Description
The presentation about various financial derivatives. It also explains factors Contributing to the Growth of Derivatives
INTRODUCTION TO FINANCIAL DERIVATIVES : Structure and Products
• Derivatives transactions are financial contracts. • Derivatives are synthetic instruments • They derive value from an underlying asset class • Such underlying assets may range from financial instruments such as equity, debt instrument to commodity, currency. • Along with assets other underlying parameters such as borrowings as well as or weather may be may be considered for derivatives. • However the common underlying theme of derivatives is that they are leveraged products • Derivatives are not always priced at respective asset value (fair value)
•
With Securities Laws (Second Amendment) Act, 1999, Derivatives has been included in the definition of Securities. The term Derivative has been defined in Securities Contracts (Regulations) Act, as :
A Derivative includes : (a) A security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security; b) A contract which derives its value from the prices, or index of prices, of underlying securities;
Underlying Asset Class
• It is important to understand the underlying asset class before using derivatives • Asset classes can be classified into two broad categories- financial which includes currencies and commodities • Financial asset classes can be broadly categorised into interest rates, equities and currencies • Commodities range from agricultural commodities to minerals and metals
• • • • •
Financial Asset Classes Broadly categorized into equity, interest rates and currencies Equity as an asset class will include single stocks and equity indices Interest rates as an asset class will include government bonds, government bond benchmarks and money market benchmarks. Currencies as an asset class will include currency pairs such as USD/INR, USD/JPY etc Credits as defined by corporate bonds can also be categorised into financial assets and derivatives on them are called credit derivatives
Derivative instruments are a key part of the financial markets. • Derivatives market is comprised of (a) Derivative products or financial contracts (b) Participants in the derivatives market (c) Regulator(s) Commodity linked derivatives remained sole form of such products for almost three hundred years. Financial derivatives came into spotlight after 1970 due to growing instability in the financial markets.
• The derivatives market performs a number of economic functions:
1. They help in transferring risks from risk adverse people to risk oriented people 2. They help in the discovery of future as well as current prices 3. They catalyze entrepreneurial activity 4. They increase the volume traded in markets because of participation of risk adverse people in greater numbers 5. They increase savings and investment in the long run
Global Derivatives Industry - Chronology of Instruments
• Forward contract - is the oldest instrument.
• 1874 - Commodity futures.
• 1972 Futures contract on foreign currencies. • 1973 Equity options. • 1975 Interest rate futures. • 1981 Currency swaps
• 1982 Interest rate swaps, equity index futures.
• 1983 Stock index options • 1994 Introduction of credit derivatives.
Derivatives Market in India
• The prohibition on options in SCRA was removed in 1995. • The Reserve Bank of India has permitted currency options, interest rate swaps, currency swaps and other risk reductions OTC derivative products.
• Besides the Forward market in currencies has been a vibrant market in India for several decades.
• In addition the Forward Markets Commission has allowed the setting up of commodities futures exchanges. Today we have 18 commodities exchanges most of which trade futures. e.g. The Indian Pepper and Spice Traders Association (IPSTA) and the Coffee Owners Futures Exchange of India (COFEI).
• In 2000 an amendment to the SCRA expanded the definition of securities to included Derivatives thereby enabling stock exchanges to trade derivative products. • In the year 2000 exchange traded equity derivatives were introduced in the Indian market.
Structure of Derivatives in India
Underlying Variables Asset like securities/loan assets Borrowed amount Asset-like Equity Derivative Products Regulators
Currency Exchange Rate
Commodity
Interest rate derivatives ? Interest rate swaps ? Forward rate agreement Stock related derivative products ? Stock option ? Stock index options ? Stock index futures Currency linked derivative ? Forward contract ? Currency option ? Currency future Commodity linked derivative products ? Forward contract ? Futures contract
RBI/FIMMDA
SEBI/Stock Exchanges
RBI
Forward market Commission and stock exchanges
Factors Contributing to the Growth of Derivatives
• Price volatility and thus price risk.
?
Price of any commodity is a function of demand and supply. Market participant is subject to a price risk of a financial asset or commodity. Continuous changes in the price over a period of year.
?
?
• Deregulation of markets
?
Interest forces.
rates
are
determined
by the market
?
Market participant is subjected to an interest rate risk. Awareness among the participants in the financial markets to develop and use more sophisticated risk management tools.
?
• Globalisation of the markets
?
?
Opening of economy
Investment of FIIs and others industry and in financial instruments. in the domestic
? ?
Investment by domestic companies in abroad. Increase in exports and imports.
All these have resulted in the currency risk for the participants in the international market.
• Innovations in the derivative products, participation of large number of institutions and individuals.
• Growing use of technology and further advancement in technology.
? ? ?
Development of high speed processors. Network system. Advanced software programmes.
• Development of new theories in financial derivatives subject :
?
Option pricing model developed by Black and Scholes in 1973 is being used extensively to determine prices of call and put options.
Derivative Products
• OTC products (over the counter) (a) Forward contracts (b) Interest rate swaps (c) Forward rate agreements.
• Traded through exchanges
(a) Futures contracts (b) Options contract.
OTC v/s Exchange Traded Products
• Derivatives that trade on an exchange are called exchange traded derivatives, whereas privately negotiated derivative contracts are called OTC contracts • Exchange traded derivatives are standardized contracts in terms of contract size, settlement, maturity date while OTC derivatives can be both standardized and customized
• The exchange takes on settlement risk in exchange traded derivatives while OTC derivatives counterparty risk is present • Margin system is followed by exchanges while OTC derivatives do not usually follow margining system
• Exchange traded derivatives can be accessed by retail and institutional investors while OTC derivatives is typically traded within institutions • Exchange traded derivatives come under regulatory purview while many OTC derivatives are outside the purview of regulators
Features of OTC Derivatives
• The management of country party (credit ) risk is decentralized and located within individual institutions. • There are no formal centralized limits on individual positions, leverage etc,. • There are no formal rules for risk and burden sharing
• There are no formal rules or mechanisms for ensuring market stability and integrity and for safeguarding the collective interests of market participants and • The OTC contracts are generally not regulated by a regulatory authority and the exchanges self regulatory organization.
Drawbacks of OTC Products
• Excessive credit exposure( high concentration of OTC derivative activities in major institutions) • Absence of any liquidity • No market information is available for regulation.
• Highly leveraged institutions and their OTC derivative positions were the main cause of turbulence in financial markets in 1998. These episodes of turbulence revealed the risk posed to market stability originating in features of OTC derivative instruments and markets.
Main Players in the Market
• Hedgers face risk associated with price of an asset. They use future or options markets to reduce or eliminate this risk. • Speculators wish to bet on future movements in the price of an asset. Futures and options contracts can give them an extra leverage ; that is they can increase both the potential gains and potential losses in a speculative venture. • Arbitrageurs are in a business to take advantage of a discrepancy between prices in two different markets.
Basic Derivative Products
• Forward Contracts: A forward contract is a customized contract between two entities where settlement takes place on a specific date in the future at today’s pre agreed price. Forward contracts are executed in respect assets like commodity or currency.
Currency Forwards
• Currency forwards are the most widely used currency derivatives • The currency forwards are basically futures contracts where the payers or receivers of forwards contract to buy or sell a currency pair at a future date
Spot Contract
The contract is entered today for immediate settlement. Example :
Suppose Mr Anand enters into a forward contract with ABN Amro Bank to buy 10,000 dollars after one month from today (i.e. January 16, 2005) at Rs. 45. Rs. 45/- is the price per dollar at the time of execution of contract.
Exactly after one month Mr Anand will buy 10,000 dollars by paying Rs. 45/- per dollar and ABN Amro Bank will sell dollar by collecting Rs. 45/- per dollar. If on the settlement date, dollar is quoted at Rs. 46/- then Mr Anand gains Rs. 1/- per purchase of one dollar. On the other hand, if on the settlement date dollar is quoted at Rs. 44/- then ABN Amro Bank gains Rs. 1/-. Features • Each forward contract is hence is unique in terms expiration date, etc. • Both the parties are obliged to perform. custom designed of contract size and and
• The contract price is generally not available in public.
• No margin is required.
• The contract is to be executed on a specified future date and it has to be settled by delivery of the asset.
• Such contract carries default risk. Hence, each party faces the risk of default. • This contract is not tradeable. Therefore it lacks liquidity. Why forward contract is executed? • To eliminate price risk or hedge against the price risk. • To earn more profit from speculative transaction.
Example :
Exporter expects to receive payment say in dollar three months later expects to make payments after to 2 months in dollar exposed to the risk exchange rate fluctuations exposed to the risk exchange rate fluctuations Can use forward contract to reduce uncertainty He can reduce his exposure to exchange rate fluctuations through buying dollar in forward market
Importer
What are the problems of forward contract? • Lack of centralization of trading • Illiquidity
• Counterparty risk.
Futures Contracts
• Futures are essentially deferred spot contracts • Spot is the immediate delivery for settlement of a bond or stock • Futures are purchase or sale contracted for settlement for a later date • Futures are exchange traded derivatives • Forwards are the OTC version of futures • Futures are traded on margin
Futures Contract A future contract is a customized contract between the two parties where one of the parties commits to sell and other commits to buy a specified quantity of assets like security commodity etc., at a certain price on a given date in the future. Futures contracts are special types of forward contract. contract are standardised exchange traded contracts. Types of Futures Contracts • Commodity Futures Underlying assets are commodities like wheat, cotton, etc. In India, futures contracts on cotton, jute, potatoes, onions, turmeric etc. have been trading for long. The Forward Markets Commission (FMC) overseas these markets. Such
• Financial Futures
Underlying is a financial asset such as shares, stock index, etc.
Features of Futures Contracts
• Futures are highly standard contracts that provide for performance of contracts through either delivery of asset or final cash settlement. Standard contracts in terms of quantity, date and month of delivery.
• These contracts trade on organized future exchanges with clearing association that acts as an agent between the contracting parties.
• Contracts seller is called “short” and purchaser “long”. Both the parties pay margin to the clearing corporation.
• Margin paid are generally marked to market per day.
If the price goes up, the buyer’s margin is reduced and the seller’s margin is increased by an equal amount. Vice versa in case of price comes down.
Mechanism in Futures Contract Commodities Futures Market
• Buy a future to agree to take delivery of a commodity to protect against a rise in price in the spot market. Buying a future is said to be going long.
• Sell a future to agree to make delivery of a commodity to protect against a fall in the spot market. Selling a future is said to be going short.
Interest Rate Futures
• Selling short an interest rate futures contract protects against a rise in interest rates.
• Purchasing long an interest rate futures contract protects against a fall in interest rates.
Futures
• Future contracts have maturities ranging from one month to one year or more • In India futures contracts have a maximum tenor of three months • Future price and spot price converge on settlement date • Futures are marked to market on a daily basis and settlement of mark to market profit or loss is also on a daily basis • Futures can be cash settled or settled by physical delivery- In India futures are cash settled
Options
• An option is a contract between two parties under which the buyer of the option buys the right and not the obligation to buy or sell a standardized quantity (contract size) of a financial instrument (underlying asset) at or before a pre-determined date (expiry date) at a price which is decided in advance (exercise price or strike price).
Aspects of options contract :
• An option is a derivative instrument involving a right.
• The party who buys the option is called the buyer or holder of the option. The one who sells the right is called the seller or the writer of the option. • Call and Put Option : A call option is right (but not obligations) to buy an underlying asset. A put option is the right (but not obligation) to sell an underlying asset. • Obligation : The holder can demand performance. He is not obliged to perform. The writer of an option is obliged to perform. He cannot demand performance. • Exercise price : It is also called as strike price at which underlying asset can be bought or sold.
• Expiry Date : The date by which the right should be exercised is called the expiry date. • Option premium : Buyer of an option has to pay premium to the writer of an option. European Option : The holder of an option can exercise his right on the expiration date. American Option : The holder of an option can exercise his right any time between purchase date and the expiration date. Features
• Standardisation.
Option contract is standardised as to quantity, date and month of delivery, price.
• The clearing house of the exchange guarantees performance. Consequently there is no risk of default. • Mark to Market Margin : As the clearing house acts as a guarantor, the parties are required to maintain a deposit with it.
In the Money, At the Money and out of the Money
In the Money Call Option Strike price < spot price of underlying asset Put Option Strike price > spot price of underlying asset
At the Money
Strike price = spot Strike price = spot price of underlying price of underlying asset asset Strike price > spot Strike price < spot price of underlying price of underlying asset asset
Out of the Money
Example on Put Option
An investor buys one put option (European) at the strike price of Rs. 900/- at a premium of say Rs. 40/-. If the market price of Reliance on the date of expiry is less than Rs. 900/- the option can be exercised as it is in the money. The investors break even point is Rs. 860/- (strike price premium paid) investor will earn profits if the market falls below Rs. 860/-. Suppose stock price is 840/-, the buyer of the put option immediately sales reliance share in the market @ Rs. 840/- and exercises his put option (i.e. selling the reliance share at Rs. 900/- to the option writer thus making a profit of Rs. 20/- [(strike price - spot price) premium paid]
Consider another scenario, if at the time of expiry date, market price of reliance is Rs. 920/- the buyer of the put option will choose not to exercise his option to sell as he can sell in the market at a higher price. In this case, investor loses the preimum paid (Rs. 40/-) which shall be the profit of seller of the put option.
Example on Call Option
An investor buys one call option (European) on Infosys at the strike price of Rs. 3500/- at a premium of Rs. 100/-. If the market price of Infosys on the day of expiry is more than Rs. 3500/- the option will be exercised. The investor will earn profit once the share price crosses Rs. 3600/- (strike price + premium i.e. 3500 + 100). Suppose stock price on the expiration date is Rs. 3800/- the option will be exercised and investor will buy 1 share of Infosys from the seller of the
Option at Rs. 3500/- and sell it in the market making a profit of Rs. 200/-. In another scenario, if at the time of expiry stock price falls below Rs. 3500/- say suppose it touches Rs. 3000/-. The buyer of the call option will choose not to exercise his option. In this case investor loses the premium (Rs. 100/-) paid which shall be the profit earned by the seller of the call option.
Differences in Futures and Options (i) In case of futures contracts, both the buyer and seller are obliged to buy and sell the underlying asset. In case of options the buyer enjoys the right but not the obligation to buy or sell the underlying asset.
(ii) The futures contracts prices are affected mainly by the prices of the underlying asset.
The prices of options are, however, affected by the prices of underlying asset, time remaining for expiry of the contract, interest rate and volatility of the underlying asset. Who are the players in the options market?
Development institutions, mutual funds, domestic and foreign institution investors, brokers and retail investors.
Benefits of Option
• High leverage as by investing small amount of capital (in the form of premium), one can take exposure in the underlying asset of much greater value.
• Pre-known maximum risk for an option buyer.
• Large profit potential and limited risk for option buyer. What are the risks for an option buyer?
The risk/loss of an option buyer is limited to the premium that he has paid.
What are the risks for an option writer?
The risk of an options writer is unlimited whereas his gains are limited to the premium earned.
Who can write options in Indian derivatives market?
In the Indian derivatives market, SEBI has not created any particular category of options writers. Any market participant can write options. However, the margin requirements are stringent for options writers.
Index derivatives are derivative contracts which derive their value from as underlying index. The two most popular index derivatives are index, futures and index options. Index, derivatives have become very popular worldwide. Index derivatives offer various advantages and hence have become very popular.
Institutional and large equity-holders need portfolio-hedging facility. Index-derivatives are more suited to them and more cost-effective than derivatives based on individual stocks. Pension funds in the US are known to use stock index futures for risk hedging purposes. Index derivatives offer case of use for hedging any portfolio irrespective of its composition.
Stock index is difficult to manipulate as compared to individual stock prices, more so in India, and the possibility of cornering is reduced. This is partly because as individual stock has a limited supply which can be concerned. Stock index, being an average, is much less volatile than individual stock prices. This implies such lower capital adequacy and margin requirements.
Index derivatives are cash settled, and hence do not suffer from settlement delays and problems related to bad delivery, forged/fake certificates. What are options on individual stocks? Options contacts where the underlying asset is an equity stock, are termed as options on stocks. Prices are normally quoted in terms of the premium per share, although each contract is invariably for a larger number of shares, e.g. 100.
Swaps:
Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. The two commonly used swaps are: ?Interest Rate Swap An interest rate swap is a financial contract between two parties exchanging or swapping a stream of interest payments for notional principal amount during a specified period in the same currency. Such contracts generally involve exchange of a ‘fixed to floating' or ‘floating to floating’ rates of interest. Accordingly, on each payment date that occurs during the swap period - cash payments based on fixed / floating and floating rates are made by the parties to each other. However, there will not be any exchange of principles.
• Currency Swaps: These entails swapping both principal and interest between the parties with the cash flows in one direction being in a different currency than those in the opposite direction.
Example of Interest Rate Swap Example : ? Borrower say sun Ltd. raises 5 year fixed rate funds through bonds at an 8% annual coupon. ? Borrower say Moon Ltd. raises a 5 year floating rate bank loan with interest paid semi-annually at MIBOR plus 100 basis points with a bullet repayment at maturity. ? Both the borrowers Sun Ltd. and Moon Ltd. enter into a swap transaction where Moon Ltd pays to borrower Sun Ltd. 8 per cent per annum and borrower Sun Ltd pays to borrower Moon Ltd. semi-annually MIBOR plus 50 basis points.
The Cash flows are as follows :
Borrower Sun Ltd.
Payment Schedule
Pays/(Receives)
Semi annually
Interest to Borrowers Moon Ltd. Coupon to Bondholders Coupon from borrowers Moon Ltd.
MIBOR + 50 basis points p.a. 8%
Annually
8%
MIBOR + 50 basis points
Annual Cost
Borrower Moon Ltd.
Semi-annually
Payment Schedule
To service floating rate debt From Borrower Sun Ltd.
Pays/(Receives)
MIBOR+100 basis points MIBOR + 50 basis points
Annually
Coupon to Borrower Sun Ltd.
8% 8.50% p.a.
Annual Cost
doc_766191921.ppt
The presentation about various financial derivatives. It also explains factors Contributing to the Growth of Derivatives
INTRODUCTION TO FINANCIAL DERIVATIVES : Structure and Products
• Derivatives transactions are financial contracts. • Derivatives are synthetic instruments • They derive value from an underlying asset class • Such underlying assets may range from financial instruments such as equity, debt instrument to commodity, currency. • Along with assets other underlying parameters such as borrowings as well as or weather may be may be considered for derivatives. • However the common underlying theme of derivatives is that they are leveraged products • Derivatives are not always priced at respective asset value (fair value)
•
With Securities Laws (Second Amendment) Act, 1999, Derivatives has been included in the definition of Securities. The term Derivative has been defined in Securities Contracts (Regulations) Act, as :
A Derivative includes : (a) A security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security; b) A contract which derives its value from the prices, or index of prices, of underlying securities;
Underlying Asset Class
• It is important to understand the underlying asset class before using derivatives • Asset classes can be classified into two broad categories- financial which includes currencies and commodities • Financial asset classes can be broadly categorised into interest rates, equities and currencies • Commodities range from agricultural commodities to minerals and metals
• • • • •
Financial Asset Classes Broadly categorized into equity, interest rates and currencies Equity as an asset class will include single stocks and equity indices Interest rates as an asset class will include government bonds, government bond benchmarks and money market benchmarks. Currencies as an asset class will include currency pairs such as USD/INR, USD/JPY etc Credits as defined by corporate bonds can also be categorised into financial assets and derivatives on them are called credit derivatives
Derivative instruments are a key part of the financial markets. • Derivatives market is comprised of (a) Derivative products or financial contracts (b) Participants in the derivatives market (c) Regulator(s) Commodity linked derivatives remained sole form of such products for almost three hundred years. Financial derivatives came into spotlight after 1970 due to growing instability in the financial markets.
• The derivatives market performs a number of economic functions:
1. They help in transferring risks from risk adverse people to risk oriented people 2. They help in the discovery of future as well as current prices 3. They catalyze entrepreneurial activity 4. They increase the volume traded in markets because of participation of risk adverse people in greater numbers 5. They increase savings and investment in the long run
Global Derivatives Industry - Chronology of Instruments
• Forward contract - is the oldest instrument.
• 1874 - Commodity futures.
• 1972 Futures contract on foreign currencies. • 1973 Equity options. • 1975 Interest rate futures. • 1981 Currency swaps
• 1982 Interest rate swaps, equity index futures.
• 1983 Stock index options • 1994 Introduction of credit derivatives.
Derivatives Market in India
• The prohibition on options in SCRA was removed in 1995. • The Reserve Bank of India has permitted currency options, interest rate swaps, currency swaps and other risk reductions OTC derivative products.
• Besides the Forward market in currencies has been a vibrant market in India for several decades.
• In addition the Forward Markets Commission has allowed the setting up of commodities futures exchanges. Today we have 18 commodities exchanges most of which trade futures. e.g. The Indian Pepper and Spice Traders Association (IPSTA) and the Coffee Owners Futures Exchange of India (COFEI).
• In 2000 an amendment to the SCRA expanded the definition of securities to included Derivatives thereby enabling stock exchanges to trade derivative products. • In the year 2000 exchange traded equity derivatives were introduced in the Indian market.
Structure of Derivatives in India
Underlying Variables Asset like securities/loan assets Borrowed amount Asset-like Equity Derivative Products Regulators
Currency Exchange Rate
Commodity
Interest rate derivatives ? Interest rate swaps ? Forward rate agreement Stock related derivative products ? Stock option ? Stock index options ? Stock index futures Currency linked derivative ? Forward contract ? Currency option ? Currency future Commodity linked derivative products ? Forward contract ? Futures contract
RBI/FIMMDA
SEBI/Stock Exchanges
RBI
Forward market Commission and stock exchanges
Factors Contributing to the Growth of Derivatives
• Price volatility and thus price risk.
?
Price of any commodity is a function of demand and supply. Market participant is subject to a price risk of a financial asset or commodity. Continuous changes in the price over a period of year.
?
?
• Deregulation of markets
?
Interest forces.
rates
are
determined
by the market
?
Market participant is subjected to an interest rate risk. Awareness among the participants in the financial markets to develop and use more sophisticated risk management tools.
?
• Globalisation of the markets
?
?
Opening of economy
Investment of FIIs and others industry and in financial instruments. in the domestic
? ?
Investment by domestic companies in abroad. Increase in exports and imports.
All these have resulted in the currency risk for the participants in the international market.
• Innovations in the derivative products, participation of large number of institutions and individuals.
• Growing use of technology and further advancement in technology.
? ? ?
Development of high speed processors. Network system. Advanced software programmes.
• Development of new theories in financial derivatives subject :
?
Option pricing model developed by Black and Scholes in 1973 is being used extensively to determine prices of call and put options.
Derivative Products
• OTC products (over the counter) (a) Forward contracts (b) Interest rate swaps (c) Forward rate agreements.
• Traded through exchanges
(a) Futures contracts (b) Options contract.
OTC v/s Exchange Traded Products
• Derivatives that trade on an exchange are called exchange traded derivatives, whereas privately negotiated derivative contracts are called OTC contracts • Exchange traded derivatives are standardized contracts in terms of contract size, settlement, maturity date while OTC derivatives can be both standardized and customized
• The exchange takes on settlement risk in exchange traded derivatives while OTC derivatives counterparty risk is present • Margin system is followed by exchanges while OTC derivatives do not usually follow margining system
• Exchange traded derivatives can be accessed by retail and institutional investors while OTC derivatives is typically traded within institutions • Exchange traded derivatives come under regulatory purview while many OTC derivatives are outside the purview of regulators
Features of OTC Derivatives
• The management of country party (credit ) risk is decentralized and located within individual institutions. • There are no formal centralized limits on individual positions, leverage etc,. • There are no formal rules for risk and burden sharing
• There are no formal rules or mechanisms for ensuring market stability and integrity and for safeguarding the collective interests of market participants and • The OTC contracts are generally not regulated by a regulatory authority and the exchanges self regulatory organization.
Drawbacks of OTC Products
• Excessive credit exposure( high concentration of OTC derivative activities in major institutions) • Absence of any liquidity • No market information is available for regulation.
• Highly leveraged institutions and their OTC derivative positions were the main cause of turbulence in financial markets in 1998. These episodes of turbulence revealed the risk posed to market stability originating in features of OTC derivative instruments and markets.
Main Players in the Market
• Hedgers face risk associated with price of an asset. They use future or options markets to reduce or eliminate this risk. • Speculators wish to bet on future movements in the price of an asset. Futures and options contracts can give them an extra leverage ; that is they can increase both the potential gains and potential losses in a speculative venture. • Arbitrageurs are in a business to take advantage of a discrepancy between prices in two different markets.
Basic Derivative Products
• Forward Contracts: A forward contract is a customized contract between two entities where settlement takes place on a specific date in the future at today’s pre agreed price. Forward contracts are executed in respect assets like commodity or currency.
Currency Forwards
• Currency forwards are the most widely used currency derivatives • The currency forwards are basically futures contracts where the payers or receivers of forwards contract to buy or sell a currency pair at a future date
Spot Contract
The contract is entered today for immediate settlement. Example :
Suppose Mr Anand enters into a forward contract with ABN Amro Bank to buy 10,000 dollars after one month from today (i.e. January 16, 2005) at Rs. 45. Rs. 45/- is the price per dollar at the time of execution of contract.
Exactly after one month Mr Anand will buy 10,000 dollars by paying Rs. 45/- per dollar and ABN Amro Bank will sell dollar by collecting Rs. 45/- per dollar. If on the settlement date, dollar is quoted at Rs. 46/- then Mr Anand gains Rs. 1/- per purchase of one dollar. On the other hand, if on the settlement date dollar is quoted at Rs. 44/- then ABN Amro Bank gains Rs. 1/-. Features • Each forward contract is hence is unique in terms expiration date, etc. • Both the parties are obliged to perform. custom designed of contract size and and
• The contract price is generally not available in public.
• No margin is required.
• The contract is to be executed on a specified future date and it has to be settled by delivery of the asset.
• Such contract carries default risk. Hence, each party faces the risk of default. • This contract is not tradeable. Therefore it lacks liquidity. Why forward contract is executed? • To eliminate price risk or hedge against the price risk. • To earn more profit from speculative transaction.
Example :
Exporter expects to receive payment say in dollar three months later expects to make payments after to 2 months in dollar exposed to the risk exchange rate fluctuations exposed to the risk exchange rate fluctuations Can use forward contract to reduce uncertainty He can reduce his exposure to exchange rate fluctuations through buying dollar in forward market
Importer
What are the problems of forward contract? • Lack of centralization of trading • Illiquidity
• Counterparty risk.
Futures Contracts
• Futures are essentially deferred spot contracts • Spot is the immediate delivery for settlement of a bond or stock • Futures are purchase or sale contracted for settlement for a later date • Futures are exchange traded derivatives • Forwards are the OTC version of futures • Futures are traded on margin
Futures Contract A future contract is a customized contract between the two parties where one of the parties commits to sell and other commits to buy a specified quantity of assets like security commodity etc., at a certain price on a given date in the future. Futures contracts are special types of forward contract. contract are standardised exchange traded contracts. Types of Futures Contracts • Commodity Futures Underlying assets are commodities like wheat, cotton, etc. In India, futures contracts on cotton, jute, potatoes, onions, turmeric etc. have been trading for long. The Forward Markets Commission (FMC) overseas these markets. Such
• Financial Futures
Underlying is a financial asset such as shares, stock index, etc.
Features of Futures Contracts
• Futures are highly standard contracts that provide for performance of contracts through either delivery of asset or final cash settlement. Standard contracts in terms of quantity, date and month of delivery.
• These contracts trade on organized future exchanges with clearing association that acts as an agent between the contracting parties.
• Contracts seller is called “short” and purchaser “long”. Both the parties pay margin to the clearing corporation.
• Margin paid are generally marked to market per day.
If the price goes up, the buyer’s margin is reduced and the seller’s margin is increased by an equal amount. Vice versa in case of price comes down.
Mechanism in Futures Contract Commodities Futures Market
• Buy a future to agree to take delivery of a commodity to protect against a rise in price in the spot market. Buying a future is said to be going long.
• Sell a future to agree to make delivery of a commodity to protect against a fall in the spot market. Selling a future is said to be going short.
Interest Rate Futures
• Selling short an interest rate futures contract protects against a rise in interest rates.
• Purchasing long an interest rate futures contract protects against a fall in interest rates.
Futures
• Future contracts have maturities ranging from one month to one year or more • In India futures contracts have a maximum tenor of three months • Future price and spot price converge on settlement date • Futures are marked to market on a daily basis and settlement of mark to market profit or loss is also on a daily basis • Futures can be cash settled or settled by physical delivery- In India futures are cash settled
Options
• An option is a contract between two parties under which the buyer of the option buys the right and not the obligation to buy or sell a standardized quantity (contract size) of a financial instrument (underlying asset) at or before a pre-determined date (expiry date) at a price which is decided in advance (exercise price or strike price).
Aspects of options contract :
• An option is a derivative instrument involving a right.
• The party who buys the option is called the buyer or holder of the option. The one who sells the right is called the seller or the writer of the option. • Call and Put Option : A call option is right (but not obligations) to buy an underlying asset. A put option is the right (but not obligation) to sell an underlying asset. • Obligation : The holder can demand performance. He is not obliged to perform. The writer of an option is obliged to perform. He cannot demand performance. • Exercise price : It is also called as strike price at which underlying asset can be bought or sold.
• Expiry Date : The date by which the right should be exercised is called the expiry date. • Option premium : Buyer of an option has to pay premium to the writer of an option. European Option : The holder of an option can exercise his right on the expiration date. American Option : The holder of an option can exercise his right any time between purchase date and the expiration date. Features
• Standardisation.
Option contract is standardised as to quantity, date and month of delivery, price.
• The clearing house of the exchange guarantees performance. Consequently there is no risk of default. • Mark to Market Margin : As the clearing house acts as a guarantor, the parties are required to maintain a deposit with it.
In the Money, At the Money and out of the Money
In the Money Call Option Strike price < spot price of underlying asset Put Option Strike price > spot price of underlying asset
At the Money
Strike price = spot Strike price = spot price of underlying price of underlying asset asset Strike price > spot Strike price < spot price of underlying price of underlying asset asset
Out of the Money
Example on Put Option
An investor buys one put option (European) at the strike price of Rs. 900/- at a premium of say Rs. 40/-. If the market price of Reliance on the date of expiry is less than Rs. 900/- the option can be exercised as it is in the money. The investors break even point is Rs. 860/- (strike price premium paid) investor will earn profits if the market falls below Rs. 860/-. Suppose stock price is 840/-, the buyer of the put option immediately sales reliance share in the market @ Rs. 840/- and exercises his put option (i.e. selling the reliance share at Rs. 900/- to the option writer thus making a profit of Rs. 20/- [(strike price - spot price) premium paid]
Consider another scenario, if at the time of expiry date, market price of reliance is Rs. 920/- the buyer of the put option will choose not to exercise his option to sell as he can sell in the market at a higher price. In this case, investor loses the preimum paid (Rs. 40/-) which shall be the profit of seller of the put option.
Example on Call Option
An investor buys one call option (European) on Infosys at the strike price of Rs. 3500/- at a premium of Rs. 100/-. If the market price of Infosys on the day of expiry is more than Rs. 3500/- the option will be exercised. The investor will earn profit once the share price crosses Rs. 3600/- (strike price + premium i.e. 3500 + 100). Suppose stock price on the expiration date is Rs. 3800/- the option will be exercised and investor will buy 1 share of Infosys from the seller of the
Option at Rs. 3500/- and sell it in the market making a profit of Rs. 200/-. In another scenario, if at the time of expiry stock price falls below Rs. 3500/- say suppose it touches Rs. 3000/-. The buyer of the call option will choose not to exercise his option. In this case investor loses the premium (Rs. 100/-) paid which shall be the profit earned by the seller of the call option.
Differences in Futures and Options (i) In case of futures contracts, both the buyer and seller are obliged to buy and sell the underlying asset. In case of options the buyer enjoys the right but not the obligation to buy or sell the underlying asset.
(ii) The futures contracts prices are affected mainly by the prices of the underlying asset.
The prices of options are, however, affected by the prices of underlying asset, time remaining for expiry of the contract, interest rate and volatility of the underlying asset. Who are the players in the options market?
Development institutions, mutual funds, domestic and foreign institution investors, brokers and retail investors.
Benefits of Option
• High leverage as by investing small amount of capital (in the form of premium), one can take exposure in the underlying asset of much greater value.
• Pre-known maximum risk for an option buyer.
• Large profit potential and limited risk for option buyer. What are the risks for an option buyer?
The risk/loss of an option buyer is limited to the premium that he has paid.
What are the risks for an option writer?
The risk of an options writer is unlimited whereas his gains are limited to the premium earned.
Who can write options in Indian derivatives market?
In the Indian derivatives market, SEBI has not created any particular category of options writers. Any market participant can write options. However, the margin requirements are stringent for options writers.
Index derivatives are derivative contracts which derive their value from as underlying index. The two most popular index derivatives are index, futures and index options. Index, derivatives have become very popular worldwide. Index derivatives offer various advantages and hence have become very popular.
Institutional and large equity-holders need portfolio-hedging facility. Index-derivatives are more suited to them and more cost-effective than derivatives based on individual stocks. Pension funds in the US are known to use stock index futures for risk hedging purposes. Index derivatives offer case of use for hedging any portfolio irrespective of its composition.
Stock index is difficult to manipulate as compared to individual stock prices, more so in India, and the possibility of cornering is reduced. This is partly because as individual stock has a limited supply which can be concerned. Stock index, being an average, is much less volatile than individual stock prices. This implies such lower capital adequacy and margin requirements.
Index derivatives are cash settled, and hence do not suffer from settlement delays and problems related to bad delivery, forged/fake certificates. What are options on individual stocks? Options contacts where the underlying asset is an equity stock, are termed as options on stocks. Prices are normally quoted in terms of the premium per share, although each contract is invariably for a larger number of shares, e.g. 100.
Swaps:
Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. The two commonly used swaps are: ?Interest Rate Swap An interest rate swap is a financial contract between two parties exchanging or swapping a stream of interest payments for notional principal amount during a specified period in the same currency. Such contracts generally involve exchange of a ‘fixed to floating' or ‘floating to floating’ rates of interest. Accordingly, on each payment date that occurs during the swap period - cash payments based on fixed / floating and floating rates are made by the parties to each other. However, there will not be any exchange of principles.
• Currency Swaps: These entails swapping both principal and interest between the parties with the cash flows in one direction being in a different currency than those in the opposite direction.
Example of Interest Rate Swap Example : ? Borrower say sun Ltd. raises 5 year fixed rate funds through bonds at an 8% annual coupon. ? Borrower say Moon Ltd. raises a 5 year floating rate bank loan with interest paid semi-annually at MIBOR plus 100 basis points with a bullet repayment at maturity. ? Both the borrowers Sun Ltd. and Moon Ltd. enter into a swap transaction where Moon Ltd pays to borrower Sun Ltd. 8 per cent per annum and borrower Sun Ltd pays to borrower Moon Ltd. semi-annually MIBOR plus 50 basis points.
The Cash flows are as follows :
Borrower Sun Ltd.
Payment Schedule
Pays/(Receives)
Semi annually
Interest to Borrowers Moon Ltd. Coupon to Bondholders Coupon from borrowers Moon Ltd.
MIBOR + 50 basis points p.a. 8%
Annually
8%
MIBOR + 50 basis points
Annual Cost
Borrower Moon Ltd.
Semi-annually
Payment Schedule
To service floating rate debt From Borrower Sun Ltd.
Pays/(Receives)
MIBOR+100 basis points MIBOR + 50 basis points
Annually
Coupon to Borrower Sun Ltd.
8% 8.50% p.a.
Annual Cost
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