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DEFINITION / HISTORY AND TYPES OF DERIVATIVES

DEFINTION

“Derivative is a product whose value is derived from the value of one or more basic variables,
called as bases ( underlying asset, index or reference rate ), in a contractual manner”.

In the Indian context the Securities Contracts ( Regulation ) Act, 1956 ( SC(R)A) defines “Derivative”
as under:

1. A security derived from a debt instrument, share, and loan whether secured or unsecured,
risk instrument or contract for differences or any other form of security.

2. A contract, which derives its value from the prices, or index of prices, of underlying
securities.

HISTORY OF DERIVATIVES MARKETS

• Financial Derivatives came into spotlight in the post –1970 period due to growing instability in
the financial markets. These products have become very popular by 1990s.

• In the class of derivatives the word over, futures and options on stock indices have gained
more popularity than on individual stocks, especially among institutional investors, who are
major users of index-linked derivatives.

• In the US, there were buyers and sellers for commodities, but ‘credit risk’ remained a serious
problem. To deal with the problem, a group of Chicago businessmen formed the Chicago
Board of Trade (CBOT) in 1848. In 1865, the CBOT went one step further and listed the first
“exchange traded” derivatives contract in the US. These contracts were called as “Futures
Contracts”.

• 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 Mid eighties, financial futures became the most active derivative instruments.

TYPES OF DERIVATIVES

There are various types of Derivative instruments available in the market. But we are going to see the
instruments available in Equity Market.

1. FUTURES

&

2. OPTIONS

FUTURES

Definition:

“ 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. ”

Explanation: To understand in a simpler way, we will consider one example.

• A farmer is coming to the city to sell his crops, he is not sure about the best rate for selling,
what he is going to get. Therefore, before coming to the markets in the city to sell his crops,
first he comes to the market and asks the Broker ( agent for the selling of crops ) to do the
agreement to buy the crops at a fixed price and on a fixed date in the future (say 1 month
ahead from the current date ).

• Suppose he has made an agreement with the broker @Rs.100 /- per bag of crop. When he is
going to come to market after one month time and the rate for the same crop in the market is
Rs.90. Then farmer has nothing to do with the price in the market. He will get the payment
from the broker @Rs.100/- bag of crop.

• Suppose the market rate for the same crop is Rs.110/- on that day, then farmer cannot claim
for the higher rate in the market. He will get the payment @Rs.100/- per bag from the broker
as per the agreement.

CONTRACT: It is always between a buyer and seller.

Explanation: To understand in a simpler way, we will consider one example.

• We buy lot many things from the market on cash payment basis, e.g. A shirt, Trouser, Goggle,
Shoes, Mobile etc. We pay 100 % cash to the seller and get the delivery of goods. But when
we buy a Motorcycle, we ask to the dealer for a commonly available Finance Scheme, to buy
the motorcycle.

• What Finance company says, “ The price of Motorcycle is Rs.50,000/-. You pay a 10% down
payment of the value of the goods i.e. Rs.5000/- and take a loan of Rs.45,000/- for the period
of 3 years.

• This is a common incidence in everybody’s life. But just think about it. By paying only
Rs.5000/- (10% of the price of the good ) we start enjoying the fruits of the product.

• For the above said transaction, we do a contract with the Finance company and for that we
always pay a higher amount of Rs.12000 to Rs.15000 which is an interest cost. We can call it
as Financial Leverage.
Actual Trade in Equity and Equity Futures.

Example:

• Reliance Ind. Equity Price is running Rs.980/- and


We want to buy 600 shares of Reliance, we will require
Rs.980 X 600 shares = Rs.5,88,000/-

To Buy a Futures Contract of 600 shares, we will use the following method.

Reliance Futures Price – Rs.985/- X 1 Contract of 600 shares = Rs.5,91,000/-


Rs.5,91,000/- is a CONTRACT VALUE

• We will have to pay approximately 15 % margin money to buy the contract of Reliance
Futures.
Rs.5,91,000 X 15 % = Rs.88,650/- ( It is a margin money* or refundable security deposit )

By paying Rs.88,650/- we can buy or sell the contract.

* Margin Money: The amount that must be deposited in the margin account at the time a
futures contract is traded ( whether it’s a buy or sell )

• How we can do a transaction of Futures ?

Case –1
Reliance Equity Price 980
Reliance Future Price 985
• When share price increases the Futures price increase, in following manner:
Market Price Transaction Type Price Reached

Reliance Equity Price 980 Buy -----------  990

Reliance Future Price 985 Buy ------------ 995


Notes:

When share price reaches from 980 to 990 and if we sell the shares then there will be a profit
of Rs.5.That means Rs.5 X 600 shares = Rs.3000 is a profit booked.

When Future price reaches from 985 to 995 and if we sell the contract then there will be profit
of Rs.5. That means Rs.5 X 1 contract of 600 shares = Rs.3000 is a profit booked.

After selling the contract, person will get back the Margin money and profit.

• What is the difference?

We have made profit of Rs.3000 after buying shares of Rs.5,88,000/- and

Made a profit of Rs.3000 after buying a contract by paying Rs.88,650/-

Short Sell in Shares

There is a system available on NSE that, if the share price is going down that a person can
sell the shares first, without having a delivery in his De-mat account, and buy it on the lower
side. But it is mandatory that the person who has sold the shares first, should buy the share
irrespective of the share price before 3.30 pm ( Before the market gets closed ).

• Short Sell in Contracts

A person can sell the contract first and there is no need to buy it before the market gets closed
on the same day. He can keep open the contract for the next day.
See the Example:

Case - 2

• When the share price decreases the Futures price decrease, in following manner

Market Price Transaction Type Price Reached

Reliance Equity Price 980 Short Sell ---------- 970


(Buy shares same day if there is no delivery of shares)

Reliance Future Price 985 Short Sell ----------- 975


( No need to buy the contract on same day )

Same profit can be made as we have seen in Case – 1

• CONTRACT FEATURES:

• The contract is having a fixed maturity or expiry day.

• The contract is not having any kind of delivery like shares. The contract can be sold within a
day or next day, after two days and on or before the expiry day.

• A person can do any number of transactions on or before the expiry day.

• If the market is going down, a person can sell the contract first and keep it open up to the
expiry day.

• For this contract Splits / Bonus / Dividends will not be applicable.


This is only a contract.
• EXPIRY OF CONTRACTS

• It is the date or day, specified in the futures contract. On NSE ( National Stock Exchange ) it is
the last Thursday of every month. That means if a person buy or sell the contract, he can keep
it open up to last Thursday of every month before 3.30 pm.

• It is mandatory that a person who has taken the position in Futures, he should complete the
transaction on or before the expiry day.

• On NSE ( National Stock Exchange ) futures contracts have one month, two months and three
months expiry cycles which expires on the last Thursday of every month.

Example:
Contracts Expiry

1st Month Contract ( August 08 ) Last Thursday of August 08

2nd Month Contract (September 08 ) Last Thursday of September 08

3rd Month Contract ( October 08 ) Last Thursday of October 08

A person can buy a contract of September 08 and can sell today or tomorrow. He need not have to
wait up to the last Thursday of the September 08. Same is with October 08.

It is not mandatory to wait up to last Thursday of every month. Only advantage to this is that a person
gets more time when he trade second or third month contract.

MARKET LOTS

Contracts are available for trading on lot basis. That means, one has to trade the contract ( Buy or
Sell ) only on lot basis.
e.g. Reliance Ind’s contract is having a market lot 600 shares. One has to Buy the contract of 600
shares and sell the same contract with 600 shares. One cannot break the lot size.
NSE has decided the market lots of the shares available in Derivative trading. The market lots are
decided on the basis of Share price and its fluctuations.

Some of Market Lots available on NSE:

Company Name Market Lot

Reliance Industries 600


Satyam Computers 600
Tisco 625
Tata Motors 825
Bhel 300
Suzlon 400
Maruti 800
NTPC 3250
Cipla 2500
SBI 500
NIFTY 100

Not all the companies listed on Exchanges are available for Derivative trading. 130* companies are
available for trading in Derivative. The list will of those companies is available at any Broking House or
it is available in Economic Times or Business Standard newspaper.

NIFTY FUTURES ( INDEX FUTURES ) & STOCK FUTURES

• Index Futures are derivative contracts, which derive their value from an underlying index. And
Stock Futures are derivative contracts, which derive their value from an underlying stock.

• The two most popular index Derivatives are Index Futures and Index Options. Index
derivatives have become very popular worldwide. Index derivatives offer various advantages.

• Therefore, we can say that NIFTY ( Index ) Futures price is derived from the underlying NIFTY
price. In short NIFTY is considered as a share, and one can take advantage of NIFTY
movement.
MARK - TO - MARKET DAILY SETTLEMENT

SETTLEMENT : When we trade any contract ( Buy or Sell ), the transaction has to completed on or
before the expiry of the contract. It is called as settlement. In short the transaction is complete.

MARK - TO - MARKET :

In the Futures market, at the end of each trading day, the margin account is adjusted to reflect the
investor’s gain or loss depending upon the futures closing price. This is called market – to - market.

Explanation:

If we buy Reliance Ind 600 shares @ Rs. 980 and the share price goes down say by Rs.10/- then we
say, we are having a notional loss of 600 shares X Rs.10= Rs.6000

EQUITY MARKET

Reliance Ind. Bought 600 shares @Rs.980

Reliance Ind. Share price gone down to Rs.970

Loss to - Reliance Ind. 600 shares X Rs. 10/- = Rs.6000/-

To Buy the shares we give 100 % money means full payment.

FUTURES MARKET
If the Reliance share price goes down, the Future price will also go down. As we have seen that the
Future price is derived from the share price.

Reliance Ind. Bought 1 Contract of 600 shares @Rs.985

Reliance Ind. Future contract price will go down to Rs.975

Loss to - Reliance Ind. 1 Contract of 600 shares X - Rs. 10/- = - Rs.6000/-


But this loss we have to pay to NSE through broker after the market is closed. Because we have paid
only 15 % margin money to trade the contract ( Buy or Sell ).

If Reliance share price will go done tomorrow by another Rs.10/- then again we will have to pay a loss
Rs.6000/-

Reliance Ind. Bought 1 Contract of 600 shares @Rs.985

Reliance Ind. Future contract price will go down to Rs.975

Reliance Ind. Future contract price will go down to Rs.965

Loss to - Reliance Ind. 1 Contract of 600 shares X - Rs. 10/- = - Rs.6000/-

Therefore, total loss paid is Rs.12000/-

Conclusively, whatever the share price will go down, we will have to pay the loss.

When the share price will rise again, Future price will also rise and when it will cross the price at which
we have bought the Future, the loss will be credited to our account. And when we will sell the contract
in profit, we will get back our Margin money ( Refundable security Deposit ) + Profit + Loss paid.
See the example as under:

Reliance Ind ( Share ) Rs.985


Reliance Ind (Future ) Rs.990 Sell
------
Reliance Ind (Share ) Rs.960

Reliance Ind. Bought 1 Contract of 600 shares @Rs.985 Rs.6000 Credited

Reliance Ind. Future contract price will go down to Rs.975 Rs.6000 Credited

Reliance Ind. Future contract price will go down to Rs.965


The Funds will be returned to us as under:

• Margin Money (Refundable Security Deposit) = Rs.88,650 /- *

Reliance Futures Price – Rs.985/- X 1 Contract of 600 shares = Rs.5,91,000/-


Rs.5,91,000/- is a CONTRACT VALUE

Rs.5,91,000 X 15 % = Rs.88,650/- ( It is a margin money* or refundable security deposit )

Profit = Rs.3000/-

Sold the Future @990 – Bought the Future @985 = Rs.5/-


Rs.5 X 600 (Market Lot) = Rs.3000/-

• Loss Paid = Rs.12000 /-

Bought the Future @Rs.985 – Future Price gone down to Rs.965/- = Rs.20/-
Rs.20 X 600 (Market Lot) = Rs.12000/-

Therefore,
Margin Money + Profit + Loss Paid Mark to Market

Rs.88,650 + 3000 + 12000 = Rs.1,03,650/-

Here the transaction is complete.

The above said transaction will help you to understand the MARK – TO – MARKET daily settlement
and how the transaction will be completed.
• ARBITRAGE

We have seen market players in the Chapter 1. They bring lot of funds to the market. Their view
towards the trading is that they should not go in losses. Arbitrage is such a kind of transaction, which
helps the market players to safeguard their positions in Equities. Means they should be able to take
exit from the equities, and their losses should be covered.

To the conclusion, we will say that the FUTURES & OPTIONS are the two Financial Instruments
designed to take care of the positions in equity market.

COST OF CARRY

“The relationship between futures prices & spot prices can be summarized in terms of what is
known as the Cost of Carry”. This measures the storage cost plus the interest cost plus the interest
that is paid to Finance the asset less the income earned on the asset.

Explanation

We can see the prices of spot (Share) & Future running in the market at different prices. The
difference between the spot (Share) price & Future price is called as “Cost of Carry”. The Future price
can be more or less than the spot price.

Example :

Case – I
Reliance Ind. Share price 980

} Difference is + Rs.5 = Cost of Carry

Reliance Ind. Future Price 985

( In above case Future price is more than the spot price. When the future price is more than spot price
then futures will be called as – they are in Premium )
Case – II

Reliance Ind. Share price 980

} Difference is - Rs.5 = Cost of Carry

Reliance Ind. Future Price 975

( In this case Future price is less than the spot price. When the Future price is less than the spot price
then Futures will be called as – they are in Discount. )

ARBITRAGE

First , We will consider the Case – I


( When the cost of carry is more than spot price. )

Market players can see very easily this difference and they take advantage for their trade. There is
always a risk when buying in shares, irrespective of the market directions. Therefore, they buy shares
at current price and sell Futures at higher price.

Example:

Case – I

Reliance Ind. Share price 980 - Buy in shares

Reliance Ind. Future Price 985 - Sell in Future

The market players take both the positions at a time. That means they Buy shares in anticipation with
the share price to go up & Sell future in anticipation with the share price to go down.
We will see what happens when market goes up.
UPSIDE Market goes
Up Share price reached
Reliance Ind. Share price 980 - Buy in shares 990 --- Shares Sold in profit
Future price reached
Reliance Ind. Future Price 985 - Sell in Future 990 --- Stop Loss

Result : Reliance Ind Share transaction profit = Rs.10


Reliance Ind Future transaction loss = Rs.5
========
Net Gain = Rs.5

Explanation: After buying the shares @Rs.980, players will sell the shares @ Rs.990. When share
price will rise, future price will also rise. But future is already sold @Rs.985. Therefore, they will start
making loss, so they will use a stop loss ( Stop loss is a concept, means Future contract will be settled
jus tr Rs.5 loss on upside ) for the future.

Downside:
Why Future contract sold ? : At the time of buying the shares, players have considered the
downside risk also. Therefore, they have sold the future contract on higher price.

We will see what happens when market goes down.


DOWNSIDE Market goes
Down Share price reached
Reliance Ind. Share price 980 - Buy in shares 970 --- Shares Sold in loss
Future price reached
Reliance Ind. Future Price 985 - Sell in Future 970 --- Settled the contract
on Lower side
Result : Reliance Ind Share transaction Loss = Rs.10
Reliance Ind Future transaction Profit = Rs.15
========
Net Gain = Rs.5
Explanation:

After buying the shares, if market goes down then the players will sell the shares using s stop loss
means exit from the shares. At the same time they have sold the futures con higher price; so they will
settle (Buy) the contract on lower level (lower price).

CONCLUSION:

• The ARBITRAGE will help the market players to take easy exit from the shares as their loss is
already considered in Future contract.

• The important point to be considered is that the Future contract is a financial instruments
introduced in the market to take care the loss in shares.

• ARBITRAGE is widely used by market players like HNIs ( High Networth Individuals ), FIs
( Indian Financial Institutions ) FIIs ( Foreign Institutional Investors ), MF ( Mutual Funds ) etc.

• In another way, it is called as COVERED POSITION. Cover for the anticipated loss in shares.

• REVERSE ARBITRAGE

Now, we will consider the Case – II


( When the cost of carry is less than spot price. )

Case – II

Reliance Ind. Share price 980

} Difference is - Rs.5 = Cost of Carry

Reliance Ind. Future Price 975


( In this case, Future price is less than the spot price. When the Future price is less than the spot price
then Futures will be called as – they are in Discount. )

In the following case the cost of carry is less. Therefore, players will Sell in Shares and Buy in Future,
irrespective of the market directions. They will take positions at a time in following manner.

Reliance Ind. Share price 980 - Sell in shares

Reliance Ind. Future Price 985 - Buy in Future

Note: The above said transaction will be generally carried out Intra-day. If the player is having delivery
to his De Mat account then he can mark delivery after the market is closed, but if is carrying any
delivery of shares then he will have to complete the transaction before the market is closed.

The transaction will be exactly opposite to the Case – I.

We will see what happens when market goes up.


UPSIDE Market goes
Up Share price reached
Reliance Ind. Share price 980- Sell ( Short Sell ) in shares 985 Shares Bought in Loss

Future price reached


Reliance Ind. Future Price 985 - Buy in Future 990 Future Sold in Profit

Result : Reliance Ind Share transaction Loss = Rs.5


Reliance Ind Future transaction Profit =Rs.10
========
Net Gain = Rs.5

Explanation: After selling the shares @Rs.980, players will buy the shares @ Rs.985 using a stop
loss on higher levels. When share price will rise, future price will also rise. But future is already bought
@Rs.985. Therefore; they will start making profit, so they will sell Future @Rs.990/-.
Downside:
Why Shares are sold ? : At the time of buying the future contract, players have considered the
downside risk also. Therefore, they have sold the shares on higher price.

We will see what happens when market goes down.


DOWNSIDE Market goes
Down Share price reached
Reliance Ind. Share price 980- Sell (Short Sell ) in shares 970- Shares bought in profit

Future price reached


Reliance Ind. Future Price 985 - Buy in Future 980 Sold the contract
on Lower side using stop loss
Result : Reliance Ind Share transaction Profit = Rs.10
Reliance Ind Future transaction Loss = Rs.5
========
Net Gain = Rs.5

Explanation:

After selling the shares, if market goes down then the players will buy the shares using in profit means
covering the position in shares. At the same time they have bought the futures contract on lower price;
so they will sell the contract on lower level (lower price).

UNCOVERED OR NAKED TRADES IN FUTURES

• We have seen the ARBITRAGE, which is also called as covered transaction. But market
players go with a speculative transaction mode also. That means they only predict the share
price to go up & buy future contract or they predict the share price to go down & sell future
contract. This is called as uncovered or naked trade. To the conclusion futures are traded
without buying the shares.

• Those trades carry lot of risk. If your decision goes wrong then immediately loss will start and
you will have to keep the funds ready to pay the mark – to – market.
OPEN INTEREST

When a person trade a contract, buy or sell and not settles before the market is closed, then that
contract is open for selling or buying respectively, for the next day. Therefore, the total number of
contracts remained open for trading is called as open interest.

MARKET WIDE LIMIT

The market wide limit of open position on Futures & Option Contracts on a particular stock should be
lower of 30 times the average number of shares traded daily during the previous calendar month or
20% of the number of shares held by non-promoters in the relevant security i.e. free float market cap.

This limit is applicable on al open positions in all futures & options contracts on a particular stock. The
enforcement of the market wide limits is done in the following manner.

a) At the end of the day ( after market is closed ) the exchange tests whether the market
wide open interest for any scrip exceeds 95% of the market wide position limit for that
scrip. In case it does so, the exchange takes note of open position of all clients as at
the end of that day for that scrip & from next day onwards they can trade only to
decrease their positions through offsetting positions.

b) The normal trading in the scrip is resumed after the open outstanding position comes
down to 80% or below of the market wide position limit. Further, the exchange also
checks on a monthly basis, whether a stock has remained subject to ban on new
position for a significant part of the month consistently for three months. If so, then the
exchange phases out derivative contracts on that stock.

FINAL SETTLEMENT

The final settlement of the futures contract is similar to the daily settlement process except for the
method of computation of final settlement price. The final settlement profit / loss is completed as the
difference between trade price or the previous day’s settlement price, as the case may be & the final
settlement price of the relevant futures contract. Final settlement loss / profit amount s debited /
credited on T + 1 day (T= Expiry day )