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DERIVATIVES (Instrument for risk reduction)

INTRODUCTION
The past decade witness the multiple growths in the volume of international trade usiness due to the wave of glo ali!ation and li erali!ation all over the world" As a result# the demand for the international mone$ and financial instruments increased significantl$ at the glo al level" In this respect# changes in the interest rate# e%change rate# and stock market price at the different financial market have increased the financial risk to the corporate world" It is therefore to manage such risks& the new financial instrument has een developed in this financial market# which is also known as financial Derivatives" The asic purpose of this instrument is to provide commitment to price for future date for giving protection against adverse movement in future price in order to reduce the e%tent of financial risks" 'ot onl$ this# the$ also provide opportunit$ to earn profit for those who are read$ to go for high risks" This instrument facilitates to transfer the risks from those who wish to avoid it to those who are willing to accept the risks"

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DERIVATIVES (Instrument for risk reduction)

WHAT IS A DERIVATIVE?
Derivatives is a product( contract# which does not have an$ value on its own i"e" it# derives its value from some underl$ing" Derivatives or derivatives securities are contracts which are written etween two parties (counter parties) and whose values is derived from underl$ing widel$ held and easil$ marketa le assets such as agricultural and other ph$sical (tangi le) commodities or currencies or short term and long term financial instruments tangi le things like commodities price inde% (inflation rate)# e)uit$ price inde% or ond price inde%" The counter parties to such contract are those other than the original issuer (holder ) of the underl$ing assets " The e%change*traded derivatives are )uit li)uid and have low transaction cost" It is possi le to com ine them to match specific re)uirements" The value of derivatives and those of their underl$ing assets are closel$ related" +suall$ in trading derivatives# the taking or making of deliver$ of underl$ing assets is not involved & the transactions are mostl$ settled $ taking offsetting positions in the derivatives themselves" There is therefore# no effective limit on the claims# which can e traded in respect of underl$ing assets" Derivatives are ,off alance- instruments# a fact is said to e o scure the leverage and financial might give to the part$" The$ are mostl$ secondar$ market instruments and have little usefulness in mo ili!ing fresh capital $ the companies" Although the standardi!ed# general e%change traded derivatives are eing increasingl$ evolved# still there are man$ privatel$ negotiated# customi!ed# .T/* traded financial contracts which are in vogue and which e%pose the uses to operational risk" There is also and uncertaint$ a out the regulator$ status of such derivatives" Derivatives are used to facilitate hedging of price risk of inventor$ holding or a financial ( commercial transaction over a certain period" In practice# ever$ derivatives 0contract1 has a fi%ed e%piration date # mostl$ in the range of 2 to 23 months from the date of commencement of the contract" (4resentl$ 2#3#5# month-s contracts are availa le in India) Example: A ver$ simple e%ample of derivatives is curd# which is derivative of milk" The price of curd depends upon the price of milk which in turn depends upon the demand 6 suppl$ of milk" TYBBI 2

DERIVATIVES (Instrument for risk reduction)

CLASSIFICATION OF DERIVATIVES

Derivatives markets can asicall$ e classified into commodit$ and 7inancial Derivatives market" /ommodit$ markets are further classified into tangi le commodities 6 intangi le commodities" 7inancial derivatives roadl$ has four ranches vi!" Real Estate# 7ore%# E)uit$ derivatives and De t Derivatives" E)uit$ derivatives are further divided into inde% 4roducts and derivatives on securities and De t derivatives are further divided into Interest rate 4roducts and 8.I Securities # onds# T* ills"

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DERIVATIVES (Instrument for risk reduction)

HISTORY OF DERIVATIVES
The first centrali!ed commodities market in 9ritain was founded in the 2:;<s in the Ro$al E%change (later to ecome the first home of the =ondon International 7inancial 7utures E%change)" +nfortunatel$ the 8reat 7ire of =ondon destro$ed the Ro$al E%change in 2;;;# although trading continued in the various coffee houses that were springing up in the /it$ of =ondon at the time" Eventuall$ each coffee house started to speciali!e in one particular product> the =ondon /ommodit$ E%change in the Virginian and 9altic coffee house the =ondon ?etal E%change in @erusalem and the =ondon Stock E%change in @onathans" At the same time there was an options market in Aolland at the Amsterdam Trade /enter ased on tulips" +nfortunatel$ the speculative use of these options collapse of the Dutch econom$ .rgani!ed futures markets# as we know them toda$ reall$ developed in the last centur$# primaril$ in the +S# when the /hicago 9oard of Trade (/9.T) was esta lished in 2BCB" At that time /hicago was not onl$ at the center of the railroads& it was also an important port on the 8reat =akes and close to the ?idwest farmlands" Dith /hicago eing such an important center for agricultural markets the /9.T was esta lished to provide farmers with a central market place to guarantee the prices for their livestock and grain" rought a out the

THE NEED FOR A DERIVATIVES MARKET


The derivatives market performs a num er of economic functions> 2" The$ help in transferring risks from risk averse people to risk oriented people 3" The$ help in the discover$ of future as well as current prices 5" The$ catal$!e entrepreneurial activit$ C" The$ increase the volume traded in markets ecause of participation of risk averse people in greater num ers :" The$ increase savings and investment in the long run

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DERIVATIVES (Instrument for risk reduction)

FACTORS DRIVING THE GROWTH OF FINANCIAL DERIVATIVES:


2" Increased volatilit$ in asset prices in financial markets# 3" Increased integration of national financial markets with the international markets# 5" ?arked improvement in communication facilities and sharp decline in their costs# C" Development of more sophisticated risk management tools# providing economic agents a wider choice of risk management strategies# and :" Innovations in the derivatives markets# which optimall$ com ine the risks and returns over a large num er of financial assets leading to higher returns# reduced risk as well as transactions costs as compared to individual financial assets"

WHAT KINDS OF RISKS DO PARTICIPANTS IN THE DERIVATIVES MARKETS FACE?


Some example o! "# $ a"e p"o%#&e& 'elo( > Co)*+e"pa"+, -o" &e!a)l+. "# $ E ver$ low or almost !ero ecause the e%change takes on the responsi ilit$ Ope"a+#o*al "# $ E risk that operational s$stems might fail Le/al "# $ E risk that legal o Fections might e raised# regulator$ framework might disallow some activities Ma"$e+ "# $ E risk that market prices ma$ move ups or down L#0)#&#+, "# $ E risk that unwinding of transactions might difficult if the market is illi)uid" e

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DERIVATIVES (Instrument for risk reduction)

TYPES OF DERIVATIVES
Fo"(a"& > A forward contract is a customi!ed contract entities# where settlement takes place specific date in the future at toda$-s pre*agreed price" F)+)"e > A futures contract is an agreement etween two parties to u$ or 4rofit contracts are special t$pes of forward contracts which are standardi!ed e%change*traded contracts" Op+#o* > .ptions are of two t$pes * calls and puts" /alls give the u$er the right ut not the o ligation to u$ a given )uantit$ of the underl$ing asset# at a given price on or u$er the right# efore a given future date" 4uts give the ut not the o ligation to sell a given )uantit$ of the etween two on a

underl$ing asset at a given price on or efore a given date" Wa""a*+ : .ptions generall$ have life of upto one $ear# the maForit$ of options traded on options e%changes having a ma%imum maturit$ of nine months" =onger*dated options are called warrants and are generall$ traded over*the*counter" LEAPS: The acron$m =EA4S means =ong *Term E)uit$ Anticipation Securities" These are options having a maturit$ of upto three $ears" =EA4S are not currentl$ availa le in India" 1a $e+ : 9asket options are options on portfolios of underl$ing assets" The underl$ing asset is usuall$ a moving average or a asket of assets" E)uit$ inde% options are a form of asket options"

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DERIVATIVES (Instrument for risk reduction)

S(ap > Swaps are private agreements etween two parties to e%change cash flows in the future according to a prearranged formula" The$ can e regarded as portfolios of forward contracts" T2e +(o 3ommo*l, ) e& (ap a"e 45 I*+e"e + "a+e (ap 65 C)""e*3, (ap I*+e"e + "a+e (ap : These entail swapping onl$ the interest related

cash flows etween the parties in the same currenc$" C)""e*3, (ap > These entail swapping oth principal and interest

etween the parties with the cashflows in one direction eing in a different currenc$ than those in the opposite direction" S(ap+#o*: Swaption are options to u$ or sell a swap that will ecome operative at the e%pir$ of the options" Thus a Swaption is an option on a forward swap" Rather than have calls and puts# the Swaption market has receiver Swaption and pa$er Swaption" A receiver Swaption is an option to receive fi%ed and pa$ floating interest" A pa$er Swaption is an option to pa$ fi%ed and receives floating interest"

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DERIVATIVES (Instrument for risk reduction)

DERIVATIVES MEM1ERSHIP
The Derivatives Segment mem ership is open to the e%isting mem ers of the /ash Segment as well as non*mem ers provided the$ fulfill the mem ership re)uired as laid down from time to time" The following are the different t$pes of mem ership presentl$ availa le for the Derivatives Segment> 2) P"o!e #o*al Clea"#*/ Mem'e" -PCM.: 4/? means a /learing

?em er# who is permitted to clear and settle trades on his own account# on account of his clients and ( or on account of trading mem ers and their clients" 3) C) +o&#a* Clea"#*/ Mem'e" -CCM.: //? means /ustodian registered as /learing ?em er# who ma$ clear and settle trades on his own account# on account of his clients and ( or on account of trading mem ers and their clients" 5) T"a&#*/ C)m Clea"#*/ Mem'e" -TCM.: A T/? means a Trading ?em er who is also a /learing ?em er and can clear and settle trades on his own account# on account of his clients and on account of associated Trading ?em ers and their clients" C) Sel! Clea"#*/ Mem'e" -SCL)> A S/? means a Trading ?em er who is also a /learing ?em er and can clear and settle trades on his own account and on account of his clients" :) T"a&#*/ Mem'e" -TM.: AT? is a mem er of the E%change who has $ the /learing onl$ trading rights and whose trades are cleared and settled ?em er with whom he is associated" ;) L#m#+e& T"a&#*/ Mem'e" -LTM.: A =T? is a mem er# who is not the mem ers of the /ash Segment of the E%change# and would like to e a Trading ?em er in the Derivatives Segment at 9SE" An =T? has onl$ the trading rights and his trades are cleared and settled $ the clearing mem er with is associated" As on @anuar$ 2# 3<<5# there are 2 4rofessional /learing ?em er# 5 /ustodian /learing ?em ers# G: Trading cum /learing ?em ers# H5Trading ?em ers and 2G =imited Trading ?em ers in the Derivative Segment of the E%change" whom he

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DERIVATIVES (Instrument for risk reduction)

"

F#*a*3#al "e0)#"eme*+ !o" &e"#%a+#%e mem'e" 2#p


The most asic means of controlling counter*part$ credit and li)uidit$ risks is to deal onl$ with creditworth$ counter*parties" The E%change seek to ensure that their mem ers are creditworth$ $ la$ing down a set of financial re)uirements for mem ership" The mem ers are re)uired to meet# oth initiall$ and on an ongoing asis# minimum networth re)uirement" +nlike /ash Segment mem ership where all the trading mem ers are also the clearing mem ers#in the derivatives Segment the trading and clearing rights are oth clearing and segregated" In other words# a mem er ma$ opt to have cleared and settled

trading rights or he ma$ opt for trading rights onl$ in which case his trades are $ his associated /learing ?em er" Accordingl$# the networth re)uirement is ased on the t$pe of mem ership and is as under>

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DERIVATIVES (Instrument for risk reduction)

NET WORTH TYPES OF MEM1ERSHIPS RE7UIREMENTS -RS5 LAKHS.


4rofessional /learing ?em er# /ustodian /learing ?em er and Trading cum /learing ?em er Self /learing ?em er Trading ?em er =imited Trading ?em er =imited Trading ?em er (for mem ers of other stock e%change whose /learing ?em er is a su sidiar$ compan$ of a Regional Stock E%change)

5<< 2<< 3: 3: 2<

CAPITAL ADE7UACY RE7UIREMENT


Ever$ /learing ?em er of the Derivatives Segment is re)uired to maintain a minimum capital deposit of Rs" :< lakhs with the E%change# of which# the 3:I is to e deposited in cash# 3:I $ wa$ of cash ( fi%ed deposit receipts of ank(s) and the alance $ wa$ of ank guarantee(s) or eligi le securities" In addition to a ove# a /learing ?em er is re)uired to deposit Rs" G": lakhs with the E%change in the specified form for ever$ T? ( =T? associated with him" Amount deposited $ a /learing ?em er in addition to Rs" :< lakhs is treated as his additional capital deposit or initial margin deposit" :<I of the additional capital deposit should e in the form of cash or cash e)uivalents# vi!"# /ash# 7DRs# ank guarantees" At all points of time# a /learing ?em er-s li)uid networth# i"e"# total capital deposited less capital used towards margin should e greater than or e)ual to Rs" :< lakhs"

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DERIVATIVES (Instrument for risk reduction)

TYPES OF DERIVATIVES TYPES OF DERIVATIVES FORWARD CONTRACT

FUTURE CONTRACT OPTION CONTRACT SWAP CONTRACT

FORWARD CONTRACT
A forward contract is an agreement to u$ or sell an asset on a It is a deal for the

specified date for a specified price agreed upon toda$ "

purchase or sale of a commodit$# securit$ or other asset in the spot or forward market" The essential idea of entering into a forward contract is to peg the price and there $ avoid the price risk" +suall$ no part$ changes hands when forward contracts are entered" Although a forward contract is a good means of avoiding price risk ut it entails an element of risk that the part$ to the contract ma$ not honor its part of the o ligation" .nce a position of u$er or seller is taken an investor cannot retreat e%cept through mutual consent or u$ entering into an identical contract $ reversing his position" Dith forward contracts entered into on a one to one asis and with no standardi!ation the forward contracts have a ver$ low degree of li)uidit$" Therefore# the pro lem associated with the forward contracts led to the emergence of future contracts"

E8AMPLE
Imagine $ou are a farmer" Jou grow 2#<<< do!ens of mangoes ever$ $ear" Jou want to sell these mangoes to a merchant ut are not sure what the price

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DERIVATIVES (Instrument for risk reduction)

will e when the season comes" Jou therefore agree with a merchant to sell all $our mangoes for a fi%ed price for Rs 3 lakhs" This is a forward contract wherein $ou are the seller of mangoes forward and the merchant is the u$er" The price is agreed toda$ in advance and the deliver$ will take place sometime in the future"

WHERE ARE FORWARDS USED?


7orwards have een used in the commodities market since centuries" 7orwards are also widel$ used in the foreign e%change market"

ESSENTIAL FEATURES OF A FORWARD CONTRACT


K /ontract etween two parties (without an$ e%change etween them) K 4rice decided toda$ K Luantit$ decided toda$ (can e ased on convenience of the parties) K Lualit$ decided toda$ (can e ased on convenience of the parties) K Settlement will take place sometime in future (can e ased on convenience of the parties) K 'o margins are generall$ pa$a le $ an$ of the parties to the other

LIMITATIONS OF FORWARDS
7orwards involve counter part$ risk" In the a ove e%ample# if the merchant does not u$ the mangoes for Rs 3 lakhs when the season comes# what can $ou doM Jou can onl$ file a case in the court# ut that is a difficult process" 7urther# the price of Rs 3 lakhs was negotiated merchant" If some od$ else wants to u$ these mangoes from $ou# there is no mechanism of knowing what the right price is" etween $ou and the

T2) 9 +2e +(o ma:o" l#m#+a+#o* o! !o"(a"& a"e:


K /ounter part$ risk K 4rice not eing transparent

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DERIVATIVES (Instrument for risk reduction)

/ounter part$ risk is also referred to as ,default- risk or ,credit- risk"

FUTURE CONTRACT
7utures trading was started in the mid E western part of +SA during 2HG<-s # ut toda$ it is traded through out the world" 7utures markets were designed to solve the pro lems that e%ist in forward markets" A futures contract is an agreement etween two parties to u$ or sell an asset at a certain time in the future at a certain price" 7utures are similar to forwards ut unlike forward contracts# the futures contracts are standardi!ed and e%change traded" " 4rices are availa le to all those who want to u$ or sell ecause the trading takes place on a transparent computer s$stem" To facilitate li)uidit$ in the futures contracts# the e%change specifies certain standard features of the contract" It is a standardi!ed contract with standard underl$ing instrument# a standard )uantit$ and )ualit$ of the underl$ing instrument that can e delivered# (or which can e used for reference purposes in settlement) and a standard timing of such settlement" A futures contract ma$ e offset prior to maturit$ $ entering into an e)ual and opposite transaction" ?ore than HHI of futures transactions are offset this wa$"

T2e +a*&a"&#;e& #+em #* a !)+)"e 3o*+"a3+ a"e: <


Luantit$ of the underl$ing Lualit$ of the underl$ing The date and the month of deliver$ The units of price )uotation and minimum price change =ocation of settlement

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DERIVATIVES (Instrument for risk reduction)

FEATURES OF FUTURES
K /ontract etween two parties through an e%change K E%change is the legal counter part$ to oth parties K 4rice decided toda$ K Luantit$ decided toda$ ()uantities have to specified $ the e%change) K Lualit$ decided toda$ ()ualit$ should e as per the specifications decided $ the e%change) K Tick si!e (i"e" the minimum amount $ which the price )uoted can change) is decided $ the e%change K Deliver$ will take place sometime in future (e%pir$ date is specified $ the e%change) K ?argins are pa$a le $ oth the parties to the e%change K In some cases# the price limits (or circuit filters) can e%change" e decided $ the e in standard denominations

LIMITATION OF FUTURE:
7utures suffer from lack of fle%i ilit$" Suppose $ou want to u$ 2<5 shares of Sat$am for a future deliver$ date of 2Cth 7e ruar$# $ou cannot" The e%change will have standardi!ed specifications for each contract" Thus# $ou ma$ find that $ou can u$ Sat$am futures in lots of 2#3<< onl$" Jou ma$ find that e%pir$ date will e the last Thursda$ of ever$ month" Thus# while forwards can e structured according to the convenience of the trading parties involved# futures specifications are standardi!ed e%change" $ the

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DERIVATIVES (Instrument for risk reduction)

FUTURE TERMINOLOGY
Spo+ p"#3e: The price at which an asset trades in the spot market" F)+)"e p"#3e: The price at which the futures contract trades in the futures market" Co*+"a3+ 3,3le: The period over which a contract trades" The inde% futures contracts on the 'SE have one*month# two*months and three* months e%pir$ c$cles# which e%pire on the last Thursda$ of the month" Thus a @anuar$ e%piration contract e%pires on the last Thursda$ of @anuar$ and a 7e ruar$ e%piration contract ceases trading on the last Thursda$ of 7e ruar$" .n the 7rida$ following the last Thursda$# a new contract having a three*month e%pir$ is introduced for trading" Exp#", &a+e: It is the date specified in the futures contract" This is the last da$ on which the contract will e traded# at the end of which it will cease to e%ist" Co*+"a3+ #;e: The amount of asset that has to e delivered under one contract" 7or in*stance# the contract si!e on 'SE-s futures market is 3<< 'ifties" 1a # : In the conte%t of financial futures# asis can e defined as the futures price minus the spot price" There will e a different asis for each deliver$ month for each contract" In a normal market# asis will e positive" This reflects that futures prices normall$ e%ceed spot prices" Co + o! 3a"",: The relationship etween futures prices and spot prices can e summari!ed in terms of what is known as the cost of carr$" This measures the storage cost plus the interest that is paid to finance the asset less the income earned on the asset" I*#+#al ma"/#*: The amount that must e deposited in the margin account at the time a futures contract is first entered into is known as initial margin"

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DERIVATIVES (Instrument for risk reduction)

Ma"$#*/<+o<ma"$e+: In the futures market# at the end of each trading da$# the margin ac*count is adFusted to reflect the investor-s gain or loss depending upon the futures closing price" This is called markingEtoE market"

Ma#*+e*a*3e ma"/#*: This is somewhat lower than the initial margin" This is set to ensure that the alance in the margin account never ecomes negative" If the alance in the margin account falls elow the maintenance margin# the investor receives a margin call and is e%pected to top up the margin account to the initial margin level efore trading commences on the ne%t da$"

Ma+)"#+, o! !)+)"e 3o*+"a3+


Inde% futures of different maturities trade simultaneousl$ on the e%changes" 7or instance# 9SE trades three contracts on 9SE SE'SEN with one# two and three month-s maturit$" These contracts of different maturities are called near month (one month)# middle month (two months) and far month (three months) contracts" At an$ point of time there will e three futures contracts availa le for trading"

Mea*#*/ o! exp#", o! F)+)"e


7utures contracts will e%pire on a certain pre*specified date" In India# futures contracts e%pire on the last Thursda$ of ever$ month"

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DERIVATIVES (Instrument for risk reduction)

7or e%ample# a 7e ruar$ 7utures contract will e%pire on the last Thursda$ of 7e ruar$" In this case# 7e ruar$ is referred to as the /ontract month" If the last Thursda$ is a holida$# 7utures and .ptions will e%pire on the previous working da$" .n e%pir$# all contracts will Settlement can e effected in cash or through deliver$" e compulsoril$ settled"

Co*%e"/e*3e a+ Exp#"a+#o*
7utures pricing have e%pectations and a time value uilt into them" This is the reason as time period e%pires the e%pectation value and the time value deca$s and the futures price converges into the cash market price" This process of convergence results in price discover$ of cash inde% at a given point in time" /onvergence also forces the respective market participants to s)uare off their respective e%posures or rollover their e%posures to the ne%t contract month" /onvergence also reiterates the fact that derivatives instruments have limited life"

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DERIVATIVES (Instrument for risk reduction)

WHAT TYPE OF MARGINS ARE PAYA1LE ON FUTURES?


9oth u$ers and sellers of 7utures should pa$ an Initial ?argin to the e%change at the point of entering into 7utures contracts" This Initial ?argin is retained $ the e%change till these transactions are s)uared up" 7urther# ?ark to ?arket ?argins are pa$a le ased on closing prices at the end of each trading da$" These ?argins will e paid $ the part$ who suffered losses and will e received $ the part$ who made profits" The e%change thus collects these margins from the losers and pa$s them to the winners on a dail$ asis"

MARK = TO< MARKET


Ever$ da$ all the open positions in 7utures contracts are marked to the closing price and the variation# if an$# is collected ( paid to the mem ers $ de iting ( crediting their settlement ank accounts with the respective clearing anks on T O 2 morning" Also# where the positions are closed# profit ( loss on such positions is also credited ( de ited to the mem er-s ank accounts"

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DERIVATIVES (Instrument for risk reduction)

Me+2o&olo/, !o" 3al3)la+#*/ 3lo #*/ p"#3e !o" &a#l, ma"$ +o ma"$e+:
The dail$ closing price of the futures contract for calculating mark*to*market margin is arrived at using following algorithm>* Deighted average price of all the trades in last half an hour of the continuous trading session" If there are no trades during last half an hour# then the theoretical price would e taken as the official closing price" The theoretical price is arrived at using the following algorithm>* $

T2eo"e+#3al p"#3e > Clo #*/ %al)e o! )*&e"l,#*/ ? - 3lo #*/ %al)e o! )*&e"l,#*/ @ No5 o! &a, +o exp#", @ "# $ !"ee #*+e"e + "a+e - a+ p"e e*+ A5BC . D EFB .5

HOW CAN I S7UARE UP A FUTURES CONTRACT?


If $ou have ought a 7utures contract# $ou can sell it and thus s)uare up" If $ou sold a 7utures contract# $ou can u$ it ack and s)uare up"

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DERIVATIVES (Instrument for risk reduction)

If $ou do not s)uare up till the da$ of e%pir$# it will e automaticall$ s)uared up $ the e%change"

HOW TO 1ENEFIT FROM STOCK FUTURES


Jou are ullish on a stock sa$ Sat$am# which is currentl$ )uoting at Rs 3B< per share" Jou elieve that in one month it will touch Rs 55<" 7)e +#o*: Dhat do $ou doM A* (e"> Jou u$ Sat$am" E!!e3+> It touches Rs 55< as $ou predicted E $ou made a profit of Rs :< on an investment of Rs 3B< i"e" a Return of 2BI in one month E 7antastic PP Wa#+> /an it get an$ etter M Ye GG 7)e +#o*> Dhat should $ou do M A* (e"> 9u$ Sat$am 7utures instead" E!!e3+> .n u$ing Sat$am 7utures# $ou get the same position as Sat$am in the cash market# ut $ou pa$ a margin and not the entire amount" 7or

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DERIVATIVES (Instrument for risk reduction)

e%ample# if the margin is 3<I# $ou would pa$ onl$ Rs :;" If Sat$am goes upto Rs 55<# $ou will still earn Rs :< as profit" 'ow that translates into a fa ulous return of BHI in one month" U*'el#e%a'le GG1)+ T")e *e%e"+2ele GG

This is the advantage of ,leverage- which Stock 7utures provide" 9$ investing a small margin (ranging from 2< to 3:I)# $ou can get into the same positions as $ou would e a le to in the cash market" The returns therefore get accordingl$ multiplied"

7)e +#o* > Dhat are the risksM A* (e" > The risks are that losses will e get leveraged or multiplied in the same manner as profits do" 7or e%ample# if Sat$am drops from Rs 3B< to Rs 3:<# $ou would make a loss of Rs 5<" The Rs 5< loss would translate to an 22I loss in the cash market and a :CI loss in the 7utures market" 7)e +#o* > what is the main advantage of 7uturesM A* (e" > A great advantage of 7utures (at the moment) is that the$ are not linked to ,deliver$-" Dhich means# $ou can sell 7utures (short sell) of Sat$am even if $ou do not have an$ shares of Sat$am" Thus# $ou can enefit from a downturn as well as from an upturn" If $ou predict an upturn# $ou should u$ 7utures and if $ou predict a downturn# $ou can alwa$s sell 7utures E thus $ou can make mone$ in a falling market as well as in a rising one E an opportunit$ that till recentl$ was availa le onl$ to rokers(operators and not easil$ to retail investors" Jou should look for opportunities where futures prices are higher than cash prices" 7or e%ample# if Sat$am is )uoting at Rs 3:< in the cash market and one month Sat$am futures are )uoting at Rs 3:5 in the futures market# $ou TYBBI 21

DERIVATIVES (Instrument for risk reduction)

can earn Rs 5 as difference" Jou will then u$ Sat$am in the cash market and at the same time# sell Sat$am one month futures" .n or around the e%pir$ da$ (last Thursda$ of each month)# $ou will s)uare up oth the positions# i"e" $ou will sell Sat$am in the cash market and u$ futures" The two prices will e the same (or ver$ nearl$ the same) as cash and futures prices will converge on e%pir$" It does not matter to $ou what the price is" Jou will make $our profit of Rs 5 an$wa$" Fo" example# if the price is Rs 3G<# $ou will make a profit of Rs 3< on selling $our /ash market Sat$am and a loss of Rs 2G on u$ing ack Sat$am futures" The net profit is Rs 5" .n the other hand# if the price is Rs 33:# $ou make a loss of Rs 3: on selling /ash market Sat$am and a profit of Rs 3B on Sat$am futures" The net profit remains Rs 5" Jour investment in this transaction will e Rs 3:< on cash market Sat$am plus a margin of sa$ 3<I on Sat$am futures (sa$ Rs :< appro%)" Thus an investment of Rs 5<< has generated a return of Rs 5 i"e" 2I per month or 23I per annum" 'ow take a situation where onl$ 2: da$s are left for e%pir$ and $ou spot the same opportunit$ as a ove" Jou will still generate Rs 5 which will translate into a return of 3I per month or 3CI per annum" In this manner# $ou will generate returns whenever the futures prices are a ove cash market prices"

TYBBI

22

DERIVATIVES (Instrument for risk reduction)

TRADERSD PARTICIPANTSD OPERATORS OF FUTURE MARKETS


HEDGER SPECULATOR AR1ITRAGEURS SPREADERS
7uture contracts are ought and sold u$ large num er of individuals# e categori!ed on the asis of the a

usiness organi!ations# governments and others for variet$ of purposes" The trader in the future market can U )all, !#*a*3#al &e"#%a+#%e )*&e": purposes for which the$ deal in the market" a++"a3+ !ollo(#*/ +,pe o! +"a&e"

TYBBI

23

DERIVATIVES (Instrument for risk reduction)

HEDGER

A Aedging is a position taken in futures or other markets for the purpose of reducing e%posure to one or more t$pes of risk" A person who undertakes such position is called as 0Aedger1" In other words# a hedger uses future markets to reduce risk caused $ the movement in prices of securities# commodities# e%change rate# interest rate# indices# etc" as such# a hedger will take an opposite position to a perceived risk is called (hedging strateg$ in future markets1" The essence of hedging strateg$ is the adoption of future position that# on average# generates profits when the market value of the commitment is higher than the e%pected value"

SPECULATOR
A Speculator ma$ e defined as investors who are willing to take a risk $ taking future position with the e%pectation to earn profits" The speculators forecast the future economic condition and decide which position (long and short) to e taken that will $ield a profit if the forecast is reali!ed" In other words# Speculators are those who do not have an$ position on which the$ enter in futures and options market" The$ onl$ have a particular view on the market# stock# commodit$# etc" In short# speculators put their mone$ at risk in the hope of profiting from an anticipated price change" The$ consider various factors such as demand# suppl$# market positions# open interests# economic fundamentals and other data to take their positions"

Ill) +"a+#o*:
Speculators usuall$ trade in the future markets to earn profits on the asis of difference in spot and future prices of the underl$ing asset"

TYBBI

24

DERIVATIVES (Instrument for risk reduction)

Ram is a trader ut has no time to track and anal$!e the stocks" Aowever# he fancies his chances in predicting the market trend" So instead of u$ing different stocks# he u$s SE'SEN futures" .n ?a$ 2# 3<<2# he u$s 2<< SE'SEN futures Q 5;<< on the e%pectations that the inde% will rise in future" .n @une 2# 3<<2# the SE'SEN rises to C<<< and at that time he sells an e)ual num er of contracts to close out his position" Selling price > C<<< % 2<< Ne+ Ga#* R Rs" C#<<#<<< Rs C<#<<< $ taking a call on the

=ess> 4urchase /ost > 5;<< % 2<< R Rs 5#;<#<<<

Ram has made a profit of Rs C<#<<<

future value of the SE'SEN" Aowever if the SE'SEN had fallen# he would have made a loss" In Inde% futures# pla$ers can have a long*term view of the market up to atleast 5 monthsS"

AR1ITRAGEURS
Ar itrageurs are another important group of participants in the future markets" An ar itrageur is a trader who attempts to make profits $ locking in a risk less trading $ simultaneousl$ entering into two or mare markets" In other words ar itrageurs tr$ to earn risk less profit from discrepancies etween future and spot prices and among future prices" An ar itrageur is asicall$ risk averse" Ae enters into those contracts were he can earn risk less profits" Dhen markets are imperfect# u$ing in one market and simultaneousl$ selling in other market gives risk less profit" Ar itrageurs are alwa$s in the look out for such imperfections" In the futures market one can take advantages of ar itrage opportunities $ u$ing from lower priced market and selling at the higher priced market" In Inde% futures ar itrage is possi le etween the spot market and the futures market ('SE has provided a special software for u$ing all :< 'ift$ stocks in the spot market)"

TYBBI

25

DERIVATIVES (Instrument for risk reduction)

Take the case of the 'SE 'ift$" Assume that 'ift$ is at 23<< and 5 month-s 'ift$ futures is at 25<<" The futures price of 'ift$ futures can e worked out $ taking the interest cost of 5 months into account" If there is a difference then ar itrage opportunit$ e%ists" =et us take the e%ample of single stock to understand the concept etter" If Dipro is )uoted at Rs 2<<< per share and the 5 months futures of Dipro is Rs 2<G< then one can purchase IT/ at Rs2<<< in spot orrowing Q 23I annum for 5 months at Rs 2<G<" Sale Ar itrage profit R 2<G< R C< /ost R 2<<<O5< R 2<5< $

These kind of imperfections continue to e%ist in the markets ut one has to e altert to the opportunities as the$ tend to get e%hausted ver$ fast"

SPREADERS
Spreading is a specific activit$ trading activit$ in which offsetting futures position is involved $ creating almost net position" So the spreads ut at the less risk" A successful ehaviour is an elieves in lower e%pected return

trading in spreading# the spreaders must forecast the relevant factors which affect the changes in the spreads" Interest rate important factor which causes changes in the spreads" In a profita le spread position# normall$# there is a large gain on one side of the spread in comparison to the loss on the other side of the spread" In this wa$# a spread reduces the risks even if the forecast is incorrect" .n the other hand# the pure speculators would make mone$ profita le side of the market ut at ver$ high risk" $ taking onl$ the

TYBBI

26

DERIVATIVES (Instrument for risk reduction)

TYPES OF FUTURES
F)+)"e 3o*+"a3+ a"e '"oa&l, &#%#&e& #*+o +(o +,pe :

COMMODITY FUTURES FINANCIAL FUTURES

COMMODITY FUTURES

TYBBI

27

DERIVATIVES (Instrument for risk reduction)

A commodit$ futures is a contract in commodit$ like agricultural products# metals 6 minerals etc" in organi!ed commodit$ futures markets# contractscontracts are standardi!ed with standard )uantities" .f course this standard varies from commodit$ to commodit$ "the$ also have fi%ed deliver$ dates in each month or a few months on a $ear" I* I*&#a 3ommo&#+, !)+)"e #* a/"#3)l+)"al p"o&)3+ a"e pop)la"5

Some o! +2e (ell e +a'l# 2e& 3ommo&#+, !)+)"e !ollo( :


2" =ondon metal stock e%change (=?E) to deal in gold 3" /hicago oard of trade (/9T) to deal in so$a ean oil 5" 'ew Jork cotton e%change (/T') to deal in cotton

a"e a

C" /ommodit$ e%change# 'ED Jork (/.?EN) to deal in agricultural products :" International petroleum e%change of =ondon (I4E) to deal in crude oil

FINANCIAL FUTURES
The standardi!ed features or specification make 7utures trada le like a contract" And since 7utures are derivatives# the 7utures contracts are ased on an underl$ing" It is the movement of the underl$ing that decides how the 7utures price will move" There are onl$ two possi le trades with a futures contract E 9u$ or Sell" If investor-s e%pectations for the underl$ing asset are ullish the$ should u$ futures" If the e%pectations prove to e correct# the futures contract will rise in value allowing them to close out the position at a profit" If# on the other hand# investors view the underl$ing asset as earish# then the$ should sell the futures contract" If the view is correct# the$ will e a le to u$ ack the futures at a lower price than the$ were sold for# the difference eing the profit the$ have made" Inde% 7utures contracts can e used to take a view on the directions of the overall market with the added advantage of gearing"

TYBBI

28

DERIVATIVES (Instrument for risk reduction)

7or e%ample# lets take the underl$ing asset on SE'SEN" If $ou elieve the SE'SEN will rise $ou can SE'SEN futures) or if $ou u$ the futures contract ( $ going long on the elieve the SE'SEN will fall# $ou can sell the

SE'SEN futures ( $ going short on the SE'SEN futures)" 7inancial Derivatives like futures do not generall$ terminate in deliver$" ?ost positions are closed out efore e%pir$" So if investor# 0A1 had ought two SE'SEN futures contracts giving them a long position# then he is re)uired to sell two SE'SEN futures# which will result in the investor having a short position" This will mean that as far as the /learing Aouse is concerned the investor is oth long and short of two contracts" Sell it ack into the market (If he is long) 9u$ it ack from the market (If he is short)

These two positions are then filed awa$ together netting one off with the other" 'ot onl$ this will result in the investors having no outstanding position in the futures# ut will also ena le investors either to reali!e their profits or reduce their losses"

TYPES OF FINANCIAL FUTURE


4. INTEREST RATE FUTURE CONTRACT:

It is one of the important financial future instruments in the world" 7uture trading on interest earing securities started onl$ in 2HG:# ut growth in the market has treasur$ municipal een tremendous" Important interest earing securities are like earing ills# notes# onds# de enture# euro dollar time deposits and

onds" In this market almost entire ranges of maturities

securities are traded"

TYBBI

29

DERIVATIVES (Instrument for risk reduction)

Fo" e/> Three month maturit$ instruments like treasur$ financial future e%change (=I77E)# @apanese govt" traded"

ills 6 # including

foreign de t instruments at /?E# 9ritish govt" ond at =ondon International " ond at /9.T etc" are

6. FOREIGN CURRENCY FUTURE CONTRACT:


This financial future # as the name indicates# trade in 7oreign currencies # thus known as e%change rate futures " active future trading in certain currencies started in the earl$ 2HG<s" Important 7oreign currencies in which this future contract are made are +S T #4ound sterling# Jen 7rench 7rancs etc" these contracs have directl$ corresponding to spot market# known as inter 'ormall$ this contracts are used for hedging purpose ank foreign currenc$ market # and also have a parallel inter ank foreign market" $ the e%porters# importers# ankers# financial institutions and large companies"

E. STOCK INDE8 FUTURE:


A futures contract is a standardi!ed contract to securit$ at a future date at an u$ or sell a specific agreed price"

An inde% future is# as the name suggests# a future on the inde% i"e" the underl$ing is the inde% itself" There is no underl$ing securit$ or a stock# which is to e delivered to fulfill the o ligations as inde% futures are cash settled" As other derivatives# the contract derives its value from the underl$ing inde%" The underl$ing indices in this case will e the various eligi le indices and as permitted $ the Regulator from time to"

CONTRACT SPECIFICATIONS OF SENSE8 FUTURES

Fea+)"e
TYBBI

SENSE8 F)+)"e
30

DERIVATIVES (Instrument for risk reduction)

+nderl$ing inde% /ontract ?ultiplier

9SE sensitive inde% (SE'SEN) :<

Tick si!e or minimum price <"2 inde% point or Rs" : difference =ast trading da$(e%piration da$ =ast Thursda$ of the e%piration month" If it happens to e a holida$# the contract will e%pire on the previous da$" /ontract months 5 contracts of 5<# ;< and H< da$s maturit$" Thus# at an$ point of time# there will availa le for trading Dail$ settlement price 7inal settlement price /losing price of the futures contract" /losing price of the cash inde% on the e%pir$ date of the futures contract" e 5 contracts

H. STOCK FUTURE CONTRACT


A stock futures contract is a standardi!ed contract to u$ or sell a specific stock at a future date at an agreed price" A stock future is# as the name suggests# a future on a stock i"e" the underl$ing is a stock" The contract derives its value from the underl$ing stock" Single stock futures are cash settled"

CONTRACT SPECIFICATIONS OF STOCK FUTURES

TYBBI

31

DERIVATIVES (Instrument for risk reduction)

Fea+)"e
+nderl$ing Stock /ontract ?ultiplier Tick si!e or minimum price difference

S+o3$ F)+)"e
Respective Stock (Anne%ure) Varies from Stock to Stock (Anne%ure) * =ast Thursda$ of the e%piration month" If it happens to e a holida$# the contract will e%pire on the previous da$" 5 contracts of 5<# ;< and H< da$s maturit$" Thus# at an$ point of time# there will e 5 contracts availa le for trading /losing price of the futures contract" /losing price of the underl$ing scrip on the e%pir$ date of the futures contract"

=ast trading da$(e%piration da$

/ontract months

Dail$ settlement price

7inal settlement price

PAYOFF

A pa$off is the likel$ profit(loss that would accrue to a market participant with change in the price of the underl$ing asset" This is generall$ depicted in the form of pa$off diagrams which show the price of the underl$ing asset on the NEa%is and the profits(losses on the JEa%is"

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32

DERIVATIVES (Instrument for risk reduction)

PAYOFF FOR FUTURES


7utures contracts have linear pa$offs" In simple words# it means that the losses as well as profits for the u$er and the seller of a futures contract are unlimited" These linear pa$offs are fascinating as the$ can e com ined with options and the underl$ing to generate various comple% pa$offs"

PAYOFF FOR 1UYER OF FUTURES: LONG FUTURES


The pa$off for a person who u$s a futures contract is similar to the pa$off for a person who holds an asset" Ae has a potentiall$ unlimited upside as well as a potentiall$ unlimited downside" Take the case of a speculator who u$s a two*month 'ift$ inde% futures

contract when the 'ift$ stands at 233<" The underl$ing asset in this case is the 'ift$ portfolio" Dhen the inde% moves up# the long futures position starts making profits# and when the inde% moves down it starts making losses" 7igure 2 shows the pa$off diagram for the u$er of a futures contract"

PAYOFF FOR A 1UYER OF NIFTY FUTURES


The figure shows the profits(losses for a long futures position" The investor ought futures when the inde% was at 233<" If the inde% goes up# his futures position starts making profit" If the inde% falls# his futures position starts showing losses"

Profit

TYBBI

33

DERIVATIVES (Instrument for risk reduction)

1220 0 Nifty

Loss

- FIGURE 4.

PAYOFF FOR FUTURES

SELLER

OF

FUTURES:

SHORT

The pa$off for a person who sells a futures contract is similar to the pa$off for a person who shorts an asset" Ae has a potentiall$ unlimited upside as well as a potentiall$ unlimited downside" Take the case of a speculator who sells a two*month 'ift$ inde% futures contract when the 'ift$ stands at 233<" The underl$ing asset in this case is the 'ift$ portfolio" Dhen the inde% moves down# the short futures position starts making profits# and when the inde%

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34

DERIVATIVES (Instrument for risk reduction)

moves up# it starts making losses" 7igure 3 shows the pa$off diagram for the seller of a futures contract"

PAYOFF FOR A SELLER OF NIFTY FUTURES


The figure shows the profits(losses for a short futures position" The investor sold futures when the inde% was at 233<" If the inde% goes down# his futures position starts making profit" If the inde% rises# his futures position starts showing losses" 4rofit

233< < 'ift$

=oss

-FIGURE 6.

FORWARD VDS FUTURE

TYBBI

35

DERIVATIVES (Instrument for risk reduction)

Fea+)"e
.perational ?echanism

Fo"(a"& Co*+"a3+

F)+)"e Co*+"a3+

'ot traded on Traded on e%change e%change Traded directl$ etween 3 parties" Differs from trade to /ontracts trade" contracts" are standardi!ed

/ontract Specifications /ounter Risk

part$ E%ists

E%ists# ut assumed /orporation( house"

$ /learing

=i)uidation 4rofile

4oor =i)uidit$ as Ver$ high =i)uidit$ as contracts are contracts are tailor standardi!ed contracts" maid contracts"

4rice Discover$ 4oor& as markets are 9etter& as fragmented markets are fragmented" rought to the common platform"

E%amples

/urrenc$ India

market

in Inde%# Stock6 commodit$ futures

OPTIONS
.ption is a securit$ that represents the right# ut not the o ligation# to u$ or sell a specified amount of an underl$ing securit$ (stock# ond# futures contract# etc") at a specified price within a specified time" .ption Aolder is the u$er of either a call or put option" .ption Driter is the seller of either a call or put option"

TYBBI

36

DERIVATIVES (Instrument for risk reduction)

.ptions are different from futures in man$ wa$s" 'ot onl$ instrument have separate pa$off profiles

oth the

ut also .ptions have host of

parameters that affect their pricing compared to Fust e%pectations and time in the case of 7utures pricing" The risk return profile of options is different from futures"

.ptions unlike futures are also concerned with speed of the trend and not Fust the underl$ing trend" This makes them a little more comple% than 7utures# ut then itUs this in uilt comple%it$ in them that also makes them more versatile instruments" Dith .ptions traders can pla$ non * directional strategies i"e" strategies which will make mone$ for $ou no matter whether markets move up# down or remain sidewa$s" Even Directional strategies can e implemented using .ptions" @ust like 7utures there can e an underl$ing view even in .ptions# a view to u$ or a view to sell" 9ut the u$er pa$s up an upfront premium to protect himself if his view is incorrect" The seller on the other hand though is pla$ing on a view wants to e the one to ook an upfront premium# as a trade off against a possi le loss" The seller gets paid onl$ ecause he is providing the hedge to the long positions at his own risk" .ptions can e categori!ed as call and put options" The option# which

gives the u$er a right to u$ the underl$ing asset# is called /all option and the option# which gives the u$er a right to sell the underl$ing asset# is called 4ut option" .ptions are instruments that give the u$er a right and the seller an o ligation" Aowever# a u$er can u$ a right to u$ or right to sell an underl$ing securit$" The writer on the other hand charges a premium to fulfil oth these o ligations" De will discuss this at length later" =ong option (a call or a put) position has no downside risk as his loss is protected to the premium he pa$s whereas a seller (of a call or put) aka writer can suffer an unlimited loss if the market moves against him" There are four asic pa$offs that an option has a long call# a short call# a long put and a short put" The four pa$offs or as we call them strategies

TYBBI

37

DERIVATIVES (Instrument for risk reduction)

are discussed later" These are the asic four pa$offs are at the heart of the .ption theor$"

HISTORY OF OPTIONS
Although options have e%isted for a long time# the$ were traded .T/# without much knowledge of valuation" Toda$ e%change*traded options are activel$ traded on stocks# stock inde%es# foreign currencies and futures contracts" The first trading in options egan in Europe and the +S as earl$ as the eighteenth centur$" It was onl$ in the earl$ 2H<<s that a group of firms set up what was known as the put and call 9rokers and Dealers Association with the aim of providing a mechanism for ringing u$ers and sellers together" If someone wanted to u$ an option# he or she would contact one of the mem er firms" The firm would then attempt to find a seller or writer of the option either from its own clients or those of other mem er firms" If no seller could e found# the firm would undertake to write the option itself in return for a price" This market however suffered from two deficiencies" 7irst# there was no secondar$ market and second# there was no mechanism to guarantee that the writer of the option would honor the contract" It was in 2HG5# that 9lack# ?erton and Scholes invented the famed 9lack Scholes formula" In April 2HG5# /9.E was set up specificall$ for the purpose of trading options" The market for options developed so rapidl$ that $ earl$ -B<s# the num er of shares underl$ing the option contract sold each da$ e%ceeded the dail$ volume of shares traded on the 'JSE" Since then# there has een no looking ack"

OPTION TERMINOLOGY
I*&ex op+#o* : These options have the inde% as the underl$ing" Some options are European while others are American" =ike inde% futures contracts# inde% options contracts are also cash settled"

TYBBI

38

DERIVATIVES (Instrument for risk reduction)

S+o3$ op+#o* : Stock options are options on individual stocks" .ptions currentl$ trade on over :<< stocks in the +nited States" A contract gives the holder the right to u$ or sell shares at the specified price"

1),e" o! a* op+#o*: The u$er of an option is the one who $ pa$ing the option premium u$s the right ut not the o ligation to e%ercise his option on the seller(writer"

W"#+e" o! a* op+#o*: The writer of a call(put option is the one who receives the option premium and is there $ o liged to sell( u$ the asset if the u$er e%ercises on him" There are two asic t$pes of options# call options and put options" Call option> A call option gives the holder the right ut not the o ligation to u$ an asset $ a certain date for a certain price" Put option> A put option gives the holder the right ut not the o ligation to sell an asset $ a certain date for a certain price"

Op+#o* p"#3e: .ption price is the price which the option u$er pa$s to the option seller" Exp#"a+#o* &a+e: The date specified in the options contract is known as the e%piration date# the e%ercise date# the strike date or the maturit$" S+"#$e p"#3e: The price specified in the options contract is known as the strike price or the e%ercise price" Ame"#3a* op+#o* : American options are options that can e e%ercised at an$ time upto the e%piration date" ?ost e%change*traded options are American"

E)"opea* op+#o* : European options are options that can e e%ercised onl$ on the e%piration date itself" European options are easier to anal$!e than American options# and properties of an American option are fre)uentl$ deduced from those of its European counterpart"

I*<+2e<mo*e, op+#o*: An in*the*mone$ (IT?) option is an option that would lead to a positive cashflow to the holder if it were e%ercised immediatel$" A call option on the inde% is said to e in*the*mone$ when the current inde% stands at a level higher than the strike price (i"e" spot price V strike price)" If the inde% is much higher than the strike price# the

TYBBI

39

DERIVATIVES (Instrument for risk reduction)

call is said to e deep IT?" In the case of a put# the put is IT? if the inde% is elow the strike price" A+<+2e<mo*e, op+#o*: An at*the*mone$ (AT?) option is an option that would lead to !ero cashflow if it were e%ercised immediatel$" An option on the inde% is at*the*mone$ when the current inde% e)uals the strike price (i"e" spot price R strike price)"W O)+<o!<+2e<mo*e, op+#o*: An out*of*the*mone$ (.T?) option is an option that would lead to a negative cashflow it it were e%ercised immediatel$" A call option on the inde% is out*of* the*mone$ when the current inde% stands at a level which is less than the strike price (i"e" spot price X strike price)" If the inde% is much lower than the strike price# the call is said to e deep .T?" In the case of a put# the put is .T? if the inde% is a ove the strike price" I*+"#* #3 %al)e o! a* op+#o* : The option premium can e roken down into two components * intrinsic value and time value" The intrinsic value of a call is the amount the option is IT?# if it is IT?" If the call is .T?# its intrinsic value is !ero" 4utting it another wa$# the intrinsic value of a call is'Y4 which means the intrinsic value of a call is ?a% Z<# (S t E [)\ which means the intrinsic value of a call is the (S t E [)" Similarl$# the intrinsic value of a put is ?a% Z<# ([ *S t )\ #i"e" the greater of < or ([ * S t )" [ is the strike price and St is the spot price" T#me %al)e o! a* op+#o* : The time value of an option is the difference etween its premium and its intrinsic value" A call that is .T? or AT? has onl$ time value" +suall$# the ma%imum time value e%ists when the option is AT?" The longer the time to e%piration# the greater is a call-s time value# all else e)ual" At e%piration# a call should have no time value"
2

TYPES OF OPTIONS Call op+#o* P)+ op+#o*


1

TYBBI

40

DERIVATIVES (Instrument for risk reduction)

CALL OPTION
/all .ptions give the u$er the right to u$ a specified underl$ing at a set price on or efore a particular date" Fo" example# Sat$am 3;< 7e /all .ption gives the 9u$er the right to u$ Sat$am at a price of Rs ;< per share on or the e%ercise price" /all .ptions are also called teFi in the Indian markets" efore the last Thursda$ of 7e ruar$" The price of 3;< in the a ove e%ample is called the strike price or

PUT OPTION
4ut .ptions give the u$er the right to sell a specified underl$ing at a set price on or efore a particular date" Fo" example# Sat$am 3;< 7e 4ut .ption gives the 9u$er the right to sell Sat$am at a price of Rs 3;< per share on or 7e ruar$" 4ut .ptions are also called mandi in the Indian markets" efore the last Thursda$ of

OPTIONS CLASSIFICATIONS Op+#o* a"e o!+e* 3la #!#e& a :

I* +2e mo*e, * These result in a positive cash flow towards the investor

TYBBI

41

DERIVATIVES (Instrument for risk reduction)

A+ +2e mo*e, * These result in a !ero*cash flow to the investor O)+ o! mo*e, * These result in a negative cash flow for the investor

IIN THE MONEYI9IAT THE MONEYIJ KOUT OF THE MONEYI OPTIONS5

OPTION:
An op+#o* is said to e Ia+<+2e<mo*e,I9 when the optionUs strike price is e)ual to the underl$ing asset price" This is true for oth puts and calls"

CALL OPTION:
e K#* +2e mo*e,L when the strike price of the

A 3all op+#o* is said to

option is less than the underl$ing asset price" Fo" example> A Sense% call option with strike of 5H<< is Uin*the*mone$U# when the spot Sense% is at C2<< as the call option has value" The call option holder has the right to u$ a Sense% at 5H<<# no matter $ what amount the spot price e%ceeded the strike price" Dith the spot price at C2<<# selling Sense% at this higher price can make a profit" .n the other hand# a call option is o)+<o!<+2e<mo*e, when the strike price is greater than the underl$ing asset price" +sing the earlier e%ample of Sense% call option# if the Sense% falls to 5G<<# the call option no longer has positive e%ercise value" The call holder will not e%ercise the option to u$ Sense% at 5H<< when the current price is at 5G<< and allow his ,option- right to lapse"

PUT OPTION :
A put option is #*<+2e<mo*e, when the strike price of the option is greater than the spot price of the underl$ing asset" Fo" example# a Sense% put at strike of CC<< is in*the*mone$ when the Sense% is at C2<<" Dhen this is the case# the put option has value ecause TYBBI 42

DERIVATIVES (Instrument for risk reduction)

the put option holder can sell the Sense% at CC<<# an amount greater than the current Sense% of C2<<" =ikewise# a put option is o)+<o!<+2e<mo*e, when the strike price is less than the spot price of underl$ing asset" In the a ove e%ample# the u$er of Sense% put option wonUt e%ercise the option when the spot is at CB<<" The put no longer has positive e%ercise value and therefore in this scenario# the put option holder Dill allow his ,optionright to lapse"

CALL OPTION
I*<+2e< mo*e, A+<+2e< mo*e, O)+<o!<+2e< mo*e,
Strike price X Spot price of underl$ing asset Strike price R Spot price of underl$ing asset Strike price V Spot price of underl$ing asset

PUT OPTION
Strike price V Spot price of underl$ing asset Strike price R Spot price .f underl$ing asset Strike price X Spot price .f underl$ing asset

AMERICAN J EUROPEAN OPTION T2e"e a"e +(o $#*& o! op+#o* 'a e& o* +2e &a+e5
The first is the E)"opea* Op+#o*# which can efore or on the maturit$ date" TYBBI 43 e e%ercised onl$ on the

maturit$ date" The second is the Ame"#3a* Op+#o*# which can e e%ercised

DERIVATIVES (Instrument for risk reduction)

Ame"#3a* a*& E)"opea* Exe"3# e S+,le o! Op+#o*

American and European are primaril$ natures of e%ercise or settlement of .ptions" American .ptions can e E%ercised an$time prior to the the e%piration date" European options in the other hand can onl$ e e%ercised at the E%piration da$" Indian stock options have the American E%ercise settlement while Inde% .ptions can onl$ e settles at E%piration" In India# oth st$les are availa le" Inde% .ptions are European st$le# while individual stock options are American st$le"

E8CHANGE TRADE AND OTC = TRADE OPTIONS:<


The option can e traded like other financial assets either on an organi!ed e%change or on the over*the counter (.T/) market" E%change option contracts# like future contracts are traded on the recogni!ed e%changes" .n the other hand# over the counter (.T/) option are customer

TYBBI

44

DERIVATIVES (Instrument for risk reduction)

tailored agreement sold directl$

$ the dealer rather than through the

organi!ed e%change" The terms and conditions of these contracts are negotiated $ the parties to the contracts" 9oth the option has have different mechanism of functioning# which are discussed here as under : E%change traded option like futures contracts# are standardi!ed and are traded on organi!ed (or government designated) e%changes" .n the other hand# the .T/ options are written on the counters of the large commercial and investment ankers" E%change traded option have certain specified norms relating to )uantit$# maturit$ date# underl$ing assets# etc" which are determined $ the e%changes how ever in the case of .T/ option all such terms are su Fect to negotiation and mutuall$ determined $ u$er and seller of the option contracts" 9eing standardi!e in nature an option contract traded through the recogni!ed e%change has uniform underl$ing assets# limited no of strike prices# limited e%piration dates and so on" E%change traded option are performed and cleared through a clearing house corporation which interposes it self as a thirt$ part$ to the all options contracts" Since# these options are guaranteed $ the e%changes# hence default risks is almost eliminated"

O* '),#*/ a* op+#o* 3o*+"a3+ !"om a "e3o/*#;e& ex32a*/e9 +2e (2#32 a"e

o'l#/a+#o* 3a* 'e !)l!#lle& #* o*e o! +2e +2"ee (a, me*+#o*e& a !ollo( :

TYBBI

45

DERIVATIVES (Instrument for risk reduction)

2" The option u$er ma$ not e%ercise the current# allowing the option to e%pire" The entire premium is retained $ the seller and seller-s o ligation is discharged" 3" In case of the parties to the option# the u$er can e%ercise his right on or efore the e%piration date" 5" Either of the parties to the option contract can e%ecute an offsetting transaction in the option market to eliminate the o ligation"

THE UNDERLYING ASSET IN E8CHANGE TRADED OPTION


Various assets # which are activel$ traded on recogni!ed e%changes are stocks# stocks indices# foreign currencies and future contract " TYBBI 46

DERIVATIVES (Instrument for risk reduction)

T2e e a"e expla#*e& a !ollo( 5 45 S+o3$ op+#o* 65 S+o3$ #*&#3e 9 E5 Fo"e#/* 3)""e*3#e H5 F)+)"e Op+#o* B5 I*+e"e + "a+e Op+#o*

45 STOCKS OPTIONS:
.ptions on Individual Stocks are options contracts where the underl$ings are individual stocks" 9ased on eligi ilit$ criteria and su Fect to the approval from the regulator# stocks are selected on which options are introduced" These contracts are cash settled and are American st$le" Trading on standardi!ed call option on e)uit$ shares started in 2HG5 on /9.E where as on 4ut option egan in 2HGG" Stock options are most popular asset # which are traded on various e%changes all over the world" In India# 'SE and 9SE have started option trading in certain stock from the $ear 3<<2"

CONTRACT SPECIFICATIONS OF STOCK OPTIONS

U*&e"l,#*/> Individual scrip TYBBI 47

DERIVATIVES (Instrument for risk reduction)

Co*+"a3+ M)l+#pl#e"> As specified

T#3$e" S,m'ol> As specified

S+"#$e P"#3e > minimum of : strikes (3 in the mone$# 2 near the mone$# 3 .ut of the mone$)"

P"em#)m 7)o+a+#o*> Rupees per share"

La + T"a&#*/ Da,> =ast Thursda$ of the month" If it is a holida$ than the preceding usiness da$"

Exp#"a+#o* Da,> =ast Thursda$ of contract month" If it is a holida$ than the preceding usiness da$"

No+e> 9usiness da$ is a da$ during which the underl$ing stock market is open for trading

Co*+"a3+ Mo*+2> 2# 3 and 5 months

Exe"3# e S+,le> American"

Se++leme*+ S+,le> /ash

T"a&#*/ Ho)" > H>5< A"?" to 5>5< 4"?"

T#3$ S#;e> <"<2

TYBBI

48

DERIVATIVES (Instrument for risk reduction)

65 INDE8 OPTION5
?an$ different inde% options are currentl$ traded on the different e%changes in different countries" 7or e% "ST4 2<< inde% at /9.E and maFor inde% at A?EN are traded in the +S option markets" Similarl$# in India# such inde% option has een started on national stock e%change and 9om a$ stock e%change" =ike stock option# inde% options strike prices are the inde% value at which the u$er of the option can u$ or sell the underl$ing stock inde%" The strike inde% is converted into dollar (rupee) value multiple for the contract" If the u$er of the stock inde% option indented to e%ercise the option then the stock must e delivered" It would e complicated settle a stock inde% option $ delivering all the stock that makes the particular inde%" If the option is e%ercise# the stock e%change assigned option writer pa$s cash to the option u$er# and there will no deliver$ of an$ share" The mone$ value of the stock inde% underl$ing an inde% option is e)ual to the current cash inde% value multiplied $ the contracts multiplied" Rupees value of the underl$ing inde% R cash inde% value % contract multiplies $ multipl$ing the strike inde% $ the

E5 FOREIGN CURRENCIES OPTION5


7oreign currencies is another important assets# which is traded on varies stock e%changes" 7oreign e%change option has traded on the 4hiladelphia stock e%change since 2HBC" ?aFor currencies traded in the option markets are

TYBBI

49

DERIVATIVES (Instrument for risk reduction)

us dollar# Australian dollar# 9ritish pounds# /anadian dollar# 8erman mark# 7rench franc# @apanese $en# Swiss franc# etc" /all option gives the owner the right to u$ stated amount of foreign e%change at strike rate" The strike price is itself e%change rate" 7oreign currencies puts give the owner the right to sell foreign e%change at strike prices" The e%change traded currenc$ option market is )uit li)uid"

H5 FUTURE OPTION5
In the future option (or option on futures)# the underl$ing assets is a future contract at a designated price at a time during life of the options" If the future option is call option# the u$er has the right to ac)uire a long future position" Similarl$# a put option on a future contract grants the u$er the right"

B5 INTEREST RATE OPTION5


Interest rate options are another important option contract# which are popular in the international financial markets" Interest rate option can e written on cash instrument or future" These are various de t instruments which are used as underl$ing instrument for interest rate option in different e%changes" These contracts are referred as option on ph$sicals" Recentl$# these instrument rate option have also gained popularit$ on the over the E counter markets like on treasur$ ounds# agenc$ de entures# large anking firms# and mortgage * acked E securities

OPTIONS PAY OFFS


The optionalit$ characteristic of options results in a non*linear pa$off for options" In simple words# it means that the losses for the u$er of an option are limited# however the profits are potentiall$ unlimited" 7or a writer# the

TYBBI

50

DERIVATIVES (Instrument for risk reduction)

pa$off is e%actl$ the opposite" Ais profits are limited to the option premium# however his losses are potentiall$ unlimited" These non*linear pa$offs are fascinating as the$ lend themselves to e used to generate various pa$offs underl$ing" $ using com inations of options and the

PAYOFF PROFILE FOR 1UYER OF CALL OPTIONS: LONG CALL


A call option gives the u$er the right to u$ the underl$ing asset at the strike price specified in the option" The profit(loss that the u$er makes on the option depends on the spot price of the underl$ing" If upon e%piration# the spot price e%ceeds the strike price# he makes a profit" Aigher the spot price# more is the profit he makes" If the spot price of the underl$ing is less than the strike price# he lets his option e%pire un*e%ercised" Ais loss in this case is the premium he paid for u$ing the option" 7igure 5 gives off for the u$er of a three month call option (often referred to as long call) with a strike of 23:< ought at a premium of B;";<"

PAY OFF FOR 1UYER OF CALL OPTION


The figure shows the profits(losses for the u$er of a three*month 'ift$ 23:< call option" As can e seen# as the spot 'ift$ rises# the call option is in*the* mone$" If upon e%piration# 'ift$ closes a ove the strike of 23:<# the u$er would e%ercise his option and profit to the e%tent of the difference etween the

TYBBI

51

DERIVATIVES (Instrument for risk reduction)

'ift$*close and the strike price" The profits possi le on this option are potentiall$ unlimited" Aowever if 'ift$ falls elow the strike of 23:<# he lets the option e%pire" Ais losses are limited to the e%tent of the premium he paid for u$ing the option"

Profit 1250 0 86.60 Loss Nifty

- FIGURE E .

PAYOFF PROFILE FOR WRITER OF CALL OPTIONS: SHORT CALL


A call option gives the u$er the right to u$ the underl$ing asset at the strike price specified in the option" 7or selling the option# the writer of the option charges a premium" The profit(loss that the u$er makes on the option depends on the spot price of the underl$ing" Dhatever is the u$er-s profit is the seller-s loss" If upon e%piration# the spot price e%ceeds the strike price# the u$er will e%ercise the option on the writer" Aence as the spot price increases the writer of the option starts making losses" Aigher the spot price# more is the loss he makes" If upon e%piration the spot price of the underl$ing is less than the strike price# the u$er lets his option e%pire un*e%ercised and the writer gets to keep the premium" 7igure C gives for the writer of a three month call option (often referred to as short call) with a strike of 23:< sold at a premium of B;";<"

PAYOFF FOR WRITER OF CALL OPTIONS


TYBBI 52

DERIVATIVES (Instrument for risk reduction)

The figure shows the profits(losses for the seller of a three*month 'ift$ 23:< call option" As the spot 'ift$ rises# the call option is in*the*mone$ and the writer starts making losses" If upon e%piration# 'ift$ closes a ove the strike of 23:<# the u$er would e%ercise his option on the writer who would suffer a loss to the e%tent of the difference etween the 'ift$*close and the strike price" The loss that can e incurred $ the writer of the option is potentiall$ unlimited# whereas the ma%imum profit is limited to the e%tent of the up*front option premium of Rs"B;";< charged $ him" Profit

Profit 86.60 1250 0 Nifty

Loss

-FIGURE H.

PAYOFF PROFILE FOR 1UYER OF PUT OPTIONS: LONG PUT


A put option gives the u$er the right to sell the underl$ing asset at the strike price specified in the option" The profit(loss that the u$er makes on the option depends on the spot price of the underl$ing" If upon e%piration# the spot price is elow the strike price# he makes a profit" =ower the spot price# more is the profit he makes" If the spot price of the underl$ing is higher than the strike

TYBBI

53

DERIVATIVES (Instrument for risk reduction)

price# he lets his option e%pire un*e%ercised" Ais loss in this case is the premium he paid for u$ing the option" 7igure :gives the pa$off for the u$er of a three*month put option (often referred to as long put) with a strike of 23:< ought at a premium of ;2"G<"

PAYOFF FOR 1UYER OF PUT OPTIONS


The figure shows the profits(losses for the u$er of a three*month 'ift$ 23:< put option" As can e seen# as the spot 'ift$ falls# the put option is in*the* mone$" If upon e%piration# 'ift$ closes elow the strike of 23:<# the u$er would e%ercise his option and profit to the e%tent of the difference etween the strike price and 'ift$*close" The profits possi le on this option can e as high as the strike price" Aowever if 'ift$ rises a ove the strike of 23:<# he lets the option e%pire" Ais losses are limited to the e%tent of the premium he paid for u$ing the option" Profit 1250 0 61.70 Nifty

Loss

- FIGURE B .

PAYOFF PROFILE FOR WRITER OF PUT OPTIONS: SHORT PUT


A put option gives the u$er the right to sell the underl$ing asset at the strike price specified in the option" 7or selling the option# the writer of the option charges a premium" The profit(loss that the u$er makes on the option depends on the spot price of the underl$ing" Dhatever is the u$er-s profit is

TYBBI

54

DERIVATIVES (Instrument for risk reduction)

the seller-s loss" If upon e%piration# the spot price happens to e elow the strike price# the u$er will e%ercise the option on the writer" If upon e%piration the spot price of the underl$ing is more than the strike price# the u$er lets his option e%pire un*e%ercised and the writer gets to keep the premium" 7igure ;gives the pa$off for the writer of a three*month put option (often referred to as short put) with a strike of 23:< sold at a premium of ;2"G<"

PAYOFF FOR WRITER OF PUT OPTIONS


The figure shows the profits(losses for the seller of a three*month 'ift$ 23:< put option" As the spot 'ift$ falls# the put option is in*the*mone$ and the writer starts making losses " If upon e%piration# 'ift$ closes elow the strike of 23:<# the u$er would e%ercise his option on the writer who would suffer a loss to the e%tent of the difference etween the strike price and 'ift$*close" The loss that can e incurred $ the writer of the option is a ma%imum e%tent of the strike price(Since the worst that can happen is that the asset price can fall to !ero) whereas the ma%imum profit is limited to the e%tent of the up*front option premium of Rs";2"G< charged $ him" Profit 61.70 1250 0 Nifty

Loss

- FIGURE F .

FUTURE VDS OPTIONS

Lo*/ F)+)"e

S2o"+ F)+)"e

Lo*/ Call S2o"+ Call

Lo*/ P)+

S2o"+ P)+

TYBBI

55

DERIVATIVES (Instrument for risk reduction)

T"a&e"L "#/2+ a*& o'l#/a+#o* P"em#)m pa#& o" "e3e#%e& Ma"/#* "e0)#"eme*+

Right and o ligation to u$

Right and o ligation to sell

Right ut not the o ligation to u$

. ligation to deliver

Right ut not the o ligation to sell

. ligation to u$

4aid

Received

4aid

Received

Jes

Jes

'one

Jes

'one

Jes

R# $ -lo

+nlimited in case of a decline in prices

+nlimited in case prices rise"

=oss and risk limited to the premium paid upfront"

+nlimited in case prices rise

=oss and +nlimited risk limited in case of a to the decline in premium prices paid upfront

Re+)"* -P"o!#+.

+nlimited# if prices rise

+nlimited in case of a decline in prices

+nlimited in case prices rise

Return limited the premium received upfront

+nlimited# in case prices decline

Return limited to the e%tent of the premium received upfront

WHAT ARE SWAPS?


A contract etween two parties# referred to as counterparties# to e%change ased on the underl$ing notional using 56

two streams of pa$ments for agreed period of time" The pa$ments# commonl$ called legs or sides# are calculated TYBBI

DERIVATIVES (Instrument for risk reduction)

applica le rates" Swaps contracts also include other provisional specified $ the counterparties" Swaps are not de t instrument to raise capital# ut a tool used for financial management" Swaps are arranged in man$ different currencies and different periods of time" +ST swaps are most common followed $ @apanese $en# sterling and Deutsche marks" The length of past swaps transacted has ranged from 3 to 3: $ears"

WHY DID SWAPS EMERGE?


In the late 2HG<Us# the first currenc$ swap was engineered to circumvent the currenc$ control imposed in the +[" A ta% was levied on overseas investments to discourage capital outflows" Therefore# a 9ritish compan$ could not transfer funds overseas in order to e%pand its foreign operations without pa$ing si!ea le penalt$" ?oreover# this 9ritish compan$ had to take an additional currenc$ risks arising from servicing a sterling de t with foreign currenc$ cash flows" To overcome such a predicament# ack*to* ack loans were used to e%change de ts in different currencies" 7or e%ample# a 9ritish compan$ wanting to raise capital in the 7rance would raise the capital in the +[ and e%change its o ligations with a 7rench compan$# which was in a reciprocal position" Though this t$pe of arrangement was providing relief from e%isting protections# one could imagine# the task of locating companies with matching needs was )uite difficult in as much as the cost of such transactions was high" In addition# ack*to* ack loans re)uired drafting multiple loan agreements to state respective loan o ligations with clarit$" Aowever this t$pe of arrangement lead to development of more sophisticated swap market of toda$"

TYPES OF SWAP 4. C)""e*3, (ap

TYBBI

57

DERIVATIVES (Instrument for risk reduction)

C)""e*3, (ap can e defined as a legal agreement etween two or more parties to e%change interest o ligation or interest receipts different currencies" I+ #*%ol%e +2"ee +ep > Initial e%change of principal etween the counter parties at an agreed upon rate of e%change which is usuall$ ased on spot e%change rate" This e%change is optional and its sole o Fective is to esta lish the )uantum of the respective principal amounts for the purpose for calculating the ongoing pa$ments of interest and to esta lish the principal amount to e re*e%changed at the maturit$ of the swap" .ngoing e%change of interest at the rates agreed upon at the outset of the transaction" Re*e%change of principal amount on maturit$ at the initial rate of e%change" This straight forward# three step process results in the effective transformation of the de t raised in one currenc$ into a full$ hedged lia ilit$ in other currenc$" etween two

6. I*+e"e + Ra+e S(ap


An I*+e"e + Ra+e S(ap -IRS. is a financial contract etween two parties

e%changing or swapping a stream of interest pa$ments for a notional principal amount of multiple occasions on specified periods" Accordingl$# on each pa$ment date that occurs during the swap period*/ash pa$ments ased on fi%ed(floating and floating rates are made $ the parties to one another"

E. De'+ = E0)#+, S(ap


In De'+ = E0)#+, S(ap # a firm u$ a counter de t on the secondar$ loan market at a discount 6 Swap it into local e)$uit$ " in other words # the de t-s are e%changed for e)uit$ $ one firm with another"

DEVELOPMENT OF DERIVATIVES MARKET IN INDIA

TYBBI

58

DERIVATIVES (Instrument for risk reduction)

The first step towards introduction of derivatives trading in India was the promulgation of options in securities" The market for derivatives# however# did not take off# as there was no regulator$ framework to govern trading of derivatives" SE9I set up a 3CEmem er committee under the /hairmanship of Dr"="/"8upta on 'ovem er 2B# 2HH; to develop appropriate regulator$ framework for derivatives trading in India" The committee su mitted its report on ?arch 2G# 2HHB prescri ing necessar$ preEconditions for introduction of derivatives trading in India" The committee recommended that derivatives should e declared as ,securities- so that regulator$ framework applica le to trading of ,securities - could also govern trading of securities" SE9I also set up a group in @une 2HHB under the /hairmanship of 4rof"@"R"Varma# to recommend measures for risk containment in derivatives mark et in India" The report# which was su mitted in .cto er 2HHB# worked out the operational details of margining s$stem# methodolog$ for charging initial margins# roker net worth# deposit re)uirement and realEtime monitoring re)uirements" The Securities /ontract Regulation Act ( SCRA) was amended in Decem er 2HHH to include derivatives within the am it of ,securities- and the regulator$ framework was developed for governing derivatives trading" The act also made it clear that derivatives shall e legal and valid onl$ if such contracts are traded on a recogni!ed stock e%change# thus precluding .T/ derivatives" The government also rescinded in ?arch 3<<<# the threeE decade old notification# which prohi ited forward trading in securities" Derivatives trading commenced in India in @une 3<<< after SE9I granted the final approval to this effect in ?a$ 3<<2" SE9I permitted the derivative segments of two stock e%changes# 'SE and 9SE# and their clearing house(corporation to commence trading and settlement in approved derivatives contracts" To egin with# SE9I approved trading in inde% futures contracts ased on S64 /'N 'ift$ and 9SEE5<(Sense%) inde%" This was followed $ approval for trading in options ased on these two inde%es and options on individual securities"

TYBBI

59

DERIVATIVES (Instrument for risk reduction)

The trading in 9SE Sense% options commenced on @une C# 3<<2 and the trading in options on individual securities commenced in @ul$ 3<<2" 7utures contracts on individual stocks were launched in 'ovem er 3<<2" The derivatives trading on 'SE commenced with S64 /'N 'ift$ Inde% futures on @une 23# 3<<<" The trading in inde% options commenced on @une C# 3<<2 and trading in options on individual securities commenced on @ul$ 3# 3<<2" Single stock futures were launched on 'ovem er H# 3<<2" The inde% futures and options contract on 'SE are ased on S64 /'N" Trading and settlement in derivative contracts is done in accordance with the rules# $elaws# and regulations of the respective e%changes and their clearing house(corporation dul$ approved $ SE9I and notified in the official ga!ette"

INDIAN DERIVATIVES MARKET


Starting from a controlled econom$# India has moved towards a world where prices fluctuate ever$ da$" The introduction of risk management instruments in India gained momentum in the last few $ears due to li eralisation process TYBBI 60

DERIVATIVES (Instrument for risk reduction)

and Reserve 9ank of India-s (R9I) efforts in creating currenc$ forward market" Derivatives are an integral part of li eralisation process to manage risk" 'SE gauging the market re)uirements initiated the process of setting up derivative markets in India" In @ul$ 2HHH# derivatives trading commenced in India"

CHRONOLOGY OF INSTRUMENTS
4MM4 4H 4MMB 4N 4MMF 44 Ma, 4MMN A O)l, 4MMM 6H Ma, 6PPP 6B Ma, 6PPP M O)*e 6PPP 46 O)*e 6PPP 6B 6PPP 6 O)*e 6PP4 Individual Stock .ptions 6 Derivatives No%em'e" SE9I setup ="/"8upta /ommittee to draft a polic$ framework for inde% futures" ="/"8upta /ommittee su mitted report" R9I gave permission for .T/ forward rate agreements (7RAs) and interest rate swaps" SI?EN chose 'ift$ for trading futures and options on an Indian inde%" SE9I gave permission to 'SE and 9SE to do inde% futures trading" Trading of 9SE Sense% futures commenced at 9SE" Trading of 'ift$ futures commenced at 'SE" =i eralisation process initiated De3em'e" 'SE asked SE9I for permission to trade inde% futures"

Sep+em'e" 'ift$ futures trading commenced at S8N"

CONCLUSION
This proFect conclude that derivatives are powerful and innovative product which transfer the risk from those who do not want to take it at a price to those who are capa le of and e%pert in managing risk" Aedger# Speculator and Ar itrageurs are the people who are prepared to deal wIth the risk"

TYBBI

61

DERIVATIVES (Instrument for risk reduction)

7inancial institution are ver$ sensitive to the risk e%poser measures so the$ look 7orward to derivatives market and use various innovative products like 7orward# 7uture# .ptions and Swaps" Indian derivatives market is strongl$ routed through the stock e%changes and commodities market derivatives" 7uture traders deal through the stock e%changes in a standardi!e manner" 'SE India is the 4ioneer of derivatives product in India" Derivatives are important tools which help in growth of Indian /apital ?arkets" SE9I on time to time issue various guidelines to all the dealers of derivatives to ring transparenc$ in the working"

TYBBI

62