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FINANCIAL DERIVATIVES complete description....
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FINANCIAL DERIVATIVES
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kiran51083
Kiran .
FINANCIAL DERIVATIVES
A derivative instrument (or simply derivative) is a financial instrument which derives its value from the value of some other financial instrument or variable. For example, a stock option is a derivative because it derives its value from the value of a stock. An interest rate swap is a derivative because it derives its value from one or more interest rate indices. The value(s) from which a derivative derives its value is called its underlier(s).
By contrast, we might speak of primary instruments, although the term cash instruments is more common. A cash instrument is an instrument whose value is determined directly by markets. Stocks, commodities, currencies and bonds are all cash instruments. The distinction between cash and derivative instruments is not always precise, but it is a useful informal distinction.
Derivative instruments are categorized in various ways. One is the distinction between linear and non-linear derivatives. The former have payoff diagrams (The P&L from a long or short option position held to expiration is called the position's payoff. Payoff is a function of underlier value at expiration. It can be depicted with a graph, which is called a payoff diagram. ) that are linear or almost linear. The latter has payoff diagrams that are highly non-linear. Such non-linearity is always due to the derivative either being an option or having an option embedded in its structure.
A somewhat arbitrary distinction is between vanilla and exotic derivatives. The former tend to be simple and more common; the latter more complicated and specialized. There is no definitive rule for distinguishing one from the other, so the distinction is mostly a matter of custom. Usage does vary.
A derivative instrument (or simply derivative) is a financial instrument which derives its value from the value of some other financial instrument or variable. For example, a stock option is a derivative because it derives its value from the value of a stock. An interest rate swap is a derivative because it derives its value from one or more interest rate indices. The value(s) from which a derivative derives its value is called its underlier(s).
By contrast, we might speak of primary instruments, although the term cash instruments is more common. A cash instrument is an instrument whose value is determined directly by markets. Stocks, commodities, currencies and bonds are all cash instruments. The distinction between cash and derivative instruments is not always precise, but it is a useful informal distinction.
Derivative instruments are categorized in various ways. One is the distinction between linear and non-linear derivatives. The former have payoff diagrams (The P&L from a long or short option position held to expiration is called the position's payoff. Payoff is a function of underlier value at expiration. It can be depicted with a graph, which is called a payoff diagram. ) that are linear or almost linear. The latter has payoff diagrams that are highly non-linear. Such non-linearity is always due to the derivative either being an option or having an option embedded in its structure.
A somewhat arbitrary distinction is between vanilla and exotic derivatives. The former tend to be simple and more common; the latter more complicated and specialized. There is no definitive rule for distinguishing one from the other, so the distinction is mostly a matter of custom. Usage does vary.
kiran51083
Kiran .
OPTIONS
An option is a contract, or a provision of a contract, that gives one party (the option holder) the right, but not the obligation, to perform a specified transaction with another party (the option issuer or option writer) according to specified terms. The owner of a property might sell another party an option to purchase the property any time during the next three months at a specified price. A lease might contain a provision granting the renter the option to extend the lease for an additional year. A corporate bond might have an option provision allowing the issuer to purchase the bond back from the purchaser five years prior to maturity for a specified price. A speculator might purchase an option to sell at any time during the next three months 100 shares of a particular stock for a specified price.
Option contracts are a form of derivative instrument. Stand-alone options trade on exchanges or OTC. They are linked to a variety of underliers. Most exchange-traded options have stocks or futures as underliers. OTC options have a greater variety of underliers, including bonds, currencies, physical commodities, swaps, or baskets of assets. Options can be embedded in almost any contract. Above, we gave examples of options embedded in a lease and a bond.
Options take many forms. The two most common are:
Call options, which provide the holder the right to purchase an underlier at a specified price;
Put options, which provide the holder the right to sell an underlier at a specified price.
The strike price of a call (put) option is the contractual price at which the underlier will be purchased (sold) in the event that the option is exercised. The last date on which an option can be exercised is called the expiration date. Options may allow for one of two forms of exercise:
With American exercise, the option can be exercised at any time up to the expiration date.
With European exercise, the option can be exercised only on the expiration date.
The origins of the names "American" and "European" in this context are unknown. They are unrelated to practices common in any particular geographic region.
A third form of exercise, which is occasionally used with OTC options, is Bermudan exercise. A Bermuda option can be exercised on a few specific dates prior to expiration. Yes, the name was chosen because Bermuda is half way between America and Europe.
As an example, consider a three-month, European exercise, strike USD 22.50 put option on 100,000 barrels of Brent oil. Such an option might trade OTC. It has:
Underlier: Brent oil
Notional amount: 100,000 barrels
Expiration: in three months
Strike price: USD 22.50
It gives the holder the right, but not the obligation, to sell the issuer 100,000 barrels of Brent oil three months from today, for a price of USD 22.50 per barrel.
Puts and calls are sometimes called vanilla options to distinguish them from more exotic structures.
An option is a contract, or a provision of a contract, that gives one party (the option holder) the right, but not the obligation, to perform a specified transaction with another party (the option issuer or option writer) according to specified terms. The owner of a property might sell another party an option to purchase the property any time during the next three months at a specified price. A lease might contain a provision granting the renter the option to extend the lease for an additional year. A corporate bond might have an option provision allowing the issuer to purchase the bond back from the purchaser five years prior to maturity for a specified price. A speculator might purchase an option to sell at any time during the next three months 100 shares of a particular stock for a specified price.
Option contracts are a form of derivative instrument. Stand-alone options trade on exchanges or OTC. They are linked to a variety of underliers. Most exchange-traded options have stocks or futures as underliers. OTC options have a greater variety of underliers, including bonds, currencies, physical commodities, swaps, or baskets of assets. Options can be embedded in almost any contract. Above, we gave examples of options embedded in a lease and a bond.
Options take many forms. The two most common are:
Call options, which provide the holder the right to purchase an underlier at a specified price;
Put options, which provide the holder the right to sell an underlier at a specified price.
The strike price of a call (put) option is the contractual price at which the underlier will be purchased (sold) in the event that the option is exercised. The last date on which an option can be exercised is called the expiration date. Options may allow for one of two forms of exercise:
With American exercise, the option can be exercised at any time up to the expiration date.
With European exercise, the option can be exercised only on the expiration date.
The origins of the names "American" and "European" in this context are unknown. They are unrelated to practices common in any particular geographic region.
A third form of exercise, which is occasionally used with OTC options, is Bermudan exercise. A Bermuda option can be exercised on a few specific dates prior to expiration. Yes, the name was chosen because Bermuda is half way between America and Europe.
As an example, consider a three-month, European exercise, strike USD 22.50 put option on 100,000 barrels of Brent oil. Such an option might trade OTC. It has:
Underlier: Brent oil
Notional amount: 100,000 barrels
Expiration: in three months
Strike price: USD 22.50
It gives the holder the right, but not the obligation, to sell the issuer 100,000 barrels of Brent oil three months from today, for a price of USD 22.50 per barrel.
Puts and calls are sometimes called vanilla options to distinguish them from more exotic structures.
kiran51083
Kiran .
VANILLA
A vanilla swap is any swap with fairly standardized provisions. The term is usually applied to vanilla interest rate swaps or vanilla currency swaps. Vanilla swaps are appealing because pricing tends to be transparent and transaction costs are small. Vanilla swaps can be used to speculate or to quickly hedge the market risk of a position without necessarily offsetting the specific cash flows of that position.
Swaps can also be customized to offset the specific cash flows of a position. Dealers often structure such non-vanilla swaps for clients. They may charge a fee for doing so, and pricing may reflect a large bid-ask spread (caveat emptor).
A vanilla swap is any swap with fairly standardized provisions. The term is usually applied to vanilla interest rate swaps or vanilla currency swaps. Vanilla swaps are appealing because pricing tends to be transparent and transaction costs are small. Vanilla swaps can be used to speculate or to quickly hedge the market risk of a position without necessarily offsetting the specific cash flows of that position.
Swaps can also be customized to offset the specific cash flows of a position. Dealers often structure such non-vanilla swaps for clients. They may charge a fee for doing so, and pricing may reflect a large bid-ask spread (caveat emptor).
kiran51083
Kiran .
TYPES:
Option styles
the style or family of an option is a general term denoting the class into which the option falls, usually defined by the dates on which the option may be exercised. The vast majority of options are either European or American (style) options. These options - as well as others where the payoff is calculated similarly - are referred to as "vanilla options". Options where the payoff is calculated differently are categorised as "exotic options". Exotic options can pose challenging problems in valuation and hedging.
American and European options
The key difference between American and European options relates to when the options can be exercised:
• A European option may be exercised only at the expiry date of the option, i.e. at a single pre-defined point in time.
• An American option on the other hand may be exercised at any time before the expiry date.
For both, the pay-off - when it occurs - is via:
Max [ (S – K), 0 ], for a call option
Max [ (K – S), 0 ], for a put option:
(Where K is the Strike price and S is the spot price of the underlying asset)
Option contracts traded on futures exchanges are mainly American-style, whereas those traded over-the-counter are mainly European.
Difference in value
European options are typically valued using the Black-Scholes or Black model formula. This is a simple equation with a closed-form solution that has become standard in the financial community. There are no general formulae for American options, but a choice of models to approximate the price are available (for example Whaley, binomial options model, and others - there is no consensus on which is preferable).
American options are rarely exercised early. This is because any option has a non-negative time value and is usually worth more unexercised. Owners who wish to realise the full value of their option will mostly prefer to sell it on, rather than exercised immediately, sacrificing the time value.
Where an American and a European option are otherwise identical (having the same strike price, etc.), the American option will be worth at least as much as the European (which it entails). If it is worth more, then the difference is a guide to the likelihood of early exercise. In practice, one can calculate the Black-Scholes price of a European option that is equivalent to the American option (except for the exercise dates of course). The difference between the two prices can then be used to calibrate the more complex American option model.
To account for the American's higher value there must be some situations in which it is optimal to exercise the American option before the expiration date. This can arise in several ways, such as:
• An in the money (ITM) call option on a stock is often exercised just before the stock pays a dividend which would lower its value by more than the option's remaining time value
• A deep ITM currency option (FX option) where the strike currency has a lower interest rate than the currency to be received will often be exercised early because the time value sacrificed is less valuable than the expected depreciation of the received currency against the strike.
• An American bond option on the dirty price of a bond (such as some convertible bonds) may be exercised immediately if ITM and a coupon is due.
• A put option on gold will be exercised early when deep ITM, because gold tends to hold its value where as the currency used as the strike is often expected to lose value through inflation if the holder waits until final maturity to exercise the option (they will almost certainly exercise a contract deep ITM, minimizing its time value).
Option styles
the style or family of an option is a general term denoting the class into which the option falls, usually defined by the dates on which the option may be exercised. The vast majority of options are either European or American (style) options. These options - as well as others where the payoff is calculated similarly - are referred to as "vanilla options". Options where the payoff is calculated differently are categorised as "exotic options". Exotic options can pose challenging problems in valuation and hedging.
American and European options
The key difference between American and European options relates to when the options can be exercised:
• A European option may be exercised only at the expiry date of the option, i.e. at a single pre-defined point in time.
• An American option on the other hand may be exercised at any time before the expiry date.
For both, the pay-off - when it occurs - is via:
Max [ (S – K), 0 ], for a call option
Max [ (K – S), 0 ], for a put option:
(Where K is the Strike price and S is the spot price of the underlying asset)
Option contracts traded on futures exchanges are mainly American-style, whereas those traded over-the-counter are mainly European.
Difference in value
European options are typically valued using the Black-Scholes or Black model formula. This is a simple equation with a closed-form solution that has become standard in the financial community. There are no general formulae for American options, but a choice of models to approximate the price are available (for example Whaley, binomial options model, and others - there is no consensus on which is preferable).
American options are rarely exercised early. This is because any option has a non-negative time value and is usually worth more unexercised. Owners who wish to realise the full value of their option will mostly prefer to sell it on, rather than exercised immediately, sacrificing the time value.
Where an American and a European option are otherwise identical (having the same strike price, etc.), the American option will be worth at least as much as the European (which it entails). If it is worth more, then the difference is a guide to the likelihood of early exercise. In practice, one can calculate the Black-Scholes price of a European option that is equivalent to the American option (except for the exercise dates of course). The difference between the two prices can then be used to calibrate the more complex American option model.
To account for the American's higher value there must be some situations in which it is optimal to exercise the American option before the expiration date. This can arise in several ways, such as:
• An in the money (ITM) call option on a stock is often exercised just before the stock pays a dividend which would lower its value by more than the option's remaining time value
• A deep ITM currency option (FX option) where the strike currency has a lower interest rate than the currency to be received will often be exercised early because the time value sacrificed is less valuable than the expected depreciation of the received currency against the strike.
• An American bond option on the dirty price of a bond (such as some convertible bonds) may be exercised immediately if ITM and a coupon is due.
• A put option on gold will be exercised early when deep ITM, because gold tends to hold its value where as the currency used as the strike is often expected to lose value through inflation if the holder waits until final maturity to exercise the option (they will almost certainly exercise a contract deep ITM, minimizing its time value).
kiran51083
Kiran .
Non-Vanilla Exercise Rights
There are other, more unusual exercise styles in which the pay-off value remains the same as a standard option (as in the classic American and European options above) but where early exercise occurs differently:
• A Bermudan option is an option where the buyer has the right to exercise at a set (always discretely spaced) number of times. This is intermediate between a European option--which allows exercise at a single time, namely expiry--and an American option, which allows exercise at any time (the name is a pun: Bermuda is between America and Europe). For example a typical Bermudan swaption might confer the opportunity to enter into an interest rate swap. The option holder might decide to enter into the swap at the first exercise date (and so enter into, say, a ten-year swap) or defer and have the opportunity to enter in six months time (and so enter a nine-year and six-month swap). Most exotic interest rate options are of Bermudian style.
• A capped-style option is not an interest rate cap but a conventional option with a pre-defined profit cap written into the contract. A capped-style option is automatically exercised when the underlying security closes at a price making the option's mark to market match the specified amount.
• A compound option is an option on another option, and as such presents the holder with two separate exercise dates and decisions. If the first exercise date arrives and the 'inner' option's market price is below the agreed strike the first option will be exercised (European style), giving the holder a further option at final maturity.
• A shout option allows the holder effectively two exercise dates: during the life of the option they can (at any time) "shout" to the seller that they are locking-in the current price, and if this gives them a better deal than the pay-off at maturity they'll use the underlying price on the shout date rather than the price at maturity to calculate their final pay-off.
• A swing option gives the purchaser the right to exercise one and only one call or put on any one of a number of specified exercise dates (this latter aspect is Bermudan). Penalties are imposed on the buyer if the net volume purchased exceeds or falls below specified upper and lower limits. Allows the buyer to "swing" the price of the underlying asset. Primarily used in energy trading.
There are other, more unusual exercise styles in which the pay-off value remains the same as a standard option (as in the classic American and European options above) but where early exercise occurs differently:
• A Bermudan option is an option where the buyer has the right to exercise at a set (always discretely spaced) number of times. This is intermediate between a European option--which allows exercise at a single time, namely expiry--and an American option, which allows exercise at any time (the name is a pun: Bermuda is between America and Europe). For example a typical Bermudan swaption might confer the opportunity to enter into an interest rate swap. The option holder might decide to enter into the swap at the first exercise date (and so enter into, say, a ten-year swap) or defer and have the opportunity to enter in six months time (and so enter a nine-year and six-month swap). Most exotic interest rate options are of Bermudian style.
• A capped-style option is not an interest rate cap but a conventional option with a pre-defined profit cap written into the contract. A capped-style option is automatically exercised when the underlying security closes at a price making the option's mark to market match the specified amount.
• A compound option is an option on another option, and as such presents the holder with two separate exercise dates and decisions. If the first exercise date arrives and the 'inner' option's market price is below the agreed strike the first option will be exercised (European style), giving the holder a further option at final maturity.
• A shout option allows the holder effectively two exercise dates: during the life of the option they can (at any time) "shout" to the seller that they are locking-in the current price, and if this gives them a better deal than the pay-off at maturity they'll use the underlying price on the shout date rather than the price at maturity to calculate their final pay-off.
• A swing option gives the purchaser the right to exercise one and only one call or put on any one of a number of specified exercise dates (this latter aspect is Bermudan). Penalties are imposed on the buyer if the net volume purchased exceeds or falls below specified upper and lower limits. Allows the buyer to "swing" the price of the underlying asset. Primarily used in energy trading.
kiran51083
Kiran .
"Exotic" Options with Standard Exercise Styles
These options can be exercised either European style or American style; they differ from the plain vanilla option only in the calculation of their pay-off value:
• A cross option (or composite option) is an option on some underlying in one currency with a strike denominated in another currency. For example a standard call option on IBM, which is denominated in dollars pays $MAX(S-K,0) (where S is the stock price at maturity and K is the strike). A composite stock option might pay £MAX(S/Q-K,0), where Q is the prevailing FX rate. The pricing of such options naturally needs to take into account FX volatilty and the correlation between the exchange rate of the two currencies involved and the underlying stock price.
• A quanto option is a cross option in which the exchange rate is fixed at the outset of the trade, typically at 1. The payoff of an IBM quanto call option would then be £max(S-K,0).
• An exchange option is the right to exchange one asset for another (such as a sugar future for a corporate bond).
• A basket option' is an option on the weighted average of several underlyings
• A rainbow option is a basket option where the weightings depend on the final performances of the components. A common special case is an option on the worst-performing of several stocks.
Non-vanilla path dependent "exotic" options
The following "exotic options" are still options, but have payoffs calculated quite differently from those above. Although these instruments are far more unusual they can also vary in exercise style (at least theoretically) between European and American:
• A lookback option is a path dependent option where the option owner has the right to buy (sell) the underlying instrument at its lowest (highest) price over some preceding period.
• An Asian option is an option where the payoff is not determined by the underlying price at maturity but by the average underlying price over some pre-set period of time. For example an asian call option might pay MAX(DAILY_AVERAGE_OVER_LAST_THREE_MONTHS(S) - K, 0).
• A Russian option is a lookback option which runs for perpetuity. That is, there is no end to the period into which the owner can look back.
• A game option or Israeli option is an option where the writer has the opportunity to cancel the option he has offered, but must pay the payoff at that point plus a penalty fee.
• The payoff of a Parisian option is dependent of the amount of time the option has spent above or below a strike price.
• A barrier option involves a mechanism where if a price is crossed by the underlying, the option either can be exercised or can no longer be exercised.
• A binary option (also known as a digital option) pays a fixed amount, or nothing at all, depending on the price of the underlying instrument at maturity.
• A chooser option gives the purchaser a fixed period of time to decide whether the derivative will be a vanilla call or put.
These options can be exercised either European style or American style; they differ from the plain vanilla option only in the calculation of their pay-off value:
• A cross option (or composite option) is an option on some underlying in one currency with a strike denominated in another currency. For example a standard call option on IBM, which is denominated in dollars pays $MAX(S-K,0) (where S is the stock price at maturity and K is the strike). A composite stock option might pay £MAX(S/Q-K,0), where Q is the prevailing FX rate. The pricing of such options naturally needs to take into account FX volatilty and the correlation between the exchange rate of the two currencies involved and the underlying stock price.
• A quanto option is a cross option in which the exchange rate is fixed at the outset of the trade, typically at 1. The payoff of an IBM quanto call option would then be £max(S-K,0).
• An exchange option is the right to exchange one asset for another (such as a sugar future for a corporate bond).
• A basket option' is an option on the weighted average of several underlyings
• A rainbow option is a basket option where the weightings depend on the final performances of the components. A common special case is an option on the worst-performing of several stocks.
Non-vanilla path dependent "exotic" options
The following "exotic options" are still options, but have payoffs calculated quite differently from those above. Although these instruments are far more unusual they can also vary in exercise style (at least theoretically) between European and American:
• A lookback option is a path dependent option where the option owner has the right to buy (sell) the underlying instrument at its lowest (highest) price over some preceding period.
• An Asian option is an option where the payoff is not determined by the underlying price at maturity but by the average underlying price over some pre-set period of time. For example an asian call option might pay MAX(DAILY_AVERAGE_OVER_LAST_THREE_MONTHS(S) - K, 0).
• A Russian option is a lookback option which runs for perpetuity. That is, there is no end to the period into which the owner can look back.
• A game option or Israeli option is an option where the writer has the opportunity to cancel the option he has offered, but must pay the payoff at that point plus a penalty fee.
• The payoff of a Parisian option is dependent of the amount of time the option has spent above or below a strike price.
• A barrier option involves a mechanism where if a price is crossed by the underlying, the option either can be exercised or can no longer be exercised.
• A binary option (also known as a digital option) pays a fixed amount, or nothing at all, depending on the price of the underlying instrument at maturity.
• A chooser option gives the purchaser a fixed period of time to decide whether the derivative will be a vanilla call or put.
kiran51083
Kiran .
Call
A call option is a financial contract between two parties, the buyer and the seller of this type of option. Often it is simply labeled a "call". The buyer of the option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument (the underlying instrument) from the seller of the option at a certain time (the expiration date) for a certain price (the strike price). The seller (or "writer") is obligated to sell the commodity or financial instrument should the buyer so decide. The buyer pays a fee (called a premium) for this right.
The buyer of a call option wants the price of the underlying instrument to rise in the future; the seller either expects that it will not, or is willing to give up some of the upside (profit) from a price rise in return for (a) the premium (paid immediately) plus (b) retaining the opportunity to make a gain up to the strike price (see below for examples).
Call options are most profitable for the buyer when the underlying instrument is moving up, making the price of the underlying instrument closer to the strike price. When the price of the underlying instrument surpasses the strike price, the option is said to be "in the money."
The initial transaction in this context (buying/selling a call option) is not the supplying of a physical or financial asset (the underlying instrument). Rather it is the granting of the right to buy the underlying asset, in exchange for a fee - the option price or premium.
Exact specifications may differ depending on option style. A European call option allows the holder to exercise the option (i.e., to buy) only on the option expiration date. An American call option allows exercise at any time during the life of the option.
Call options can be purchased on many financial instruments other than stock in a corporation - options can be purchased on futures on interest rates, for example (see interest rate cap) - as well as on commodities such as gold or crude oil. A call option should not be confused with either Incentive stock options or with a warrant. An incentive stock option, the option to buy stock in a particular company, is a right granted by a corporation to a particular person (typically executives) to purchase treasury stock. When an incentive stock option is exercised, new shares are issued. Incentive stock options are not traded on the open market. In contrast, when a call option is exercised, the underlying asset is transferred from one owner to another.
A call option is a financial contract between two parties, the buyer and the seller of this type of option. Often it is simply labeled a "call". The buyer of the option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument (the underlying instrument) from the seller of the option at a certain time (the expiration date) for a certain price (the strike price). The seller (or "writer") is obligated to sell the commodity or financial instrument should the buyer so decide. The buyer pays a fee (called a premium) for this right.
The buyer of a call option wants the price of the underlying instrument to rise in the future; the seller either expects that it will not, or is willing to give up some of the upside (profit) from a price rise in return for (a) the premium (paid immediately) plus (b) retaining the opportunity to make a gain up to the strike price (see below for examples).
Call options are most profitable for the buyer when the underlying instrument is moving up, making the price of the underlying instrument closer to the strike price. When the price of the underlying instrument surpasses the strike price, the option is said to be "in the money."
The initial transaction in this context (buying/selling a call option) is not the supplying of a physical or financial asset (the underlying instrument). Rather it is the granting of the right to buy the underlying asset, in exchange for a fee - the option price or premium.
Exact specifications may differ depending on option style. A European call option allows the holder to exercise the option (i.e., to buy) only on the option expiration date. An American call option allows exercise at any time during the life of the option.
Call options can be purchased on many financial instruments other than stock in a corporation - options can be purchased on futures on interest rates, for example (see interest rate cap) - as well as on commodities such as gold or crude oil. A call option should not be confused with either Incentive stock options or with a warrant. An incentive stock option, the option to buy stock in a particular company, is a right granted by a corporation to a particular person (typically executives) to purchase treasury stock. When an incentive stock option is exercised, new shares are issued. Incentive stock options are not traded on the open market. In contrast, when a call option is exercised, the underlying asset is transferred from one owner to another.
kiran51083
Kiran .
Example of a call option on a stock
• An investor buys a call on Microsoft Corporation stock with a strike price of $50 and an option expiration date of June 16 2006, and pays a premium of $5 for this call option. The current price is $40.
• Assume that the share price (the spot price) rises, and is $60 on the strike date. The investor would exercise the option (i.e., buy the share from the counter-party), and could then hold the share, or sell it in the open market for $60. The profit would be $10 minus the fee paid for the option, $5, for a net profit of $5. The investor has thus doubled his money, having paid $5, and ending up with $10.
• If however the share price never rises to $50 (that is, it stays below the strike price) up through the exercise date, then the option would expire as worthless. The investor loses the premium of $5.
• Thus, in any case, the loss is limited to the fee (premium) initially paid to purchase the stock, while the potential gain is theoretically unlimited (consider if the share price rose to $100).
• From the viewpoint of the seller, if the seller thinks the stock is a good one, he/she is $5 better (in this case) by selling the call option, should the stock in fact rise. However, the strike price (in this case, $50) limits the seller's profit. In this case, the seller does realize the profit up to the strike price (that is, the $10 rise in price, from $40 to $50, belongs entirely to the seller of the call option), but the increase in the stock price thereafter goes entirely to the buyer of the call option.
________________________________________
From the above, it is clear that a call option has positive monetary value when the underlying instrument has a spot price (S) above the strike price (K). Since the option will not be exercised unless it is "in-the-money", the payoff for a call option is
Max[(S - K);0] or formally, (S - K) +
where
Prior to exercise, the option value, and therefore price, varies with the underlying price and with time. The call price must reflect the "likelihood" or chance of the option "finishing in-the-money". The price should thus be higher with more time to expiry (except in cases when a significant dividend is present), and with a more volatile underlying instrument. The science of determining this value is the central tenet of financial mathematics. The most common method is to use the Black-Scholes formula. Whatever the formula used, the buyer and seller must agree on the initial value (the premium), otherwise the exchange (buy/sell) of the option will not take place.
• An investor buys a call on Microsoft Corporation stock with a strike price of $50 and an option expiration date of June 16 2006, and pays a premium of $5 for this call option. The current price is $40.
• Assume that the share price (the spot price) rises, and is $60 on the strike date. The investor would exercise the option (i.e., buy the share from the counter-party), and could then hold the share, or sell it in the open market for $60. The profit would be $10 minus the fee paid for the option, $5, for a net profit of $5. The investor has thus doubled his money, having paid $5, and ending up with $10.
• If however the share price never rises to $50 (that is, it stays below the strike price) up through the exercise date, then the option would expire as worthless. The investor loses the premium of $5.
• Thus, in any case, the loss is limited to the fee (premium) initially paid to purchase the stock, while the potential gain is theoretically unlimited (consider if the share price rose to $100).
• From the viewpoint of the seller, if the seller thinks the stock is a good one, he/she is $5 better (in this case) by selling the call option, should the stock in fact rise. However, the strike price (in this case, $50) limits the seller's profit. In this case, the seller does realize the profit up to the strike price (that is, the $10 rise in price, from $40 to $50, belongs entirely to the seller of the call option), but the increase in the stock price thereafter goes entirely to the buyer of the call option.
________________________________________
From the above, it is clear that a call option has positive monetary value when the underlying instrument has a spot price (S) above the strike price (K). Since the option will not be exercised unless it is "in-the-money", the payoff for a call option is
Max[(S - K);0] or formally, (S - K) +
where
Prior to exercise, the option value, and therefore price, varies with the underlying price and with time. The call price must reflect the "likelihood" or chance of the option "finishing in-the-money". The price should thus be higher with more time to expiry (except in cases when a significant dividend is present), and with a more volatile underlying instrument. The science of determining this value is the central tenet of financial mathematics. The most common method is to use the Black-Scholes formula. Whatever the formula used, the buyer and seller must agree on the initial value (the premium), otherwise the exchange (buy/sell) of the option will not take place.
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Put
A put option (sometimes simply called a "put") is a financial contract between two parties, the buyer and the writer of the option. The put allows the buyer the right but not the obligation to sell a commodity or financial instrument (the underlying instrument) to the writer of the option for a certain time for a certain price (the strike price). The writer has the obligation to purchase the underlying asset at that strike price, if the buyer exercises the option.
Note that the writer of the option is agreeing to buy the underlying asset if the put holder exercises the option. In exchange for having this option, the buyer pays the writer a fee (the premium). (Note: Although option writers are frequently referred to as sellers, because they initially sell the option that they create, thus, taking a short position in the option, they are not the only sellers. An option holder can also sell his long position in the option. However, the difference between the two sellers is that the option writer takes on the legal obligation to buy the underlying asset at the strike price, whereas, the option holder is merely selling his long position, and is not contractually obligated by the sold option.)
Exact specifications may differ depending on option style. A European put option allows the holder to exercise the put option for a short period of time right before expiration. An American put option allows exercise at any time during the life of the option.
The most widely-known put option is for stock in a particular company. However, options are traded on many other assets: financial - such as interest rates (see interest rate floor) - and physical, such as gold or crude oil.
The buyer of the put either expects the price of the underlying asset to fall or to protect a long position in the asset. The advantage of buying a put over shorting the asset is that the risk is limited to the premium. The put writer does not expect the price of the underlying to fall, and so writes the put to collect the premium. Puts can also be used to limit portfolio risk, and may be part of an option spread.
________________________________________
Example of a put option on a stock
• I purchase a put contract to sell 100 shares of XYZ Corp. for $50. The current price is $55, and I pay a premium of $5. If the price of XYZ stock falls to $40 per share right before expiration, then I can exercise my put by buying 100 shares for $4,000, then selling it to a put writer for $5,000. My total profit would equal $500 ($5,000 from put writer - $4,000 for buying the stock - $500 for buying the put contract of 100 shares at $5 per share, excluding commissions).
• If, however, the share price never drops below the strike price (in this case, $50), then I would not exercise the option. (Why sell a stock to someone at $50, the strike price, if it would cost me more than that to buy it?) My option would be worthless and I would have lost my whole investment, the fee (premium) for the option contract, $500 ($5 per share, 100 shares per contract). My total loss is limited to the cost of the put premium plus the sales commission to buy it.
________________________________________
This example illustrates that the put option has positive monetary value when the underlying instrument has a spot price (S) below the strike price (K). Since the option will not be exercised unless it is "in-the-money", the payoff for a put option is
max[ (K − S) ; 0 ] or formally, (K - S) +
where :
Prior to exercise, the option value, and therefore price, varies with the underlying price and with time. The put price must reflect the "likelihood" or chance of the option "finishing in-the-money". The price should thus be higher with more time to expiry, and with a more volatile underlying instrument. The science of determining this value is the central tenet of financial mathematics. The most common method is to use the Black-Scholes formula. Whatever the formula used, the buyer and seller must agree this value initially.
A put option (sometimes simply called a "put") is a financial contract between two parties, the buyer and the writer of the option. The put allows the buyer the right but not the obligation to sell a commodity or financial instrument (the underlying instrument) to the writer of the option for a certain time for a certain price (the strike price). The writer has the obligation to purchase the underlying asset at that strike price, if the buyer exercises the option.
Note that the writer of the option is agreeing to buy the underlying asset if the put holder exercises the option. In exchange for having this option, the buyer pays the writer a fee (the premium). (Note: Although option writers are frequently referred to as sellers, because they initially sell the option that they create, thus, taking a short position in the option, they are not the only sellers. An option holder can also sell his long position in the option. However, the difference between the two sellers is that the option writer takes on the legal obligation to buy the underlying asset at the strike price, whereas, the option holder is merely selling his long position, and is not contractually obligated by the sold option.)
Exact specifications may differ depending on option style. A European put option allows the holder to exercise the put option for a short period of time right before expiration. An American put option allows exercise at any time during the life of the option.
The most widely-known put option is for stock in a particular company. However, options are traded on many other assets: financial - such as interest rates (see interest rate floor) - and physical, such as gold or crude oil.
The buyer of the put either expects the price of the underlying asset to fall or to protect a long position in the asset. The advantage of buying a put over shorting the asset is that the risk is limited to the premium. The put writer does not expect the price of the underlying to fall, and so writes the put to collect the premium. Puts can also be used to limit portfolio risk, and may be part of an option spread.
________________________________________
Example of a put option on a stock
• I purchase a put contract to sell 100 shares of XYZ Corp. for $50. The current price is $55, and I pay a premium of $5. If the price of XYZ stock falls to $40 per share right before expiration, then I can exercise my put by buying 100 shares for $4,000, then selling it to a put writer for $5,000. My total profit would equal $500 ($5,000 from put writer - $4,000 for buying the stock - $500 for buying the put contract of 100 shares at $5 per share, excluding commissions).
• If, however, the share price never drops below the strike price (in this case, $50), then I would not exercise the option. (Why sell a stock to someone at $50, the strike price, if it would cost me more than that to buy it?) My option would be worthless and I would have lost my whole investment, the fee (premium) for the option contract, $500 ($5 per share, 100 shares per contract). My total loss is limited to the cost of the put premium plus the sales commission to buy it.
________________________________________
This example illustrates that the put option has positive monetary value when the underlying instrument has a spot price (S) below the strike price (K). Since the option will not be exercised unless it is "in-the-money", the payoff for a put option is
max[ (K − S) ; 0 ] or formally, (K - S) +
where :
Prior to exercise, the option value, and therefore price, varies with the underlying price and with time. The put price must reflect the "likelihood" or chance of the option "finishing in-the-money". The price should thus be higher with more time to expiry, and with a more volatile underlying instrument. The science of determining this value is the central tenet of financial mathematics. The most common method is to use the Black-Scholes formula. Whatever the formula used, the buyer and seller must agree this value initially.
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The following factors have generally been identified as the major driving force behind growth of financial derivatives:
1. Increased volatility in asset prices in financial markets.
2. Increased integration of national financial markets with the international markets.
3. Marked improvement in communication facilities and sharp decline in their costs.
4. Development of more sophisticated risk management tools, providing economic agents a wider choice of risk management strategies.
5. Innovations in the derivatives markets, which optimally combine the risks and returns over a large number of financial assets, leading to higher returns, reduced risk as well as transaction costs as compared to individual financial assets
1. Increased volatility in asset prices in financial markets.
2. Increased integration of national financial markets with the international markets.
3. Marked improvement in communication facilities and sharp decline in their costs.
4. Development of more sophisticated risk management tools, providing economic agents a wider choice of risk management strategies.
5. Innovations in the derivatives markets, which optimally combine the risks and returns over a large number of financial assets, leading to higher returns, reduced risk as well as transaction costs as compared to individual financial assets
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FUNCTIONS OF DERIVATIVE MARKET:-
The derivative market performs a number of economic functions:
First, prices in an organized derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. The prices of derivatives converge with the prices of the underlying at the expiration of derivative contract. Thus derivatives help in discovery of future as well as current prices.
Second, the derivatives market helps to transfer risks from those who have them but may not like them to those who have appetite for them.
Third, derivatives, due to their inherent nature, are linked to the underlying cash markets. With the introduction of derivatives, the underlying market witnesses higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk.
Fourth, speculative trades shift to a more controlled environment of derivatives market. In the absence of an organized derivatives market, speculators trade in the underlying cash markets. Margining, monitoring and surveillance of the activities of various participants become extremely difficult in these kind of mixed markets.
Fifth, an important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. The derivatives have a history of attracting many bright, creative, well-educated people with an entrepreneurial attitude. They often energize others to create new businesses, new products and new employment opportunities, the benefit of which are immense.
Sixth, derivatives markets help increase savings and investment in the long run. Transfer of risk enables market participants to expand their volume of activity.
The derivative market performs a number of economic functions:
First, prices in an organized derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. The prices of derivatives converge with the prices of the underlying at the expiration of derivative contract. Thus derivatives help in discovery of future as well as current prices.
Second, the derivatives market helps to transfer risks from those who have them but may not like them to those who have appetite for them.
Third, derivatives, due to their inherent nature, are linked to the underlying cash markets. With the introduction of derivatives, the underlying market witnesses higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk.
Fourth, speculative trades shift to a more controlled environment of derivatives market. In the absence of an organized derivatives market, speculators trade in the underlying cash markets. Margining, monitoring and surveillance of the activities of various participants become extremely difficult in these kind of mixed markets.
Fifth, an important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. The derivatives have a history of attracting many bright, creative, well-educated people with an entrepreneurial attitude. They often energize others to create new businesses, new products and new employment opportunities, the benefit of which are immense.
Sixth, derivatives markets help increase savings and investment in the long run. Transfer of risk enables market participants to expand their volume of activity.
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DEVELOPMENT OF DERIVATIVE MARKET IN INDIA:-
The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on options in securities. The market for derivatives, however, did not take off, as there was no regulatory framework to govern trading of derivatives. SEBI set up a 24-member committee under the Chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop appropriate regulatory framework for derivatives trading in India. The committee submitted its report on March 17, 1998 prescribing necessary pre-conditions for introduction of derivatives trading in India. The committee recommended that derivatives should be declared as ‘securities’ so that regulatory framework applicable to trading of ‘securities’ could also govern trading of securities. SEBI also set up a group in June 1998 under the Chairmanship of Prof.J.R.Varma, to recommend measures for risk containment in derivatives market in India. The report, which was submitted in October 1998, worked out the operational details of margining system, methodology for charging initial margins, broker net worth, deposit requirement and real-time monitoring requirements.
The Securities Contract Regulation Act (SCRA) was amended in December 1999 to include derivatives within the ambit of ‘securities’ and the regulatory framework was developed for governing derivatives trading. The act also made it clear that derivatives shall be legal and valid only if such contracts are traded on a recognized stock exchange, thus precluding OTC derivatives. The government also rescinded in March 2000, the three decade old notification, which prohibited forward trading in securities.
Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2001, SEBI permitted the derivative segments of two stock exchanges, NSE and BSE, and their clearing house/corporation to commence trading and settlement in approved derivatives contracts. To begin with, SEBI approved trading in index futures contracts based on S&P CNX Nifty and BSE-30 (Sensex) index. This was followed by approval for trading in options based on these two indexes and options on individual securities.
The trading in BSE Sensex options commenced on June 4, 2001 and the trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001. The derivatives trading on NSE commenced with S&P CNX Nifty Index future on June 12, 2000. The trading in index options commenced on June 4, 2001 and trading in options on individuals securities commenced on July 2, 2001. Single stock futures were launched on November 9, 2001. The index futures and options contract on NSE are based on S&P CNX.
Trading and settlement in derivative contracts is done in accordance with the rules, byelaws, and regulations of the respective exchanges and their clearing house/corporation duly approved by SEBI and notified in the official gazette. Foreign Institutional Investors (FIIs) are permitted to trade in all Exchange traded derivative products.
The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on options in securities. The market for derivatives, however, did not take off, as there was no regulatory framework to govern trading of derivatives. SEBI set up a 24-member committee under the Chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop appropriate regulatory framework for derivatives trading in India. The committee submitted its report on March 17, 1998 prescribing necessary pre-conditions for introduction of derivatives trading in India. The committee recommended that derivatives should be declared as ‘securities’ so that regulatory framework applicable to trading of ‘securities’ could also govern trading of securities. SEBI also set up a group in June 1998 under the Chairmanship of Prof.J.R.Varma, to recommend measures for risk containment in derivatives market in India. The report, which was submitted in October 1998, worked out the operational details of margining system, methodology for charging initial margins, broker net worth, deposit requirement and real-time monitoring requirements.
The Securities Contract Regulation Act (SCRA) was amended in December 1999 to include derivatives within the ambit of ‘securities’ and the regulatory framework was developed for governing derivatives trading. The act also made it clear that derivatives shall be legal and valid only if such contracts are traded on a recognized stock exchange, thus precluding OTC derivatives. The government also rescinded in March 2000, the three decade old notification, which prohibited forward trading in securities.
Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2001, SEBI permitted the derivative segments of two stock exchanges, NSE and BSE, and their clearing house/corporation to commence trading and settlement in approved derivatives contracts. To begin with, SEBI approved trading in index futures contracts based on S&P CNX Nifty and BSE-30 (Sensex) index. This was followed by approval for trading in options based on these two indexes and options on individual securities.
The trading in BSE Sensex options commenced on June 4, 2001 and the trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001. The derivatives trading on NSE commenced with S&P CNX Nifty Index future on June 12, 2000. The trading in index options commenced on June 4, 2001 and trading in options on individuals securities commenced on July 2, 2001. Single stock futures were launched on November 9, 2001. The index futures and options contract on NSE are based on S&P CNX.
Trading and settlement in derivative contracts is done in accordance with the rules, byelaws, and regulations of the respective exchanges and their clearing house/corporation duly approved by SEBI and notified in the official gazette. Foreign Institutional Investors (FIIs) are permitted to trade in all Exchange traded derivative products.
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The following are some observations based on the trading statistics provided in the NSE report on the futures and options (F&O):
• Single-stock futures continue to account for a sizable proportion of the F&O segment. It constituted 70 per cent of the total turnover during June, 2002. A primary reason attributed to this phenomenon is that traders are comfortable with single-stock futures than equity options, as the former closely resembles the erstwhile badla system.
• On relative terms, volumes in the index options segment continues to remain poor. This may be due to the low volatility of the spot index. Typically, options are considered more valuable when the volatility of the underlying (in this case, the index) is high. A related issue is that brokers do not earn high commissions by recommending index, options to their clients, because low volatility leads to higher waiting time for round-trips.
• Put volumes in the index options and equity options segment have increased since January 2002. The call-put volumes in index options have decreased from 2.86 to January 2002 to 1.32 in June. The fall in call-put volumes ratio suggests that the traders are increasingly becoming pessimistic on the market.
• Farther month futures contracts are still not actively traded. Trading in equity options on most stocks for even the next month was non-existent.
• Daily option price variations suggest that traders use the F&O segment as a less risky alternative to generate profits from the stock price movements. The fact that the option premiums Tail intra-day stock prices is evidence to this calls on Satyam fall, while puts rise when Satyam falls intra-days. If calls and puts are not looked as just substitutes for Spot Trading, the intra-day stock price variations should not have a one-to-one impact on the option premiums.
• Single-stock futures continue to account for a sizable proportion of the F&O segment. It constituted 70 per cent of the total turnover during June, 2002. A primary reason attributed to this phenomenon is that traders are comfortable with single-stock futures than equity options, as the former closely resembles the erstwhile badla system.
• On relative terms, volumes in the index options segment continues to remain poor. This may be due to the low volatility of the spot index. Typically, options are considered more valuable when the volatility of the underlying (in this case, the index) is high. A related issue is that brokers do not earn high commissions by recommending index, options to their clients, because low volatility leads to higher waiting time for round-trips.
• Put volumes in the index options and equity options segment have increased since January 2002. The call-put volumes in index options have decreased from 2.86 to January 2002 to 1.32 in June. The fall in call-put volumes ratio suggests that the traders are increasingly becoming pessimistic on the market.
• Farther month futures contracts are still not actively traded. Trading in equity options on most stocks for even the next month was non-existent.
• Daily option price variations suggest that traders use the F&O segment as a less risky alternative to generate profits from the stock price movements. The fact that the option premiums Tail intra-day stock prices is evidence to this calls on Satyam fall, while puts rise when Satyam falls intra-days. If calls and puts are not looked as just substitutes for Spot Trading, the intra-day stock price variations should not have a one-to-one impact on the option premiums.
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The SCF recommended following measures to safeguard the integrity of the market and protect investors:
1. Dr.L.C.Gupta committee appointed by SEBI has drawn out detailed guidelines pertaining to the regulatory framework on derivatives prescribing necessary preconditions which should be adopted before the introduction of derivatives.
2. There is an urgent need to educate Indian investors by creating investment awareness among them by conducting intensive educational programmes, so that they are able to understand their risk profiles in a better way.
3. The steps should be taken to strengthen the cash marker so that they become strong and efficient.
4. It is incumbent on the regulatory authorities to ensure a strong surveillance/ vigilance and enforcement machinery.
5. SEBI should in consultation with the stock exchanges endeavour to conduct the certification programme on derivatives trading with a view to educate the investors and market players.
6. There is a need to protect particularly the small investors by preventing them from venturing into options and futures market, who may be lured by sheer speculative gains. Threshold limit of the derivatives transactions should be pegged not below Rs.2 lakh.
7. There is an urgent need to prescribe pronounced accounting standards in the case of investors/ dealers and also back office standards for intermediaries with a view to reducing the possibility of concealing the loss and perpetrating the frauds by companies/ intermediaries to a minimum. Institute of Chartered Accountants of India, in consultation with the stock exchanges, should formulate suitable accounting standard and SEBI should prescribe the same before trading in derivatives is commenced.
Group on Risk Management
SEBI constituted a group in June 1998 under the Chairmanship of one of its members, Prof. J.R.Varma, to recommend measures for risk containment in the derivatives market in India. The group submitted its report in October, 1998, covering the operational details of the margining system, methodology for charging initial margins, broker net worth, deposit (liquid assets) requirement and real-time monitoring requirements, including intra-day violations etc. to be followed by all exchanges/ clearing corporations, which allow stock index futures trading. The main recommendations of the Group were accepted by SEBI in March 1999.
1. Dr.L.C.Gupta committee appointed by SEBI has drawn out detailed guidelines pertaining to the regulatory framework on derivatives prescribing necessary preconditions which should be adopted before the introduction of derivatives.
2. There is an urgent need to educate Indian investors by creating investment awareness among them by conducting intensive educational programmes, so that they are able to understand their risk profiles in a better way.
3. The steps should be taken to strengthen the cash marker so that they become strong and efficient.
4. It is incumbent on the regulatory authorities to ensure a strong surveillance/ vigilance and enforcement machinery.
5. SEBI should in consultation with the stock exchanges endeavour to conduct the certification programme on derivatives trading with a view to educate the investors and market players.
6. There is a need to protect particularly the small investors by preventing them from venturing into options and futures market, who may be lured by sheer speculative gains. Threshold limit of the derivatives transactions should be pegged not below Rs.2 lakh.
7. There is an urgent need to prescribe pronounced accounting standards in the case of investors/ dealers and also back office standards for intermediaries with a view to reducing the possibility of concealing the loss and perpetrating the frauds by companies/ intermediaries to a minimum. Institute of Chartered Accountants of India, in consultation with the stock exchanges, should formulate suitable accounting standard and SEBI should prescribe the same before trading in derivatives is commenced.
Group on Risk Management
SEBI constituted a group in June 1998 under the Chairmanship of one of its members, Prof. J.R.Varma, to recommend measures for risk containment in the derivatives market in India. The group submitted its report in October, 1998, covering the operational details of the margining system, methodology for charging initial margins, broker net worth, deposit (liquid assets) requirement and real-time monitoring requirements, including intra-day violations etc. to be followed by all exchanges/ clearing corporations, which allow stock index futures trading. The main recommendations of the Group were accepted by SEBI in March 1999.
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Forwarding Trading in Securities:
By a notification issued on March 1, 2000, the Government lifted the three-decade old prohibition on forward trading in securities by rescinding 1969 notification. This prohibition was imposed by Government in exercise of its powers under section 16 of the SC ( R )A by a notification issued on June 27, 1969 in order to curb certain unhealthy trends, which had developed in the securities markets at that time and to prevent undesirable speculation. In the changed financial environment, the relevance of this prohibition had vastly reduced. Through appropriate amendments in the byelaws of the exchanges, carry-forward transactions in the securities were permitted. Similarly, periodic amendments to the aforesaid notification were made to permit repo transactions in government securities by authorized intermediaries. Even though the notification of 1969 was in force, exceptions had been carved out in course of time as market needs changed and some form of forward trading (carry forward/ ready forward) was prevalent. The repeal of the June 1969 notification was desirable as a measure of market reform to make way for the introduction of derivatives trading. The L.C.Gupta Committee had also recommended in its report that this notification be amended to enable trading in futures and options.
Regulatory Amendments:
The regulations for Mutual Funds were amended to allow them to trade in derivatives. Regulations were also amended to provide for application and conditions for registration, payment of fees by trading and clearing members of derivative segment or clearing house.
Currently, FIIs do not pay any margins in the cash market and bring in funds only for transactions in equities. In derivatives trading, however, all investors, including FIIs, have to bring in up-front margins. The High Level Committee on Capital markets favoured FIIs to bring in funds in advance to meet their margin requirements for trading in equity derivatives.
By a notification issued on March 1, 2000, the Government lifted the three-decade old prohibition on forward trading in securities by rescinding 1969 notification. This prohibition was imposed by Government in exercise of its powers under section 16 of the SC ( R )A by a notification issued on June 27, 1969 in order to curb certain unhealthy trends, which had developed in the securities markets at that time and to prevent undesirable speculation. In the changed financial environment, the relevance of this prohibition had vastly reduced. Through appropriate amendments in the byelaws of the exchanges, carry-forward transactions in the securities were permitted. Similarly, periodic amendments to the aforesaid notification were made to permit repo transactions in government securities by authorized intermediaries. Even though the notification of 1969 was in force, exceptions had been carved out in course of time as market needs changed and some form of forward trading (carry forward/ ready forward) was prevalent. The repeal of the June 1969 notification was desirable as a measure of market reform to make way for the introduction of derivatives trading. The L.C.Gupta Committee had also recommended in its report that this notification be amended to enable trading in futures and options.
Regulatory Amendments:
The regulations for Mutual Funds were amended to allow them to trade in derivatives. Regulations were also amended to provide for application and conditions for registration, payment of fees by trading and clearing members of derivative segment or clearing house.
Currently, FIIs do not pay any margins in the cash market and bring in funds only for transactions in equities. In derivatives trading, however, all investors, including FIIs, have to bring in up-front margins. The High Level Committee on Capital markets favoured FIIs to bring in funds in advance to meet their margin requirements for trading in equity derivatives.
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DERIVATIVES MARKET AT NSE:
The derivatives trading on the Exchange commenced with S&P CNX Nifty Index futures on June 12, 2000. The futures contract on NSE is based on S&P CNX Nifty Index. Currently, it has a maximum of 3-month expiration cycle. Three contracts are available for trading, with 1 month, 2 months and 3 months expiry. A new contract is introduced on the next trading day following the expiry of the near month contract. Various conditions like, Good-till Day, Good-till-Cancelled, Good-till-ate, Immediate or Cancel, Stop loss, etc. can be built into an order. The salient features of S&P Index Futures Contract are presented in
The derivatives trading on the Exchange commenced with S&P CNX Nifty Index futures on June 12, 2000. The futures contract on NSE is based on S&P CNX Nifty Index. Currently, it has a maximum of 3-month expiration cycle. Three contracts are available for trading, with 1 month, 2 months and 3 months expiry. A new contract is introduced on the next trading day following the expiry of the near month contract. Various conditions like, Good-till Day, Good-till-Cancelled, Good-till-ate, Immediate or Cancel, Stop loss, etc. can be built into an order. The salient features of S&P Index Futures Contract are presented in
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Trading Mechanism:
The Futures and Options trading system of NSE, called NEAT-F&O trading system, provides a fully automated screen-based trading for S&P CNX Nifty futures on a nationwide basis and an online monitoring and surveillance mechanism. It supports an order driven market and provides complete transparency of trading operations. It is similar to that of trading of equities in the CM segment.
The NEAT-F&O trading system is accessed by two types of users. The Trading Members ™ have access to functions such as, order entry, order matching, order and trade management. The Clearing Members (CM) use the trader workstation for the purpose of monitoring the trading member (s) for whom they clear the trades. Additionally, they can enter and set limits to positions, which a trading member can
take
The Futures and Options trading system of NSE, called NEAT-F&O trading system, provides a fully automated screen-based trading for S&P CNX Nifty futures on a nationwide basis and an online monitoring and surveillance mechanism. It supports an order driven market and provides complete transparency of trading operations. It is similar to that of trading of equities in the CM segment.
The NEAT-F&O trading system is accessed by two types of users. The Trading Members ™ have access to functions such as, order entry, order matching, order and trade management. The Clearing Members (CM) use the trader workstation for the purpose of monitoring the trading member (s) for whom they clear the trades. Additionally, they can enter and set limits to positions, which a trading member can
take
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Charges
The maximum brokerage chargeable by a trading member in relation to trades affected in the contracts admitted to dealing on the derivatives segment of the Exchange is fixed at 2.5% of the contract value, exclusive of statutory levies.
The transaction charges payable by each trading member on the trades executed by him on the derivatives segment are fixed at Rs.2 per lakh or turnover (0.002%) (each side) or Rs.1 lakh annually, whichever is higher. However, these charges have been waived upto 3rd of 2000. The trading members contribute to Investor Protection Fund of derivatives segment at the rate of Rs.10 per crore of turnover (0.0001%) (each side).
The maximum brokerage chargeable by a trading member in relation to trades affected in the contracts admitted to dealing on the derivatives segment of the Exchange is fixed at 2.5% of the contract value, exclusive of statutory levies.
The transaction charges payable by each trading member on the trades executed by him on the derivatives segment are fixed at Rs.2 per lakh or turnover (0.002%) (each side) or Rs.1 lakh annually, whichever is higher. However, these charges have been waived upto 3rd of 2000. The trading members contribute to Investor Protection Fund of derivatives segment at the rate of Rs.10 per crore of turnover (0.0001%) (each side).