You are on page 1of 62

DERIVATIVES MANAGEMENT

1
DEFINITION
The Securities Contracts Regulation Act 1956 defines

Derivative as under:
Derivative includes

1. 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.

2 R. SUBASHINI 2/3/17
MEANING
In a broad sense, many commonly used instruments can be called

derivatives since they derive their value from an underlying asset.

For Eg: Equity Share itself is a derivative, since it derives its value

from the firms underlying assets.

In a strict sense, derivatives are based upon all those major

financial instruments which are explicitly traded like equities, debt

instruments and commodity based contracts.

3 R. SUBASHINI 2/3/17
WHAT IS A DERIVATIVE
In short, a derivative is a contractual relationship established by

two (or more) parties where payment is based on (or "derived"

from) some agreed-upon benchmark. Since individuals can

"create" a derivative product by means of an agreement, the

types of derivative products that can be developed are limited

only by the human imagination. Therefore, there is no definitive

list of derivative products. Some common financial derivatives.

4 R. SUBASHINI 2/3/17
Types of Financial Derivative
Can be plain vanilla or exotic

Forward

Futures

Options

Forward Rate Agreement (FRAs)

Swaps
TYPES OF FINANCIAL DERIVATIVES

6 R. SUBASHINI 2/3/17
TYPES OF FINANCIAL DERIVATIVES
FORWARDS

Forwards are the oldest of all the derivatives. A forward contract


refers to an agreement between two parties to exchange an
agreed quantity of an asset for cash at a certain date in future at
a predetermined price specified in that agreement.

The promised asset may be currency, commodity, instrument


etc.,

7 R. SUBASHINI 2/3/17
TYPES OF FINANCIAL DERIVATIVES
FORWARDS

Eg: On June 1, X enters into an agreement to buy 50 bales


of cotton on Dec 1 at Rs. 1000/- per bale from Y, a cotton
dealer. It is a case of a forward contract where X has to pay
Rs. 50,000/- on Dec 1 to Y and Y has to supply 50 bales of
cotton.

8 R. SUBASHINI 2/3/17
TYPES OF FINANCIAL DERIVATIVES
Futures: The future contract has been designed to remove

the disadvantage of a forward contract. The future contract is


like forward contract, an agreement between two parties to
buy or sell an asset at a certain time in the future for a
certain price.

9 R. SUBASHINI 2/3/17
TYPES OF FINANCIAL DERIVATIVES
A future contract is standardized contract, traded on a future

exchange, to buy or sell a certain underlying instrument at a


certain date in the future, at a pre set price. The future date
is called the delivery date or the final settlement date. The
pre set price is called the future price. The price of the
underlying asset on the delivery date is called the settlement
price.

10 R. SUBASHINI 2/3/17
TYPES OF FINANCIAL DERIVATIVES
Future contract can be broadly grouped into two types:

Commodity Futures

Financial Futures
A future contact in which the underlying asset is a commodity is referred to a
commodity future contact. Similarly if the underlying asset is financial future it is
referred to a s financial future contract.
Commodity Futures E.g.: Food grains, metals, wheat, wool, gold, copper etc.
Financial Futures E.g.: Equity shares, debentures, bonds, currencies etc.,
In Future contract the buyer is called a long position and the sellter is said to have a
short position.

11 R. SUBASHINI 2/3/17
TYPES OF FINANCIAL DERIVATIVES
OPTIONS:

An option is a particular type of contract between two parties, where one


person gives the other person the right to buy or sell a specified asset
a specified price within a specific time period. As the very name
implies , an option contract gives the buyer an option to buy or sell an
underlying asset at a predetermined price on or before a specified
date in future. The price so predetermined is called the STRIKE
PRICE OR EXERCISE PRICE.

12 R. SUBASHINI 2/3/17
TYPES OF FINANCIAL DERIVATIVES
In an options contract, the seller is usually referred to as a

WRITER since he is said to write the contract. It is


similar to the seller who is said to be in Short position in a
forward contract. He is obliged to buy shares. In an option
contract, the buyer has to pay a certain amount at the time
of writing the contact for enjoying the right to buy or sell.

13 R. SUBASHINI 2/3/17
TYPES OF FINANCIAL DERIVATIVES
AMERICAN OPTION VS EUROPEAN OPTION

In an option contract, if the option can be exercised at any time

between the writing of the contract and its expiration, it is called

as an American option.

On the other hand, if it can be exercised only at the time of

maturity it is termed as European option.

14 R. SUBASHINI 2/3/17
TYPES OF FINANCIAL DERIVATIVES
SWAPS

SWAP is yet another exciting trading instrument. Swaps are private agreements
between two parties, which are not traded on exchanges but are normally traded
among dealers. The two swaps used commonly are currency swaps and interest
rate swaps.

15 R. SUBASHINI 2/3/17
BID - PRICES ARE PROVIDED BY BUYERS

ASK - PRICES ARE QUOTED BY SELLERS

DIFFERENCE BETWEEN BID AND ASK IS CALLED


IMPACT COST

VOLATALITY

VOLATALITY IS THE EXTENT OF FLUCTUATION IN


STOCK PRICES

TERMINOLOGIES
1. Spot price: The price at which an asset trades in the spot market.

2. Futures price: The price at which the futures contract trades in the futures market.

3. Contract cycle: The period over which a contract trades. The commodity futures contracts on

the NCDEX have one month, two months, three months etc (not more than a year) expiry

cycles. Most of the agri commodities futures contracts of NCDEX expire on the 20th day of the

delivery month. Thus, a January expiration contract expires on the 20th of January and a

February expiration contract ceases to exist for trading after the 20th of February. If 20th

happens to be a holiday, the expiry date shall be the immediately preceding trading day of the

Exchange, other than a Saturday. New contracts for agri commodities are introduced on the

10th of the month.


TERMINOLOGIES
Expiry date: It is the date specified in the futures contract. This is the last day on
which the contract will be traded, at the end of which it will cease to exist.

Delivery unit: The amount of asset that has to be delivered under one contract. For
instance, the delivery unit for futures on Soybean on the NCDEX is 10 MT. The
delivery unit for the Gold futures contract is 1 kg.

Basis: Basis is the difference between the futures price and the spot price. There
will be a different basis for each delivery month for each contract. In a normal
market, futures prices exceed spot prices. Generally, for commodities basis is
defined as spot price -futures price. However, for financial assets the formula,
future price -spot price, is commonly used.
TERMINOLOGIES
Cost of carry: The relationship between futures prices and spot prices can be summarized in
terms of what is known as the cost of carry. This measures the storage cost plus the interest
that is paid to finance the asset.

Initial margin: The amount that must be deposited in the margin account at the time a futures
contract is first entered into is known as initial margin.

Marking-to-market (MTM): 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 marking to market.

Maintenance margin: This is somewhat lower than the initial margin. This is set to ensure that
the balance in the margin account never becomes negative. If the balance in the margin
account falls below the maintenance margin, the investor receives a margin call and is
expected to top up the margin account to the initial margin level before trading commences
on the next day.
DIFFERENCE BETWEEN CASH & FUTURE
MARKET
A cash market transaction occurs in the present, but a futures market transaction is an
agreement for an exchange of the underlying asset in the future.
Cash Price (Spot Price): The price of the commodity or financial instrument for current

delivery.
Cash Market (Spot Market): The market in which commodities or financial instruments

are traded for essentially immediate delivery.


There are currently two separate, yet related, markets in which commodities are traded;

the cash market and the futures market. The cash market refers to the buying and
selling of physical commodities. In a cash market transaction, the price and exchange of
product occurs in the present. In contrast, the futures market deals with the buying or
selling of future obligations to make or take delivery rather than the actual commodity.
21 R. SUBASHINI 2/3/17
CASH FUTURE ARBITRAGE
Earning risk-free profits from an unusual difference

between cash and futures prices is called cash-futures


arbitrage.
In a competitive market, cash-futures arbitrage has very slim

profit margins.

Cash prices and futures prices are seldom equal. The

difference between the cash price and the futures price


for a commodity is known as basis.
22 R. SUBASHINI 2/3/17
CASH FUTURE ARBITRAGE
For commodities with storage costs, the cash price is

usually less than the futures price, i.e. basis < 0. This is
referred to as a carrying-charge market.

Sometimes, the cash price is greater than the futures

price, i.e. basis > 0. This is referred to as an inverted


market.
BASIS = CASH PRICE FUTURES PRICE
23 R. SUBASHINI 2/3/17
USES AND ADVANTAGES
USES:

Provide leverage or gearing, such that a small movement in the underlying value can cause a

large difference in the value of the derivative

Speculate and to make a profit if the value of the underlying asset moves the way they expect

(e.g., moves in a given direction, stays in or out of a specified range, reaches a certain level)

Hedge or mitigate risk in the underlying, by entering into a derivative contract whose value

moves in the opposite direction to their underlying position and cancels part or all of it out

Obtain exposure to underlying where it is not possible to trade in the underlying (e.g., weather

derivatives)

Create option ability where the value of the derivative is linked to a specific condition or event

(e.g., the underlying reaching a specific price level)


24 R. SUBASHINI 2/3/17
Advantages

The derivative market helps people meet diverse objectives

such as:
Hedging

Profit making through price changes

Profit making through arbitrage


ILLUSTRATION OF HEDGING
ON COMMODITIES
EXCHANGE

2/3/17 26
A Dal miller and a farmer visit their respective exchange
broker to find the futures prices of chana

Buyer Seller
Dal Miller Farmer

Prices information of commodities traded on Exchanges are also


displayed on ticker in mandis, on news channels and also
I plan to take delivery of
chana in Feb for making
dal what is current Sure sir here it is
price quality
specification

Ji I am
Want to hedge my
showing
chana crop wiil be
it to you
ready in Feb what
price in Feb &
quality parameter

Buyer Exchange
Broker B
Dal Miller

Seller Exchange
Farmer Broker A
Preview of contract specification - Chana

Tick size
(minimum price
movement) Re. 1
Daily price limits 3% + 1% maximum daily price limit will be 4%.
Price Quote Desi Chana ex-warehouse Delhi inclusive of all taxes and
Levies.
Initial margin 5%
Special Margin In case of additional volatility, a special margin is imposed
Delivery unit 10 MT (with tolerance limit of +/- 500 kg), though he will get
the value only for actual quantity delivered by him.
Delivery center Delhi (up to the radius of 50 kms from the municipal limits)
Additional Bikaner (Rajasthan) and Ganj Basoda (Madhya Pradesh) (up
Delivery Centers to the radius of 50 Kms from municipal limit)
Delivery period 25% margin will be imposed on the date of expiry on buyer
margin and seller on marked quantity.
Preview of contract specification - Chana
contd
Quality specification Desi Chana The material should be free of Mathara
and Khesari and live infestation
Moisture Basis 10% up to 12% on 1:1 rebate which shall be applied
Acceptable to such content above 10% rounded off to the higher
0.5%
Varietal admixture 3% Maximum
Delivery Logic Compulsory
Tender Period Last 5 working days of the contract expiry and
1stworking day after expiry of the contract
Delivery period Three working days after expiry of the contract
Tender notice / Delivery The seller may submit Warehouse Receipt and Valid
Pay-in Quality Certificate issued by Quality Certifying
agency by tender period.
Any outstanding positions will be marked for delivery
at the expiry of the contract.
Early Delivery Pay in Seller Clearing Member can make the delivery pay
in on any of the tender period days.
See this is the screen how it looks
like
See i have encircled the prices of chana for you
now I will explain you one by one what does it mean
1st column indicates commodity name here chana 2nd
column the date of expiry of the contract 3rd price
quotation here Rs/qntl 4th shows the days spot prices at
its benchmark center i.e. Delhi mandi
Here 1st column in the box indicates quantity a buyer willing
to buy 2nd column the price at which the buyer is willing to
buy 3rd price at which seller is willing to sell and 4th qnty.
available for sale
The 1st column in the box indicates net price change in Rs
and the 2nd Indicates % change in prices
Here the columns shows the days opening price the days
high price, days low price and yesterdays closing price
Here the 1st column shows the days volume and the 2nd
column shows total open interest Open Interest is the total
outstanding positions of a futures contract
On pressing F6 key best buy and sell quotes is
displayed
DPR

DPR (Daily Price Range) is the


days maximum price movement
On pressing Shift F8 we get this screen. It
provides information when tender period
starts ends
Tender period is the period when intentions
for either taking or giving deliveries are sent
You can put your Thanks for informing
order only within the
days DPR range

As you already have


a trading account
with sufficient
balance to pay for Hmm
the margins I can
put your order

Seller
Exchange Farmer
Broker A

Exchange Buyer
Broker B Dal Miller
I need to buy 10
tons i.e. 1 lot at Rs
2640/qntl with I have
5% initial margin margins in
Rs 13200 will be my account
utilised from my
account

Buyer Seller
Dal Miller Farmer

Margin is the minimum amount users


need to deposit with Exchange. Margins
for different commodities varies from 4 to
5%
Sell Order

Want to hedge my Execution of your


crop Please sell sell order is
1 lot chana at Rs pending
2650 in Feb awaiting
month equivalent buy
side order

Seller Exchange
Farmer Broker A
Buy Order

Want to buy Order placed


chana Feb its is
contract at waiting for
Rs2640/qntl the match

Exchange
Buyer Broker B
Dal Miller
Dont worry Once the system
order already gets the buyer at
placed current your price your
buyer is at lower order will be
price matched and
trade will be
executed
Ok am ready
Ok to pay more

Exchange
Seller
Broker A Farmer Buyer Exchange
Broker B
Dal Miller
Increase my Modified your
price to Rs order and its
2650/qntl bought at your
price

Congrats your
order matched
chana contract
is sold for Rs
2650/qntl Thanks

Buyer Exchange
Broker B
Dal Miller

Exchange Seller
Broker A Farmer
Thanks for informing I
Am sure you must be will decide on the
aware that you can same depending on
either deliver chana crop market prices in Feb
against your sell position if prices fall I will
or else you can buy the deliver it on exchange
same contract before
expiry and cash settle it

Seller
Exchange Farmer
Broker A

Buyer Exchange
Broker B
Dal Miller
Also you may need to
service your account Yes I am fully
with mark-to-market aware I have Margins also applies
margins incase prices arranged the to the buyer
moves against you. finance

Exchange Seller Buyer Exchange


Broker A Farmer Dal Miller Broker B

Mark-to-market margin is the daily adjustment


of an account to reflect accrued profits and
losses against a futures position
Your contract note
indicating selling price, Contract note are also
the contract month
etc will be posted to ok sent to the buyer
your address and identity of the counterpart
keep it handy is kept secret

Exchange
Broker A Seller Buyer Exchange
Farmer Dal Miller Broker B

Contract note is a proof of trade it


contains date, time, price at which
contract was purchased
POST HARVEST FARMER
DECIDES TO DELIVER HIS CROP
ON EXCHANGE PLATFORM
FARMER TAKES HIS GOODS TO EXCHANGE WAREHOUSE

Ok store them
and collect the
receipt from the
Want to store my crop in manager and
your exchange accredited come tomorrow for
warehouse send a QC certificate
sample for QC want to
deliver on Exchange

A-1
Exch
a
Accre nge
d
ware ited
hous
e

Warehouse sends sample for quality


Your goods are fit to deliver Thanks
on Exchange here is ur
QC

QC

ware
ho
Accre use
d
Exch ited
ange
A-1
Farmer short hedges his chana crop at Rs 2650/qntl at the time of

sowing
By the time of harvest the prices have decreased to Rs 2550/qntl

Farmer finds it wise to deliver on exchange platform

Hedging gave the farmer an assured return Rs 2650/qntl his

selling price
Un-hedged position would have forced the farmer to sell his

goods at Rs 2550/qntl the prevailing price


Hedging helped him earn an extra Rs 100/qntl
FARMER GOING FOR PHYSICAL DELIVERY ON EXCHANGE

Sure I will mark


your contract for
delivery
I want to deliver on the The contract expires on
exchange against my 20th your account will
futures position here is be credited within 3
warehouse receipt and days post expiry
QC

Seller Exchange
Broker A
Farmer
TRADER GOING TO TAKE PHYSICAL DELIVERY

Yes you can Ill send


your buy intention to the
Want to take Exchange they will
delivery mark delivery against it
against my
contract Ok Ill explain
When and where you the process
my delivery will too
come

Buyer Exchange
Dal Miller Broker B
The Exchange buy & sell
may also intentions are
receive marked against each
delivery other Hmm
intention from
the sellers

Exchange
Broker B Buyer
Dal Miller
You need to deposit the total value
of the contract in your bank
account within 2 days post expiry
Exchange will pay to the seller on Ok its so
third day simple
You will be issued a
delivery receipt
take the delivery
from Exchange
warehouse

Exchange
Broker B Buyer
Dal Miller
POST HARVEST FARMER DECIDES
TO CASH SETTLE HIS FUTURES
CONTRACT
Post harvest farmer has the option to either cash settle

or deliver on exchange.
If the quality of produce doesn't matches with contract

specification farmer can cash settle.


Profit/loss on exchange can be used to offset

loss/profit in spot market respectively.


FARMER GOING FOR CASH SETTLEMENT ON EXCHANGE

What is the
current price of
chana Feb contract

Ji its Rs
2550/qntl

Seller
Farmer Exchange
Broker A
Its sold sir you
earned Rs 100 a
quintal on your sell
I want to square
position total profit
off my position
of Rs 10,000 for 10
sell at Rs 2550
tonnes
True prices in spot
has fallen too I will
use profit from futures
to offset my loss in
spot market benefit
of hedging Ha ha ha

Exchange
Broker A
Seller
Farmer
Thank
You!