Derivative

Derivative

INTRODUCTION:

Derivative is a product whose value is derived from the value of one or more basic variables,

called bases (underlying asset, index, or reference rate), in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the “underlying”.

In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R)A) defines

“derivative” to include –

1. 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.

2. A contract which derives its value from the prices, or index of prices, of underlying securities.

Derivatives are securities under the SC(R)A and hence the trading of derivatives is governed

by the regulatory framework under the SC(R)A.

PARTICIPANTS:

The following three broad categories of participants - hedgers, speculators,

and arbitrageurs trade in the derivatives market. Hedgers face risk associated with the price of an asset. They use futures 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 business to take advantage of a discrepancy between prices in two different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit.

TYPES OF DERIVATIVES:

The most commonly used derivatives contracts are forwards, futures and options.

Forwards: 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.

Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts.

Options: Options are of two types - calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts

give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a

given price on or before a given date.

Warrants: Options generally have lives of upto one year, the majority of options traded on options

exchanges having a maximum maturity of nine months. Longer-dated options are called warrants

and are generally traded over-the-counter.

LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These are options

having a maturity of upto three years.

Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average of a basket of assets. Equity index options are a form of basket options.

Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two

commonly used swaps are :

_ Interest rate swaps: These entail swapping only the interest related cash flows between the

parties in the same currency.

_ Currency swaps: These entail swapping both principal and interest between the parties,

with the cashflows in one direction being in a different currency than those in the opposite

direction.

Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of the

options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the

swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option to

receive fi xed and pay floating. A payer swaption is an option to pay fi xed and receive floating.

FACTORS DRIVING THE 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, and

5. Innovations in the derivatives markets, which optimally combine the risks and returns over a large

number of fi nancial assets leading to higher returns, reduced risk as well as transactions costs as

compared to individual fi nancial assets.

DERIVATIVES MARKET IN INDIA:

Derivatives trading commenced in India in June 2000 after SEBI granted the final approval

to this effect in May 2000. 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 index options commenced in June 2001 and the trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001. 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.

ECONOMIC FUNTIONS:

The derivatives 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 the 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 an 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. Finally, derivatives markets

help increase savings and investment in the long run. Transfer of risk enables market participants to expand their volume of activity.

Futures terminology

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

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

Contract cycle: The period over which a contract trades. The index futures contracts on the NSE

have one-month, two-months and three-months expiry cycles which expire on the last Thursday of

the month. Thus a January expiration contract expires on the last Thursday of January and a February

expiration contract ceases trading on the last Thursday of February. On the Friday following the last

Thursday, a new contract having a three-month expiry is introduced for trading.

Expiry date: It is the date specifi ed in the futures contract. This is the last day on which the contract

will be traded, at the end of which it will cease to exist.

 Contract size: The amount of asset that has to be delivered under one contract. For example:The contract size of Relaiance’s future is 150.

Basis: In the context of financial futures, basis can be defined as the futures price minus the spot

price. There will be a different basis for each delivery month for each contract. In a normal market,

basis will be positive. This reflects that futures prices normally exceed spot prices.

Cost of carry: The relationship between futures prices and spot prices can be summarized in terms

of what is known as the cost of carry. This measures the storage cost plus the interest that is paid to

finance the asset less the income earned on the asset.

Initial margin: The amount that must be deposited in the margin account at the time a futures contract

is first entered into.

Marking-to-market: In the futures market, at the end of each trading day, the margin account is

adjusted to reflect the investor’s gain or loss depending upon the futures closing price.

Maintenance margin: This is somewhat lower than the initial margin. This is set to ensure that the

balance in the margin account never becomes negative. If the balance in the margin account falls

below the maintenance margin, the investor receives a margin call and is expected to top up the

margin account to the initial margin level before trading commences on the next day.

Option terminology

_ Index options: These options have the index as the underlying. Some options are European while

others are American. Like index futures contracts, index options contracts are also cash settled.

Stock options: Stock options are options on individual stocks. A contract gives the holder the right to buy or sell shares at the specified price.

Buyer of an option: The buyer of an option is the one who by paying the option premium buys the

right but not the obligation to exercise his option on the seller/writer.

_

Writer of an option: The writer of a call/put option is the one who receives the option premium and

is thereby obliged to sell/buy the asset if the buyer exercises on him.

Option price: Option price is the price which the option buyer pays to the option seller. It is also

referred to as the option premium.

Expiration date: The date specifi ed in the options contract is known as the expiration date, the

exercise date, the strike date or the maturity.

Strike price: The price specifi ed in the options contract is known as the strike price or the exercise

price.

In-the-money option: An in-the-money (ITM) option is an option that would lead to a positive

cashflow to the holder if it were exercised immediately. A call option on the index is said to be

in-the-money when the current index stands at a level higher than the strike price (i.e. spot price _ strike price). If the index is much higher than the strike price, the call is said to be deep ITM. In the

case of a put, the put is ITM if the index is below the strike price.

_ At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cashflow

if it were exercised immediately. An option on the index is at-the-money when the current index

equals the strike price (i.e. spot price = strike price).

_

Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to a

negative cashflow it it were exercised immediately. A call option on the index is out-of-the-money

when the current index stands at a level which is less than the strike price (i.e. spot price _ strike

price). If the index is much lower than the strike price, the call is said to be deep OTM. In the case

of a put, the put is OTM if the index is above the strike price.