Indian Derivatives Market

INTRODUCTION- RISK MANAGMENT

Risk management is a discipline that helps bringing risks to manageable extent .

One risk does not get transformed into undesirable risk.

PLAYERS: Hedgers, Speculators and Arbitrageurs - Market Role

Hedgers and investors provide the economic substance to any financial market. Without them the markets would lose their purpose and become mere tools of gambling. (E.g. Banks)

Speculators provide liquidity and depth to the market.

Arbitrageurs

DERIVATIVES

Derivatives are financial contracts whose value/price is dependent on the behavior of the price of one or more basic underlying assets (often simply known as the underlying). These contracts are legally binding agreements, made on the trading screen of stock exchanges, to buy or sell an asset in future.

The asset can be a share, index, interest rate, bond, rupee dollar exchange
rate, sugar, crude oil, soybean, cotton, coffee and what have you. A very simple example of derivatives is curd, which is derivative of milk. The price of curd depends upon the price of milk which in turn depends

upon the demand and supply of milk.

HISTORY OF DERIVATIVES AND THE MARKET IN INDIA

According to Mr. Asani Sarkars research work, Derivatives market has been in existence in India since 1875

He also mentions that in early 1900s India had the largest Futures Industry
In 1952, Indian Government banned the options and futures trading

But, by 2000 various reforms assisted in lifting all such bans and the derivatives market is booming since then
The exchange traded derivative market is the largest in terms of number of contracts made In 2004, the daily trading value was 30 billion USD The commodities eligible for futures trading was 8 and in 2004 it was increased to 80

Current Scenario

Indias experience with the launch of equity derivatives market has been extremely positive. The derivatives turnover on the NSE has surpassed the equity market turnover. The turnover of derivatives on the NSE increased from Rs. 23,654 million (US $ 207 million) in 2000-01 to Rs. 110,104,821 million (US $ 2,161 bn) in 2008-09. The average daily turnover in this segment of the markets on the NSE was Rs. 453,106 mn in 2008-09.

FORWARDS

A forward contract is a customized contract between the buyer and the seller where settlement takes place on a specific date in future at a price agreed today. The rupee-dollar exchange rate is a big forward contract market in India with banks, financial institutions, corporate and exporters being the market participants.

Features of forward contract

It is a negotiated contract between two parties and hence exposed to counter party risk.

eg: Trade takes place between A&B@ 100 to buy & sell x commodity.After 1 month it is trading at Rs.120. If A was he buyer he would gain Rs. 20 & B Loose Rs.20. In case B defaults you are exposed to counter party Risk i.e. you will now entitled to your gains. In case of Future, the exchange gives a counter guarantee even if the counter party defaults you will receive Rs.20/- as a gain.

Features of forward contract

Each contract is custom designed and hence unique in terms of contract size, expiration date, asset type, asset quality etc. A contract has to be settled in delivery or cash on expiration date. In case one of the two parties wishes to reverse a contract, he has to compulsorily go to the other party. The counter party being in a monopoly situation can command the price he wants.

FUTURES

Futures are exchange-traded contracts to buy or sell an asset in future at a price agreed upon today. The asset can be share, index, interest rate, bond, rupeedollar exchange rate, sugar, crude oil, soybean, cotton, coffee etc.

The standard Feature in any futures contract

Obligation to buy or sell Stated quantity At a specific price Stated date (Expiration Date) Marked to Market on a daily basis For example: when you are dealing in March 2002 Satyam futures contract, you know that the market lot, ie the minimum quantity you can buy or sell, is 1,200 shares of Satyam, the contract would expiry on March 28, 2002, the price is quoted per share, the tick size is 5 paise per share or (1200*0.05) = Rs60 per contract/ market lot, the contract would be settled in cash and the closing price in the cash market on expiry day would be the settlement price.

Motives behind using Futures

Hedging: It provides an insurance against an increase in the price. The futures market has two main types of foreseeable risk: - price risk - quantity risk

Interest Rate Futures

An interest rate futures contract is an agreement to buy or sell a standard quantity of specific interest bearing instruments, at a predetermined future date and a price agreed upon between parties

DIFFERENCE BETWEEN FORWARD AND FUTURE CONTRACT.

Customised vs Standardised contract:

Counter Party Risk Liquidity

Squaring off:

FUTURES TERMINOLOGY

COST OF CARRY INITIAL MARGIN MARKING TO MARKET MAINTENANCE MARGIN

OPTIONS

Options contracts grant their purchasers the right but not the obligation to buy or sell a specific amount of the underlying at a particular price within a specified period.

OPTIONS Terminology

Commodity options Stock Options Buyer of an option Writer of an option Call option Put option Option price

OPTIONS Terminology

Expiration date Strike Price American option European option

Pay-off for Options

Buyer of call options : long call Writer of call options : short call Buyer of put options : long put Writer of call options : short put

Buyer of call options : long call

Writer of call options : short call

Buyer of put options : long put

Writer of call options : short put

Long Straddle

Short Straddle

Long Strangle

Short Strangle

Distinguishing Options & Futures