Department of Applied Economics and Commerce, Patna University, Patna Financial Derivatives Paper Code: MBFC 44 MBA Semester IV Finance Specialisation HIGHLIGHTS The era of derivatives trading in India began with the amendments in the SCRA in the month of December 1999. The amendment was to include the derivatives (options, futures, forwards, swaps, etc.) in the ambit of ‘securities’ along with this a regulatory framework was also framed for the trading of derivatives on the regulated exchanges. Derivatives trading commenced in the month of June 2000 only after a notification by SEBI in the month of May 2000 which provided detailed guidelines for the trading and settlement of derivatives in the system of BSE and NSE. The committees headed by Dr. L.C. Gupta and another under the chairmanship of Prof. J. R. Varrna Were constituted to recommend the necessary changes required for the implementation of the derivatives trading in India, In India it has been launche: the year 2008 by The Stock Exchange Mumbai(BSE) and MCX. Initially, only futures transactions have been launched in USD by BSE. An exchange traded futures is a contract between two parties to buy or sell the underlying asset for settlement on a future date. As it is exchange traded certain parameters are regulated by the exchange where it is traded, these are like lot size, contract duration, value date and margin deposit. Duration of the contract is monthly maturities from 1 to 12 months, ie. at a time transaction for ‘twelve month duration would be available with an interval of one month. Itwas the year 1991 when government Set,Kabra committee under the chairmanship of Prof. K. N. Kabra to suggest a framework for the introduction of commodity futures in a well structured are regulated environment. After considering the recommendations government resolved in its budget of the year 2002-03 to introduce nationwide commodity and derivatives exchanges on the lines of Kabra committee suggestions. ‘There are three major commodity exchanges on the national level namely * National Commodity & Derivatives Exchange of India Limited (NCDEX) ‘© Multi Commodity Exchange of India Limited (MCX) * National Multi Commodity Exchange of India Limited (NMCE) At present the following for categories of commodities are traded on the commodit using futures transactions only «Agricultural products exchanges by 1[Page OUAHNeU WILT Gd oc* Precious metal * Other metal * Energy Derivatives Market in India The era of derivatives trading in India began with amendments in the Securities Contract Regulation Act (SCRA) in December, 1999.The The amendment was to include the derivatives (options, futures, forwards, swaps, etc.) in the ambit of ‘securities’. Along with this, a regulatory framework was also framed for the trading of derivatives on the regulated exchanges. The amendments provided that derivatives trading in India shall be valid only if it is traded on a recognized stock exchange. The effect of this amendment was that, derivatives were regarded equivalent to other securities and now, could be traded and settled as any other eligible security is traded and settled on recognized stock exchanges in India. The amendment also provided that a proper trading and settlement system is to be placed in order to provide for orderly trading and settlement of trades in derivatives. Derivatives trading commenced in June 2000, only after SEBI sent a notification in May 2000.This provided detailed guidelines for trading and settlement of derivatives in the system of BSE and NSE.To give effect to this, a separate segment at these two exchanges was developed as futures and options (F & O) segment for trading in stock derivatives and index derivatives. Prior to this, two committees were setup by SEBI -one under the chairmanship of Dr. L. C. Gupta and other under the chairmanship of Professor J. R. Varma — to recommend the necessary changes required for the implementation of derivatives trading in india in an organized manner. The scope of the committees was to suggest a system for trading, clearing and settlement, margin, position limits, brokers net worth, membership criterion, surveillance, etc. The recommendations of experts resulted in starting derivatives trading in india. Contracts in index option were started in June 2000 on BSE and in June 2001 on NSE.Futures contracts on individual stocks were started in November 2001. Derivatives Derivatives are instruments, the value of which depends on the underlying asset on which it is created. These underlying assets may be commodity, currency, securities (shares and debentures) or index. The most common derivatives are: © Option Contracts e Future Contracts Forward Contracts «Index Future © Swaps Derivatives are used for different purposes - to hedge the risk arising from an investment made in the underlying asset, to speculate in the underlying asset and gain from fluctuations in prices, to create synthetic products. These are also used to make investment strategies for 2|Page Scanned with CamScsafe and 'sk-free investment. The derivatives like option contracts offer two benefits, /.¢ protection from risk of loss, that too at a nominal cost of the premium and a chance to have unlimited gain from the fluctuating prices of the underlying asset. Similarly, futures provides for counterbalancing risk arising from a commitment and swap provides a chances to have loan at the lowest possible rate of interest. Trading in these instruments involves high degree of risk. Therefore all the transactions are regulated by stock exchange rules in case of securities, and in case of commodity it is regulated by the rules of the concerned commodity exchange. The regulation and intervention of exchange is mainly to eliminate/minimize counter party risk. For all the exchange traded derivatives, exchange happens to be the counter party. Exchange mainly regulates the following: * Decision about the underlying assets in which transactions are to be done © Margin requirements * Type of derivatives offered + Settlement of transactions ¢ Lot size Option contracts It is an agreement between two parties, whereby exchange of the commitment takes place to buy or sell the underlying asset. On the date of contract, buyer of the contract buys the commitment of another party(seller of the option) to buy or sell the underlying asset on some pre-specified future date. The terms and conditions of the contract are decided mutually, by both the parties on the date of transaction. In case of exchange traded options, the following is regulated by exchange: * Underlying asset © Lotsize * Strike date/expiration date ‘© Margins In these transactions, the buyer of the option always has the right to buy/sell the underlying asset without any obligation towards the seller of the option. For this he has to pay premium upfront, to seller of the option, whereas the seller of the option has only the obligation to honour his commitment but no rights to claim any thing against the buyer about the of the option. Option contracts are like insurance about the price at which deal can be executed by simply paying a premium. Following are the futures of these transactions: © Strike Price/Exercise Price Strike Date/Exercise Date + Premium * Call Option versus Put Option American versus European Option ‘* Expiration of the option © Margin Deposit Status of Option Contract 31Page Scanned with CamScPay-ofts from option contracts Pay-off option contracts are generally viewed from the angle of the buyer of option contract; it is nothing but the gain or loss arising from the option contract and splited into two: * Intrinsic value © Time value FIGURE 01 Graph Showing Pay-off of Long on Call option Profit nN Pay offline +15) 970 985 1000 4015 Price of underlying share 15 Loss scanned with LamscFIGURE 02 j Graph Showing Pay-off of Long on put option Profit Pay offline Price of Underlying share Loss Intrinsic value Intrinsic value of an option is the base, which helps in fixing the premium, as well as creating a demand for the option. It is the difference between spot price and strike price; it is present. only when an option is ‘In-the-money’, otherwise it is zero. Intrinsic Value of call option = Spot Price - Strike Price Intrinsic value of put option = Strike Price - Spot Price ‘The moment intrinsic value of an option increases, the premium charged for this increases too because of the rising demand for such option contracts and vice-versa Time Value It is the absolute difference between intrinsic value and option premium, which results in net gain/loss for the buyer of the option. If it is positive for the buyer of the option, then it will be negative for the seller of the option. This is called time value because the seller of the option is ready to pay this amount for the time gap between current time and exercise date. Factors Affecting Price of Option Contract Premium paid by the buyer of the option is called option price. Although this price fixation is done mutually by both the parties according to the demand and supply position, the following factors play a critical role in deciding price of these: S|Page Scanned with CamSc1, Volatility 2. Expiration date 3. Strike price 4. Market trends 5. Dividend 6. Interest rate Futures Contracts These are the transactions in which two parties decide the price and quantity for buying or selling an underlying asset. All parameters of an underlying asset are decided on the date of transaction with the understanding to settle the transaction on some pre-specified future date. In case of exchange traded futures transaction, various parameters like duration of transaction, lot size, value date and underlying asset are decided by the exchange. These transactions are entered for one/two/three duration with value date being the last Thursday of the respective month. In the Indian stock market, only about 100 to 125 securities have been specified for futures transactions. Both the buyer and seller of this are required to deposit margin with the stock exchange. The rules for margin deposit are decided by the stock exchange, which keep on changing from time to time. [ FIGURE 03 Graph Showing Pay-off of short on futures Profit, Pay-off line +15) 970 985 1000 1015 Price of underlying share -15) Loss 6|Page Scanned with CamSc[_Ficure oa | Graph Showing Pay-off of Long on futures Profit Pay-off ine—_, +15 970 985 1000 1015 Price of underlying share -15) Loss Features of Futures Contract 1. Underlying Asset Exercise Price Duration and Value Date Margin Settlement ‘Square up Position Standardised No Expiration penanawn Forward Contracts These transactions are meant for buying or selling an underlying asset — shares. Herein a transaction is done in the present, with the settlement taking place on some future date decided mutually by the parties. All the critical parameters of the transaction are decided by the parties mutually, and hence, these are non-standardized (customised). Both the parties decide about the underlying asset, exercise price, value date, and quantity without any intervention of the exchange. Transactions are reported to the exchange to give these a validity mark and to provide coverage for counter party risk. Netting of these transactions is difficult 7\Page OUCAHNEU WILT UdIIOUdue to customization; each transaction is settled individually, These transactions are done on “over the counter exchange (OTC)". Both parties are required to deposit margin according to the rules of the exchange and both have rights as well as obligation, Features of Forward Transaction 1. Underlying Asset Exercise Price Duration and Value Date Margin Settlement Square up Position Customised No Expiration Index Futures Index futures is a transaction to buy or sell a particular index, for which a transaction is entered in the present with the settlement date in futures. It is like any other futures contract with the only difference that here, underlying asset is an index. All parameters of the contract are specified by the stock exchange, except strike price and the choice of duration of the contracts, Due to this, it is called standardized product. These are pure speculative tools and also used to hedge risk. Since the underling asset (index) can not be executed for delivery by any one, all transactions are settled through differences on the value date. The settlement is done by exchanging a money value, which is equal to certain times (50 or 200), of the difference between the transacted index (A) and the actual index on the value date (B). Ifthe difference between ‘A’ and ‘8’ (A-B) is negative, then buyer of the futures receives the money and the seller pays it, and vice-versa when it is positive. In case of BSE SENSEX, the difference is multiplied with 25 and in case of NIFTY, it is multiplied with 50, as lot size of BSE Sensex is 25 and of Nifty is 50. Features of Index Futures Absolute derivative product A tool to speculate A tool for hedging the risk Settlement by differences Based on widely accepted index Regulated by stock exchange Margin Deposit Open interest exon eene Derivatives Trading at National Stock Exchange of India (NSE) The Futures and Options (F&O) segment called NEAT-F&O trading system is a fully-automated trading system for index options & futures, as well as for stock options & futures. The system is similar to the capital market system for trading of individual shares in the cash market. It provides for online order entry, automated matching, confirmation, order and trade management. It can be considered as efficient as in practice for capital market cash segment. 8lPage OCdHNHEU WILT Ud I1ocThe identity of clients and brokers is not disclosed on the screen. The system provides real-time display of quotes and related information. The order entry is allowed only for brokers of the F&O segment; for this separate membership is required even for the existing capital market members, Ashim Lal Chakraborty Cell Phone No. - 9431492750 Mail ID - ashimlalchakraborty@yahoo.com Books Recommended for Reading 1, Security Analysis and Portfolio Management by Dhanesh Khatri, Macmillan Publishers India Ltd. 2. Security Analysis and Portfolio Management by Punithavathy Pan House Pvt. Ltd., Noida -201301 (UP) n, Vikas Publishing, Scanned with CamSc