FINANCIAL DERIVATIVES

INTRODUCTION TO FINANCIAL DERIVATIVES

BACKGROUND TO DERIVATIVES In recent decades, financial markets have been marked by excessive volatility. As foreign exchange rates, interest rates continue to experience sharp and unexpected movements, it has become increasingly important that corporations exposed to these risks be equipped to manage them effectively. Price fluctuations make it hard to businesses to estimate their future production cost and revenues. Derivative securities provide them a valuable set of tools for managing their risk. Risk management, the managerial process that is used to control such price volatility, has consequently risen to the top of financial agendas. It is here that the derivative instruments are of utmost utility. As instruments of risk management, these gradually do not influence the fluctuations in the underlying asset prices. However, by locking-in asset prices, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of riskaverse investors. Derivatives are very similar to insurance. Insurance protects against specific risks, such as fire, floods, theft and so on. Derivatives on the other hand, take care of market risks volatility in interest rates, currency rates, and share prices. Derivatives offer a sound mechanism for insuring against various kinds of risks arising in the world of finance. In this era of globalization, the world is a riskier place and exposure to risk is growing. Risk cannot be avoided or ignored. Man, however is risk averse. The risk adverse characteristic of human beings has brought about growth in derivatives. Derivatives help the risk adverse individuals by offering a mechanism for hedging risks. WHAT ARE FINANCIAL DERIVATIVES The term ‘Derivative’ means 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
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common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage. According to the Securities Contract Regulation Act, (1956) the term “derivative” includes: i. a security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security; ii. a contract which derives its value from the prices, or index of prices, of underlying securities. Derivatives are securities under the Securities Contract (Regulation) Act and hence the trading of derivatives is governed by the regulatory framework under the Securities Contract (Regulation) Act.

FINANCIAL DERIVATIVES

REAL ESTATE

FOREX

EQUITY

DEBT

INDEX PRODUCTS

DERIVATIVE ON SECURITY

INTEREST RATE PRODUCTS

GOI SECURITIES, BONDS, T-BILLS.

• •

INDEX OPTIONS INDEX FUTURES

• •

STOCK OPTIONS STOCK FUTURES

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Indian Derivative contracts can be traded either on Exchange or Over-the-counter (OTC) market: Exchange: Derivatives traded on the regulated exchanges are highly standardized. Options and Futures are standardized. In other words, the parties to the contracts do not decide the terms of futures/option contracts; but they merely accept terms of contract standardized by exchange. Exchange-traded derivatives offer the maximum protection to the investors because of the various regulatory measures offered by SEBI to provide for fairness and transparency in trading. Stock Exchange is one important constituent of capital market. Stock Exchange is an organized market for the purchase and sale of industrial and financial security. It is convenient place where trading in securities is conducted in systematic manner i.e. as per certain rules and regulations. It performs various functions and offers useful services to investors and borrowing companies. It is an investment intermediary and facilitates economic and industrial development of a country. Stock exchange is an organized market for buying and selling corporate and other securities. Here, securities are purchased and sold out as per certain well-defined rules and regulations. It provides a convenient and secured mechanism or platform for transactions in different securities. Such securities include shares and debentures issued by public companies which are duly listed at the stock exchange and bonds and debentures issued by government, public corporations and municipal and port trust bodies. Stock exchanges are indispensable for the smooth and orderly functioning of corporate sector in a free market economy. A stock exchange need not be treated as a place for speculation or a gambling den. It should act as a place for safe and profitable investment, for this, effective control on the working of stock exchange is necessary. This will avoid misuse of this platform for excessive speculation, scams and other undesirable and anti-social activities. Over-the counter: OTC is an alternative trading platform linked to the network of dealers who does not physically meet but instead communicate through a network of phones and computers. The buyers and sellers to suite their requirements can customize the contracts traded in these market. Encompass tailored financial derivatives such as swaps, swaptions, caps and collars that are traded in the offices of the world’s leading financial institutions.
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These contracts are customized. In other words, the terms of OTC contracts are individually agreed upon two counter-parties The main difference between the above two is on account of counterparty risk and liquidity. Whereas exchange traded instruments do not have any counter party risk, it is present in OTC instruments. Further, in exchange-traded instruments, one can exit any time at the prevailing rate, since these instruments are regularly quoted in the exchange market. Liquidity is not available in OTC instruments. These contracts can be terminated only to the disadvantage of the holder. FEATURES OF DERIVATIVES Price discovery: The futures and options market serve an all important functions of price discovery. The individuals with better information and judgment participate in these markets to take advantage of such information. When some new information arrives, perhaps some good news about the economy, for instance, the action of speculators quickly feed their information into the derivatives market causing changes in the price of derivatives. These markets are usually the first one to react because the transaction cost is much lower in these markets than in the spot market. Therefore, these markets indicate what is likely to happen and thus assist in better discovery. Transfer risks: The derivatives market helps to transfer risks from those who have them but may not like them, to those who have an appetite for them. An investor having large exposure to equity may transfer his risk of downside in his portfolio due to volatility in markets, to another market participant, by using various hedging strategies available in the derivatives market. Leverage: Derivatives market requires the trader to pay a small fraction of the value of the total contract as margin. The trader is able to take position in equity or index with a relatively lower capital as compared to the spot market. He is able to control the total value of the contract with a relatively small amount of margin. Leverage enables the trader to make a large profit or loss with a comparatively small amount of capital employment.

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Low transaction cost and better surveillance: Derivatives market involves the lowest possible transaction cost due to the large number of participants and the trader’s volume as compared to the cash market. Retail investor is attracted to the derivatives market due to the low transaction cost which in turn increases their margin. What is noteworthy is that notwithstanding, a small set of scripts and surveillance and reporting requirements the derivatives volume have surpassed cash market volumes within such a short time. Derivatives have a number of advantages such as hassle free settlement, lower transaction cost, flexibility in terms of various permutations and combination of trading strategies etc. Maximize returns and minimize risks: The primary objectives of any investor are to maximize returns and minimize risks. Derivatives are contracts that originated from the need to minimize risk. Increased savings and investment: Derivatives markets help increase savings and investment in the end. Transfer of the risk enables market participants to expand their volumes of activity. RISKS IN DERIVATIVES MARKET There are different types of risks associated with the derivative instruments are as follows: 1) Credit risk: These are the usual risks associated with the counterparty default and which must be assessed as a part of any financial transaction. However, in India the two major stock exchanges that offer equity derivative products have settlement/Trade guarantee funds that address the risk. 2) Financial risks: The financial risk is the function of the company’s capital structure or financial leverage. The company may fall on financial grounds, if its capital structure tends to make earnings unstable. Financial leverage is the percent change in net earnings for given results from the use of debt financing in the capital structure. If company uses a large amount of debt, then it has contracted to pay a relatively large fixed amount for its sources of capital. When the operating profits falls, the company will have to pay a large interest payment and thus the net profit will fall even more.

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3) Market risk: The market risk means the variability in the rate of return caused by the market up swings or market down swings. It is caused by the investor’s reactions to tangible as well as intangible events in market. Most investors are quick to note about the security markets that returns on securities tend to move together. That is, on a good day, the fact that some stocks in the market are rising seems to fuel enthusiasm, and other stock tends to rise also. On the other hand, when some stock begins to fall, other will also tend to fall as a mood of pessimism pervades the market. When a relatively small increase in the market usually accompanies a relatively larger increase in the price of stock, the stock has a high degree of market. 4) Liquidity risk: Liquidity risk arises from the inability to convert an investment quickly into cash. It refers to the ease with which a stock may be sold. If a stock is highly liquid, it can be sold very quickly at a price which is more or less equal to its previous market price. In a security market, liquidity risk is function of the marketability of the security. When an investor wants to sell a stock he is concerned with its liquidity. On the other hand, when an investor wants to buy a stock, he is interested in its availability. A stock may be regarded as not easily available, if purchaser has to wait for quite some time to buy it at a price which is more or less equal to its previous price. Thus, the lower marketability of stock give a degree of liquidity risk that makes the price of stock a bit uncertain. 5) Systematic risk: The fluctuations in an investment’s return attributable to changes in broad economic social or political factors which may influence the return on investment as a systematic risk. It is that portion of total risk of security which is caused by the influence of certain economic-wide factors like money supply, inflation, level of government spending etc. It is undiversifiable risk and investors cannot avoid the risk arising from the above factors. 6) Unsystematic risk: Unsystematic risk is the variation in returns due to factors related to the individual firm or security. It is that portion of total risk which arises from factors specific to particular firm such as plant breakdown, labor strikes, sources of materials etc. It is possible to reduce unsystematic risk by adding more securities to the investor’s portfolio. All risky securities have some degree of unsystematic risk but combining securities into diversified portfolios reduces unsystematic risk from the portfolio.
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Therefore, unsystematic risk is often referred to as diversified risk. The sum of systematic and unsystematic risks is equal to the total risk of the security. 7) Default risk: It is the risk of issuer of investment going bankrupt. An investor who purchases shares or debentures will have to face the possibility of default and bankruptcy of the company. In the case of fixed income securities such as debenture or fixed deposits of companies, the investor make take the care to see that the credit rating given to the company, so that the risk can be minimized. 8) Strategic risk : These risks arise from activities such as Entrepreneurial behavior of traders in financial institutions, Misreading client requests, Costs getting out of control, Trading with inappropriate counterparties. 9) Legal risk :Legal risk is the risk that contracts are not legally enforceable or documented correctly. Legal risks should be limited and managed through policies developed by the institution’s legal counsel (typically in consultation with officers in the risk management process) that have been approved by the institution’s senior management and board of directors. At a minimum, there should be guidelines and processes in place to ensure then force ability of counterparty agreements. Prior to engaging in derivatives transactions, an institution should reasonably satisfy itself that its counterparties have the legal and necessary regulatory authority to engage in those transactions. In addition to determining the authority of a counter party to enter into a derivatives transaction, an institution should also reasonably satisfy itself that the terms of any contract governing its derivatives activities with a counterparty are legally sound. HISTORY OF FINANCIAL DERIVATIVES MARKET Financial derivatives have emerged as one of the biggest markets of the world during the past two decades. A rapid change in technology has increased the processing power of computer sand has made them a key vehicle for information processing in financial markets. Globalization of financial markets has forced several countries to change laws and introduce innovative financial contracts which have made it easier for the participants to undertake derivatives transactions.

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Early forward contracts in the US addressed merchants’ concerns about ensuring that there were buyers and sellers for commodities. ‘Credit risk’, however remained a serious problem. To deal with this problem, a group of Chicago businessmen formed the Chicago Board of Trade(CBOT) in 1848. The primary intention of the CBOT was to provide a centralized location for buyers and sellers to negotiate forward contracts. In1865, the CBOT went one step further and listed the first ‘exchange traded” derivatives contract in the US. These contracts were called ‘futures contracts. The CBOT and the CME remain the two largest organized futures exchanges, indeed the two largest “financial” exchanges of any kind in the world today. The first exchange-traded financial derivatives emerged in 1970’s due to the collapse of fixed exchange rate system and adoption of floating exchange rate systems. As the system broke down currency volatility became a crucial problem for most countries. To help participants in foreign exchange markets hedge their risks under the new floating exchange rate system, foreign currency futures were introduced in 1972 at the Chicago Mercantile Exchange. In1973, the Chicago Board of Trade (CBOT) created the Chicago Board Options Exchange (CBOE) to facilitate the trade of options on selected stocks. The first stock index futures contract was traded at Kansas City Board of Trade. Currently the most popular stock index futures contract in the world is based on S&P 500 index, traded on Chicago Mercantile Exchange. During the mid-eighties, financial futures became the most active derivative instruments generating volumes many times more than the commodity futures. Index futures, futures on T-bills and Euro-Dollar futures are the three most popular futures contracts

traded today other popular international exchanges that trade derivatives are LIFFE in England, DTB in Germany, SGX in Singapore, TIFFE in Japan, MATIF in France, Eurex etc.

TYPES OF DERIVATIVE CONTRACTS The most commonly used derivatives contracts are forwards, futures and options, which we shall discuss in detail later. Here we take a brief look at various derivatives contracts that have come to be used. Forwards: A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at today's pre-agreed price.

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Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts.

Options: Options are of two types - calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.

Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are:

Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency.

Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction.

Warrants: Options generally have lives of upto one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter.

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.

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DERIVATIVES INTRODUCTION IN INDIA The first step towards introduction of derivative trading in India was the promulgation of the Securities Law Ordinance, 1995, which withdrew the prohibition on the option in securities. SEBI set up a 24-member committee under the chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop appropriate regulatory framework for derivatives market in India, submitted its report on March 17, 1998. The committee recommended that the derivatives should be declared as ‘securities’ so that regulatory framework applicable to trade of the ‘securities’ could also govern trading of derivatives. SEBI also set up a group in June 1998 under the chairmanship of Prof. J.R.Varma, to recommend measures for risk containment in a derivatives market in India. The report, which was submitted in October 1998, work out the operational details of margining system, methodology for charging initial margins, broker net worth, deposit requirement and real-time monitoring requirements. The Securities Contract Regulation Act (SCRA) was amended in December 1999 to shall be legal and valid only if such contracts are traded on a recognized stock exchange precluding OTC derivatives. The government also rescinded in March 2000, the three-decade old notification, which prohibited forward trading in securities. Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2000. SEBI permitted the derivative segment of two stock exchanges- NSE and BSE, and their clearing house to commence trading and settlement in approved derivatives contract. Include derivatives within the ambit of ‘securities’ and act made it clear that derivatives SEBI approved trading in index futures contract based on S&P CNX Nifty and BSE-30 (Sensex) index. This was followed by approval for trading in option based on these two indices and options on individual securities. The trading in index options commenced in June 2001 and the trading in options on individual securities commenced in July 2001.Futures contracts on individual stocks were launched in November 2001.

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Products available for trading on Derivatives segment Products on Derivative Segment S & P CNX Nifty Futures S & P CNX Nifty Options Single Stock Options Single Stock Futures Interest Rate Futures CNX IT Futures & Options Bank Nifty Futures & Options CNX Nifty Junior Futures & Options CNX 100 Futures & Options Nifty Midcap 50 Futures & Options Mini Nifty Futures & Options on S&P CNX Nifty Long Term Options on S&P CNX Nifty S&P CNX Defty Futures & Options (source: Derivatives market by Laila Ahmed Patel) Date of launch 12-June-2000 4-June-01 2-July-01 9-Nov-01 24-June-03 29-Aug-03 13-June-05 1-June-07 1-June-07 5-Oct-07 1-Jan-08 3-March-08 10-Dec-08

PARTICIPANTS IN DERIVATIVE MARKETS Hedgers: Hedgers are those traders who wish to eliminate price risk associated with the underlying security being traded. The objective of these kinds of traders is to safeguard their existing positions by reducing the risk. They are not in the derivatives market to make profits. Apart from equity markets, hedging is common in the foreign exchange markets where fluctuations in the exchange rate have to be taken care of in foreign currency transactions. For example, an importer has to pay US $ to buy goods and rupee is expected to fall to Rs. 50/$ from Rs. 48/$, then the importer can minimize his losses by paying a currency futures at Rs. 49/$.

Speculators: While hedgers might be adept at managing the risks, there are parties who are adept at managing and even making money out of such exogenous risk. Using their own capital and that of their clients, some individuals and organization may accept such risks in
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the expectation of the return. But unlike investing in business with its risks, speculators have no clear interest in the underlying activity itself. For the possibility of a reward, they are willing to accept certain risks. They are traders with a view and objective of making profits. These are people who take long or short position and assume risk to profit from fluctuations in prices. They are willing to take risks and they bet upon whether the markets would go up or come down. Speculators may be either day traders or position traders. The former speculate on the price movements during one trading day, while the latter attempt to gain keep their position for longer time period to gain from price fluctuations. For example, an investor expected that the stock price of Coal India Ltd will go upto Rs 500 in a month and he buys a 1 month futures of Coal India Ltd at Rs. 350 and make profits.

Arbitrageurs: The Institute of Chartered Accountant of India, the word “ARBITRAGE” has been defined as follows: “Simultaneous purchase of securities in one market where the price there of is low and sale thereof in another market, where the price thereof is comparatively higher. These are done when the same securities are being quoted at different prices in the two markets, with a view to make profit and carried on with conceived intention to derive advantagefro0m difference in prices of securities prevailing in the two different markets” Riskless profit making is the prime goal of arbitrageurs. It is useful for the people who buy or sell to make money on price differentials in different markets. For example BHEL is quoting Rs. 2078 in the Equity market, and Rs. 2082 in Futures market. Since there is price difference in both the markets and at the end of expiry the price converges to one, one can buy BHEL in equity market and sell in futures market to earn a risk-free profit of Rs. 4.

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FORWARD CONTRACTS
INTRODUCTION A contract that obligates one counter party to buy and the other to sell a specific underlying asset at a specific price, amount and date in the future is known as a forward contract. Forward contracts are the important type of forward-based derivatives. They are the simplest derivatives. There is a separate forward market for multitude of underlying, including currencies and interest rates. The change in the value of a forward contract is roughly proportional to the change in the value of its underlying asset. These contracts create credit exposures. As the value of the contract is conveyed only at the maturity, the parties are exposed to the risk of default during the life of the contract. Forward contracts are customized with the terms and conditions tailored to fit the particular business, financial or risk management objectives of the counter parties. Negotiations often take place with respect to contract size, delivery grade, delivery locations, and delivery date and credit terms.

DEFINITION A forward contract can be defined as an agreement between two parties, a buyer and a seller, that calls for the delivery of an asset at a future date with a price agreed today. It is a personalized contract between parties. The forward market is a general term use to describe the in formal market through which these contracts are entered into .Standardized forward contracts are known as futures contracts and are traded on futures exchanges. Often, the buyer of the contract is called long and seller of the contract is called short.

The salient features of forward contracts are as given below: i. ii. They are bilateral contracts and hence exposed to counter party risk. Each contract is custom designed, and hence is unique in terms of contract size, expiration date, and the asset type and quality. iii. iv. The contract price is generally not available in public domain. On the expiration date, the contract has to be settled by delivery of asset.
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v.

If the counter party wishes to reverse the contract, it has to compulsorily go to the same counter-party, which often results in high price charged.

CLASSIFICATION OF FORWARD CONTRACTS Forward contracts in India are broadly governed by the Forward Contracts (regulation) Act, 1952. According to this act, forward contracts are of the following three major categories.

a) Hedge contracts: These are freely transferable contracts which do not require specification of a particular lot size, quality or delivery standards for the underlying assets. Most of these are necessary to be settled through delivery of underlying assets. b) Transferable specific delivery forward contracts: Apart from being freely transferable between parties concerned, these forward contracts refer to a specific and predetermined lot size and variety of the underlying asset. It is compulsory for delivery of the underlying assets to take place at the expiration of contract. c) Non-Transferable Specific Delivery Forward Contract : These contracts are normally exempted from the provision of regulation under Forward Contract Act, 1952 but the Central Government reserves the right to bring them back under the Act when it feels necessary. These contracts which cannot be transferred to another party. These contracts, the consignment lot size, and quality of underlying asset are required to be settled at expiration through delivery of the assets.

ADVANTAGES AND DISADVANTAGES OF FORWARDS Advantages • • • Forward contracts can be used to hedge or lock-in the price of purchase or sale of an financial asset on the future commitment date. On forward contracts, generally, margins are not paid and there is also no upfront premium. So, it does not involve initial cost. Since forwards are tailor made, price risk exposure can be hedged up to 100% which may not be possible in futures and options.

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Disadvantages • Counter party risk is very much present in forward contracts since there is no performance guarantee. On due date, the possibility of counterparty’s failure to perform his obligation creates another risk exposure. • Forward contracts do not allow the investor to derive any gain from favorable price movement or to unwind the transaction once the contract is made. At the most, the contract can be cancelled on the terms agreed upon by the counterparty. • • Since forwards are not exchange-traded, they have no liquidity. Further, it is difficult to get counter party on one’s term. One of the counterparties of these contracts is generally a bank or a trader who squares up their position by entering into reverse contracts. These transactions do not take place simultaneously, so these parties normally keep large bid-ask spread to avoid any loss due to price fluctuations. This increases the cost of hedging.

TYPES OF FINANCIAL FORWARD CONTRACTS:

Currency Forward Contracts: Currency forward market’s development over the years can be attributed to relaxation of government controls over exchange rates of most of the currencies. Currency forwards contracts are mostly used by banks and companies to manage foreign exchange risk. For example, Microsoft its European subsidiary to send it 12 million Euros in period of 3months. On receiving the Euros form the subsidiary, Microsoft will convert them into dollars. Thus, Microsoft is essentially long on Euros, as it has to sell Euros. At the same time it is short on dollars as it has to buy the dollars. In such a situation, a currency forward contract proves useful because it enables Microsoft to lock-in the exchange rate at which it can sell Euros and buy dollars in 3 months. This can be done if Microsoft goes short on forwards. This implies than Microsoft will go short on euro and long on dollar. This arrangement will offset its otherwise long-euro, short-dollar position. In other words, Microsoft requires a forward contract to sell Euros and buy dollars.

Equity Forward Contracts : Equity forward can be defined as a contract calling for the purchase of an individual stock, a stock portfolio or a stock index on a forward date.
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a) Forward Contract On Individual Stock A portfolio can consist of small number of stocks or sometimes stocks that have been over a number of years. For example, lets us consider a stock XYZ. The client has heavily invested in this stock and her portfolio is not diversified. The client informs her portfolio manager of her requirement of $2 million in cash in a period of 6 months. This amount is raised by selling 16000 shares at the current price of $125 per share. Thus, the risk exposure is related to the market value of $2 million of stock. It is better not to sell the stock any earlier than is required. The portfolio manager feels that forward contracts to sell the stock XYZ in 6months will serve the purpose. Hence, the manager contacts a forward contract dealer and obtains a quote of $128.13 per share. This implies that the portfolio manager will enter into a contract with the dealer to sell the stock at $128.13. Let us assume that the shares will be delivered when the actual sale is made. Further, lets us assume that the client has some flexibility in the required amount. So the contract is signed for the sale of 15000 shares at 128.13 per share. This will raise an amount of $1,998,828. However, if the contract expires, the stock could be sold for any price. The client may either gain or lose on the transaction. Even if the stock price rises above $128.13 during the 6 months, the client must and should deliver the stock for $128.13. Conversely, if the price falls, still the client will get $128.13 per share. b) Interest rate forwards An Interest Rate Forward contact is commonly known as a Forward Rate Agreement or FRA. In finance, a forward rate agreement (FRA) is a forward contract, an over-the-counter contract between parties that determines the rate of interest, or the currency exchange rate, to be paid or received on an obligation beginning at a future start date. The contract will determine the rates to be used along with the termination date and notional value. On this type of agreement, it is only the differential that is paid on the notional amount of the contract. It is paid on the effective date. The reference rate is fixed one or two days before the effective date, dependent on the market convention for the particular currency. FRAs are over-the counter derivatives. A FRA differs from a swap in that a payment is only made once at maturity. Many banks and large corporations will use FRAs to hedge future interest or exchange rate exposure. The buyer hedges against the risk of rising interest rates, while the seller hedges against the risk of
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falling interest rates. Other parties that use Forward Rate Agreements are speculators purely looking to make bets on future directional changes in interest rates. In other words, a forward rate agreement (FRA) is a tailor-made, over-the-counter financial futures contract on short-term deposits. A FRA transaction is a contract between two parties to exchange payments on a deposit, called the Notional amount, to be determined on the basis of a short-term interest rate, referred to as the Reference rate, over a predetermined time period at a future date. FRA transactions are entered as a hedge against interest rate changes. The buyer of the contract locks in the interest rate in an effort to protect against an interest rate increase, while the seller protects against a possible interest rate decline. At maturity, no funds exchange hands; rather, the difference between the contracted interest rate and the market rate is exchanged. The buyer of the contract is paid if the reference rate is above the contracted rate, and the buyer pays to the seller if the reference rate is below the contracted rate. A company that seeks to hedge against a possible increase in interest rates would purchase FRAs, whereas a company that seeks an interest hedge against a possible decline of the rates would sell FRAs. FORWARDS AS A ZERO-SUM-GAME In essence, a forward transaction typically involves a contract, most often with a bank, under which both the buyer of the contract and the seller of the contract are obligated to execute a transaction at a specified price on a pre-specified date. This means that the seller is ‘obligated’ to deliver a specified asset to the buyer on a specified date in future, and the buyer is ‘obligated’ to pay the seller a specified price upon the delivery. This specified price is known as ‘forward price’ At the inception of the contract, the contract value is zero in the eyes of both buyer and the seller. But the value of the underlying asset changes throughout the life of the contract, and as such there is change in the value of the contract vise versa the buyer and the seller. The value changes for the benefit of one party and at the expense of the other. This property of the forward contract makes it as “zero-sum-game” for the buyer and seller.

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FUTURES & OPTIONS (F&O)
In the recent decade financial markets have been marked by excessive volatility and are associated with various risks, therefore derivative instruments have become increasingly important in the field of finance. While futures and options are now actively traded on may exchanges, forward contracts are popular in OTC markets. Fortunately, efficient-minded entrepreneurs discovered that standardized agreements can facilitate transactions in a much quicker manner than a privately negotiated forward contract, and thus, the ‘futures and options contract’ were born.

FUTURE CONTRACTS Futures were designed to solve the limitations that existed the forward markets. A future contract is a very similar to a forward contract in all respect excepting the fact that it is a completely standardized one. It is always traded on organized exchange. A futures contract is a standardized agreement between two parties that commits one to sell and the other to buy stipulated quantity and grade of a currency, security, index or other specified item at a set price on or before a given date in future, requires the daily settlement of all gains and losses as long as the contract remains open; and for contracts remaining open until trading terminates, provides either for delivery or a final cash payment (cash settlement). To facilitate liquidity, exchange specified standard features for the contract: • • • • • Quantity and quality of the underlying. Date and month of delivery. Units of price quotation and minimum price change. Location and mode of settlement. Futures can be offset prior to maturity.

Example: Investor A is bullish about TCS Company and buys ten-one month TCS futures contracts at Rs. 3,00,000. On the last Thursday of the month, TCS closes at Rs. 270. At Rs. 3,00,000 per futures contract, it costs him Rs. 300 per unit of futures, i.e. 3,00,000/(10 x 100). On expiration day the spot and futures converge. He makes a loss of Rs. 30,000.

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The mechanics of future trading are straightforward: both buyers and sellers deposit funds—traditionally called margin but more correctly characterized as a performance bond or good faith deposit deposit—with a brokerage firm. This amount is typically a small percentage –less than 20 percent—of the total value of the item underlying the contract.

Features of Futures: Organized Exchanges: Unlike forward contracts which are traded in an over- the- counter market, futures are traded on organized exchanges with a designated physical location where trading takes place. This provides a ready, liquid market which futures can be bought and sold at any time like in a stock market. Standardization: In the case of forward contracts the amount of commodities to be delivered and the maturity date are negotiated between the buyer and seller and can be tailor made to buyer’s requirement. In a futures contract both these are standardized by the exchange on which the contract is traded. Clearing House: The exchange acts a clearinghouse to all contracts struck on the trading floor. For instance a contract is struck between capital A and B. upon entering into the records of the exchange, this is immediately replaced by two contracts, one between A and the clearing house and another between B and the clearing house. In other words the exchange interposes itself in every contract and deal, where it is a buyer to seller, and seller to buyer. The advantage of this is that A and B do not have to undertake any exercise to investigate each other’s credit worthiness. It also guarantees financial integrity of the market. The enforces the delivery for the delivery of contracts held for until maturity and protects itself from default risk by imposing margin requirements on traders and enforcing this through a system called marking – to – market. Margins: In order to avoid unhealthy competition among clearing members in reducing margins to attract customers, a mandatory minimum margins are obtained by the members from the customers. Such a stop insures the market against serious liquidity crises arising out of possible defaults by the clearing members. The members collect margins from their clients has may be stipulated by the stock exchanges from time to time and pass the margins to the

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clearing house on the net basis i.e. at a stipulated percentage of the net purchase and sale position. Secondary market: Futures are dealt in organized exchanges for e.g. NSE F&O, BSE F&O and as such they have secondary market too. Futures contracts enable investors to use various tactics that can prove profitable while trading. One can resort to arbitrage, hedging and speculation depending on one’s objectives. While hedging safeguards against risks due to price variation, arbitrage results in the riskfree profit and speculation aims at generating very large profits or losses. However, a futures contract is an obligation and, consequently, the investor must fulfill it even if the asset price on the settlement date is not favorable for him.

FUTURES V/S FORWARDS

1. Meaning A futures contract is a contractual agreement A Forward contract refers to an agreement between two parties to buy or sell a between two parties to exchange an agreed standardized quantity and quality of asset on a quantity of an asset for cash at a certain date specific future date on a futures exchange. in future at a predetermined price specified in that agreement. A forward contract is not traded on the exchange. 2. Trading place market.

A futures contract is traded on the centralized A forward contract is traded in an OTC trading platform of an exchange. 3. Transparency The contract price of a futures contract is The contract price of a forward contract is transparent as it is available on the centralized not transparent, as it is not publicly disclosed. trading screen of the exchange. 4. Settlement In a future contract, valuation of open In a forward contract, valuation of open position is calculated as on a daily basis and position is not calculated on a daily basis and mark-to-market (MTM) margin requirement there is no requirement of MTM on daily
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exists.

basis since the settlement of contract is only on the maturity date of contract.

5. Liquidity A futures contract is more liquid as it is traded A forward contract is less liquid due to its on the exchange. 6. Counterparty risk In futures contract, the exchange clearing In forward contracts, counterparty risk is house provides trade guarantee. Therefore, high due to the customized nature of the counterparty risk is almost eliminated. 7. Regulations A regulatory authority and the exchange A forward contract is not regulated by any regulate a futures contract. 8. Price discovery Efficient, as markets are centralized and all Not efficient, as markets are scattered. buyers and sellers come to a common platform to discover the price. exchange. transaction. customized nature.

Stock index Futures: Stock index futures are most popular financial futures, which have been used to hedge or manage systematic risk by the investors of the stock market. They are called hedgers, who own portfolio of securities and are exposed to systematic risk. Stock index is the apt hedging asset since, the rise or fall due to systematic risk is accurately shown in the stock index. Stock index futures contract is an agreement to buy or sell a specified amount of an underlying stock traded on a regulated futures exchange for a specified price at a specified time in future. Stock index futures will require lower capital adequacy and margin requirement as compared to margins on carry forward of individual scrip’s. The brokerage cost on index futures will be much lower. Savings in cost is possible through reduced bid-ask spreads where stocks are traded in packaged forms. The impact cost will be much lower in case of stock index futures as opposed to dealing in individual scripts. The market is conditioned to think in terms of the index and therefore,

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would refer trade in stock index futures. Further the chances of manipulation are much lesser. The stock index futures are expected to be extremely liquid, given the speculative nature of our markets and overwhelming retail participation expected to be fairly high. In the near future stock index futures will definitely see incredible volumes in India. It will be a blockbuster product and is pitched to become the most liquid contract in the world in terms of contracts traded. The advantage to the equity or cash market is in the fact that they would become less volatile as most of the speculative activity would shift to stock index futures. The stock index futures market should ideally have more depth, volumes and act as a stabilizing factor for the cash market. However, it is too early to base any conclusions on the volume are to form any firm trend. The difference between stock index futures and most other financial futures contracts is that settlement is made at the value of the index at maturity of the contract. Example: If BSE Sensex is at 6800 and each point in the index equals to Rs.30, a contract struck at this level could work Rs.204000 (6800x30). If at the expiration of the contract, the BSE Sensex is at 6850, a cash settlement of Rs.1500 is required (6850-6800) x30).

Stock Futures: With the purchase of futures on a security, the holder essentially makes a legally binding promise or obligation to buy the underlying security at same point in the future (the expiration date of the contract). Security futures do not represent ownership in a corporation and the holder is therefore not regarded as a share holder. A futures contract represents a promise to transact at same point in the future. In this light, a promise to sell security is just as easy to make as a promise to buy security. Selling security futures without previously owing them simply obligates the trader to sell a certain amount of the underlying security at same point in the future. It can be done just as easily as buying futures, which obligates the trader to buy a certain amount of the underlying security at some point in future.

Example: If the current price of the ACC share is Rs.170 per share. We believe that in one month it will touch Rs.200 and we buy ACC shares. If the price really increases to Rs.200,we made a profit of Rs.30 i.e. a return of 18%.If we buy ACC futures instead, we get the same position as ACC
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in the cash market, but we have to pay the margin not the entire amount. In the above example if the margin is 20%, we would pay only Rs.34 initially to enter into the futures contract. If ACC share goes up to Rs.200 as expected, we still earn Rs.30 as profit. Currency futures A currency future, also FX future or foreign exchange future, is a futures contract to exchange one currency for another at a specified date in the future at a price (exchange rate) that is fixed on the purchase date; see Foreign exchange derivative. Typically, one of the currencies is the US dollar. The price of a future is then in terms of US dollars per unit of other currency. This can be different from the standard way of quoting in the spot foreign exchange markets. The trade unit of each contract is then a certain amount of other currency, for instance €125,000. Most contracts have physical delivery, so for those held at the end of the last trading day, actual payments are made in each currency. However, most contracts are closed out before that. Investors can close out the contract at any time prior to the contract's delivery date. Investors use these futures contracts to hedge against foreign exchange risk. If an investor will receive a cash flow denominated in a foreign currency on some future date, that investor can lock in the current exchange rate by entering into an offsetting currency futures position that expires on the date of the cash flow. For example, A is a US-based investor who will receive €1,000,000 on December 1. The current exchange rate implied by the futures is $1.2/€. He can lock in this exchange rate by selling €1,000,000 worth of futures contracts expiring on December 1. That way, He is guaranteed an exchange rate of $1.2/€ regardless of exchange rate fluctuations in the meantime. Interest Rate Futures An interest rate future is a financial derivative (a futures contract) with an interest-bearing instrument as the underlying asset. Examples include Treasury-bill futures, Treasury-bond futures and Eurodollar futures. Interest rate futures are used to hedge against the risk of that interest rates will move in an adverse direction, causing a cost to the company.

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For example, borrowers face the risk of interest rates rising. Futures use the inverse relationship between interest rates and bond prices to hedge against the risk of rising interest rates. A borrower will enter to sell a future today. Then if interest rates rise in the future, the value of the future will fall (as it is linked to the underlying asset, bond prices), and hence a profit can be made when closing out of the future (i.e. buying the future). Treasury futures are contracts sold on the Globex market for March, June, September and December contracts. As pressure to raise interest rates rises, futures contracts will reflect that speculation as a decline in price. Price and yield will always be in an inversely correlated relationship. OPTIONS CONTRACT In finance, an option is a contract whereby one party (the holder or buyer) has the right but not the obligation to exercise a feature of the contract (the option) on or before a future date (the exercise date or expiry). The other party (the writer or seller) has the obligation to honor the specified feature of the contract. Since the option gives the buyer a right and the seller an obligation, the buyer has received something of value. The amount the buyer pays the seller for the option is called the option premium. Most often the term “option” refers to a type of derivative which gives the holder of option the right but not the obligation to purchase (a “call option”) or sell (a “put option”) a specified amount of a security within a specified time span. Definition An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An option, just like a stock or bond, is a security. It is also a binding contract with strictly defined terms and properties. For example, Anand is bullish about the Index. Spot Nifty stands at 2200. He decides to buy one three-month Nifty call option contract with a strike of 2260 at a premium of Rs. 15 per

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call. Three months later, the index closes at 2295. His pay off position- each call option earns him Rs.1000. Types of option There are two basic types of options—call option and put option. i. Call option: A call option gives the holder the right but not the obligation to buy an asset by a certain date for a certain price. ii. Put option: A Put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price. The price of options decided between the buyers and sellers on trading screens of the exchange in a transparent manner. The investors can see the best five orders by price and quantity. The investor can place a market limit order, stop loss order, etc. the investor can modify or delete his pending orders. The whole process is similar to that of trading in shares. In simple words, a call option gives the holder the right to buy an asset at a certain price within or at the end of a specific period of time. Calls are similar to having a long position on a stock. Buyers of call hope that the stock will increase substantially before the option expires. Similarly, a put option gives the holder the right to sell an asset at a certain price within or at the end of a specific period of time. Puts are similar to having a short position on a short position on a stock. Buyers of the put option hope that the stock will decrease substantially before the option expires. An investor with a long expiry call or put position may exercise that contract at any time before the contract expires, up to and including the Friday (in the Indian stock market) before its expiration. To do so, the investor must notify his brokerage firm of intent to exercise in a manner, and by the deadline specified by that particular firm. Any investor with an open short position in a call or put option may nullify the obligations inherent in that short (or written) contract by making an offsetting closing purchase transaction of a similar option (same series) in the marketplace. This transaction must be
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made before the assignment is received, regardless of whether you have been notified by your brokerage firm to this effect or not. Categories of Options There are three main categories of options: European, American and Bermudan. The distinction between American and European options has nothing to do with its geographical location. European options can be exercised only at the expiration time whereas American option can be exercised at any moment prior to maturity (expiration). A third form of exercise, which is occasionally used with OTC options, is Bermudan exercise. A Bermudan was chosen perhaps because Bermuda is half way between America and Europe. There are hundreds of different types of options which differ in their payoff structures, path-dependence, and payoff trigger and termination conditions. Pricing some of these options represent a complex mathematical problem. Advantages and Disadvantages of Options Advantages: • • • • An investor can gain leverage in a stock without committing to a trade. Option premiums are significantly cheaper on a per-share basis than the full price of the underlying stock. Risk is limited to the option premium (except when writing options for a security that is not already owned). Options allow investors to protect their positions against price fluctuations

Disadvantages: • The costs of trading options (including both commissions and the bid/ask spread) is significantly higher on a percentage basis than trading the underlying stock, and these costs can drastically eat into any profits. • Options are very complex and require a great deal of observation and maintenance.
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• •

The time-sensitive nature of options leads to the result that most options expire worthless. Making money by trading options is extremely difficult, and the average investor will fail. Some option positions, such as writing uncovered options, are accompanied by unlimited risk.

Option Components An option for a given stock has three main components: an expiration date, a strike price and a premium. The expiration date tells the month in which the option will expire. Options expire one day after the third Friday of the expiration month. The strike price is the price at which the holder is allowed to buy or sell the underlying stock at a later date. The premium is amount that the holder must pay for the right to exercise the option. Because the holder acquires the right to trade 100 shares, the total cost of the option, if exercised, is 100 times the premium. In order to relate them to the price of the underlying stock at any given time, options are classified as in-the-money, out-of-the-money or at-the-money. A call option is in-the-money when the stock price is above the strike price and out-of-the-money when the stock price is below the strike price. For put options, the reverse is true. When the stock price and strike price are equal, both types of options are considered at-the-money. Of course, when calculating profit and loss, the premium, as well as taxes and commissions must be factored in. Therefore, an option must be far enough in-the-money to cover these costs in order to be profitable. Valuing and Pricing Options The price of an option is primarily affected by: • • • The difference between the stock price and the strike price The time remaining for the option to be exercised The volatility of the underlying stock

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Affecting the premium to a lesser degree are factors such as interest rates, market conditions, and the dividend rate of the underlying stock. Because the value of an option decreases as its expiration date approaches and becomes worthless after that date, options are considered "wasting assets". The total value consists of intrinsic value, which is simply how far in-the-money an option is, and time value, which is the difference between the price paid and the intrinsic value In general, premiums should increase as the volatility of the underlying stock increases because the greater fluctuation makes the right to buy in the future at the current price more valuable. Volatility can be historical or implied. Historical volatility is based on the past performance of the stock. Implied volatility is a reflection of the way options are being priced in general. Options Clearing Corporation (OCC) Founded in 1973, the Options Clearing Corporation is the largest equity derivatives clearing organization in the world. The OCC's mission and values statement states, "OCC is a customer-driven clearing organization that delivers world-class risk management, clearance and settlement services at a reasonable cost; and provide value-added solutions that support and grow the markets we serve." An organization that acts as both the issuer and guarantor for option and futures contracts. The Options Clearing Corporation operates under the jurisdiction of the U.S. Securities and Exchange Commission (SEC). Under its SEC jurisdiction, the OCC clears transactions for put and call options, stock indexes, foreign currencies, interest rate composites and single-stock futures. The OCC substantially reduces the credit risk aspect of trading options, as the OCC requires that every buyer and every seller have a clearing member and that both sides of the transaction are matched. It also has the authority to make margin calls on firms during the trading day. The OCC has a AAA credit rating from Standard & Poor’s Corporation. As a registered Derivatives Clearing Organization (DCO) regulated by the CFTC, the OCC provides clearing and settlement services for transactions in futures products, as well as
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options on futures. For securities lending transactions, the OCC offers central counterparty clearing and settlement services. A clearing member dominated board of directors oversees the Options Clearing Corporation. Most of its revenues are received from clearing fees charged to its members; volume discounts on fees are available. Exchanges and markets that OCC serves include BATS Options Exchange; C2 options Exchange, Inc; Chicago board Options Exchange, Inc; International Securities Exchange, NASDAQ OMX BX, Inc; NASDAQ OMX PHLX, Nasdaq Stock Market; NYSE Amex Options; and NYSE Arca Options. Moneyness of Options Intrinsic Value and Time Value The option premium is broken down into two components: the intrinsic value and the speculative or time value. The intrinsic value is an easy calculation - the market price of an option minus the strike price - and it represents the profit that the holder of the option would enjoy if he or she exercised the option, took delivery of the underlying asset and sold it in the current marketplace. The time value is calculated by subtracting the intrinsic value of the option from the option premium In-The-Money Options For example, let's say it's September and Pat is long (owns) a Google (Nasdaq:GOOG) December 400 call option. The option has a current premium of 28 and GOOG is currently trading at 420. The intrinsic value of the option would be 20 (market price of 420 - strike price of 400 = 20). Therefore, the option premium of 28 is comprised of $20 of intrinsic value and $8 of time value (option premium of 28 - intrinsic value of 20 = 8).

Pat's option is in the money. An in-the-money option is an option that has intrinsic value. With regard to a call option, it is an option with a strike price below the current market price. It would make the most financial sense for Pat to sell her call option, as then she would get $8 more per share than she would by taking delivery of the shares (calling them away) and selling them in the open market.
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Out-Of-The-Money Options Returning to the example, if Pat were long a December 400 GOOG put option with a current premium of 5, and if GOOG had a current market price of 420, she would not have any intrinsic value (the entire premium would be considered time value), and the option would be out of the money. An out-of-the-money put option is an option with a strike price that is lower than the current market price.

The intrinsic value of a put option is determined by subtracting the market value from the strike price (strike price of 400 - market value of 420 = -20). Intuitively, it looks as if the intrinsic value is negative, but in this scenario the intrinsic value can never be negative; the lowest it can ever be is zero. At-The-Money Options A third scenario would be if the current market price of GOOG was 400. In that case, both the call and put options would be at the money, and the intrinsic value of both would be zero, as immediate exercise of either option would not result in any profit. However, that doesn't mean that the options have no value - they could still have time value. Uses of options One can combine options and other derivatives in a process known as financial engineering to control the risk in a given transaction. The risk taken on can be anywhere from zero to infinite, depending on the combination of derivative features used. By using derivatives one party transfers (buys or sells) risk to or from another. When using options for insurance, the option-holder reduces the risk he bears by paying the option seller a premium to assume it. Because one can use options to assume risk, one can purchase options to create leverage. The payoff to purchasing an option can be much greater than by purchasing the underlying instrument directly. For example buying an at-the-money call option for 2 monetary units per share for a total of 200 units on a security priced at 20 units, will lead to a 100% return on premium if the option is exercised when the underlying security’s price has risen by 2 units, whereas buying the security directly for 20 units per share would have led to a 10% return.
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The greater leverage comes at the cost of greater risk of losing 100% of the option premium if the underlying security does not rise in price. Employee stock options are also widely used as a compensation vehicle for employees and, particular, senior executives of publicly traded corporations. However, employees stock options use is being curbed thanks in part to a decision by the Financial Accounting Standards Board (FASB) requiring that stock option grants are recorded on the income statement as an expense. Previously, options granted with fair market value exercise prices were not considered to have a cost to the company. This was significant factor in their ascendancy as a compensation tool. Stock Options Stock Options are contracts that grant the holder the right to buy or sell a specific stock at a specific price before the contract expires. A stock option is a contract which conveys to its holder the right, but not the obligation, to buy or sell shares of the underlying security at a specified price on or before a given date. After this given date, the option ceases to exist. The seller of an Option is, in turn, obligated to sell (or buy) the shares to (or from) the buyer of the Option at the specified price upon the buyer's request. Options are currently traded on the following U.S. exchanges: The American Stock Exchange, Inc. (AMEX), the Chicago Board Options Exchange, Inc. (CBOE), the New York Stock Exchange, Inc. (NYSE), the Pacific Stock Exchange, Inc. (PSE), and the Philadelphia Stock Exchange, Inc. (PHLX). Like trading in stocks, option trading is regulated by the Securities and Exchange Commission (SEC).The purpose of this publication is to provide an introductory understanding of stock options and how they can be used. Options are also traded on indexes (AMEX, CBOE, NYSE, PHLX, PSE), on U.S. Treasury securities (CBOE), and on foreign currencies(PHLX); information on these option products is not included in this document but can be obtained by contacting the appropriate exchange. These exchanges which trade options seek to provide competitive, liquid, and orderly markets for the purchase and sale of standardized options.

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Index Options

A financial derivative that gives the holder the right, but not the obligation, to buy or sell a basket of stocks, such as the S&P 500, at an agreed-upon price and before a certain date. An index option is similar to other options contracts, the difference being the underlying instruments are indexes. Options contracts, including index options, allow investors to profit from an expected market move or to reduce the risk of holding the underlying instrument Index options provide diversification as investors are exposed to a large number of securities in one trading instrument. The degree of exposure varies with the particular index option. Popular index options include S&P 500 Index Options (SPX), Dow Jones Industrial Average Index Options (DJX) and Nasdaq-100 Index Options (NDX). Index options are typically cash settled. Currency Option A contract that grants the holder the right, but not the obligation, to buy or sell currency at a specified exchange rate during a specified period of time. For this right, a premium is paid to the broker, which will vary depending on the number of contracts purchased. Currency options are one of the best ways for corporations or individuals to hedge against adverse movements in exchange rates.

Investors can hedge against foreign currency risk by purchasing a currency option put or call. For example, assume that an investor believes that the USD/EUR rate is going to increase from 0.80 to 0.90 (meaning that it will become more expensive for a European investor to buy U.S dollars). In this case, the investor would want to buy a call option on USD/EUR so that he or she could stand to gain from an increase in the exchange rate (or the USD rise). Bond option In finance, a bond option is an option to buy or sell a bond at a certain price on or before the option expiry date. These instruments are typically traded OTC.

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A European bond option is an option to buy or sell a bond at a certain date in future for a predetermined price.

An American bond option is an option to buy or sell a bond on or before a certain date in future for a predetermined price.

Generally, one buys a call option on the bond if one believes that interest rates will fall, causing an increase in bond prices. Likewise, one buys the put option if one believes that the opposite will be the case. One result of trading in a bond option, is that the price of the underlying bond is "locked in" for the term of the contract, thereby reducing the credit risk associated with fluctuations in the bond price. Interest Rate Options An investment tool whose payoff depends on the future level of interest rates. Interest rate options are both exchange traded and over-the-counter instruments. An Interest rate is similar to an equity option. There are two types, Calls and Puts. Calls give the bearer the right, but not the obligation, to benefit off a rise in interest rates. A put gives the bearer the right, but not the obligation, to profit off a decrease in interest rates. All of these options are cash settled. A quantity of bonds does not have to be delivered, but the differences between the interest rates are settled using a scale of 100, much like equity options are. Interest Rate options, however, differ from equity options in that excise in the European style. This allows the option to be excised only on a specified date and not at any point leading up to it. Speculating on interest rates, or on any investment, is a risky strategy. Interest rate options should only be used by sophisticated investors with a high tolerance for risk. Interest rate options from exchanges in the United States are offered on Treasury bond futures, Treasury note futures and Eurodollar futures. An investor taking a long position in interest rate call options believes that interest rates will rise, while an investor taking a position in interest rate put options believes that interest rates will fall.

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TRADING OF DERIVATIVES CONTRACTS

Futures and Options Trading System The futures & options trading system of NSE, called NEAT-F&O trading system, provides a fully automated screen-based trading for Index futures & options and Stock futures & options on a nationwide basis as well as an online monitoring and surveillance mechanism. It supports an order driven market and provides complete transparency of trading operations. It is similar to that of trading of equities in the cash market segment. The software for the F&O market has been developed to facilitate efficient and transparent trading in futures and options instruments. Keeping in view the familiarity of trading members with the current capital market trading system, modifications have been performed in the existing capital market trading system so as to make it suitable for trading futures and options. Market Timings Trading on the derivatives segment takes place on all days of the week (except Saturdays and Sundays and holidays cleared by the Exchange in advance). The market timings of the derivatives segment are: Normal Market / Exercise Market Open time : 09:55 hour’s Normal market close : 15:30 hours Set up cut of time for Position limit/Collateral value : till 15:30hrsTrade modification end time / Exercise Market : 16:15 hours Trading Locations Till the advent of NSE, an investor wanting to transact in a security not traded on the nearest exchange had to route orders through a series of correspondent brokers to the appropriate exchange. This resulted in a great deal of uncertainty and high transaction costs. One of the objectives of NSE was to provide a nationwide trading facility and to enable investors spread all over the country to have an equal access to NSE.NSE has made it possible for an investor to access the same market and order book, irrespective of location, at the same price and at the same cost. NSE uses sophisticated telecommunication technology through which members can trade remotely from their offices located in any part of the country. NSE trading terminals (F&O segment) are present in various cities and towns all over India.
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Entities in the trading system • Trading members: Trading members are members of NSE. They can trade either on their own account or on behalf of their clients including participants. The exchange assigns a trading member ID to each trading member. Each trading member can have more than one user. The number of users allowed for each trading member is notified by the exchange from time to time. Each user of a trading member must be registered with the exchange and is assigned an unique user ID. The unique trading member ID functions as a reference for all orders/trades of different users. This ID is common for all users of a particular trading member. It is the responsibility of the trading member to maintain adequate control over persons having access to the firm’s User IDs. •

Clearing members: Clearing members are members of NSCCL. They carry out risk management activities and confirmation/inquiry of trades through the trading system.

Professional clearing members: A professional clearing member is a clearing member who is not a trading member. Typically, banks and custodians become professional clearing members and clear and settle for their trading members.

Participants: A participant is a client of trading members like financial institutions. These clients may trade through multiple trading members but settle through a single clearing member.

Basis of trading The NEAT F&O system supports an order driven market, wherein orders match automatically. Order matching is essentially on the basis of security, its price, time and quantity. All quantity fields are in units and price in rupees. The exchange notifies the regular lot size and tick size for each of the contracts traded on this segment from time to time. When any order enters the trading system, it is an active order. It tries to find a match on the other side of the book. If it finds a match, a trade is generated. If it does not find a match, the order becomes passive and goes and sits in the respective outstanding order book in the system.

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Corporate hierarchy In the F&O trading software, a trading member has the facility of defining a hierarchy amongst users of the system. • Corporate manager: The term is assigned to a user placed at the highest level in a trading firm. Such a user can perform all the functions such as order and trade related activities of all users, view net position of all dealers and at all clients level, can receive end of day consolidated trade and order reports dealer wise for all branches of the trading member firm and also all dealers of the firm. Only a corporate manager can sign off any user and also define exposure limits for the branches of the firm and its dealers. • Branch manager: This term is assigned to a user who is placed under the corporate manager. Such a user can perform and view order and trade related activities for all dealers under that branch. • Dealer: Dealers are users at the bottom of the hierarchy. A Dealer can perform view order and trade related activities only for one and does not have access to information on other dealers under either the same branch or other branches. • Admin: Another user type, ‘Admin’ is provided to every trading member along with the corporate manager user. This user type facilitates the trading members and the clearing members to receive and capture on a real-time basis all the trades, exercise requests and give up requests of all the users under him. The clearing members can receive and capture all the above information on a real time basis for the member sand participants linked to him. All this information is written to comma separated files which can be accessed by any other program on a real time basis in a read only mode. This however does not affect the online data capture process. Besides this the admin users can take online backup, view and upload net position, view previous trades.

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Order types and conditions The system allows the trading members to enter orders with various conditions attached to them as per their requirements. These conditions are broadly divided into the following categories: • Time conditions - Day order: A day order, as the name suggests is an order which is valid for the day on which it is entered. If the order is not executed during the day, the system cancels the order automatically at the end of the day. - Immediate or Cancel (IOC): An IOC order allows the user to buy or sell a contract as soon as the order is released into the system, failing which the order is cancelled from the system. Partial match is possible for the order, and the unmatched portion of the order is cancelled immediately. • Price condition - Stop-loss: This facility allows the user to release an order into the system, after the market price of the security reaches or crosses a threshold price e.g. if for stop-loss buy order, the trigger is 1027.00, the limit price is1030.00 and the market (last traded) price is 1023.00, then this order is released into the system once the market price reaches or exceeds 1027.00.This order is added to the regular lot book with time of triggering as the time stamp, as a limit order of 1030.00. For the stop-loss sell order, the trigger price has to be greater than the limit price. • Other conditions - Market price: Market orders are orders for which no price is specified at the time the order is entered (i.e. price is market price). For such orders, the system determines the price. - Trigger price: Price at which an order gets triggered from the stop-loss book. - Limit price: Price of the orders after triggering from stop-loss book. - Pro: Pro means that the orders are entered on the trading member’s own account.
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- Cli: Cli means that the trading member enters the orders on behalf of a client. The Trader Workstation The Market Watch Window The following windows are displayed on the trader workstation screen: • Title bar • Ticker window of futures and options market • Ticker window of underlying (capital) market • Toolbar • Market watch window • Inquiry window • Snap quote • Order/trade window • System message window The market watch window is the third window from the top of the screen which is always visible to the user. The purpose of market watch is to allow continuous monitoring of contracts or securities that are of specific interest to the user. It displays trading information for contracts selected by the user. The user also gets a broadcast of all the cash market securities on the screen. This function also will be available if the user selects the relevant securities for display on the market watch screen. Display of trading information related to cash market securities will be on “Read only” format, i.e. the dealer can only view the information on cash market but, cannot trade in them through the system. This is the main window from the dealer’s perspective.

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Eligibility criteria of stocks • The stock is chosen from amongst the top 500 stocks in terms of average daily market capitalization and average daily traded value in the previous six months on a rolling basis. • The stock’s median quarter-sigma order size over the last six months should be not less than Rs. 5 lakhs. For this purpose, a stock’s quarter-sigma order size should 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 should not be less than Rs.100 crores. The market wide position limit (number of shares) is valued taking the closing prices of stocks in the underlying cash market on the date of expiry of contract in 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. Eligibility criteria of indices 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 should 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 would be issued on that index, However, the existing unexpired contacts will be permitted to trade till expiry and new strike scan also be introduced in the existing contracts.

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CLEARING & SETTLEMENT
National Securities Clearing Corporation Limited (NSCCL) is the clearing and settlement agency for all deals executed on the Derivatives (Futures & Options) segment. NSCCL acts as legal counter-party to all deals on NSE's F&O segment and guarantee settlement .A Clearing Member (CM) of NSCCL has the responsibility of clearing and settlement of all deals executed by Trading Members(TM) on NSE, who clear and settle such deals through them. Clearing Members A Clearing Member (CM) of NSCCL has the responsibility of clearing and settlement of all deals executed by Trading Members(TM) on NSE, who clear and settle such deals through them. primarily, the CM performs the following functions: 1. Clearing: Computing obligations of all his TM's i.e. determining positions to settle. 2. Settlement: Performing actual settlement. Only funds settlement is allowed at present in Index as well as Stock futures and options contracts. 3. Risk Management: Setting position limits based on up front deposits / margins for each TM and monitoring positions on a continuous basis Clearing Member Eligibility Norms • • • •Net worth of at least Rs.300 lakhs. The net worth requirement for a CM who clears and settles only deals executed by him is Rs. 100 lakhs. •Deposit of Rs. 50 lakhs to NSCCL which forms the Base Minimum Capital (BMC) of the CM. •Additional incremental deposits of Rs.10 lakhs to NSCCL for each additional TM in case the CM undertakes to clear and settle deals for other TMs.

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Clearing Banks

NSCCL has empanelled 13clearing banks namely Axis Bank Ltd., Bank of India, Canara Bank, Citibank N.A, HDFC Bank, Hongkong & Shanghai Banking Corporation Ltd., ICICI Bank, IDBI Bank, IndusInd Bank, Kotak Mahindra Bank, Standard Chartered Bank, State Bank of India and Union Bank of India. Every Clearing Member is required to maintain and operate a clearing account with any one of the empanelled clearing banks at the designated clearing bank branches. The clearing account is to be used exclusively for clearing & settlement operations. Settlement Mechanism Daily Mark-to-Market Settlement The positions in the futures contracts for each member are marked-to-market to the daily settlement price of the futures contracts at the end of each trade day. The profits/ losses are computed as the difference between the trade price or the previous day’s settlement price, as the case may be, and the current day’s settlement price. The CMs who have suffered a loss are required to pay the mark-to-market loss amount to NSCCL which is in turn passed on to the members who have made a profit. This is known as daily mark-to-market settlement. Final Settlement On the expiry of the futures contracts, NSCCL marks all positions of a CM to the final settlement price and the resulting profit / loss is settled in cash. The final settlement of the futures contracts is similar to the daily settlement process except for the method of computation of final settlement price. The final settlement profit / loss are computed as the difference between trade price or the previous day’s settlement price, as the case may be, and the final settlement price of the relevant futures contract. Final settlement loss/ profit amount is debited/ credited to the relevant CMs clearing bank account on T+1 day (T= expiry day).Open positions in futures contracts cease to exist after their expiration day.

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Risk Management NSCCL has developed a comprehensive risk containment mechanism for the F&O segment. Risk containment measures include capital adequacy requirements of members, monitoring of member performance and track record, stringent margin requirements, position limits based on capital, online monitoring of member positions and automatic disablement from trading when limits are breached. The salient features of risk containment mechanism on the F&O segment are: There are stringent requirements for members in terms of capital adequacy measured in terms of net worth and security deposits. 1. NSCCL charges an upfront initial margin for all the open positions of a CM. It specifies the initial margin requirements for each futures/options contract on a daily basis. The CM in turn collects the initial margin from the TMs and their respective clients. 2. Client margins: NSCCL intimates all members of the margin liability of each of their client. Additionally members are also required to report details of margins collected from clients to NSCCL, which holds in trust client margin monies to the extent reported by the member as having been collected form their respective clients. 3. The open positions of the members are marked to market based on contract settlement price for each contract. The difference is settled in cash on a T+1 basis. 4. NSCCL’s on-line position monitoring system monitors a CM’s open positions on a realtime basis. Limits are set for each CM based on his capital deposits. The on-line position monitoring system generates alerts whenever a CM reaches a position limit set up by NSCCL. At 100% the clearing facility provided to the CM shall be withdrawn. Withdrawal of clearing facility of a CM in case of a violation will lead to withdrawal of trading facility for all TMs and/ or custodial participants clearing and settling through the CM 5. CMs are provided a trading terminal for the purpose of monitoring the open positions of all the TMs clearing and settling through him. A CM may set exposure limits for a TM clearing and settling through him. NSCCL assists the CM to monitor the intra-day exposure limits set up by a CM and whenever a TM exceeds the limits, it stops that particular TM from further trading. Further trading members are monitored based on

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positions limits. Trading facility is withdrawn when the open positions of the trading member exceeds the position limit. 6. A member is alerted of his position to enable him to adjust his exposure or bring in additional capital.. 7. A separate settlement guarantee fund for this segment has been created out of the capital of members. The most critical component of risk containment mechanism for F&O segment is the margining system and on-line position monitoring. The actual position monitoring and margining is carried out on-line through Parallel Risk Management System (PRISM). PRISM uses SPAN(r) (Standard Portfolio Analysis of Risk) system for the purpose of computation of on-line margins, based on the parameters defined by SEBI.

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CONCLUSION
The economic benefits of derivatives are not dependent on the size of the institution trading them. The decision about whether to use derivatives should be driven, not by the company’s size, but by its strategic objectives. However, it is important that all users of derivatives, regardless of size, understand how their contacts are structured, the unique price and risk characteristics of those instruments, and how they will perform under stressful and volatile economic conditions. The primary data collected resulted into the following information: although equities are popularly traded, most of retail investors and trader also prefer derivative trading. Many investors ranging below the age of 30, professional in their field of finance showed their interest trading in derivative instrument. However due to fear of losing capital and lack of complete knowledge of derivative segment, some avoid into entering such contracts. Although derivatives were derived for the purpose of hedging, now it is a popular speculation tool. Many of the traders rather almost all of them invest in F&O segment only with the objective of earning profits. Without denying the fact equities are the most popular investment avenue, it is also proved that professional managers with their expertise skill put their large share of surplus capital into derivative segment. As within a small capital for investment they earn fat returns. The concept of margin payment, gives leverage and flexibility to small investors to get into the market. But just with the aim of making money won’t work out, what is actually required is the in depth knowledge of derivative and keen market watch on the fundamentals and technicals of particular investment. Derivatives market in India is still in its development stage. It is not at par with world’s derivatives market. Speculation has caused many small investors to lose their valuable savings. Derivatives instruments are only for higher value of transaction. An individual trader finds it difficult to invest in derivative market. As it is still in development stage people are unaware of derivative instruments available.

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