CHAPTER 10: UNDERSTANDING DERIVATIVES

LEARNING OBJECTIVES:

After studying this chapter, you should know about:

 Basics of Derivatives
 Underlying concepts in derivatives
 Types of derivative products
 Structure of derivative markets
 Purpose of Derivatives
 Benefits, Costs and risks of Derivatives
 Equity, Currency and Commodity derivatives
 Derivative markets, products and strategies

10.1 Basics of Derivatives

Derivative is a contract or a product whose value is derived from the value of some other
asset known as underlying. Derivatives are based on a wide range of underlying assets such
as metals (Gold, silver etc.), energy resources (oil, coal, gas etc.), agri commodities (wheat,
coffee) and financial assets (shares, bonds).

In the Indian context the Securities Contracts (Regulation) Act, 1956 [SC(R)A] defines
"derivative" to include-

1. 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.
2. A contract which derives its value from the prices, or index of prices, of underlying
securities.
Derivatives are securities under the SC(R)A and hence the trading of derivatives is governed
by the regulatory framework under the SC(R)A.
The term derivative has also been defined in section 45U(a) of the RBI Act 1934 as follows:
An instrument, to be settled at a future date, whose value is derived from change in interest
rate, foreign exchange rate, credit rating or credit index, price of securities (also called
“underlying”), or a combination of more than one of them and includes interest rate swaps,
forward rate agreements, foreign currency swaps, foreign currency-rupee swaps, foreign
currency options, foreign currency-rupee options or such other instruments as may be
specified by RBI from time to time.

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10.2 Underlying concepts in derivatives
Zero Sum Game
In a futures contract, the counterparties who enter into the contract have opposing views and
needs. The seller of gold futures thinks prices will fall, and benefits if the price falls below the
price at which she entered into the futures contract. The buyer of gold futures thinks prices
will rise, and benefits if the price rises beyond the price at which she has agreed to buy gold
in the future. On maturity the market price of the underlying would be same for both the
futures contracts, leading to profits to only one of them. But when the net positions of the
both the buyer and seller are considered, it always amounts to zero. Hence the word Zero
Sum Game suits appropriately to describe the net positions of derivative instruments.
However, there are the two usual assumptions to this conclusion, that there are no taxes and
no transaction costs.
Settlement Mechanism
Earlier most derivative contracts were settled in cash. Cash settlement is a settlement method
where upon expiration or exercise of the derivatives contract, the counterparties to the
contract settle their position through exchange of the price differentials and do not deliver
the actual (physical) underlying asset.
However, SEBI has mandated physical settlement (settlement by delivery of underlying stock)
for all stock derivatives i.e. all the stock derivatives which are presently being cash settled
shall move compulsorily to physical settlement in a phased manner. The stock exchanges have
initiated the transition from cash settlement to physical settlement based on the criteria
notified by the relevant SEBI circulars.
Margining Process
Margin is defined as the funds or securities which must be deposited by Clearing Members as
collateral before executing a trade. The provision of collateral is intended to ensure that all
financial commitments related to the open positions of a Clearing Member can be offset
within a specified period of time.
There are different kinds of margins. The initial margin is charged to the trading account on
the assumption that the position will be carried out till the expiry of the contract. The initial
margin has two components; SPAN 11 margins and ELM (extreme loss margin) margins based
on exposure. Both margins have to be mandatorily deposited before taking a trade. The initial
margin should be large enough to cover the loss in 99 per cent of the cases. The greater the
volatility of the stock, greater the risk and, therefore greater is the initial margin.

11The margin calculation is carried out using a software called - SPAN® (Standard Portfolio Analysis of Risk). It is a product
developed by Chicago Mercantile Exchange (CME) and is extensively used by leading stock exchanges of the world.

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In addition to Initial Margin, a Premium Margin is charged to trading members trading in
Option contracts.
The premium margin is paid by the buyers of the Options contracts and is equal to the value
of the options premium multiplied by the quantity of Options purchased.
Open Interest
Open interest is commonly associated with the futures and options markets. Open interest is
the total number of outstanding derivative contracts that have not been settled. The open
interest number only changes when a new buyer and seller enter the market, creating a new
contract, or when a buyer and seller meet—thereby closing both positions. Open interest is a
measure of market activity. However, it is to be noted that it is not trading volume. Open
interest is a measure of the flow of money into a futures or options market. Increasing open
interest represents new or additional money coming into the market while decreasing open
interest indicates money flowing out of the market.

10.3 Types of derivative products

The four commonly used derivative products are Forwards, Futures, Options and Swaps.
10.3.1 Forwards

Forward contract is an agreement made directly between two parties to buy or sell an asset
on a specific date in the future, at the terms decided today. Forwards are widely used in
commodities, foreign exchange, equity and interest rate markets.

Let us understand with the help of an example. What is the basic difference between the cash
market and forwards? Assume on March 9, 2018 you wanted to purchase gold from a
goldsmith. The market price for gold on March 9, 2018 was Rs. 30,425 for 10 gram and
goldsmith agrees to sell you gold at market price. You paid him Rs. 30,425 for 10 gram of gold
and took gold. This is a cash market transaction at a price (in this case Rs. 30,425) referred to
as spot price.

Now suppose you want to agree to buy gold on March 9, 2018, but take delivery of the same
and pay for the same only after 1 month. Goldsmith quotes you Rs. 30,450 for 10 grams of
gold to be delivered after 1 month. You agree to the forward price for 10 grams of gold and
go away. There is no exchange of money or gold on March 9th, 2018. After 1 month, you come
back to the goldsmith pay him Rs.30,450 and collect your gold. This is a forward, where both
the parties are obliged to go through with the contract irrespective of the value of the
underlying asset (in this case gold) at the point of delivery. Here, in this example, you have
bought forward or you are long forward, whereas the goldsmith has sold forwards or short
forwards.

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In other words, Forwards are bilateral over-the-counter (OTC) transactions where the terms
of the contract, such as price, quantity, quality, time and place are negotiated between two
parties to the contract. Any alteration in the terms of the contract is possible if both parties
agree to it. Corporations, traders and investing institutions extensively use OTC transactions
to meet their specific requirements. The essential idea of entering into a forward is to fix the
price and thereby avoid the price risk. Thus, by entering into forwards, one is assured of the
price at which one can buy/sell an underlying asset.

Major limitations of forward contracts

Liquidity Risk

As forwards are tailor made contracts i.e. the terms of the contract are according to the
specific requirements of the parties, other market participants may not be interested in these
contracts. Forwards are not listed or traded on exchanges, which makes it difficult for other
market participants to easily access these contracts or contracting parties.

Counterparty risk

Counterparty risk is the risk of an economic loss from the failure of counterparty to fulfil its
contractual obligation. For example, A and B enter into a bilateral agreement, where A will
purchase 100 kg of rice at Rs.20 per kg from B after 6 months. Here, A is counterparty to B
and vice versa. After 6 months, if the price of rice is Rs.30 in the market then B may forego his
obligation to deliver 100 kg of rice at Rs.20 to A. Similarly, if the price of rice falls to Rs.15 then
A may purchase from the market at a lower price, instead of honouring the contract. Thus, a
party to the contract may default on his obligation if there is incentive to default. This risk is
also called default risk or credit risk.

In addition to the illiquidity and counterparty risks, there are several issues like lack of
transparency, settlement complications as it is to be done directly between the contracting
parties. Simple solution to all these issues lies in bringing these contracts to the centralized
trading platform. This is what futures contracts do.

10.3.2 Futures

Futures markets were innovated to overcome the limitations of forwards. A futures contract
is an agreement made through an organized exchange to buy or sell a fixed amount of a
commodity or a financial asset on a future date at an agreed price. Simply, futures are
standardised forward contracts that are traded on an exchange. Exchange becomes
counterparty to both buyer and seller of a futures contract through a clearing house. Futures
create an obligation on both buyer and seller’s part. The terms of the contract are specified
by the exchange and are subjected to change as and when necessary. The clearing corporation

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associated with the exchange guarantees settlement of these trades. A trader, who buys
futures contract, takes a long position and the one, who sells futures, takes a short position.
The words buy and sell are figurative only because no money or underlying asset changes
hands, between buyer and seller, when the deal is signed.

Features of futures contract

In the futures market, exchange decides all the contract terms of the contract other than
price. Accordingly, futures contracts have the following features:

 Contract between two parties is through Exchange

 Centralised trading platform i.e. exchange
 Price discovery through free interaction of buyers and sellers
 Margins are payable by both the parties
 Quality decided today (standardized)
 Quantity decided today (standardized)

10.3.3 Options

An Option is a contract that gives its buyers the right, but not an obligation, to buy or sell the
underlying asset on or before a stated date/day, at a stated price, for a premium (price). The
party taking a long position i.e. buying the option is called buyer/ holder of the option and the
party taking a short position i.e. selling the option is called the seller/ writer of the option.
The option buyer has the right but no obligation with regards to buying or selling the
underlying asset, while the option writer has the obligation to its commitment in the contract.
Therefore, option buyer/ holder will exercise his option only when the situation is favourable
to her, but, when she decides to exercise, option writer is legally bound to honour the
contract. Options are of mainly two types—Call and Put:

Option, which gives buyer a right to buy the underlying asset, is called Call option and the
option which gives buyer a right to sell the underlying asset, is called Put option.

The options can be given names like In-The-Money, At-The-Money, and Out-of-The-Money,
depending on whether the strike price of the option is greater, equal, or lesser than the
underlying asset’s market price, respectively. When the underlying asset’s price is greater
than the strike price, in the case of a call option, the investor would benefit by exercising the
option and buy the asset at the strike price, and immediately sell it in the market at a higher
price to enjoy the gain. In the same manner there is no gain in the case of At-The-Money and
there would be a loss in the case of Out-Of-the-Money.

Similarly, there are two connotations of value, namely intrinsic value and time value. Time
value is the excess price a buyer of an option is ready to pay over and above the intrinsic value

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of that option. This is with an intention that the value of the option would increase in the
future, especially when there is adequate time for maturity. Intrinsic value is the excess of the
current price over and above the strike price. Essentially In-The-Money options have positive
intrinsic value and hence can generate gains for option holders.

10.3.4 Swaps

A swap is a contract in which two parties agree to a specified exchange of cash flows on a
future date(s). Interest Rate Swaps and Currency Swaps are most common swaps.

Example:

A borrower has to pay a quarterly interest rate defined as the Treasury bill rate on that date,
plus a spread. This floating rate interest payment means that the actual obligation of the
borrower will depend on what the Treasury bill rate would be over the period under
consideration e.g. six months or one year. The borrower however prefers to pay a fixed rate
of interest.

She can use the interest rate swap markets to get into the following swap arrangement:

• Pay a fixed rate to the swap dealer every quarter

• Receive T-bill plus spread from the swap dealer every quarter

The swap in this contract is that one party pays a fixed rate to the other, and receives a floating
rate in return. The principal amount on which the interest will be computed is agreed upon
between counterparties and is never exchanged. Only the interest rate on this amount is
exchanged on each settlement date (every quarter) between counterparties. The principal
amount is also known as notional amount.

The borrower will use the floating rate that she has received from the swap market and pay
the floating rate dues on her borrowing. These two legs are thus cancelled, and her net
obligation is the payment of a fixed interest rate to the swap dealer. By using the swap market,
the borrower has converted his floating rate borrowing into a fixed rate obligation.

Swaps are very common in currency and interest rate markets. Though swap transactions are
OTC, they are governed by rules and regulations accepted by Swap Dealer Associations.

Role of FIMMDA

FIMMDA stands for The Fixed Income Money Market and Derivatives Association of India
(FIMMDA). It is an Association of Commercial Banks, Financial Institutions and Primary
Dealers. FIMMDA is a voluntary market body for the bond, Money and Derivatives Markets.

The objectives of FIMMDA are:

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 1. To function as the principal interface with the regulators on various issues that impact
the functioning of bond, money and derivatives markets.
2. To undertake developmental activities, such as, introduction of benchmark rates and
new derivatives instruments, etc.
3. To provide training and development support to dealers and support personnel at
member institutions.
4. To adopt/develop international standard practices and a code of conduct in the above
fields of activity.
5. To devise standardized best market practices.
6. To function as an arbitrator for disputes, if any, between member institutions.
7. To develop standardized sets of documentation.
8. To assume any other relevant role facilitating smooth and orderly functioning of the
said markets.

10.4 Structure of derivative markets

A derivative market is formed when different market players interested to manage their price
risks come together and try to secure themselves from the prospective risks that they fear.

In India the following derivative products are available: indices, stocks, interest rates and
commodities. Apart from the above, forward markets for agricultural commodities and swap
markets for interest rates are available in the OTC markets.

OTC Markets

Some derivative contracts are settled between counterparties on terms mutually agreed
upon between them. These are called over the counter (OTC) derivatives. They are non-
standard and they depend on the trust between counterparties to meet their commitment as
promised. These are prevalent only between institutions, which are comfortable dealing with
each other.
Exchange Traded Markets
Exchange-traded derivatives are standard derivative contracts defined by an exchange, and
are usually settled through a clearing house. The buyers and sellers maintain margins with
the clearing-house, which enables players that do not know one another (anonymous) to
enter into contracts on the strength of the settlement process of the clearing house. Forwards
are OTC derivatives; futures are exchange-traded derivatives.

10.5 Purpose of Derivatives

A derivative is a risk management product used commonly in financial investments where
there is market-based price risk due resulting in an unknown future value of the investment.
Derivatives are typically used for three purposes—Hedging, Speculation and Arbitrage.

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Hedging
When an investor has an investment in any asset or portfolio of assets, and further she also
has a desired return or any specific investment objective, then she can use the derivative
markets to protect the desired value of that investment from the risk of future price
movements.
Speculation
A speculative trade in a derivative is not supported by an underlying existing investment in
asset or portfolio. It simply involves implementation of an investment or trading strategy
based on a view about the future prices of the relevant asset underlying the specific derivative
product. For instance, a buyer of a futures contract carries the view that the price of the
underlying asset would move up, and she would gain having bought the futures contract at a
lower price, as of now, because such a view is not reflecting in the current futures price. In
the process the investor has to bear the cost of this long position, which is related to cost
incurred in the management of margins required in the futures contracts.
Arbitrage

The law of one price states that two goods (assets) that are identical, cannot trade at different
prices in two different markets. If not, one would buy from the cheaper market and sell at the
costlier market, and make riskless profits. However, such buying and selling itself will reduce
the gap in prices. The demand in the cheaper market will increase prices there and the supply
into the costlier market will reduce prices, bringing the prices in both markets to the same
level. Arbitrageurs are specialists who identify such price differential in two markets and
indulge in trades that reduce such differences in price. Prices in two markets for the same
tradable asset will be different only to the extent of transaction costs. These costs can include
transportation, storage, insurance, interest costs and any other cost that impacts the
activities of buying and selling.

10.6 Benefits, Costs and risks of Derivatives

The applications of derivatives in hedging, speculation and arbitrage demonstrates the
following key benefits of derivative:

 Enables hedging and better management of risk, by providing various alternative ways
to structure symmetrical and asymmetrical pay offs.
 Enhances the liquidity of underlying markets and reduce overall costs of trading for
cash and derivatives.
 Increases participation, information dissemination and price discovery.

Market Participants must understand that derivatives, being leveraged instruments, have
risks like counterparty risk (default by counterparty), price risk (loss on position because of
price move), liquidity risk (inability to exit from a position), legal or regulatory risk

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(enforceability of contracts), operational risk (fraud, inadequate documentation, improper
execution, etc.) and may not be an appropriate avenue for someone of limited resources,
trading experience and low risk tolerance. A market participant should therefore carefully
consider whether such trading is suitable for him/her based on these parameters. Market
participants, who trade in derivatives are advised to carefully read the Model Risk Disclosure
Document, given by the broker to his clients at the time of signing agreement. Model Risk
Disclosure Document is issued by the members of Exchanges and contains important
information on trading in Equities and F&O Segments of exchanges. All prospective
participants should read this document before trading on Capital Market/Cash Segment or
F&O segment of the Exchanges.

10.7 Equity, Currency and Commodity derivatives

The basic concept of a derivative contract remains the same for all the underlying assets,
whether the underlying happens to be a commodity or currency. When the underlying asset
is a commodity, e.g. Oil or Wheat, the contract is termed a “commodity derivative”. When
the underlying is an exchange rate, the contract is termed a “currency derivative”. Both future
and options contracts are available on commodities and as well as on currencies.

Commodity derivatives
Derivatives have become an integral part of today’s commodity trading and are used for
various types of risk protection and in innovative investment strategies. Commodity
derivatives markets play an increasingly important role in the commodity market value chain
by performing key economic functions such as risk management through risk reduction and
risk transfer, price discovery and transactional efficiency. Commodity derivatives markets
allow market participants such as farmers, traders, processors, etc. to hedge their risk against
price volatility through commodity futures and options.
Commodity Futures contracts are highly uniform and are well-defined. These contracts
explicitly state the commodities (quantity and quality of the goods) that have to be delivered
at a certain time and place (acceptable delivery date) in a certain manner (method for closing
the contract) and define their permissible price fluctuations (minimum and maximum daily
price changes). Therefore, a commodity futures contract is a standardized contract to buy or
sell commodities for a particular price and for delivery on a certain date in the future.
For instance, if a Biscuit manufacturer wants to buy 10 tonnes of wheat today, he can buy the
wheat in the spot market for immediate use. If he wants to buy 10 tonnes of wheat for future
use, he can buy wheat futures contracts at a commodity futures exchange. The futures
contracts provide for the delivery of a physical commodity at the originally contracted price
at a specified future date, irrespective of the actual price prevailing on the actual date of
delivery.

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Futures trading in commodities can be conducted between members of an approved
exchange only. Futures trading in commodities is organized by these exchanges after
obtaining a certificate of registration from the SEBI. The national exchanges in which
commodity derivatives are currently traded in India are: Multi Commodity Exchange of India
Limited (MCX), National Commodity & Derivatives Exchange Limited (NCDEX), Indian
Commodity Exchange Limited (ICEX), National Stock Exchange of India Limited (NSE) and BSE
Limited (Bombay Stock Exchange).
Commodities that are traded on Indian exchanges can be grouped into four major categories:
Bullion, Metals, Energy and Agriculture.

Currency derivatives
Unlike any other traded asset class, the most significant part of the currency market is the
concept of currency pairs. In the currency market, while initiating a trade you buy one
currency and sell another currency. Every trade in FX market is a currency pair: one currency
is bought with or sold for another currency. In case of currency derivatives, the underlying is
an exchange rate. Currency risks could be managed through any of the currency derivatives
i.e. forwards, futures, swaps and options. Each of these instruments has its role in managing
the currency risk.

A currency future, also known as FX 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. Currency Options are contracts that grant the buyer of the option the right, but not the
obligation, to buy or sell underlying currency at a specified exchange rate during a specified
period of time. For this right, the buyer pays a premium to the seller of the option.

Currency Derivatives are available on four currency pairs viz. US Dollars (USD), Euro (EUR),
Great Britain Pound (GBP) and Japanese Yen (JPY). Cross Currency Futures & Options
contracts on EUR-USD, GBP-USD and USD-JPY are also available for trading in Currency
Derivatives segment.

10.8 Derivative markets, products and strategies

Derivative trading was introduced in India in June 2000and turnover has increased
dramatically since then. India's equity derivative markets are thus among the largest in the
world.

Pricing a Futures Contract

The pricing of a futures contract is based on the simple principle of carry cost. Suppose a stock
is selling for Rs.100 in the spot equity markets today. We can buy this stock in the spot market
and the price to be paid is the spot price (S).

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There is another market, namely the equity futures market, where it is possible to trade in
the same stock, for delivery on a future date. Let us say the stock future is selling for Rs. 120,
delivery date being 20 days away. This is the futures price of the same stock (F).

The difference between the two prices is nothing but the interest rate on the money for those
20 days. Therefore, the relationship between the two can be shown as:

120 = 100 + (interest for 20 days)

F = S + carry costs

The logic for such pricing is that given the same amount of information about the stock at a
point in time, there is no arbitrage profit to be made between the spot and the futures
market. The law of one price stipulates that if the same good is traded in two markets, the
price has to be the same, unless there are costs involved in buying in one market and selling
in another. The presence of these costs makes it impossible to make money by buying the
same good in one market and selling it at another.

If the spot price is Rs. 100 and the futures price is Rs. 120, traders would like to buy spot and
sell futures, to take advantage of the difference in price. However, if the cost of borrowing
funds to buy spot and repay the borrowing after selling the futures, is equal to Rs. 20, there
is no profit in the trade.

The difference between the spot and the futures price thus adjusts to the market rates of
interest, for the period between spot and futures delivery. This interest is called as 'carry cost'.

The carry cost is not a risk-free rate or a fixed interest rate, but a market-driven rate that is
driven by the risk assumed by the lenders to the trading position.

The difference between the spot price and the futures price is called basis. If futures trade at
a level higher than spot prices, the basis is positive. The gains to the trader will be equal to
the difference between the two prices. If the trader’s cost of carry is different from the basis,
there is arbitrage profit to be made on the basis.

After the trade, the spot and future prices are bound to change. However, given that opposite
positions have been locked into, that net position will remain unaltered on settlement date.

On settlement date, both the spot and the futures are at the same level. This is known as the
spot-future convergence. The carry cost of buying spot and selling futures on settlement date
is zero, since settlement is on the same day as the contract expiration day. Therefore, on
expiration day, spot and future prices of the same underlying is identical.

Spot-Future Arbitrage
Sometimes the spot price and the futures price for the same stock vary much more than what
is justified by a normal rate of interest (cost of carry). There is then the scope to create equal
but opposite positions in the cash and futures market (arbitrage) using lower cost funds.

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For example, on March 3rd, 2017, stock XYZ was selling in the cash market at Rs. 3,984 and on
the same date, futures (delivery March30 th) were selling at Rs. 4,032.

Buy XYZ in the cash market Rs. 3,984

Sell XYZ futures Rs. 4,032

Difference in prices Rs. 48

Profit from the transaction: (48/3,984) *365/27

= 16.287% p.a.

On the settlement date, the contract will expire and be closed out automatically at the
settlement price. Since opposite positions have been taken in the two markets, the profit is
locked in provided both the positions are closed at the same price, which is possible given the
spot-future convergence at settlement. Arbitrage funds work on this principle.

Option Pay-offs
An option contract features an asymmetric pay-off. The upside and the downside are not
uniform.

The payoff profile of various option positions is explained below.

Long on option
Buyer of an option is said to be “long on option”. As described above, a person would have a
right and no obligation with regard to buying/ selling the underlying asset in the contract.
When you are long on equity option contract:
You have the right to exercise that option.
Your potential loss is limited to the premium amount you paid for buying the option.
Profit would depend on the level of underlying asset price at the time of exercise/expiry of
the contract.
Short on option

Seller of an option is said to be “short on option”. As described above, he/she would have
obligation but no right with regard to selling/buying the underlying asset in the contract.
When you are short (i.e., the writer of) an equity option contract:

 Your maximum profit is the premium received.

 You can be assigned an exercised option any time during the life of option contract
(for American Options only). All option writers should be aware that assignment is a
distinct possibility. In the Indian market it is mostly European Options (on expiry).
 Your potential loss is theoretically unlimited as defined below.
Similarly hedging can be done using futures and options.

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