capital
markets by taking advantage of the entitys relative advantage in raising funds in the shorter
maturity buckets.
4.2.24 Valuation of swaps
a) Identify the cash flows. To simplify things, many people draw diagrams with inflows
and outflows of funds over time.
b) Construct the swap curve, obtained from the government yield curve and the swap
spread curve.
c) Construct a zero-coupon curve from the swap curve. (See the Fixed Income
section).
d) Present value the cash flows using the zero-coupon rates.
The swap spread is obtained from market makers. It is the market-determined
additional yield that compensates counter-parties who receive fixed payments in a swap
for the credit risk involved in the swap. The swap spread will differ with the creditworthiness
of the counter-party.
Just like an option, a swap can be at-the-money, in-the-money or out-of-the-money.
Most swaps are priced to be at-the-money at inception meaning that the value of the
floating rate cash flows is exactly the same as the value of the fixed rate cash flows at the
NOTES
inception of the deal. Naturally, as interest rates change, the relative value may shift. Receiving
the fixed rate flow will become more valuable than receiving the floating rate flow if interest
rates drop or if credit spreads tighten.
Investment banks and commercial banks are the market makers for most of these
swaps. Most of them warehouse the risk in portfolios, managing the residual interest rate
risk of the cash flows.
4.2.25 Equity Swaps
Having discussed interest rate swaps and their cross-currency extension to currency
swaps as exchanges of cash flows predicated on pre-set indices, it is natural for us to think
of structuring swaps involving non-interest indices. Equity swaps are exchanges of cash
flows in which at least one of the indices is an equity index. An equity index is a measure of
the performance of an individual stock or a basket of stocks. Common equity indices with
which the general investor is probably familiar include the Standard & Poors 500 Index,
the Dow Jones Industrial Average or the Toronto Stock Exchange Index.
The outstanding performance of equity markets in the 1980s and the 1990s,
technological innovations that have made widespread participation in the equity market
more feasible and more marketable and the demographic imperative of baby-boomer
saving has generated significant interest in equity derivatives. In addition to the listed equity
options on individual stocks and individual indices, a burgeoning over-the-counter
(OTC) market has evolved in the distribution and utilization of equity swaps.
There are many reasons to use equity swaps, some of which come from the motivation
behind index trading.
This passive investing strategy is gaining ground in the fund management community.
Instead of trying to buy individual stocks that are deemed to be undervalued by some
method of fundamental analysis, the index trading mechanism chooses a basket of stocks
that is selected for its ability to represent the general market or one particular sector of the
stock market. The fees associated with funds that engage in index trading are much lower
because the investment management is mechanically deterministic. It is prescribed by the
index that the investors have chosen. The investment manager is not paid for his discretionary
expertise.
4.2.26 Equity swaps make the index trading strategy even easier.
Consider the Bulldog S&P 500 Mutual Fund that is a fund promising to deliver the
return of the S&P 500 (less administrative and managerial costs). How do they do it?
One way would be to buy the 500 stocks that comprise the index in their exact
proportions. However, the execution of this would be cumbersome, particularly if the level
DBA 1754
NOTES
of funds in the Bulldog S&P 500 Mutual Fund were to fluctuate as people put more money
to work or as they withdraw from the fund.
Another way would be to participate in the S&P 500 through the futures market by
using the mutual funds money to purchase S&P 500 Futures. The Futures contract would
have to be rolled on a quarterly basis. There would be complex administration with the
Futures Exchange.
There is a third alternative: the equity swap. The investment manager at Bulldog calls
up First Derivatives bank and asks for an S&P 500 swap in which the fund pays First
Derivatives some money market return in exchange for receiving the return on the S&P
500 index for a period of five years with monthly payments. The return on the S&P 500
index consists of capital gains as well as income distributions.
The structure is easy for the passive investment manager to implement administratively.
And it fully accomplishes the goal with very little costs. Index trading funds typically have
much lower costs associated with them.
Summary
A Swap is an agreement between two parties, called Counterparties, who exchange
cash flows over a period of time in the future. When exchange rate and Interest rates
fluctuate, risks of forward and money market positions are so great that the forward market
& money market may not function properly.
A Parallel Loan refers to a loan which involves an exchange of currencies between 4
parties, with a promise to re-exchange the currencies at a predetermined exchange rate on
a specified future date.
Financial swaps are now used by Multinational companies, commercial banks, world
organizations and sovereign governments to minimize currency and interest-rate risks.
The difficulty in finding counterparties with matching needs. Firms must find firms with
mirror-image financing needs. Financing requirements include principals, types of interest
payments, frequency of interest payments, and length of the loan period. The search cost
for finding such counterparty is quite considerable.
counter swaps market can give you a deeper insight into the capital flows that drive the
bond markets, the way in which the companies whose stock investor own manage their
exposure to fluctuations in interest rates and the way banks and financial institutions make
a great deal of their income.
NOTES
Equity swaps are powerful tools in the hand of the passive investment manager, the
investor looking to tailor the timing of his tax events, investment managers looking for
opportunities abroad and the average investor looking to enhance his return despite the
letter of government provisos.
Questions
1 What do you mean by Interest Rate Swap? Briefly Explain
2 What are the Types of Swaps? Explain
3 Explain about the Floating Rate Cash flow Management
4 What are the drawbacks of Parallel and Back to back loans?
5 Why will the dealer only partially hedge the swaps portfolio?
6 Equity swaps make the index trading strategy even easier. Explain
DBA 1754
NOTES
NOTES
UNIT V
ACCOUNTING
CHAPTER I
ACCOUNTING TREATMENT FOR DERIVATIVE
TRANSACTIONS
5.1.1 Introduction
The accounting of financial instruments is based on whether those are used for hedging
or not. Where they are not used for hedging they could fall under any of the four categories:
(i) Financial asset/liability at fair value through profit and loss account (ii) Held-to-maturity
investments (iii) Loans and receivables and (iv) Available for sale.
Financial asset/liability at fair value through profit and loss account would generally
cover trading items and those that management voluntarily wishes to classify under this
category. All the fair value changes in the financial asset/liability are taken to the income
statement and consequently the income statement would become highly volatile.
Derivatives would fall under this category, unless they are used for hedging purposes
in which case hedge accounting would apply.
Held-to-maturity financial assets are those investments where there is positive intention
to hold those assets till the maturity period. They do not include derivatives since they are
included in the first category. A financial asset that fulfills the definition of loans and receivables
are also not included.
Besides an investment which is otherwise held-to-maturity may be classified voluntarily
by the management in the fair value category or available for sale category.
Held-to-maturity investments are accounted for through the effective interest rate
method and the consequent gains and losses are recognised in the income statement.
5.1.2 Getting Ready
The markets for derivatives have been remarkable and continued growth over the
past decade. This reflects the increasing use of such instruments by business, either for
speculation or hedging purposes. Accordingly, the accounting treatment for derivatives
and hedging activities has taken on a high degree of importance.
DBA 1754
NOTES
Hedge accounting does not sit well with the standard setters desired goal for financial
instrument accounting, i.e. a full fair value model. Further, hedge accounting relies on
management intent to link for accounting purposes what the standard setters see as two or
more separate transactions. It also overrides accounting requirements that would otherwise
apply to those transactions when viewed separately.
Standard setters believe that separate accounting is the best way to tell it as it is, in
other words, to apply the full fair value model. However, the wider financial reporting
community could not be persuaded to accept the abolition of hedge accounting. Accounting
Standard AS-30 on Financial Instruments-Recognition and Measurement has been issued
by the institute as published in January 2008 journal.
This Accounting Standard will become mandatory in respect of accounting period
commencing on or after April 1, 2011, for all commercial, industrial and business entities
except to a small and medium size entity.
Correspondingly, a limited revision has also been made to AS-11 so as to withdraw
the requirements concerning forward exchange contracts from that Standard. ICAI is also
in process of formulating a separate Accounting Standard AS-32 on Financial Instruments-
Disclosures. As such AS-30 deals with Recognition and Measurement, and AS-32 deals
with exclusively on Disclosure.
5.1.3 Hedge Accounting
As required by the standard, on the date of this standard becoming mandatory, an
entity should; measure all derivatives at fair value; and eliminate all deferred losses and
gains, if any, arising on derivatives that under the previous accounting policy of the entity
were reported as assets or liabilities.
Any resulting gain or loss (as adjusted by any related tax expense/benefit) should be
adjusted against opening balance of revenue reserves and surplus.
On the date of this standard becoming mandatory, an entity should not reflect in its
financial statements a hedging relationship of a type that does not qualify for hedge accounting
under this standard (for example, hedging relationships where the hedging instrument is a
cash instrument or written option; where the hedged item is a net position; or where the
hedge covers interest risk in a held-to-maturity investment). However, if an entity designated
a net position as a hedged item under its previous accounting policy, it may designate an
individual item within that net position as a hedged item under Accounting Standards,
provided that it does so on the date of this standard becoming mandatory.
It, before the date of this standard becoming mandatory, an entity had designated a
transaction as a hedge but the hedge does not meet the conditions for hedge accounting in
this standard, the entity should apply paragraphs 102 and 112 to discontinue hedge
NOTES
accounting. Transactions entered into before the date of this standard becoming mandatory
should not be retrospectively designated as hedges.
5.1.4 Embedded Derivatives
As entity that applies this standard for the first time should assess whether an embedded
derivative is required to be separated from the host contract and accounted for as a derivative
on the basis of the conditions that existed on the date it first became a party to the contract
or on the date on which a reassessment is required by appendix A paragraph A56, whichever
is the later date.
5.1.5 Recent Announcement
Notwithstanding the applicability of AS-30, it is very important to understand the
impact and effect of this announcement. The announcement on accounting for derivatives
issued by ICAI on March 29, 2008, clarifies the best practice treatment to be followed for
all derivatives is as follows:
i. All derivatives except forward contracts covered by AS 11, can be accounted for on
the basis of the requirements prescribed in AS 30, Financial Instruments: Recognition
and Measurement.
ii. In case an entity does not follow AS 30, keeping in view the principle of prudence as
enunciated in AS 1, Disclosure of Accounting Policies, the entity is required to provide
for losses in respect of all outstanding derivative contracts at the balance sheet date
by marking them to market.
The effect of the above announcement is as follows:
i. In case an entity does not follow AS 30, the losses in respective of derivative contracts
at the balance sheet date have to be provided for and disclosed.
ii. In case an entity follows AS 30, then the effect will be broadly as follows:
In case the derivatives do not meet the hedge accounting criteria as laid down in AS
30, the gains or losses in respect thereof will have to be recognised in the statement of
profit and loss. The derivatives will have to be shown as financial assets or financial liabilities
on the balance sheet, as the case may be, as per the requirements of the accounting standard.
In case the hedge accounting criteria, e.g., hedge effectiveness, qualifying hedges,
documentation etc, as laid down in AS 30 are met, the entity will have to consider, keeping
in view the requirements of AS 30, whether the hedge is a fair value hedge or cash flow
hedge.
Fair value hedge and cash flow hedge have been explained in AS 30 as follows:
DBA 1754
NOTES
a) Fair value hedge: A hedge of the exposure to changes in fair value of a recognised
asset or liability or an unrecognised firm commitment, or an identified portion of
such an asset, liability or firm commitment, that is attributable to a particular risk
and could affect profit or loss.
b) Cash flow hedge: A hedge of the exposure to variability in cash flows that (i) is
attributable to a particular risk associated with a recognised asset or liability (such
as all or some future interest payments on variable rate debt) or a highly probable
forecast transaction and (ii) could affect profit or loss.
As per the standard, a hedge of the foreign currency risk of a firm commitment may
be accounted for as a fair value hedge or a cash flow hedge.
5.1.6 Fair value hedges are accounted for as follows:
The gain or loss for re-measuring the derivative hedge instruments at fair value should
be recognised in the statement of profit and loss, and The gain or loss on the hedged items
(the underlying) should adjust the carrying amount of the said items and be recognised in
the statement of profit and loss.
5.1.7 Cash flow hedges are accounted for as follows:
i. In case of effective cash flow hedges, the gain or loss on the hedging derivative is
recognised directly in an appropriate equity account, say, hedge reserve account (the
ineffective hedge portion is recognised in the statement of profit and loss account).
ii. If a hedge of a forecast transaction subsequently results in the recognition of a financial
asset or a financial liability, the associated gains or losses that were recognised directly
in the appropriate equity account in accordance should be reclassified into, i.e.,
recognised in the statement of profit and loss in the same period or periods during
which the asset acquired or liability assumed affects profit or loss (such as in the
periods that interest income or interest expense is recognised).
iii. If a hedge of a forecast transaction, subsequently results in the recognition of a non-
financial asset or a non-financial liability, or a forecast transaction for a non-financial
asset or non-financial liability becomes a firm commitment for which fair value hedge
accounting is applied, then the entity should adopt (a) or (b) below:
a) It reclassifies, i.e., recognises, the associated gains and losses that were recognised
directly in the appropriate equity account into the statement of profit and loss in the
same period or periods during which the asset acquired or liability assumed affects
profit or loss (such as in the periods that depreciation expense or cost of sales is
recognised).
b) It removes the associated gains and losses that were recognised directly in the equity
account, and includes them in the initial cost or other carrying amount of the asset or
liability.
NOTES
An entity should adopt either (a) or (b) as its accounting policy and should apply it
consistently to all hedges to which
iv. above relates.
v. For cash flow hedges, other than those covered by paragraphs (ii) and (iii) above,
amounts that had been recognised directly in the equity account should be reclassified
into, i.e., recognised in the statement of profit and loss in the same period or periods
during which the hedged forecast transaction affects profit or loss (for example, when
a forecast sale occurs).
5.1.8 New Accounting Rules for Derivatives and Hedging Activity
For the last six years, the Financial Accounting Standards Board (FASB) has been
considering the way derivative instruments are reported in corporations financial statements.
The Board concluded that current accounting rules for derivatives are incomplete,
inconsistent, difficult to apply and not transparent in financial statements, and therefore
proposed a new standard.
Four fundamental principals underlie the new accounting rules:
a) Derivatives are assets and liabilities, and should be reported in financial statements
as such;
b) Fair value is the only relevant measure for derivative instruments;
c) Gains or losses on derivatives cannot be deferred; however,
d) Special accounting is permitted for items which qualify as hedges.
Of importance is that the new rules provide no circumstance for which a company
can retain off-balance sheet accounting treatment for derivatives. Any derivative instrument
must be reflected in the balance sheet at its fair value.
Derivatives that meet the criteria for an effective hedge qualify for special hedge
accounting treatment. Three types of hedges are recognized: fair value hedges, cash flow
hedges and hedges of corporations net investments in foreign operations.
5.1.9 Fair Value Hedges
Derivatives can be used to hedge changes in the fair value (market value) of financial
assets or liabilities like debt securities. For instance, a fixed rate bonds market value
changes when interest rates go up or down. Hedging the bonds price risk with a derivative
would be considered a fair value hedge.
Changes in the fair value of the derivative flow directly to the income statement, but
are offset by changes in the fair value of the hedged item which are recognized in the
income statement at the same time.
DBA 1754
NOTES
Fair Value Hedge Accounting
5.1.10 Cash Flow Hedges
Derivatives can also be used to hedge changes in future cash flows arising from existing
assets or liabilities, or from forecasted transactions. For example, interest payments on a
companys variable rate debt expose a company to interest rate risk. Hedging this exposure
using an interest rate swap (to convert the debt from floating rate to fixed interest rate)
would be considered a cash flow hedge under the new rules.
In a cash flow hedge, changes in the fair value of the interest rate swap would
accumulate first in the statement of comprehensive income. (This is similar to how foreign
exchange translation gains and losses are accumulated as a separate component of equity
under existing accounting rules.) A portion of these gains or losses would be transferred
out of comprehensive income to the income statement whenever interest is paid on the
hedged debt. The net result will be a fixed rate of interest expense.
Cash Flow Hedge Accounting
5.1.11 Hedges for Net Investment in Foreign Operations
The new rules still permit companies to hedge foreign currency exposure related to an
investment in a foreign operation. The new accounting is similar to current rules except that
Example Company issues fixed rate debt, then swaps debt
to floating rate.
Accounting for swap: Swap is marked to market and changes in value
are recognized in current earnings.
Accounting for debt: Change in value of debt related to change in
market interest rates is recognized in earnings.
Combination of swap change in value plus debt change in value is offset
in earnings.
Example: Company issues floating rate debt, then swaps to fixed rate.
Accounting
for swap:
Swap is marked to market and changes in value are
recognized first in statement of comprehensive income and
then in earnings as interest payments on hedged debt are
made. At maturity, swap's value reduces to zero. Swap's
carrying value is adjusted each period to reflect actual swap
payments or receipts.
Accounting
for floating
rate debt:
Variable interest rate expense is recognized in earnings as
incurred.
Combination of swap change in value plus debt change in value is offset in
earnings.

NOTES
the translation gains or losses on the investment and the hedge are reported in the statement
of comprehensive income instead of equity.
5.1.12 Derivatives and Income Statement Volatility
Income statements of companies that utilize derivatives as hedges will be largely
unaffected by the accounting changes. Under the new rules, effective hedges (hedges which
have a high correlation to the asset or liability being hedged) should not introduce income
statement volatility.
So as long as the hedge works effectively, changes in the fair value of the derivative
should be opposite to and offset changes in the fair value/cash flow of the hedged item.
5.1.13 Increased Derivatives Disclosure
One of the benefits of the new rules is that more information about a companys
hedging program will be revealed to investors. In addition to the more detailed information
provided in financial statements, a company must also provide an expanded description of
its risk management philosophy and strategy. From this, investors and analysts will be
better able to determine whether or not a company is hedging critical financial exposures.
This increases the likelihood that companies with prudent hedging programs will be rewarded
by the market.
5.1.14 Derivatives Management Systems
5.1.14.1 Derivatives Systems
A critical but often overlooked aspect of a competent derivatives trading operation
are the computer systems used to manage the risk, account for the positions on a mark-to-
market basis, track derivatives-related events (such as expiries and rollovers) and measure
Value-at-Risk. Once you have read some of the articles in the Derivatives section of the
Financial Pipeline, you will realize how quickly a portfolio of transactions can become
complicated. In the section on hedging swaps, we discussed some of these complications
including the problems associated with mismatched short term cash flows and maturity
bucket grouping. Options produce their own problems because of the convexity of these
products. Taking snapshots of delta, gamma and vega at an instantaneous specification of
prices is insufficient (although necessary) for competent financial risk management.
One must also have an appreciation of how these risks change with the progress of
time and the evolution of prices. In the first edition of Risk Professional magazine published
by the Global Association of Risk Professionals (see http://www.garp.com), Geoff Kates
establishes a framework for evaluating a financial risk management system and he uses this
framework to assess some of the more common off-the-shelf products on the market.
This article will discuss those criteria and it will explain the importance.
DBA 1754
NOTES
5.1.14.2 Integration
At the beginning of the global derivatives markets development, almost every bank
pursued derivatives in a stand-alone asset-class-by-asset-class fashion. That is to say, one
group managed interest rate derivatives, another group managed equity derivatives and a
third group managed foreign exchange derivatives. For many banks, this is still the case.
However, an increasing number of financial institutions are turning to a more integrated
approach, stripping the derivatives desks from each asset class cash group and combining
them into a more efficient cross-marketing machine. Once you understand interest rate
derivatives, it is straightforward to understand equity derivatives or foreign exchange
derivatives. Conversely, it is not necessarily the case that a manager who has spent his
entire career overseeing spot foreign exchange salespeople will be able to understand the
way in which a derivatives book works. It is not something youre likely to learn from a
book or a classroom. You have to have experience.
5.1.14.3 To Buy or to Build
The next question the banks senior management must ask itself is whether or not the
bank should buy an off-the-shelf system or build one using its own internal IT resources.
Buying a system is convenient, particularly if it is one that is in widespread use. Popular
systems have been tested and have had all of the kinks worked out. The more popular the
system, the less likely that it is vulnerable to internal control irregularities. That is, the more
popular the system, the less likely it is possible for individuals to manipulate the banks
official records for fraudulent purposes. Systems are typically very expensive, with charges
for both a site license and individual annual user permits. Many of the companies that sell
these systems make it easy for the user to customize reports, batch files, pricing modules,
etc.
However, many financial institutions are reticent to relinquish the responsibility for
risk management computer systems to a third party. The managers of these institutions
would prefer to have their own internal risk management personnel design the system that
is then implemented by the banks IT staff. Not only is this more expensive than buying an
off-the-shelf system in terms of up-front dollar cost and delays in implementation but the
system is vulnerable to the expertise of a handful of individuals. Lets say you are the head
of trading at ABC Bank and you commission your risk management department, all of
three people (Larry, Curly and Moe) to design and implement your interest rate risk
management system. If Larry, Curly and Moe leave to go as a team to DEF Bank, you will
have lost all of your core knowledge base and you will have to start from scratch. There is
also the possibility that Larry, Curly or Moe designed secret entrances into the system for
themselves so that they could manipulate tickets and positions and profit and loss statements.
NOTES
5.1.14.4 Speed
In order to be effective, risk management information must be at least as fast as the
markets to which it refers. On the face of it, for most people using applications designed
for home use, this is not problematic. However, for financial institutions with portfolios
consisting of thousands of different instruments, some of which use very complicated
formulae, and arrays of parameters to revalue, this is a serious database design problem.
5.1.14.5 Interface
One of the key aspects of a well-designed system is its flexibility. A good risk
management system will have a user interface that is customizable. Many of them are
beginning to use the Internet as their interface platform. The interface is also the mechanism
in which reports are designed. For an example of the kinds of reports dealers and risk
managers require, see our earlier article entitled How Do Options Traders Look At Their
Portfolios
5.1.14.6 Asset Class Coverage
Further to our discussion of the integration of asset classes in the management of
derivatives sales and trading operations at leading financial institutions, a good risk
management system will provide the senior management with the ability to immediately
access information on all of the derivatives activities in which the financial institution is
engaged, across all asset classes.
It is not uncommon for banks to have systems in place that enable their management
to take a snapshot of the firms financial price risk with the simple click of a button at any
point during the trading day, in real-time.
Covering all of the asset classes also allows for greater overall risk-taking because it
allows for the portfolio effects of diversification of risk across the different asset classes.
5.1.14.7 Pricing Model Flexibility
Model risk refers to the problems associated with discrepancies between the theoretical
pricing of a financial instrument and the way in which it actually trades in the market. The
difference in price, for a given set of input parameters, is a result of the assumptions that
are necessary for solution of the mathematical model of the price of the financial product in
question.
For some financial products, particularly the more exotic or novel ones, the choice of
pricing model is a controversial one. A good risk management system will allow management
to pick and choose the pricing model it prefers for a particular instrument and it will also
allow management to compare the model risk in different market environments associated
with individual pricing models.
DBA 1754
NOTES
5.1.14.8 Ability to Link to Other Systems
The derivatives risk management system is only one of a handful of systems with
which the dealer at a financial institution must be familiar. Other systems include ticketing
systems for cash instruments, accounting systems, credit risk management systems and,
possibly, spreadsheets tracking customer portfolios.
A dealers life is made much easier when the primary system he uses on a daily basis, the
risk management system, can communicate its information to the other relevant systems
automatically. Otherwise, the dealer (or more likely his assistant) will have to input multiple
tickets for a single transaction. This is not just a question of personal effort. It is an operational
risk issue, as well. Every time the dealer inputs a ticket, there is room for an error. Too
many errors and the bank begins to lose customers as well as money.
5.1.14.9 The key point here is that technological sophistication leads to better
management.
These are just some of the criteria that a financial institution risk manager may choose
to apply to the selection of a financial risk management computer system. In the next wave
of development, risk management platforms will be entirely web-based. Already, Goldman
Sachs and other leading American investment banks are offering web-based risk
management systems, including pricing models, to their clients. Helping their clients
understand the financial price risk they face makes it easier for the client to understand the
efficacy of financial products (products which they hopefully transact with Goldman Sachs).
Summary
Financial asset/liability at fair value through profit and loss account would generally
cover trading items and those that management voluntarily wishes to classify under this
category. All the fair value changes in the financial asset/liability are taken to the income
statement and consequently the income statement would become highly volatile.
The markets for derivatives have been remarkable and continued growth over the
past decade. This reflects the increasing use of such instruments by business, either for
speculation or hedging purposes. Accordingly, the accounting treatment for derivatives
and hedging activities has taken on a high degree of importance.
However, if an entity designated a net position as a hedged item under its previous
accounting policy, it may designate an individual item within that net position as a hedged
item under Accounting Standards, provided that it does so on the date of this standard
becoming mandatory.
Derivatives can be used to hedge changes in the fair value (market value) of financial
assets or liabilities like debt securities.
NOTES
At the beginning of the global derivatives markets development, almost every bank
pursued derivatives in a stand-alone asset-class-by-asset-class fashion. That is to say, one
group managed interest rate derivatives, another group managed equity derivatives and a
third group managed foreign exchange derivatives. For many banks, this is still the case.
Accounting standards groups around the world have been watching the FASBs
progress as it tackles the issue of accounting for derivative instruments. The International
Accounting Standards Committee continues to review the new US standard and is expected
to make a decision shortly about whether it will follow the US lead. As well, the Canadian
Institute of Chartered Accountants may adopt FASBs standards so Canadian companies
would be required to adhere to these new rules in the not-too-distant future.
Questions
1. Explain the Accounting Treatment For Derivative Transactions
2. What do you understand by Hedge Accounting?
3. What do you mean by Embedded Derivatives?
4. How are the Fair value hedges accounted?
5. What do you understand by Hedges for Net Investment in Foreign Operations?
6. Explain the Derivatives Management Systems
DBA 1754
NOTES
CHAPTER II
CREDIT DERIVATIVES
5.2.1 Introduction
A credit derivative is a financial instrument used to mitigate or to assume specific
forms of credit risk by hedgers and speculators. These new products are particularly useful
for institutions with widespread credit exposures. Some observers suggest that credit
derivatives may herald a new form of international banking in which banks resemble portfolios
of globally diversified credit risk more than purely domestic lenders.
Local banks can take advantage of their informational edge in terms of assessing the
default risk and recovery rates in their regional market. They make loans based upon this
credit assessment and then use credit derivatives to swap these cash flows for more
internationally diverse cash flows. Imagine a US regional bank that lends money in Carolina
to a local hotel. They take this credit risk and add it to their overall portfolio of credit risk.
Deciding to reduce their local exposure, they exchange the cash flows from a portfolio of
their mid-grade Carolina debt for cash flows of highly rated Northern Italian corporate
debt. This is just one example.
5.2.2 Credit Swaps
Corporate bonds trade at a premium to the risk-free yield curve in the same currency.
US Corporate Bonds trade at a premium (called a credit spread) to the US Treasury
curve. The credit spread is volatile in and of itself and it may be correlated with the level of
interest rates. For example, in a declining, low interest rate environment combined with
strong domestic growth, we might expect corporate bond spreads to be smaller than their
historical average. The corporate who has issued the bond will find it easier to service the
cash flows of the corporate bond and investors will be hungry for any kind of premium
they can add to the risk-free rate.
Imagine the fund manager who specializes in corporate bonds who has a view on the
direction of credit spreads on which he would like to act without taking a specific position
in an individual corporate bond or a corporate bond index.
One way for the fund manager to take advantage of this view is to enter into a credit
swap.
Lets say that the fund manager believes that credit spreads are going to tighten and
that interest rates are going to continue to decline.
NOTES
He would then want to enter into a swap in which he paid the corporate yield at six-
month intervals against receiving a fixed yield equal to the inception Treasury yield plus the
corporate credit spread. That is to say, at the six-month reset for the tenor of the swap, the
fund manager agrees to pay a cash flow determined to be equal to the current annual yield
on some benchmark corporate bond or corporate bond index in consideration for receiving
a fixed cash flow.
This is an off-balance sheet transaction and the swap will typically have zero value at
inception.
If corporate yields continue to fall (i.e. through a combination of a lower risk-free rate
and a lower corporate credit spread than the one he locked in with the swap), he will make
money. If corporate yields rise, he will lose money.
1998 was a dynamic year for corporate bond spreads with the backup in interest
rates in the aftermath of the Russian devaluation-inspired liquidity crisis concentrated mainly
in corporate yields. The volatility of these spreads was extreme when compared to their
historical movement. Credit swaps would have been an excellent way to play this spread
volatility.
Moreover, credit swaps (particularly ones based on a spread index) are clean
structures without the messy difficulty of finding individual corporate bond supply, etc.
Another example of a credit swap might be the exchange of fixed flows (determined
by the yield on a corporate bond at inception) against paying floating rate flows tied to the
risk-free Treasury rate for the corresponding maturity.
Naturally, swaps are flexible in their design. If you can imagine a cash flow exchange, you
can structure the swap. There might be a cost associated with it but you can certainly put
it on the books.
5.2.3 Credit Default Swaps
A credit default swap is a swap in which one counterparty receives a premium at pre-
set intervals in consideration for guaranteeing to make a specific payment should a negative
credit event take place.
One possible type of credit event for a credit default swap is a downgrade in the
credit status of some preset entity.
Consider two banks: First Chilliwack Bank and Banque de Bas.
Chilliwack has made extensive loans in its corporate credit portfolio to a property
developer called Churchill Developments. It is looking for some kind of insurance against
a downgrade of Churchill by the major ratings agency, a real possibility since the main
DBA 1754
NOTES
project Churchill has taken on is running into unforeseen delays. Chilliwack approaches
Banque de Bas with the concept of a credit default swap. They pay Banque de Bas a
premium every six months for the next five years in exchange for which de Bas agrees to
make payments to Chilliwack of a pre-set amount should Churchill be downgraded.
De Bas now has exposure to Churchill, a position they could not take directly because
they are not part of Churchills lending syndicate.
Chilliwack has some degree of protection against a Churchill credit downgrade. This
reduction in their overall credit profile means that they do not need to hold as much capital
in reserve, freeing Chilliwack up to take other business opportunities as they present
themselves.
5.2.4 Options on Credit Risky Bonds
Finally, our fund manager from the first example could use an options position to take
advantage of his view on the level of the corporate yield.
If he believed that corporate yields were set to fall through some combination of
lower risk-free interest rates and tighter corporate bond spreads, then he could just buy a
call on a corporate bond of the appropriate maturity.
These are just a few of the examples of credit derivatives. Institutional investors often
use credit derivatives when positioning themselves in emerging markets for the ease of
transaction in the same way that they might use equity swaps. Fund managers can use
credit derivatives to hedge themselves against adverse movements in credit spreads.
Corporates can use credit swaps to hedge near-term issues of corporate bonds. Banks
and other financial institutions can use credit derivatives to optimize the employment of
their capital by diversifying their portfolio-wide credit risk.
Summary
Local banks can take advantage of their informational edge in terms of assessing the
default risk and recovery rates in their regional market. They make loans based upon this
credit assessment and then use credit derivatives to swap these cash flows for more
internationally diverse cash flows. Imagine a US regional bank that lends money in Carolina
to a local hotel. They take this credit risk and add it to their overall portfolio of credit risk.
Deciding to reduce their local exposure, they exchange the cash flows from a portfolio of
their mid-grade Carolina debt for cash flows of highly rated Northern Italian corporate
debt. This is just one example.
Corporate bonds trade at a premium to the risk-free yield curve in the same currency.
US Corporate Bonds trade at a premium (called a credit spread) to the US Treasury
curve. The credit spread is volatile in and of itself and it may be correlated with the level of
interest rates
NOTES
A credit default swap is a swap in which one counterparty receives a premium at pre-
set intervals in consideration for guaranteeing to make a specific payment should a negative
credit event take place.
If he believed that corporate yields were set to fall through some combination of
lower risk-free interest rates and tighter corporate bond spreads, then he could just buy a
call on a corporate bond of the appropriate maturity.
Questions
1. What do you mean by Credit Derivatives?
2. Explain the Credit Swaps
3. What do you understand by Options on Credit Risky Bonds?
4. What is meant by Credit Default Swaps?
DBA 1754
NOTES
NOTES
NOTES
NOTES
DBA 1754
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NOTES

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