Technical Note on Derivative Instruments

GLOBAL SCENARIO The era of globalization has brought many innovations to the field of financial engineering. Subsequently, a new set of products known as derivatives emerged in the financial sector. Derivatives can be defined as financial instruments whose returns are derived from underlying assets. In other words, their performance depends on the movement of underlying assets such as commodities, indices, exchange rates, interest rates and so on. The growth of these products in the last 20 years has been one of the most extraordinary and important events in the financial markets. Towards the end of the Second World War, representatives of 44 nations gathered in 1944 in Bretton Woods, New Hampshire, USA and agreed on a fixed exchange rate system that lasted till the early 1970s. Under fixed exchange rate system, the exchange rates of all currencies were fixed against the US dollar. As the US dollar was then convertible to gold at $35 per ounce, all currencies were indirectly fixed in terms of gold. In 1973, the Bretton Woods Agreement collapsed when the US suspended the dollars convertibility into gold. This resulted in the increase of exchange rates and interest rate volatility. Two months before the collapse of Bretton Woods System, the Chicago Mercantile Exchange (CME) launched the worlds first exchange-traded currency future. In 1975, interest rate futures contracts started trading in GNMA-CDRs (Government Nation Mortgage Association Certificates of Deposit Rollover) on the Chicago Board of Trade (CBOT) and in T-Bills on the CME. As the capital markets continued growing, the derivatives market also continued playing a significant role in facilitating investors needs. INDIAN SCENARIO In India, the concept of derivatives is not a new one. In December 1999, the Securities Contract Regulation Act (SCRA) was amended to include derivatives within the sphere of securities and a regulatory framework was developed for governing derivatives trading. The act specified that derivatives shall be legal and valid only if they are traded on a recognized stock exchange, thus precluding Over-the-Counter derivatives. Besides, the government also withdrew in March 2000, the three-decade old notification, which prohibited forwards trading in securities.1 Derivatives trading commenced in India in June 2000 with the approval of the SEBI. Subsequently, derivatives trading on the National Stock Exchange (NSE) started with S&P CNX Nifty Index futures. Futures contracts on individual stocks were launched in November 2001, while trading in index options commenced in June 2001 and trading in options on individual securities began in July 2001. Similarly, trading in BSE Sensex options and options on individual securities commenced in June 2001.

This note is prepared by Prof. C. Anita Raman, Asst. Prof, Finance, IBS Hyderabad for usage of IBS class 2013. @ No part of this publication may be copied, stored, transmitted, reproduced or distributed.

Trading and settlement in derivative contracts is done in accordance with the rules, bylaws, and regulations of the respective exchanges and their clearing house/ corporation duly approved by the SEBI and notified in the official gazette. National Securities Clearing Corporation Limited (NSCCL) is the clearing and settlement agency for all deals executed on the National Stock Exchange (NSEs) futures and options segment. It acts as legal counterparty to all deals on the F&O segment and guarantees settlement. Foreign Institutional Investors (FIIs) are allowed to trade in all exchange-traded derivatives products. Types of Risk Risk in general is the possibility of some unpleasant happening or the chance of encountering loss. The same in the context of financial markets can be termed as uncertainty in future cash flows. This uncertainty arises due to number of factors such as interest rate fluctuations, exchange rate changes, market conditions and changes in prices of commodities etc. The major risks that occur in the financial markets are discussed below: Interest Rate Risk The possibility of a reduction in the value of asset (especially a bond) resulting due to interest rate fluctuations is referred to as interest rate risk. Interest rates affect a firm in two ways by affecting the profits and by affecting the value of its assets or liabilities. For example, a firm that has borrowed money on a floating rate basis faces the risk of lower profits in an increasing interest rate scenario. Similarly, a firm having fixed rate assets faces the risk of lower value of investments in an increasing interest rate scenario. Interest rate risk becomes prominent when the assets and liabilities of a firm do not match in their exposure to interest rate movements. For example, a firm that has fixed rate borrowings and floating rate investments has a higher exposure than a firm having fixed rate borrowings and fixed rate investments for the same term. It can also be defined as the risk arising due to sensitivity of the interest income/expenditure or values of assets/liabilities to the interest rate fluctuations. Exchange Rate Risk The volatility in the exchange rates will have a direct bearing on the values of the assets and liabilities that are denominated in foreign currencies. While appreciation of home currency decreases the value of an asset and liability in terms of home currency, depreciation of home currency will increase the values of assets and liabilities. While increase in the value of asset and decrease in the value of liability has a positive impact on the corporates, increase in the value of liabilities and decrease in the value of assets has a negative impact. Market Risk Market risk is the risk of the value of a firms investments going down as a result of market movements. It is also referred to as price risk. Market risk cannot be distinctly separated from other

risks, as it results from the interplay of all the risks. In addition to Interest rate risk and exchange risk, adverse movements in equity prices and commodity prices also contribute to the market risk. An instance wherein equity price risks played havoc is the stock market crash of 1929 in the United States. Similarly, commodity prices show a significant impact on the cash flow and profitability of a business. For example, a baking company can face the risk of falling wheat prices in the domestic as well as international markets, consequently resulting in loss of income. In a financial market, an investor always wishes to minimize or eliminate the risks in order to maximize profits. This can be achieved by hedging the risk through different derivative instruments available in the financial markets. How the hedging is done using different derivative instruments will be discussed in subsequent chapters. Types of Derivative Instruments Derivatives can be classified on the basis of the nature of contract, underlying asset or market mechanism. a. Underlying Asset: Most derivatives are based on one of the following four types of assets: i. ii. iii. iv. Commodities, Foreign exchange, Equities, and Interest bearing financial assets.

The nature of contract sets upon the right and obligations of both positions in the contract. b. Nature of Contract: Based on the nature of the contract, derivatives can be classified into three categories: i. ii. iii. Forward Rate Contracts and Futures, Options, and Swaps.

There can be a contract which is similar in all aspects except for the underlying asset. Thus, an option contract can exist on a currency or a stock. Similarly, a futures contract can exist on a commodity or a currency. c. Market Mechanism i. ii. OTC products, and Exchange-traded products.

ELEMENTARY PRICING PRINCIPLES Every asset has an economic value which is considered to be its fair value. Under efficient market conditions, the market price of an asset should equal its economic value or fair value. Normally, spot and derivative markets are very efficient. Different derivatives instruments such as forwards, futures and options are used for the purchase and sale of spot market assets such as stocks, bonds etc. The prices of derivatives are related to the underlying spot market assets through various important mechanisms. Now let us have a look at the fundamental linkage between spot and derivatives markets using mechanisms such as arbitrage and storage. Arbitrage Arbitrage implies obtaining risk-free profits by simultaneously buying and selling identical or similar instruments in different markets. The arbitrage opportunities cannot last for very long periods of time in a stock, but the very existence of arbitrageurs implies that there are opportunities in the markets for at least a short period. Arbitrage strategy is based on law of one price. Law of one price states that equivalent combinations of financial instruments should have same price. That is, two securities A and B having identical cash flows in the future, irrespective of future events, should have the same price. An individual engaged in arbitraging is called arbitrageur. He consistently keeps track of different markets. Sometimes, certain situations call for a second type of arbitrage. When a portfolio consisting of securities A and B results in certain payoffs, such portfolio should yield risk-free rate. An arbitrage opportunity exists when the certain return of securities A and B together is higher than the risk-free rate. An arbitrageur can borrow at the risk-free rate and buy the A+B portfolio. Thus, he can earn arbitrage profits when the certain payoff occurs. The payoff will be more than the required to pay back the loan at the risk-free rate. Storage and Carrying Costs Storage is a significant linkage between spot and derivatives market. Any asset can be purchased and stored. Storage cost can be defined as the cost involved in storing an asset over a period of time. When the future asset price is uncertain, the current asset price would be the future price less the cost of storage and interest. In the case of risk neutral investors, current asset price is the expected future price, less the storage and interest costs. However, when the investor is risk averse, the current spot price of the asset will be the expected future spot price, less storage cost, less interest foregone and less the risk premium (difference between the price paid by the risk-averse investor and current price of the asset). For goods such as electricity which are non-storable in nature, there would not necessarily be a relation between current spot price and the expected future spot price. In case of commodities (Stocks, metals, oil etc) that can be stored, the current spot price is determined according to current supply and demand conditions.

The extent to which the futures price exceeds the cash price at one point of time is determined by the concept called cost-of-carry that refers to the carrying charges. The carrying charges can be further classified into storage, insurance, transportation and financing costs. The significance of carrying costs cannot be ignored because they play a crucial role in determining pricing relationships between the spot and futures prices. Moreover, it plays a key role in determining the prices of various futures contracts of maturities. PURPOSE OF DERIVATIVES Derivative instruments serve various purposes in global social and economic systems. Price Discovery Price discovery symbolizes the process of providing equilibrium prices that reflect current and prospective demands on current and prospective supplies and making these prices visible to all. As such, derivative markets not only play a significant role in terms of actual trading, but also provide guidance to the rest of the economy to optimal production and consumption decisions. Forwards and futures markets are significant sources of information about prices. Future markets are often considered as primary means of information for determining the spot price of the asset. High degree of correlation exits between forward/futures prices and the price which people expect to prevail for the commodity/asset at the delivery date specified in the futures contract. By using the information available in the forward/futures price today, market observers try to estimate the price of a given commodity/asset at a certain time in future. For example, let us consider the price of copper. The price of copper twelve months from today cannot be said with certainty. However, the future price can be determined by using forward/futures market. The price that is quoted on the market today for a copper forward/futures contract expiring in twelve months is very essential in estimating the future price. So, a copper miner planning to open a profitable copper mine can do so, given the future expected copper price reflected in the forward/futures market is high enough to open a profitable copper mine. Thus, a futures or forward price reflects a price which a market participant can lock-in today in lieu of accepting the uncertainty of future spot price. Options markets do not directly provide information about future spot prices. However, they provide information about volatility and subsequently, the risk of the underlying spot asset. Hedging Hedging attempts to reduce price risk. It can be defined as a transaction in which an investor seeks to protect a position or anticipated position in the spot market by using an opposite position in derivatives. A person who hedges is called a hedger. These are people who are exposed to risks due to the normal business operations and would like to eliminate or minimize or reduce the risk.

Hedging is done mainly for the following reasons: To protect a purchase against price decline. To protect a sale against price increase. To protect an anticipated purchase against a price increase. To protect an anticipated sale against a price decline. The result of a hedge can be judged as the net effect of the gain or loss on the physical position plus the gain or loss on the hedging tool. Speculation Speculation involves assimilation of available information about a security and assessing the rise or fall of its price. A person engaged in speculation is called speculator. These people voluntarily accept what hedgers wish to avoid. Based on the forecast, the speculator would like to make gains by taking long and short positions on the derivatives. For example, let us see how speculators take a position to gain from the futures. FORWARD CONTRACTS In forwards, both the traders negotiate the details of the contract privately without the intervention of a third party. No doubt, this facilitates the traders to draw the details of the contract according to their needs, but this also increases the probability that one of the traders might default on fulfilling his obligation. This characteristic of the forwards contract changes the very nature of risk, as the fulfillment of the contract depends on the worth of the counterparty. This is the second real problem that one has to put-up with, if he wishes to deal in forwards. In forward contracts, since the producers are not in direct contact with the purchasers, they have to route their contracts through middlemen. Middlemen play a crucial role in forward markets, as they purchase the produce from the producer by entering into a contract and then enter into a second contract with the other purchaser regarding the supply of the same. They bear the risk and have to perform the other part of the contract even when one of the parties default. Therefore, they should not only be paid for their services, but also for credit risks they bear. FUTURES MARKETS Futures on bonds started trading on stock exchanges in 1975 and futures on equity were introduced in 1982. Prior to this, organized futures market in commodities had existed in the Chicago Board of Trade since 1848. Over the years it has experienced rapid growth in terms of volume and turnover. Today, it is the oldest and the largest futures exchange in the world. It was established as a voluntary, non-profit association by its members. Another exchange to reckon with is the Chicago Mercantile Exchange. These two exchanges between themselves account for about 80% of the total volume traded in future contracts in the US.

Futures contracts owe their origin to forward contracts. In other words, futures contracts are refined forward contracts. A futures contract is an agreement between two parties to exchange a commodity or a financial asset for certain consideration after a specified period. As we have stated before, a futures contract is a refined forwards contract. The main differences between forwards and futures contract are: i. ii. A futures contract is standardized in terms of quantity, the quality and terms of delivery, etc. The futures contracts are traded in an organized exchange, where a large part of the process is regulated. Differences between Futures and Forward Contracts From what we have seen above, listing the differences should not be a problem. They are presented in Table 2: Table 2: Differences between Futures and Forward Contracts
Futures Contracts 1. These are traded in organized location known as exchange. Forward Contracts It is an over-the-counter product.

2.

The terms of the contract are highly standardized.

Terms are structured to suit both the contracting parties.

3.

Contracts are cleared by a separate clearing house.

No such facility exists.

4.

Clearing house guarantees the performance of the contract.

No organization guarantees the performance of the counterparty. Depends on the worth of the counterparty.

5.

Traders have to deposit initial margin irrespective of their trading position.

No compulsion to make such deposits.

6.

Traders have to pay daily settlement margin depending on the No such provisions are in vogue. movement in the price of the underlying stock.

7. 8.

Futures contracts can be easily closed. Futures markets are monitored and regulated by special agencies.

Quite difficult to do so. Regulation is not as tight as in futures markets. No such adjustments are carried out.

9.

Marking to market is done at the end of every trading day.

Standardization of the Contracts Standardization of contracts facilitates trading on the exchange. When a group of traders come together they will be able to trade only if all of them know for sure what a contract carries with it. The futures contracts traded in organized exchanges are standardized in terms of features like Quantity, Quality, Expiration Month, Delivery Terms, Delivery Dates, Minimum and Maximum Price Fluctuation, and finally Trading Days and Hours. OPTIONS An option is a contract in which the seller of the option grants the buyer the right to purchase from or sell to, the seller a designated instrument or an asset at a specific price which is agreed upon at the time of entering into the contract. It is important to note that the option buyer has the right but not an obligation to buy or sell. But, if the buyer decides to exercise his right the seller of the option has an obligation to deliver or take delivery of the underlying asset at the price agreed upon. The seller of the option is also called the writer of the option. TERMINOLOGY Call Option An option contract is called a call option, if the writer gives the buyer of the option the right to purchase from him the underlying asset, at a predetermined price at sometime in future. Put Option An option contract is said to be a put option, if the writer gives the buyer of the option the right to sell the underlying asset, at a predetermined price at sometime in future. Exercise Price At the time of entering into the contract, the parties agree upon a price at which the underlying asset may be bought or sold. This price is referred to as the exercise price or the strike price. At this price, the buyer of a call option can buy the asset from the seller and the buyer of a put option can sell the asset to the writer of the option. This is regardless of the market price of the asset at the time of exercising. Expiration Period At the time of introducing an option contract, the exchange specifies the period (not more than nine months from the date of introduction of the contract in the exchange) during which the option can be exercised or traded. This period is referred to as the Expiration Period. An option can be exercised even on the last day of the expiration period. Beyond this date the option contract expires. Such options, which can be exercised on any day during the expiration period are called American options. There is another class of options called European options. European options can be exercised only on the last day of the expiration period. For these options, the expiration date is always the last day of the expiration period.

Depending on the expiration period, an option can be short-term or long-term in nature. Warrants and convertibles belong to the latter category and are often issued by companies to finance their activities. (In our country, Reliance Petroleum Ltd., has recently converted its warrants issued as a part of triple optional convertible debentures into fully paid shares.) Option Premium or Option Price This is the amount which the buyer of the option (whether it be a call or put option) has to pay to the option writer to induce him to accept the risk associated with the contract. FINANCIAL SWAPS The term swap has two different meanings in the financial markets. In one definition, it refers to the simultaneous purchase and sale of currency for different maturities or vice versa. The other definition states that it is the agreed exchange of future cash flows with or without any exchange of cash flows at present. The base on which the cash flows are exchanged may be different and it gives rise to different types of swaps. Financial swaps are broadly classified into: Interest rate swaps, Currency swaps. Swaps have been defined variously as: A transaction in which two parties agree to exchange a predetermined series of payments over time; An agreement between two parties to exchange interest payment for specific maturity on an agreed upon notional amount; An arrangement whereby one party exchanges one set of interest payments for another, example fixed for floating rate; An agreement between two parties to exchange a series of payments, the terms of which are predetermined can be regarded as a financial swap. Swaps can be divided into short-term, medium-term and long-term swaps. While short-term swaps have maturity periods of less than three years, medium-term swaps mature between three and five years and long-term swaps have a life extending beyond five years.