Derivatives

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A derivative is a financial instrument, whose value depends on the value of one or more basic underlying variables. Examples: Underlyings: stocks or market indices Derivatives: options, futures, forward contracts Not all trading is done on exchanges. The overthe-counter market is an important alternative to exchanges. Whereas futures are traded on stock exchanges, forward contracts are traded over-the-counter. Options are traded both, on stock exchanges and over-the-counter.
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Time to expiry
Time to expiry is the another factor of consideration in case of derivative trading. In India, the derivatives are traded for three months trading cycle i.e. current, near and far months. In practice, the most active instruments are of current months and the trades for the far month are very rare. In fact, the majority of the volumes are concentrated on the current and near month contracts.

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Derivative products
Forwards Futures Options Warrants LEAPS Basket Swaps Swaptions
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Participants in derivatives market
Hedgers face risk associated with the price

of an asset

Speculators

wish to bet on movements in the price of an asset

future

Arbitrageurs like to take advantage of a

discrepancy between different markets

prices

in

two

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Forward Contracts
A forward contract is an agreement between two parties to buy or sell an asset at a certain future time for a certain future price.
 Forward contracts are normally not exchange

traded.  The party that agrees to buy the asset in the future is said to have the long position.  The party that agrees to sell the asset in the future is said to have the short position.  The specified future date for the exchange is known as the delivery (maturity) date.

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Forward Contracts
The specified price for the sale is known as the delivery price As time progresses the delivery price doesn’t change, but the current spot (market) rate does. Thus, the contract gains (or loses) value over time.

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Forward Contracts
Long and Short Positions in a Forward Contract For Wheat at Rs. 4/Bushel
4 3 2 1 0 -1 0 -2 -3 -4 1 2 3 4 5 6 7 8

Short Position Long Position

f o y a P

Net Position

Wheat Price

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Problems with Forwards
Counter-party risk:

A party to the contract may not fulfill the obligation
Low degree of liquidity
 Both the parties have to wait till maturity. No one can come out

from the contract

Lack of centralized trading

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Distinction between forwards and futures
‘Futures’ was designed to solve the problems of forward markets Futures Forward Organized stock exchange OTC Standardized contractCustomized liquid less liquid Requires margin payment No margin required Daily settlement End of the period

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Futures Contracts
 A futures contract is similar to a forward contract in that it

is an agreement between two parties to buy or sell an asset at a certain time for a certain price. Futures, however, are usually exchange traded and, to facilitate trading, are usually standardized contracts. This results in more institutional detail than is the case with forwards. other directly or even know each other for that matter. The exchange acts as a clearinghouse. As far as the two sides are concerned they are entering into contracts with the exchange. In fact, the exchange guarantees performance of the contract regardless of whether the other party fails.

 The long and short party usually do not deal with each

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Futures Contracts
 The exchange will usually place restrictions and

conditions on futures. These include:
 Daily price (change) limits.  For commodities, grade requirements.  Delivery method and place.  How the contract is quoted.

 Note however, that the basic payoffs are the

same as for a forward contract.

 Basis = Futures price – spot price

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Futures payoff
 Buy futures (Long asset)

If index goes up futures position starts making profit and vice versa

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Futures payoff
 Sell futures (Short asset)

If index goes down futures position starts making profit and vice versa

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Pricing futures
Fair value = (S) e^ (r * T) r = cost of financing (continuously compound interest rate) T = Time till expiration in years e = 2.71828 Reliance industries is trading in spot market at Rs. 1150. Money can be invested at 11% p.a. Calculate the fair value of one month futures contract Fair value = (S) e^ (r * T) = 1150*(2.71828)^(0.11*(1/12)) = 1160
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Margin Money
Collected from the client/broker Minimize the risk of settlement default by either counterparty Like a security deposit or insurance against a possible future loss of value Once the transaction is successfully settled, the margin money held by the exchange is released / adjusted against the settlement liability.
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Types of Margins
Initial Margin Variation/Maintenance/Mark to market margin Additional Margin (if any)

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Initial Margin
To cover the largest potential loss in one day Both buyer and seller have to deposit the

margins Has to be deposited before opening a position

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Mark to Market Margin
Daily profit or loss obtained by marking the

member’s outstanding position to the market Receive or pay the difference in cash on the next working day

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Daily Settlement
In case the position is not closed the same

day Net total of all the flows everyday would be equal to the profit/loss calculated earlier

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Example
Let us take the illustration where a long position is opened at 15550 and closed at 15650 resulting in a profit of 100 points. Let us assume the daily closing settlement prices to be DAY CLOSING PRICE
1 2 3 4 Position closed 15550 15580 15560 15600 15650
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DAY

Calculate settlement prices
CLOSING PRICE Difference 15500 15580 15560 15600 15650 15500-15550 15580-15500 15560-15580 15600-15560 15650-15600 -50

Profit/Loss

Position opened – Long @ 15550 Day 1 2 3 4 Position closed Profit

+80 -20 +40 +50 +100

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Application of futures
Hedging – Long security, sell futures

Reliance capital is trading at Rs 390.Two month futures cost Rs. 402. Position can be hedged by shorting futures position If spot price falls to Rs. 350 loss of Rs.40 incurred on the security will be made up by the profits made on the short futures position

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Application of futures
Speculation – Bullish – buy futures

Bearish – sell futures Spot price = Rs.1000 Future price = Rs.1006 Contract value = 100 lots consisting 100 securities each Margin = Rs.20000 Two months later security closes at Rs.1010 Profit = 1010 – 1006 = 4*100 = 400 Rs.400 profit on an investment of Rs.20000 ( 12 percent)

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Application of futures
 Arbitrage – Overpriced – Buy spot sell future

Underpriced – Buy futures sell spot Tata steel trading at Rs.1000 Future price = Rs.1025 Security closes at Rs.1015 Profit of Rs.15 on spot and Rs.10 on futures position Relinfra trading at Rs.1000 Futures price = Rs.965 Security closes at Rs.975 Profit of Rs.10 on futures, Rs.25 on spot
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