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ECONOMIC FUNCTION OF THE DERIVATIVE MARKET Inspite of the fear and criticism with which the derivative markets

are commonly looked at, these markets perform a number of economic functions. 1. Prices in an organized derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. The prices of derivatives converge with the pric es of the underlying at the expiration of the derivative contract. Thus derivatives help in discovery of future as well as current prices. 2. 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. 3. Derivatives, due to their inherent nature, are linked to the underlying cash markets. With the introduction of derivatives, the underlying market witnesses higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk. 4. Speculative trades shift to a more controlled environment of derivatives market. In the absence of an organized derivatives market, speculators trade in the underlying cash markets. Margining, monitoring and surveillance of the activities of various participants become extremely difficult in these kind of mixed markets. 5. An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. The derivatives have a history of attracting many bright, creative, well-educated people with an entrepreneurial attitude. They often energize others to create new businesses, new products and new employment opportunities, the benefit of which are immense. In a nut shell, derivatives markets help increase savings and investment in the long run. Transfer of risk enables market participants to expand their volume of activity History of derivatives markets Early forward contracts in the US addressed merchants' concerns about ensuring that there were buyers and sellers for commodities. However 'credit risk" remained a serious problem. To deal with this problem, a group of Chicago businessmen formed the Chicago Board of Trade (CBOT) in 1848. The primary intention of the CBOT was to provide a centralized location known in advance for buyers and sellers to negotiate forward contracts. In 1865, the CBOT went one step further and listed the first 'exchange traded" derivatives contract in the US, these contracts were called 'futures contracts". In 1919, Chicago Butter and Egg Board, a spin-off of CBOT, was reorganized to allow futures trading. Its name was changed to Chicago Mercantile

Some options are European while others are American. OPTION TERMINOLOGY Index options: These options have the index as the underlying. financial futures became the most active derivative instruments generating volumes many times more than the commodity futures. · Strike price: The price specified in the options contract is known as the strike price or the exercise price. Options currently trade on over 500 stocks in the United States. namely options. we look at the next derivative product to be traded on the NSE. There are two basic types of options. MATIF in France. traded on Chicago Mercantile Exchange. INTRODUCTION TO OPTIONS In this section. the two parties have committed themselves to doing something. An option gives the holder of the option the right to do something. · American options: American options are options that can be exercised at any time upto the expiration date. · Buyer of an option: The buyer of an option is the one who by paying the option premium buys the right but not the obligation to exercise his option on the seller/writer. . the exercise date. Options are fundamentally different from forward and futures contracts. · Option price/premium: Option price is the price which the option buyer pays to the option seller. 30 · Stock options: Stock options are options on individual stoc ks. Whereas it costs nothing (except margin requirements) to enter into a futures contract. index options contracts are also cash settled. In contrast. Other popular international exchanges that trade derivatives are LIFFE in England. During the mid eighties. The first stock index futures contract was traded at Kansas City Board of Trade. Like index futures contracts. TIFFE in Japan. It is also referred to as the option premium. call options and put options. Eurex etc. · Writer of an option: The writer of a call/put option is the one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him. DTB in Germany. futures on T-bills and Euro-Dollar futures are the three most popular futures contracts traded today. Currently the most popular stock index futures contract in the world is based on S&P 500 index. The holder does not have to exercise this right. · 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. indeed the two largest "financial" exchanges of any kind in the world today. SGX in Singapore. Most exchange-traded options are American. Index futures. A contract gives the holder the right to buy or sell shares at the specified price. · Put option: A put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price. The CBOT and the CME remain the two largest organized futures exchanges. in a forward or futures contract. the strike date or the maturity.Exchange (CME). · Expiration date: The date specified in the options contract is known as the expiration date. the purchase of an option requires an up-front payment.

Merton and Scholes invented the famed Black-Scholes formula. In April 1973. In the case of a put. If someone wanted to buy an option. · Intrinsic value of an option: The option premium can be broken down into two components . the call is said to be deep OTM. they were traded OTC. spot price > strike price). K is the strike price and St is the spot price. Usually. This market however suffered from two deficiencies. there was no mechanism to guarantee that the writer of the option would honor the contract. spot price = strike price). without much knowledge of valuation. (St — K)] which means the intrinsic value of a call is the greater of 0 or (St — K). the intrinsic value of a put is Max[0. An option on the index is at-the-money when the current index equals the strike price (i. An option that is OTM or ATM has only time value. the intrinsic value of a call is Max[0. · In-the-money option: An in-the-money (ITM) option is an option that would lead to a positive cashflow to the holder if it were exercised immediately. European options are easier to analyze than American options. A call option on the index is said to be in-the-money when the current index stands at a level higher than the strike price (i.i. spot price < strike price). all else equal.e. CBOE was set up specifically for the . the put is OTM if the index is above the strike price. If the index is much higher than the strike price. If no seller could be found. If the index is much lower than the strike price. the greater of 0 or (K — St). there was no secondary market and second.e. The first trading in options began in Europe and the US as early as the seventeenth century. Similarly. It was only in the early 1900s that a group of firms set up what was known as the put and call Brokers and Dealers Association with the aim of providing a mechanism for bringing buyers and sellers together.e. an option should have no time value.intrinsic value and time value. Both calls and puts have time value. · At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cashflow if it were exercised immediately. the put is ITM if the index is below the strike price. In 1973. A call option on the index is out-of-the-money when the current index stands at a level which is less than the strike price (i. · Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to a negative cashflow if it were exercised immediately. the maximum time value exists when the option is ATM. the greater is an option's time value. First. the firm would undertake to write the option itself in return for a price. If the call is OTM. Putting it another way. The firm would then attempt to find a seller or writer of the option either from its own clients or those of other member firms.· European options: European options are options that can be exercised only on the expiration date itself. The longer the time to expiration. and properties of an American option are frequently deduced from those of its European counterpart. its intrinsic value is zero. K — St]. Black. he or she would contact one of the member firms. In the case of a put. The intrinsic value of a call is the amount the option is ITM. · Time value of an option: The time value of an option is the difference between its premium and its intrinsic value. At expiration. History of options Although options have existed for a long time. if it is ITM.e. the call is said to be deep ITM.

. there has been no looking back. Since then. The market for options developed so rapidly that by early '80s. the number of shares underlying the option contract sold each day exceeded the daily volume of shares traded on the NYSE.purpose of trading options.