DERIVATIVES

INTRODUCTION
_____________________________________________________________________
Introduction
The word DERIVATIVES is derived from the word itself derived of an
nderl!in" asset# It is a ftre ima"e or $o%! of an nderl!in" asset whi$h
ma! &e shares' sto$(s' $ommodities' sto$( indi$es' et$#
A derivative is a finan$ial %rod$t )shares' &onds* an! a$t whi$h is $on$erned
with lendin" and &orrowin" )&an(* does not have its vale &orrow the
vale from nderl!in" asset+ &asi$ varia&les#
A derivative is derived from the followin" %rod$ts,
A. Shares
B. Debentures
C. Mutual funds
D. Gold
E. Steel
F. Interest rate
G. Currencies.
A derivative is a t!%e of mar(et where two %arties are entered into a $ontra$t one
is &llish and other is &earish in the mar(et havin" o%%osite views
re"ardin" the mar(et# There $annot &e derivatives havin" same views
a&ot the mar(et# In short it is li(e a INSURANCE mar(et where
investors $over their ris( for a %arti$lar %osition#
A derivative tradin" has &een a new introd$tion to the Indian mar(ets# It is' in a
sense %romotion and a$$e%tan$e of mar(et e$onom!' that has reall!
1
DERIVATIVES
$ontri&ted towards the "rowin" awareness of ris( and hen$e the "radal
introd$tion of derivatives to hed"e s$h ris(s#
Initially derivatives were launched in Aerica called Chica!o. "hen in 1###$ %BI
introduced derivatives in the local currency Interest
Rate mar(ets' whi$h have not reall! develo%ed' &t with the "radal a$$e%tan$e
of the A-. "idelines &! &an(s' there shold &e an instrmental %rod$t
in hed"in" their &alan$e sheet lia&ilities#
"he first &roduct which was launched by BSE and 'SE in the derivatives ar(et was
inde) futures.
/AINERS AND -OSERS
S!m&ol -T0)Rs#* E1%# Date Ch" )2*
%E'*+A #,.-- ./0Feb011 11.,2
3E%434'DA 1#12./5 150Dec015 11.2,
3E%434'DA 1#5-.1- .,06an011 11..1
3E%434'DA 17,2.55 ./0Feb011 11.#.
S!m&ol -T0)Rs#* E1%# Date Ch" )2*
BE8 5.55 .,06an011 0155.55
9ESBA'+ .,,.,- ./0Feb011 0#..1
D8F .7,./5 ./0Feb011 0-./2
*'I:34S 1-2.25 .,06an011 0/.11
.
DERIVATIVES
DE3INITIONS
_____________________________________________________________________
Definitions
A$$ordin" to 4O5N C# 5U- A derivatives $an &e defined as a finan$ial
instrment whose vale de%ends on )or derives from* the vales of other'
more &asi$ nderl!in" varia&les#
A$$ordin" to RO6ERT -# .CDONA-D A derivative is sim%l! a finan$ial
instrment )or even more sim%l! an a"reement &etween two %eo%le*
whi$h has a vale determined &! the %ri$e of somethin" else#
7ith Se$rities -aws )Se$ond Amendment* A$t' 8999' Derivatives has &een
in$lded in the definition of Se$rities# The term Derivative has &een
defined in Se$rities Contra$ts )Re"lations* A$t' as,:
A Derivative in$ldes, :
: se$rit! derived from a de&t instrment' share' loan' whether
se$red or nse$red' ris( instrment or $ontra$t for differen$es or an!
other form of se$rit!;
: Contra$t whi$h derives its vale from the %ri$es' or inde1 of
%ri$es' of nderl!in" se$rities#
1
DERIVATIVES
Derivatives were develo%ed %rimaril! to mana"e' offset or hed"e a"ainst ris( &t
some were develo%ed %rimaril! to %rovide the %otential for hi"h retrns#
T<0ES O3 DERIVATIVES
_____________________________________________________________________
"y&es of Derivatives;0
Forwards, A forward $ontra$t is a $stomi=ed $ontra$t &etween two entities'
where settlement ta(es %la$e on a s%e$ifi$ date in the ftre at toda!>s
%re:a"reed %ri$e#
Futures, A ftres $ontra$t is an a"reement &etween two %arties to &! or
sell an asset at a $ertain time in the ftre at a $ertain %ri$e# 3tres
$ontra$ts are s%e$ial t!%es of forward $ontra$ts in the sense that the
former are standardi=ed e1$han"e:traded $ontra$ts#
4&tions, O%tions are of two t!%es : $alls and %ts# Calls "ive the &!er the
ri"ht &t not the o&li"ation to &! a "iven ?antit! of the nderl!in"
asset' at a "iven %ri$e on or &efore a "iven ftre date# 0ts "ive the &!er
the ri"ht' &t not the o&li"ation to sell a "iven ?antit! of the nderl!in"
asset at a "iven %ri$e on or &efore a "iven date#
Swa&s, Swa%s are %rivate a"reements &etween two %arties to e1$han"e
$ash flows in the ftre a$$ordin" to a %rearran"ed formla# The! $an &e
re"arded as %ortfolios of forward $ontra$ts#
"he two coonly used swa&s are;
/
DERIVATIVES
Interest rate swa&s; These entail swa%%in" onl! the interest related $ash flows
&etween the %arties in the same $rren$!#
Currency swa&s, These entail swa%%in" &oth %rin$i%al and interest &etween the
%arties' with the $ash flows in one dire$tion &ein" in a different $rren$!
than those in the o%%osite dire$tion#
7arrants, 4&tions !enerally have lives of u&to one year$ the a<ority of o&tions
traded on o&tions e)chan!es havin! a a)iu aturity of nine onths. 8on!er0
dated o&tions are called warrants and are !enerally traded over0the0counter.
-EA0S, "he acrony 8EA:S eans 8on!0"er E=uity Antici&ation Securities.
"hese are o&tions havin! a aturity of u& to three years.
Bas(ets, 6as(et o%tions are o%tions on %ortfolios of nderl!in" assets# The
nderl!in" asset is sall! a movin" avera"e or a &as(et of assets# E?it!
inde1 o%tions are a form of &as(et o%tions#
Swa&tions, Swa%tions are o%tions to &! or sell a swa% that will &e$ome
o%erative at the e1%ir! of the o%tions# Ths a swa%tion is an o%tion on a
forward swa%# Rather than have $alls and %ts' the swa%tions mar(et has
re$eiver swa%tions and %a!er swa%tions# A re$eiver swa%tion is an o%tion
to re$eive fi1ed and %a! floatin"# A %a!er swa%tion is an o%tion to %a!
fi1ed and re$eive floatin"#
-
DERIVATIVES
5ED/IN/
_____________________________________________________________________
5ed"in"
Alost all &artici&ants in derivative securities ar(ets ay be classified as hed!ers$
s&eculators$ or arbitra!eurs. 3owever$ the sae &artici&ant ay fill different roles at
different ties.
A ar(et &artici&ant is said to be hed!in! if he uses the derivative ar(et to ana!e
his e)&osure to ris(. Coon e)a&les of hed!in! include;
A food &rocessor with coitents to buy !rain at ar(et &rice in the future
will buy futures contracts now so that future increases in !rain &rice will be
offset by !ains in the futures ar(et.
A lar!e international &ension fund buys or sells forei!n currency forward so
that any losses in value of their forei!n stoc( holdin!s due to currency
oveents will be offset by !ains in the value of the forward contract.
A cor&oration that &lans to ta(e over another co&any ay buy stoc( inde)
futures to &rotect a!ainst a !eneral ar(et &rice increase durin! the tie that
shares are bein! ac=uired. If the co&any is !oin! to hold a lar!e &osition for
2
DERIVATIVES
a lon! tie they ay also use call and &ut o&tions to &rotect a!ainst stoc(
&rice oveents. For e)a&le$ buyin! &uts will co&ensate for lost value if
the stoc( &rice falls. Sellin! calls will allow the co&any to &ay for the &uts$
and if the stoc( &rice !oes u&$ the losses on the calls are co&ensated for by
the fact that the stoc( itself is worth ore.
In !eneral$ hed!in! with futures and forward contracts re=uires ta(in! a &osition
o&&osite to the &osition one holds in the &riary ar(et.
Generally$ o&tions hed!in! involve buyin! &uts or sellin! calls to &rotect a!ainst
declines in the value of stoc( one owns. 4ther$ ore co&licated variants also e)ist.
For .1/ lar!e non0financial cor&orations usin! derivatives$ the re&ort a!nitude of
their ris( e)&osure hed!ed by financial derivatives. If interest rates$ currency
e)chan!e rates$ and coodity &rices chan!e siultaneously by three standard
deviations$ the edian fir>s derivatives &ortfolio$ at ost$ !enerates ?1- illion in
cash and ?11 illion in value.
C5ARACTERISTICS O3 3UTURES AND 3OR7ARDS,:
@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@
Coon Characteristics of Futures and Forwards;0
Forward Coitents
A forward $ommitment is a $ontra$t &etween two )or more* %arties who a"ree to
en"a"e in a transa$tion at a later date and at a s%e$ifi$ %ri$e' whi$h is
"iven at the start of the $ontra$t# It is a $stomi=ed' %rivatel! ne"otiated
a"reement to e1$han"e an asset or $ash flows at a s%e$ified ftre date at
a %ri$e a"reed on at the trade date#
In its sim%lest form' it is a trade that is a"reed to at one %oint in time &t will
ta(e %la$e at some later time# 3or e1am%le' two %arties mi"ht a"ree toda!
to e1$han"e @AA'AAA &arrels of $rde oil for BCD#AE a &arrel three months
from toda!# Enterin" a forward $ontra$t t!%i$all! does not re?ire the
%a!ment of a fee#
,
DERIVATIVES
There are two maFor t!%es of forward $ommitments,
8* 3orward $ontra$ts' or forwards' are OTC:traded derivatives with
$stomi=ed terms and featres#
D* 3tres $ontra$t' or ftres' is e1$han"e:traded derivatives with standardi=ed
terms#
3tres and forwards share some $ommon $hara$teristi$s,
6oth ftres and forwards are firm and &indin" a"reements to a$t at a
later date# In most $ases this means e1$han"in" an asset at a s%e$ifi$ %ri$e
sometime in the ftre#
6oth t!%es of derivatives o&li"ate the %arties to ma(e a $ontra$t to
$om%lete the transa$tion or offset the transa$tion &! en"a"in" in anther
transa$tion that settles ea$h %art!>s o&li"ation to the other# 0h!si$al
settlement o$$rs when the a$tal nderl!in" asset is delivered in
e1$han"e for the a"reed:%on %ri$e# In $ases where the $ontra$ts are
entered into for %rel! finan$ial reasons )i#e# the en"a"ed %arties have no
interest in ta(in" %ossession of the nderl!in" asset*'
The derivative ma! &e $ash settled with a sin"le %a!ment e?al to the
mar(et vale of the derivative at its matrit! or e1%iration#
6oth t!%es of derivatives are $onsidered levera"ed instrments &e$ase
for little or no $ash otla!' an investor $an %rofit from %ri$e movements in
the nderl!in" asset withot havin" to immediatel! %a! for' hold or
warehose that asset#
The! offer a $onvenient means of hed"in" or s%e$latin"# 3or e1am%le' a
ran$her $an $onvenientl! hed"e his "rain $osts &! %r$hasin" $orn several
months forward# The hed"e eliminates %ri$e e1%osre' and it doesn>t
re?ire an initial otla! of fnds to %r$hase the "rain# The ran$her is
hed"ed withot havin" to ta(e deliver! of or store the "rain ntil it is
needed# The ran$her doesn>t even have to enter into the forward with the
ltimate s%%lier of the "rain and there is little or no initial $ash otla!#
7
DERIVATIVES
6oth %h!si$al settlement and $ash settlement o%tions $an &e (e!ed to a
wide variet! of nderl!in" assets in$ldin" $ommodities' short:term de&t'
Erodollar de%osits' "old' forei"n e1$han"e' the SG0 @AA sto$( inde1' et$#
3UNDA.ENTA- DI33ERENCES 6ET7EEN 3UTURES AND 3OR7ARDS
_____________________________________________________________________
3ndamental Differen$es &etween 3tres and 3orwards
The fndamental differen$e &etween ftres and forwards is that ftres are
traded on e1$han"es and forwards trade OTC# The differen$e in tradin"
venes "ives rise to nota&le differen$es in the two instrments,
#
DERIVATIVES
3tres are standardi=ed instrments transa$ted thro"h &ro(era"e
firms that hold a HseatH on the e1$han"e that trades that %arti$lar
$ontra$t# The terms of a ftres $ontra$t : in$ldin" deliver! %la$es and
dates' volme' te$hni$al s%e$ifi$ations' and tradin" and $redit %ro$edres
: are standardi=ed for ea$h t!%e of $ontra$t# -i(e an ordinar! sto$( trade'
two %arties will wor( thro"h their res%e$tive &ro(ers' to transa$t a
ftres trade# An investor $an onl! trade in the ftres $ontra$ts that are
s%%orted &! ea$h e1$han"e# In $ontrast' forwards are entirel!
$stomi=ed and all the terms of the $ontra$t are %rivatel! ne"otiated
&etween %arties# The! $an &e (e!ed to almost an! $on$eiva&le nderl!in"
asset or measre# The settlement date' notional amont of the $ontra$t
and settlement form )$ash or %h!si$al* are entirel! % to the %arties to the
$ontra$t#
3orwards entail &oth mar(et ris( and $redit ris(# Those who en"a"e in
ftres transa$tions assme e1%osre to defalt &! the e1$han"e>s
$learin" hose# 3or OTC derivatives' the e1%osre is to defalt &! the
$onter%art! who ma! fail to %erform on a forward# The %rofit or loss on
a forward $ontra$t is onl! reali=ed at the time of settlement' so the $redit
e1%osre $an (ee% in$reasin"#
7ith ftres' $redit ris( miti"ation measres' s$h as re"lar mar(:to:
mar(et and mar"inin"' are atomati$all! re?ired# The e1$han"es
em%lo! a s!stem where&! $onter%arties e1$han"e dail! %a!ments of
%rofits or losses on the da!s the! o$$r# Thro"h these mar"in %a!ments'
a ftres $ontra$t>s mar(et vale is effe$tivel! reset to =ero at the end of
ea$h tradin" da!# This all &t eliminates $redit ris(#
"he daily cash flows associated with ar!inin! can s(ew futures &rices$
causin! the to diver!e fro corres&ondin! forward &rices.
3tres are settled at the settlement %ri$e fi1ed on the last tradin" date of
the $ontra$t )i#e# at the end*# 3orwards are settled at the forward %ri$e
a"reed on at the trade date )i#e# at the start*#
15
DERIVATIVES
3tres are "enerall! s&Fe$t to a sin"le re"lator! re"ime in one
Frisdi$tion' while forwards : altho"h sall! transa$ted &! re"lated
firms : are transa$ted a$ross Frisdi$tional &ondaries and are %rimaril!
"overned &! the $ontra$tal relations &etween the %arties#
In $ase of %h!si$al deliver!' the forward $ontra$t s%e$ifies to whom the
deliver! shold &e made# The $onter%art! on a ftres $ontra$t is $hosen
randoml! &! the e1$han"e#
In a forward there are no $ash flows ntil deliver!' whereas in ftres
there are mar"in re?irements and %eriodi$ mar"in $alls#
11
DERIVATIVES
3OR7ARDCONTRACTS
_____________________________________________________________________
Forward Contracts
A forward is an a"reement &etween two $onter%arties I a &!er and seller# The
&!er a"rees to &! an nderl!in" asset from the other %art! )the seller*#
The deliver! of the asset o$$rs at a later time' &t the %ri$e is determined
at the time of %r$hase# Je! featres of forward $ontra$ts are,
5i"hl! $stomi=ed : Conter%arties $an determine and define the terms
and featres to fit their s%e$ifi$ needs' in$ldin" when deliver! will ta(e
%la$e and the e1a$t identit! of the nderl!in" asset#
All %arties are e1%osed to $onter%art! defalt ris( I This is the ris( that
the other %art! ma! not ma(e the re?ired deliver! or %a!ment#
Transa$tions ta(e %la$e in lar"e' %rivate and lar"el! nre"lated mar(ets
$onsistin" of &an(s' investment &an(s' "overnment and $or%orations#
Underl!in" assets $an &e sto$(s' &onds' forei"n $rren$ies' $ommodities
or some $om&ination thereof# The nderl!in" asset $old even &e interest
rates#
The! tend to &e held to matrit! and have little or no mar(et li?idit!#
An! $ommitment &etween two %arties to trade an asset in the ftre is a
forward $ontra$t#
E)a&le; Forward Contracts
8etAs assue that you have <ust ta(en u& sailin! and li(e it so well that you e)&ect you
i!ht buy your own sailboat in 1. onths. 9our sailin! buddy$ 6ohn$ owns a sailboat
but e)&ects to u&!rade to a newer$ lar!er odel in 1. onths. 9ou and 6ohn could
enter into a forward contract in which you a!ree to buy 6ohnAs boat for ?1-5$555 and
he a!rees to sell it to you in 1. onths for that &rice. In this scenario$ as the buyer$
you have entered a lon! forward contract. Conversely$ 6ohn$ the seller will have the
short forward contract. At the end of one year$ you find that the current ar(et
1.
DERIVATIVES
valuation of 6ohnAs sailboat is ?12-$555. Because 6ohn is obli!ed to sell his boat to
you for only ?1-5$555$ you will have effectively ade a &rofit of ?1-$555.
B9ou can buy the boat fro 6ohn for ?1-5$555 and iediately sell it for ?12-$555.C
6ohn$ unfortunately$ has lost ?1-$555 in &otential &roceeds fro the transaction.
8i(e all forward contracts$ in this e)a&le$ no oney e)chan!ed hands when the
contract was ne!otiated and the initial value of the contract was Dero.
11
DERIVATIVES
3UTURE CONTRACTS
_____________________________________________________________________
Future Contracts
3tre $ontra$ts are also a"reements &etween two %arties in whi$h the &!er
a"rees to &! an nderl!in" asset from the other %art! )the seller*# The
deliver! of the asset o$$rs at a later time' &t the %ri$e is determined at
the time of %r$hase#
Terms and $onditions are standardi=ed#
Tradin" ta(es %la$e on a formal e1$han"e wherein the e1$han"e %rovides
a %la$e to en"a"e in these transa$tions and sets a me$hanism for the
%arties to trade these $ontra$ts#
There is no defalt ris( &e$ase the e1$han"e a$ts as $onter%art!'
"aranteein" deliver! and %a!ment &! se of a $learin" hose#
The $learin" hose %rote$ts itself from defalt &! re?irin" its
$onter%arties to settle "ains and losses or mar( to mar(et their %ositions
on a dail! &asis#
3tres are hi"hl! standardi=ed' have dee% li?idit! in their mar(ets and
trade on an e1$han"e#
An investor $an offset his or her ftre %osition &! en"a"in" in an
o%%osite transa$tion &efore the stated matrit! of the $ontra$t#
E)a&le; Future Contracts
8etAs assue that in Se&teber the s&ot or current &rice for hydro&onics> toatoes is
?1..- &er bushel and the futures &rice is ?1.-5. A toato farer is tryin! to secure a
sellin! &rice for his ne)t cro&$ while McDonaldAs is tryin! to secure a buyin! &rice in
order to deterine how uch to char!e for a Bi! Mac ne)t year. "he farer and the
cor&oration can enter into a futures contract re=uirin! the delivery of - illion
bushels of toatoes to McDonaldAs in Deceber at a &rice of ?1.-5 &er bushel. "he
1/
DERIVATIVES
contract loc(s in a &rice for both &arties. It is this contract 0 and not the !rain &er se 0
that can then be bou!ht and sold in the futures ar(et.
In this scenario$ the farer is the holder of the short &osition Bhe has a!reed to sell the
underlyin! asset E toatoesC and McDonaldAs is the holder of the lon! &osition Bit has
a!reed to buy the assetC. "he &rice of the contract is - illion bushels at ?1.-5 &er
bushel.
"he &rofits and losses of a futures contract are calculated on a daily basis. In our
e)a&le$ su&&ose the &rice on futures contracts for toatoes increases to ?/ &er
bushel the day after the farer and McDonaldAs enter into their futures contract of
?1.-5 &er bushel. "he farer$ as the holder of the short &osition$ has lost ?5.-5 &er
bushel because the sellin! &rice <ust increased fro the future &rice at which he is
obli!ed to sell his toatoes. McDonaldAs has &rofited by ?5.-5 &er bushel.
4n the day the &rice chan!e occurs$ the farerAs account is debited ?..- illion
B?5.-5 &er bushel ) - illion bushelsC and McDonaldAs is credited the sae aount.
Because the ar(et oves daily$ futures &ositions are settled daily as well. Gains and
losses fro each dayAs tradin! are deducted or credited to each &artyAs account. At the
e)&iration of a futures contract$ the s&ot and futures &rices norally conver!e.
Most transactions in the futures ar(et are settled in cash$ and the actual &hysical
coodity is bou!ht or sold in the cash ar(et. For e)a&le$ letAs su&&ose that at the
e)&iration date in Deceber there is a bli!ht that deciates the toato cro& and the
s&ot &rice rises to ?-.-5 a bushel. McDonaldAs has a !ain of ?. &er bushel on its
futures contract but it still has to buy toatoes. "he co&anyAs ?15 illion !ain B?.
&er bushel ) - illion bushelsC will be offset a!ainst the hi!her cost of toatoes on
the s&ot ar(et. 8i(ewise$ the farerAs loss of ?15 illion is offset a!ainst the hi!her
&rice for which he can now sell his toatoes.
1-
DERIVATIVES
SENSEK 3UTURES
_____________________________________________________________________
SENSEK 3UTURES
A Futures contract is a standardiDed contract to buy or sell a s&ecific security at a
future date at an a!reed &rice. "hus a SE'SEFG future is a future on the inde) i.e.
the underlyin! is the inde) itself. "here is no underlyin! security or a stoc($ which is
to be delivered to fulfill the obli!ations as SE'SEFG futures is cash settled. As with
other derivatives$ the contract derives its value fro the underlyin! inde).
"he ain factor that differentiates the SE'SEFG fro other indices in the country is
that it e&loys HFree Float Mar(et Ca&italiDationI ethodolo!y. Essentially free float
eans the shares that are available for investors to trade in$ are only considered for
rec(onin! ar(et ca&italiDation. "hus those shares that are not available for tradin! on
a day0to0day basis are e)cluded fro the calculation for ar(et ca&italiDation. "hese
e)clusions are !iven under;
3oldin!s by foundersJdirectorsJ ac=uirers which has control eleent J &ersonsJ
bodies with KControllin! InterestK
Governent holdin! as &rooterJac=uirer
3oldin!s throu!h the FDI %oute J Strate!ic sta(es by inds.
E=uity held by associateJ!rou& co&anies Bcross0holdin!sC
E=uity held by E&loyee Lelfare "rusts
8oc(ed0in shares
"he reainin! shareholders would fall under the Free0float cate!ory.
12
DERIVATIVES
"hus it is clear that an inde) based on free float is ore accurate and indicative of the
actual trend and also reoves the sector bias that ay cree& in on account of the Kfull
ar(et ca&italiDationK odel.
O0TIONS, CA--S AND 0UTS
_____________________________________________________________________
4&tions; Calls and :uts
4&tions
An o%tion is $ommon form of a derivative# It>s a $ontra$t' or a %rovision of a
$ontra$t' that "ives one %art! )the o%tion holder* the ri"ht' &t not the
o&li"ation to %erform a s%e$ified transa$tion with another %art! )the
o%tion isser or o%tion writer* a$$ordin" to s%e$ified terms# O%tions $an
&e em&edded into man! (inds of $ontra$ts# 3or e1am%le' a $or%oration
mi"ht isse a &ond with an o%tion that will allow the $om%an! to &! the
&onds &a$( in ten !ears at a set %ri$e# Standalone o%tions trade on
e1$han"es or OTC# The! are lin(ed to a variet! of nderl!in" assets# .ost
e1$han"e:traded o%tions have sto$(s as their nderl!in" asset &t OTC:
traded o%tions have a h"e variet! of nderl!in" assets )&onds'
$rren$ies' $ommodities' swa%s' or &as(ets of assets*#
There are two main t!%es of o%tions, $alls and %ts,
Si&le Call 4&tion e)a&le 0 3ow call o&tion wor(sM.
S%%ose !o are interested in &!in" 8AA shares of a $om%an!# 3or the sa(e of
this e1am%le let s sa! that the $om%an! is Co$a Cola and the $rrent
%ri$e of its sto$( is B@A# 5owever instead of Fst &!in" the shares from
the mar(et what !o do is the followin", <o $onta$t !or friend 4ohn
and tell him H5e! 4ohn' I am thin(in" of &!in" 8AA shares of Co$a Cola
from !o at the %ri$e of B@D# 5owever I want to de$ide whether to
1,
DERIVATIVES
a$tall! &! it or not at the end of this month# 7old that &e OJL Of
$orse what !o have in mind is the followin"#
If the sto$( %ri$e rises a&ove B@D' then !o will &! the shares from 4ohn at B@D
in whi$h $ase !o will "ain &! sim%l! &!in" from 4ohn at B@D and sellin"
it in the mar(et at the %ri$e whi$h is a&ove B@D# 4ohn will &e at a loss in
this sitation#
If the sto$( %ri$e remains &elow B@D then !o sim%l! wonMt &! the shares from
him# After all' what !o are as(in" 4ohn is the >o%tion> to &! those shares
from him : !o are not ma(in" an! $ommitment#
In order to a(e the above deal AfairA fro the view&oint of 6ohn you a!ree to &ay
6ohn ?. &er share$ i.e. ?.55 in total. "his is the Bris(C &reiu or the oney you are
&ayin! 6ohn for the ris( he is willin! to ta(e 0 ris( of bein! at a loss if the &rice rises
above ?-.. 6ohn will (ee& this oney irres&ective of whether you e)ercise your
o&tion of !oin! ahead with the deal or not. "he &rice of ?-.$ at which you would li(e
to buy Bor rather would li(e to have the o&tion to buyC the shares is called the stri(e
&rice of this deal. Deals of this ty&e have a nae0 they are called a Call 4&tion. 6ohn
is sellin! Bor writin!C the call o&tion to you for a &rice of ?. &er share. 9ou are buyin!
the call o&tion. 6ohn$ the seller of the call o&tion has the obli!ation to sell his shares
even if the &rice rises above ?-. in which case you would definitely buy it fro hi.
9ou on the other hand are the buyer of the call o&tion and have no obli!ation0 you
17
DERIVATIVES
si&ly have the o&tion to buy the shares.
Si&le :ut 4&tion E)a&le 0 3ow &ut o&tion wor(sM
8et us consider a situation where now 6ohn wants the o&tion to sell you his 155 shares
of Coca Cola at ?/7. 3e a!rees to &ay you ?. &er share in order to be able to have the
Ao&tionA to sell you his 155 shares at the end of the onth. 4f course what he has in
ind is that he will sell the to you if the &rice falls below ?/7$ in which case you
will be at a loss by buyin! the shares fro hi at a &rice above the ar(et &rice and
he will be relatively better off rather than sellin! the shares in the ar(et. "he ?. he is
willin! to &ay you is all yours to (ee& irres&ective of whether 6ohn e)ercises the
o&tion or not. It is the ris( &reiu. In this case 6ohn is buyin! a :ut 4&tion fro
you. 9ou are writin! or sellin! a :ut 4&tion to 6ohn. ?/7 is the stri(e &rice of the :ut
4&tion. In this case$ you the seller or writer of the :ut 4&tion has the obli!ation to
buy the shares at the stri(e &rice. 6ohn$ the buyer of the :ut 4&tion has the o&tion to
sell the shares to you. 3e has no obli!ation.
1#
DERIVATIVES
To o&tain these ri"hts' the &!er mst %a! an o%tion %remim )%ri$e*# This is the
amont of $ash the &!er %a!s the seller to o&tain the ri"ht that the
o%tion is "rantin" them# The %remim is %aid when the $ontra$t is
initiated#
In -evel 8' the $andidate is e1%e$ted to (now e1a$tl! what role short and
lon" %ositions ta(e how %ri$e movements affe$t those %ositions and how to
$al$late the vale of the o%tions for &oth short and lon" %ositions "iven
different mar(et s$enarios#
3or e1am%le,
N. Lhich of the followin! stateents about the value of a call o&tion at e)&iration is
FA8SEM
A. "he short &osition in the sae call o&tion can result in a loss if the stoc( &rice
e)ceeds the e)ercise &rice.
B. "he value of the lon! &osition e=uals Dero or the stoc( &rice inus the E)ercise
&rice$ whichever is hi!her.
C# "he value of the lon! &osition e=uals Dero or the e)ercise &rice inus the stoc(
&rice$ whichever is hi!her.
D. "he short &osition in the sae call o&tion has a Dero value for all stoc( &rices e=ual
to or less than the e)ercise &rice.
A# "he correct answer is KCK. "he value of a lon! &osition is calculated as e)ercise
.5
DERIVATIVES
&rice inus stoc( &rice. "he a)iu loss in a lon! &ut is liited to the &rice of the
&reiu Bthe cost of buyin! the &ut o&tionC. Answer KAK is incorrect because it
describes a !ain. Answer KDK is incorrect because the value can be less than Dero Bi.e.
an uncovered &ut writer can e)&erience hu!e lossesC.
C5ARACTERISTICES O3 O0TIONS
_____________________________________________________________________
.1
DERIVATIVES
Characteristics of 4&tions
6oth %t and $all o%tions have three &asi$ $hara$teristi$s, e1er$ise %ri$e'
e1%iration date and time to e1%iration#
The &!er has the ri"ht to &! or sell the asset#
To a$?ire the ri"ht of an o%tion' the &!er of the o%tion mst %a! a %ri$e
to the seller# This is $alled the o%tion %ri$e or the %remim#
The e1er$ise %ri$e is also $alled the fi1ed %ri$e' stri(e %ri$e or Fst the
stri(e and is determined at the &e"innin" of the transa$tion# It is the fi1ed
%ri$e at whi$h the holder of the $all or %t $an &! or sell the nderl!in"
asset#
E1er$isin" is sin" this ri"ht the o%tion "rants !o to &! or sell the
nderl!in" asset# The seller ma! have a %otential $ommitment to &! or
sell the asset if the &!er e1er$ises his ri"ht on the o%tion#
The e1%iration date is the final date that the o%tion holder has to e1er$ise
her ri"ht to &! or sell the nderl!in" asset#
Time to e1%iration is the amont of time from the %r$hase of the o%tion
ntil the e1%iration date# At e1%iration' the $all holder will %a! the
e1er$ise %ri$e and re$eive the nderl!in" se$rities )or an e?ivalent $ash
settlement* if the o%tion e1%ires in the mone!# )7e will dis$ss the de"rees
of mone! ness later in this session#* The $all seller will deliver the
se$rities at the e1er$ise %ri$e and re$eive the $ash vale of those
se$rities or re$eive e?ivalent $ash settlement in lie of deliverin" the
se$rities#
Defalts on o%tions wor( the same wa! as the! do with forward $ontra$ts#
Defalts on over:the $onter o%tion transa$tions are &ased on
$onter%arties' while e1$han"e:traded o%tions se a $learin" hose#
E)a&le; Call 4&tion
..
DERIVATIVES
I6. is tradin" at 8AA toda!# )4ne 8' DAA@*
The $all o%tion is as follows, Stri(e %ri$e N 8DA' Date N A"st 8'
DAA@'0remim on the $all N BO
In this $ase' the &!er of the I6. $all toda! has to %a! the seller of the
I6. $all BO for the ri"ht to %r$hase I6. at B8D@ on or &efore A"st 8'
DAA@# If the &!er de$ides to e1er$ise the o%tion on or &efore A"st 8'
DAA@' the seller will have to deliver I6. shares at a %ri$e of B8D@ to the
&!er#
E)a&le; :ut 4&tion
I6. is tradin" at 8AA toda! )4ne 8' DAA@*
0t o%tion is as follows, Stri(e %ri$e N 9A' Date N A"st 8' DAA@'
0remim on the %t N BO#AA
In this $ase' the &!er of the I6. %t has to %a! the seller of the I6. $all
BO for the ri"ht to sell I6. at B9A on or &efore A"st 8' DAA@# If the
&!er of the %t de$ides to e1er$ise the o%tion on or &efore A"st 8'
DAA@' the seller will have to %r$hase I6. shares at a %ri$e of B9A#
E)a&le; Inter&retin! Dia!ras
3or the e1am' !o ma! &e as(ed inter%ret dia"rams s$h as the followin"'
whi$h shows the vale of a %t o%tion at e1%iration#
.1
DERIVATIVES
A t!%i$al ?estion a&ot this dia"ram mi"ht &e,
N; I!norin! transaction costs$ which of the followin! stateents about the value of the
&ut o&tion at e)&iration is "%*EM
A# The vale of the short %osition in the %t is BC if the sto$( %ri$e is BPQ#
6# The vale of the lon" %osition in the %t is BC if the sto$( %ri$e is BPQ#
C# The lon" %t has vale when the sto$( %ri$e is &elow the BEA e1er$ise
%ri$e#
D# The vale of the short %osition in the %t is =ero for sto$( %ri$es
e?alin" or e1$eedin" BPQ#
A. "he correct answer is KCK. A %t o%tion has %ositive monetar! vale
when the nderl!in" instrment has a $rrent %ri$e )BPQ* &elow the
e1er$ise %ri$e )BEA*#
./
DERIVATIVES
S7A0S
____________________________________________________________________
Swa&s
A swa% is one of the most sim%le and s$$essfl forms of OTC:traded
derivatives# It is a $ash:settled $ontra$t &etween two %arties to e1$han"e
)or Hswa%H* $ash flow streams# As lon" as the %resent vale of the streams
is e?al' swa%s $an entail almost an! t!%e of ftre $ash flow# The! are
most often sed to $han"e the $hara$ter of an asset or lia&ilit! withot
a$tall! havin" to li?idate that asset or lia&ilit!# 3or e1am%le' an
investor holdin" $ommon sto$( $an e1$han"e the retrns from that
investment for lower ris( fi1ed in$ome $ash flows : withot havin" to
li?idate his e?it! %osition#
The differen$e &etween a forward $ontra$t and
a swa% is that a swa% involves a series of
%a!ments in the ftre' whereas a
forward has a sin"le ftre %a!ment#
Two of the most &asi$ swa%s are,
Interest Rate Swa% : "his is a contract to e)chan!e cash flow streas that i!ht be
associated with soe fi)ed incoe obli!ations. "he ost &o&ular interest rate swa&s
.-
DERIVATIVES
are fi)ed0for0floatin! swa&s$ under which cash flows of a fi)ed rate loan are
e)chan!ed for those of a floatin! rate loan.
Crren$! Swa% I "his is siilar to an interest rate swa& e)ce&t that the cash flows
are in different currencies. Currency swa&s can be used to e)&loit inefficiencies in
international debt ar(ets. For e)a&le$ assue that a cor&oration needs to borrow
?14 illion euros and the best rate it can ne!otiate is a fi)ed 2.,O. In the *.S.$
lenders are offerin! 2./-O on a co&arable loan. "he cor&oration could ta(e the *.S.
loan and then find a third &arty willin! to swa& it into an e=uivalent euro loan. By
doin! so$ the fir would obtain its euros at ore favorable ters.
Cash flow streams are often str$tred so that %a!ments are s!n$hroni=ed' or
o$$r on the same dates# This allows $ash flows to &e netted a"ainst ea$h
other )so lon" as the $ash flows are in the same $rren$!*# T!%i$all!' the
%rin$i%al )or notional* amonts of the loans are netted to =ero and the
%eriodi$ interest %a!ments are s$hedled to o$$r on that same dates so
the! $an also &e netted a"ainst one another#
As is o&vios from the a&ove e1am%le' swa%s are %rivate' ne"otiated and
mostl! nre"lated transa$tions )altho"h 3AS6 8OO has &e"n to im%ose
some re"lations*#
Swa& Mar(ets and Contracts
Swa%s are non:standardi=ed $ontra$ts that are traded over the $onter )OTC*#
5owever' to fa$ilitate tradin"' mar(et %arti$i%ants have develo%ed the
ISDA .aster A"reement' whi$h $overs the Rnon:e$onomi$> terms of a
swa% $ontra$t' s$h as re%resentations and warranties' events of defalt
and termination events# 0arties to the trade still need to ne"otiate the rate
or %ri$e' notional amont' matrit!' $ollateral' et$#
Swa%s are $ontra$ts that e1$han"e assets' lia&ilities' $rren$ies' se$rities'
e?it! %arti$i%ations and $ommodities# Some are sim%le' s$h as floatin":
for:fi1ed:rate loans or 4a%anese !en for 6ritish %ond sterlin"' while
others are ?ite $om%le1 in$or%oratin" mlti%le $rren$ies' interest rates'
$ommodities and o%tions# 6oth t!%es are fle1i&le in terms of s%e$ifi$ations
s$h as %ri$in" or evalation &en$hmar(s' timin" or $ontra$tal hori=ons'
settlement %ro$edres' resets' and other varia&les#
.2
DERIVATIVES
/enerall!' swa%s are sed for ris( mana"ement &! instittions s$h as
&an(s' &ro(ers' dealers and $or%orations# Some ?alified individals ma!
also &e sita&le sers of these &asi$ derivatives %rod$ts# The followin"
lists hi"hli"ht $ommon swa%s transa$tions#
Commodities, a"ri$ltral' ener"!' metals
Crren$ies, amorti=ation or amorti=in"' differential' forward rates'
forward start
E?ities, &as(et' differential or s%read' inde1ed' individal se$rit!
related
Interest Rates, amorti=ation or amorti=in"' arrears' &asis' fi1ed for
floatin"' forward start' inverse floater' =ero $o%on
Swa& Characteristics
.ost involve mlti%le %a!ments' altho"h one:%a!ment $ontra$ts
are %ossi&le
A series of forward $ontra$ts#
7hen initiated' neither %art! e1$han"es an! $ash; a swa% has =ero
vale at the &e"innin"#
One %art! tends to %a! a fi1ed rate while the other %a!s on the
movement of the nderl!in" asset# 5owever' a swa% $an &e
str$tred so that &oth %arties %a! ea$h other on the movement of
an nderl!in" asset#
0arties ma(e %a!ments to ea$h other on a settlement date# 0arties
ma! de$ide to a"ree to Fst e1$han"e the differen$e that is de to
ea$h other# This is $alled nettin"#
3inal %a!ment is made on the termination date#
.,
DERIVATIVES
Usall! traded in the over:the:$onter mar(et# This means the!
are s&Fe$t $redit ris(#
"erinatin! a Swa& Contract
The easiest wa! to terminate the $ontra$t is to hold it to matrit!#
5owever' if one or &oth %arties in a swa% $ontra$t wish to terminate'
there are several methods,
Enter into a se%arate and offsettin" swa%# 3or e1am%le' an entit! has a
swa% on its &oo(s that %a!s a fi1ed rate and re$eives a floatin" rate &ased
on -I6OR on 4anar! 8 and 4l! 8# The entit! $an enter into a new swa%
that %a!s a floatin" rate &ased on -I6OR and re$eives a fi1ed rate with
%a!ments on 4anar! 8 and 4l! 8# 7ith this new transa$tion' !or fi1ed
rates ma! &e different &e$ase of mar(et rates' while the -I6OR
%a!ments will wash ot over the transa$tion>s life# Credit ris( will also
in$rease &e$ase !o $old have a new $onter%art! for the new swa%#
The other wa! is to have a $ash settlement &ased on mar(et vale# 3or e1am%le'
assme that a %art! holds a swa% with a mar(et vale of BQ@'AAA# The
$ontra$t $old &e terminated if the other %art! %a!s the mar(et vale of
the $ontra$t to the holder# Said another wa!' if the %art! holdin" the swa%
has a ne"ative vale' it $an terminate the swa% &! %a!in" its $onter%art!
the mar(et vale of the swa%# This terminates the $ontra$t for &oth
%arties' &t this is sall! availa&le onl! if it is stated &efore the $ontra$t
is entered into or a"rees %on &! &oth %arties at a later date#
Another wa! to terminate a swa% is to sell the swa% to another %art!# This
sall! re?ires %ermission from the other %art!# This is not $ommonl!
sed in the mar(et %la$e#
The last wa! to terminate a $ontra$t is to se a swa%tion# A swa%tion wor(s li(e
an o%tion &! "ivin" the owner the ri"ht to enter into another swa% at
terms that are set in advan$e# 6! e1e$tin" the swa%tion' the %art! $an
offset its $rrent swa% as e1%lained in the first wa! to terminate a
$ontra$t#
.7
DERIVATIVES
0UR0OSES AND 6ENE3ITS O3 DERIVATIVES
_____________________________________________________________________
:ur&oses and Benefits of Derivatives
Toda!>s so%histi$ated international mar(ets have hel%ed foster the ra%id "rowth
in derivative instrments# In the hands of (nowled"ea&le investors'
derivatives $an derive %rofit from,
Chan"es in interest rates and e?it! mar(ets arond the world
Crren$! e1$han"e rate shifts
.#
DERIVATIVES
Chan"es in "lo&al s%%l! and demand for $ommodities s$h as a"ri$ltral
%rod$ts' %re$ios and indstrial metals' and ener"! %rod$ts s$h as oil
and natral "as
Addin" some of the wide variet! of derivative instrments availa&le to a
traditional %ortfolio of investments $an %rovide "lo&al diversifi$ation in
finan$ial instrments and $rren$ies' hel% hed"e a"ainst inflation and
deflation' and "enerate retrns that are not $orrelated with more
traditional investments# The two most widel! re$o"ni=ed &enefits
attri&ted to derivative instrments are %ri$e dis$over! and ris(
mana"ement#
1. :rice Discovery
3tres mar(et %ri$es de%end on a $ontinos flow of information from
arond the world and re?ire a hi"h de"ree of trans%aren$!# A &road
ran"e of fa$tors )$limati$ $onditions' %oliti$al sitations' de&t defalt'
ref"ee dis%la$ement' land re$lamation and environmental health' for
e1am%le* im%a$t s%%l! and demand of assets )$ommodities in %arti$lar*
I and ths the $rrent and ftre %ri$es of the nderl!in" asset on whi$h
the derivative $ontra$t is &ased# This (ind of information and the wa!
%eo%le a&sor& it $onstantl! $han"es the %ri$e of a $ommodit!# This
%ro$ess is (nown as %ri$e dis$over!#
7ith some ftres mar(ets' the nderl!in" assets $an &e "eo"ra%hi$all!
dis%ersed' havin" man! s%ot )or $rrent* %ri$es in e1isten$e# The %ri$e of
the $ontra$t with the shortest time to e1%iration often serves as a %ro1!
for the nderl!in" asset#
Se$ond' the %ri$e of all ftre $ontra$ts serve as %ri$es that $an &e a$$e%ted &!
those who trade the $ontra$ts in lie of fa$in" the ris( of n$ertain ftre
%ri$es#
O%tions also aid in %ri$e dis$over!' not in a&solte %ri$e terms' &t in the wa!
the mar(et %arti$i%ants view the volatilit! of the mar(ets# This is &e$ase
o%tions are a different form of hed"in" in that the! %rote$t investors
a"ainst losses while allowin" them to %arti$i%ate in the asset>s "ains#
As we will see later' if investors thin( that the mar(ets will &e volatile' the
15
DERIVATIVES
%ri$es of o%tions $ontra$ts will in$rease# This $on$e%t will &e e1%lained
later#
.. %is( Mana!eent
This $old &e the most im%ortant %r%ose of the derivatives mar(et# Ris(
mana"ement is the %ro$ess of identif!in" the desired level of ris('
identif!in" the a$tal level of ris( and alterin" the latter to e?al the
former# This %ro$ess $an fall into the $ate"ories of hed"in" and
s%e$lation#
5ed"in" has traditionall! &een defined as a strate"! for red$in" the ris(
in holdin" a mar(et %osition while s%e$lation referred to ta(in" a
%osition in the wa! the mar(ets will move# Toda!' hed"in" and s%e$lation
strate"ies' alon" with derivatives' are sefl tools or te$hni?es that
ena&le $om%anies to more effe$tivel! mana"e ris(#
1. "hey I&rove Mar(et Efficiency for the *nderlyin! Asset
3or e1am%le' investors who want e1%osre to the SG0 @AA $an &! an
SG0 @AA sto$( inde1 fnd or re%li$ate the fnd &! &!in" SG0 @AA
ftres and investin" in ris(:free &onds# Either of these methods will "ive
them e1%osre to the inde1 withot the e1%ense of %r$hasin" all the
nderl!in" assets in the SG0 @AA#
If the $ost of im%lementin" these two strate"ies is the same' investors will
&e netral as to whi$h the! $hoose# If there is a dis$re%an$! &etween the
%ri$es' investors will sell the ri$her asset and &! the $hea%er one ntil
%ri$es rea$h e?ili&rim# In this $onte1t' derivatives $reate mar(et
effi$ien$!#
/. Derivatives Also 3el& %educe Mar(et "ransaction Costs
6e$ase derivatives are a form of insran$e or ris( mana"ement' the $ost
of tradin" in them has to &e low or investors will not find it e$onomi$all!
sond to %r$hase s$h Hinsran$eH for their %ositions#
11
DERIVATIVES
CRITICIS.S O3 DERIVATIVES
_____________________________________________________________________
Criticiss of Derivatives
O%tions offer the %otential for h"e "ains and h"e losses# 7hile the %otential for
"ain is allrin"' their $om%le1it! ma(es them a%%ro%riate for onl!
so%histi$ated investors with a hi"h toleran$e for ris(#
7hen a derivative fails to hel% investors a$hieve their
o&Fe$tives' the derivative itself is &lamed for the ensin" losses when' in
fa$t' it>s often the investor who did not fll! nderstand how it shold &e
sed' its inherent ris(' et$#
Some view derivatives as a form of le"ali=ed "am&lin" ena&lin" sers to
ma(e &ets on the mar(et# 5owever' derivatives offer &enefits that e1tend
&e!ond those of "am&lin" &! ma(in" mar(ets more effi$ient' hel%in" to
mana"e ris( and hel%in" investors to dis$over asset %ri$es#
7hile %rofessional traders and mone! mana"ers $an se derivatives
effe$tivel!' the odds that a $asal investor will &e a&le to "enerate %rofits
&! tradin" in derivatives are miti"ated &! the fndamental $hara$teristi$s
of the instrment,
8ifes&an : Derivatives are Htime:wastin"H assets# As ea$h da! %asses and
the e1%iration date a%%roa$hes' !o lose more and more HtimeH %remim
and the o%tion>s vale de$reases#
Direction and Mar(et "iin! : In order to ma(e mone! with man!
derivatives' investors mst a$$ratel! %redi$t the dire$tion in whi$h the
mar(et or inde1 will move )% or down* and the minimm ma"nitde of
the move drin" a set %eriod of time# A mista(e here almost "arantees a
s&stantial investment loss#
Costs : The &id+as( s%reads of more $ommon derivatives s$h as o%tions
$an &e dantin"# An o%tion with a &id of @#D@ and an as( of @#EP@ means
an investor $old &! a rond lot )8AA nits* for B@EP#@A &t $old onl!
sell them for B@D@' resltin" in an immediate loss of BQ8#@A &efore
fa$torin" in $ommissions#
1.
DERIVATIVES
AR6ITRA/E
_____________________________________________________________________
Arbitra!e
Ar&itra"e o%%ortnities e1ist when the %ri$es of similar assets are set at different
levels# This o%%ortnit! allows an investor to a$hieve a %rofit with =ero
ris( and limited fnds &! sim%l! sellin" the asset in the over%ri$ed mar(et
and simltaneosl! &!in" it in the $hea%er mar(et#
This &!in" and sellin" of the asset will %sh the $hea%er asset>s %ri$e %
and the hi"her asset %ri$e down# This %ro$ess will $ontine ntil the asset
%ri$e is e?al in &oth mar(ets#
A$hievin" this e?ili&rim thro"h &!in" and sellin" is referred to as the
law of one %ri$e# This law ma! loo( li(e it has &een violated at times' &t
this sall! is sall! not the $ase on$e !o fa$tor in finan$in" or deliver!
$osts asso$iated with the different mar(ets#
3or e1am%le' on e1$han"e A I6N is tradin" at BD@ and on e1$han"e 6 I6N is
tradin" at BOA dollars# If !o &! I6N on e1$han"e A and simltaneosl!
sell it on e1$han"e 6' !o $an net a %rofit of B@ with ot an! ris( or an!
otla! of $ash#
As %eo%le $ontine to &! on e1$han"e A' the %ri$e of I6N will in$rease and all of
the sellin" of I6N on e1$han"e 6 will for$e the %ri$e down ntil
e?ili&rim has &een rea$hed# This is how ar&itra"e wor(s to ma(e the
mar(et%la$e effi$ient#
Additional inforation about arbitra!e and its theories,
11
DERIVATIVES
Theoreti$all!' the lar"e nm&er of mar(et %arti$i%ants $om&ined with real:time
%ri$e:settin" me$hanisms eliminates the o%%ortnit! to "enerate ris(:free
%rofits#
This leads to an im%ortant ?estion, If there are no ar&itra"e o%%ortnities )i#e#
o%%ortnities to earn a ris(:free %rofit*' wh! does the indstr! srviveL
One reason is that individal investors ma! have different views on how'
wh! and to what de"ree mar(et %ri$es are off (ilter# Also' investors are
rel$tant to &elieve that there are no ar&itra"e o%%ortnities and so the!
s%end a "ood deal of time wat$hin" %ri$e movements' ferretin" ot
in$onsisten$ies and tradin" on those the! %er$eive to e1ist# The %ro$ess
itself ensres that an! %otential ar&itra"e o%%ortnities will &e ?i$(l!
dis$overed and eliminated# If investors &elieved there were no ar&itra"e
o%%ortnities and were no lon"er vi"ilant a&ot identif!in" and e1%loitin"
%ri$e differentials' the la$( of $ontinos oversi"ht mi"ht' in itself' lead to
ar&itra"e o%%ortnities In other words; dis&elief $on$ernin" the a&sen$e
of ar&itra"e o%%ortnities is re?ired to maintain its le"itima$! as a
%rin$i%le#
%elatively efficient ar(ets have either no arbitra!e o&&ortunities or the ar(et
&artici&ants =uic(ly reove the. "he o&&ortunity can occur$ but only throu!h
chance and it would be considered an abnoral return#
1/
DERIVATIVES
3OR7ARD .ARJETS AND CONTRACTS, SETT-E.ENT 0ROCEDURES
_____________________________________________________________________
Forward Mar(ets and Contracts; Settleent :rocedures
The differen$es &etween lon" and short %ositions in forward mar(ets are as
follows,
The lon" %osition holder is the &!er of the $ontra$t and the short
%osition holder is the seller of the $ontra$t#
The lon" %osition will ta(e the deliver! of the asset and %a! the seller of
the asset the $ontra$t vale' while the seller is o&li"ated to deliver the
asset verss the $ash vale of the $ontra$t at the ori"ination date of this
transa$tion#
7hen it $omes to defalt' &oth %arties are at ris( &e$ase t!%i$all! no
$ash is e1$han"ed at the &e"innin" of the transa$tion# 5owever' some
transa$tions do re?ire that one or &oth sides %t % some form of
$ollateral to %rote$t them from the defalted %art!#
:rocedures for Settlin! a Forward Contract at E)&iration
A forward $onta$t at e1%iration $an &e settled in one of two wa!s,
1-
DERIVATIVES
:hysical Delivery : Refers to an o%tion or ftres $ontra$t that re?ires the a$tal
nderl!in" asset to &e delivered on the s%e$ified deliver! date' rather than
&ein" traded ot with offsettin" $ontra$ts# .ost derivatives are not
a$tall! e1er$ised' &t are traded ot &efore their deliver! dates#
5owever' %h!si$al deliver! still o$$rs with some trades, it is most
$ommon with $ommodities' &t $an also o$$r with other finan$ial
instrments# Settlement &! %h!si$al deliver! is $arried ot &! $learin"
&ro(ers or their a"ents# 0rom%tl! after the last da! of tradin"' the
re"lated e1$han"e>s $learin" or"ani=ation will re%ort a %r$hase and sale
of the nderl!in" asset at the %revios da!>s settlement %ri$e )also
referred to as the Hinvoi$e %ri$eH*# Traders who hold a short %osition in a
%h!si$all! settled se$rit! ftres $ontra$t to e1%iration are re?ired to
ma(e deliver! of the nderl!in" asset# Those who alread! own the assets
ma! tender them to the a%%ro%riate $learin" or"ani=ation# Traders who
do not own assets are o&li"ated to %r$hase them at the $rrent %ri$e#
E1$han"es s%e$if! the $onditions of deliver! for the $ontra$ts the! $over#
A$$e%ta&le lo$ations for deliver! )in the $ase of $ommodities or ener"ies*
and re?irements as to the ?alit!' "rade or natre of the nderl!in"
asset to &e delivered are re"lated &! the e1$han"es# 3or e1am%le' onl!
$ertain Treasr! &onds ma! &e delivered nder the Chi$a"o 6oard of
Trade>s Treasr! &ond ftre# Onl! $ertain "rowths of $offee ma! &e
delivered nder the Coffee' S"ar and Co$oa E1$han"e>s $offee ftre# In
man! $ommodit! or ener"! mar(ets' %arties want to settle ftres &!
deliver!' &t e1$han"e rles are too restri$tive for their needs# 3or
e1am%le' the New <or( .er$antile E1$han"e re?ires that natral "as &e
delivered onl! at the 5enr! 5& in -oisiana' a lo$ation that ma! not &e
$onvenient for all ftres traders#
Cash Settleent : Refers to an o%tion or ftres $ontra$t that re?ires the
$onter%arties to the $ontra$t to net ot the $ash differen$e in the vale of
their %ositions# The a%%ro%riatel! re$eives the $ash differen$e# In the $ase
12
DERIVATIVES
of $ash settlement' no a$tal assets are delivered at the e1%iration of a
ftres $ontra$t# Instead' traders mst settle an! o%en %ositions &!
ma(in" or re$eivin" a $ash %a!ment &ased on the differen$e &etween the
final settlement %ri$e and the %revios da!>s settlement %ri$e# Under
normal $ir$mstan$es' the final settlement %ri$e for a $ash:settled
$ontra$t will refle$t the o%enin" %ri$e for the nderl!in" asset# On$e this
%a!ment is made' neither the &!er nor the seller of the ftres $ontra$t
has an! frther o&li"ations on the $ontra$t#
E)a&le; Settlin! a Forward Contract
-et>s retrn to or sail&oat e1am%le from the first se$tion of this $ha%ter#
Assme that at the end of 8D months !o are a &it am&ivalent a&ot
sailin"# In this $ase' !o $old settle !or forward $ontra$t with 4ohn in
one of two wa!s,
:hysical Delivery : 4ohn delivers that sail&oat to !o and !o %a! him B8@A'AAA'
as a"reed#
Cash Settleent I 4ohn sends !o a $he$( for BO@'AAA# )The differen$e &etween
!or $ontra$t>s %r$hase %ri$e of B8@A'AAA and the sail &oat>s $rrent
mar(et vale of B8Q@'AAA#*
"he sae o&tions are available if the current ar(et &rice is lower than the forward
contractAs settleent &rice. If 6ohnAs sailboat decreases in value to ?11-$555$ you
could si&ly &ay 6ohn ?1-$555 to settle the contract$ or you could &ay hi ?1-5$555
and ta(e &hysical &ossession of the boat. B9ou would still suffer a ?1-$555 loss when
you sold the boat for the current &rice of ?11-$555.C
1,
DERIVATIVES
ESUIT< 3OR7ARD CONTRACTS
_____________________________________________________________________
E=uity Forward Contracts
E?it! forward is a $ontra$t for the %r$hase of an individal sto$(' a sto$(
%ortfolio or a sto$( inde1 at some ftre date#
E?it! forward on an individal sto$( allows an investor to sell his or her
sto$( at some ftre date at a "aranteed %ri$e# If that "aranteed %ri$e
is &elow the mar(et %ri$e' the investor will still re$eive the "aranteed
%ri$e# If the mar(et %ri$e is a&ove the "aranteed %ri$e' the investor will
onl! re$eive the "aranteed %ri$e and not &e a&le to %arti$i%ate in an!
17
DERIVATIVES
mar(et in$rease a&ove that %ri$e#
E)a&le 1;
Assme that a $lient owns I6N at 8AA and wants to sell I6N sto$( in si1
months to raise some $ash# The $lient $an enter into an e?it! forward in
whi$h he will re$eive a %ri$e of B8D@#
If the %ri$e remains at or &elow B8D@' the $lient will re$eive B8D@ %er share in si1
months#
If the sto$( %ri$e is at B8OA' the $lient will still have to deliver! the shares to the
$onter%art! and will onl! re$eive B8D@ %er share' losin" B@ on the
transa$tion#
3orward $ontra$ts on a sto$( %ortfolio wor( the same wa! as on an
individal &asis# Instead of enterin" into se%arate $ontra$ts for ea$h of the
individal se$rities in the %ortfolio' whi$h $old &e $ostl! in terms of
fees' the mana"er $an "ive a list of se$rities in the %ortfolio to the dealer'
who will develo% a ?ote of the %ri$e for whi$h the dealer wold %r$hase
the se$rities at a ftre date#
E)a&le .;
As an e1am%le' if the dealer ?otes B8@'AAA for si1 se$rities in !or
%ortfolio and !o de$ide to enter into the $ontra$t' !o will re$eive that
amont at the e1%iration of the $ontra$t#
3orward $ontra$ts on sto$( inde1es afford %ortfolio mana"ers a wa! to
%rote$t the vale of their %ortfolios or to tr! to red$e and+or eliminate
ris( in a %ortfolio that mimi$s a maFor inde1# Instead of havin" a $ontra$t
for the individal se$rities' the mana"er $old enter into a forward
$ontra$t to sell the inde1 at a ftre date#
-et>s sa! that !o want to %rote$t !or %ortfolio of SG0 @AA se$rities#
<o $onta$t a dealer who "ives !o a ?ote of B@'AAA on a forward
$ontra$t for B8PA'AAA'AAA to sell the inde1# These $ontra$ts are t!%i$all!
settled in $ash %a!ments instead of a$tal deliver!# If the inde1 were to
dro% &! D2' !or %ortfolio wold lose BOCA'AAA )8PA'AAA'AAA T #
AD*# 6e$ase !o entered into a forward $onta$t with the dealer to sell the
inde1' !o &enefit from the mar(et de$line of D2 to the tne of BOCA'AAA
1#
DERIVATIVES
)8PA'AAA'AAA T #AD*# Or' to view it another wa!' !o $an %r$hase the inde1
at the ftre date of the $ontra$t at B8Q'QQA'AAA and sell it to the dealer at
B8PA'AAA'AAA# As !o $an see' the "ain from the forward $ontra$t =eros
ot the loss on the %ortfolio from the mar(et de$line and %rote$ts the
%ortfolio#
-oo( OtU
Dividends do have an effe$t on
forwards; however' when !o $om%are
the effe$t in a ris( mana"ement
%ers%e$tive for a %ortfolio or inde1'
dividends have a minor im%a$t when
$om%ared to the %ri$e movements in the
e?ities that nderlie the inde1 or
%ortfolio#
Most forwards do not &ay dividends e)ce&t for forwards that are Ktotal returnK
forwards. "otal return forwards ta(e into consideration the &ayents and reinvestent
of dividends within the inde) in addition to the return on the inde) and the &ayoff of
any forward contract based on it.
CO..ODIT< DERIVATIVES
___________________________________________________________
/5
DERIVATIVES
Commodit! Derivatives
"radin! in derivatives first started to &rotect farers fro the ris( of the value of their
cro& !oin! below the cost &rice of their &roduce. Derivative contracts were offered on
various a!ricultural &roducts li(e cotton$ rice$ coffee$ wheat$ &e&&er$ et cetera. "he
first or!anised e)chan!e$ the Chica!o Board of "rade BCB4"C 00 with standardised
contracts on various coodities 00 was established in 17/7. In 17,/$ the Chica!o
:roduce E)chan!e 00 which is now (nown as Chica!o Mercantile E)chan!e 00 was
fored BCMEC.
CB4" and CME are two of the lar!est coodity derivatives e)chan!es in the
world.
The Indian s$enario
Coodity derivatives have had a lon! and a che=uered &resence in India. "he
coodity derivative ar(et has been functionin! in India since the nineteenth
century with or!anised tradin! in cotton throu!h the establishent of Cotton "rade
Association in 17,-. 4ver the years$ there have been various bans$ sus&ensions and
re!ulatory do!as on various contracts.
"here are .- coodity derivative e)chan!es in India as of now and derivative
contracts on nearly 155 coodities are available for trade. "he overall turnover is
e)&ected to touch %s - la(h crore B%s - trillionC by the end of .55/0.55-.
'ational Coodity and Derivatives E)chan!e B'CDEFC is the lar!est coodity
derivatives e)chan!e with a turnover of around %s 1$555 crore B%s 15 billionC every
fortni!ht.
It is only in the last decade that coodity derivatives e)chan!es have been actively
encoura!ed. But$ the ar(ets have suffered fro &oor li=uidity and have not !rown to
any si!nificant level$ till recently.
3owever$ in the year .551$ four national coodity e)chan!es becae o&erationalP
'ational Multi0Coodity E)chan!e of India B'MCEC$ 'ational Board of "rade
B'B4"C$ 'ational Coodity and Derivatives E)chan!e B'CDEFC and Multi
Coodity E)chan!e BMCFC.
/1
DERIVATIVES
"he onset of these e)chan!es and the introduction of futures contracts on new
coodities by the Forwards Mar(et Coission have tri!!ered si!nificant levels of
trade. 'ow the coodities futures tradin! in India is all set to atch the volues on
the ca&ital ar(ets.
Investin" in $ommodit! derivatives
Coodity derivatives$ which were traditionally develo&ed for ris( ana!eent
&ur&oses$ are now !rowin! in &o&ularity as an investent tool. Most of the tradin! in
the coodity derivatives ar(et is bein! done by &eo&le who have no need for the
coodity itself.
"hey <ust s&eculate on the direction of the &rice of these coodities$ ho&in! to a(e
oney if the &rice oves in their favor.
"he coodity derivatives ar(et is a direct way to invest in coodities rather
than investin! in the co&anies that trade in those coodities.
For e)a&le$ an investor can invest directly in a steel derivative rather than investin!
in the shares of "ata Steel. It is easier to forecast the &rice of coodities based on
their deand and su&&ly forecasts as co&ared to forecastin! the &rice of the shares
of a co&any 00 which de&end on any other factors than <ust the deand 00 and
su&&ly of the &roducts they anufacture and sell or trade in.
Also$ derivatives are uch chea&er to trade in as only a sall su of oney is
re=uired to buy a derivative contract.
8et us assue that an investor buys a tone of soybean for %s 7$,55 in antici&ation that
the &rices will rise to %s #$555 by 6une 15$ .55-. 3e will be able to a(e a &rofit of
%s 155 on his investent$ which is 1./O. Co&are this to the scenario if the investor
had decided to buy soybean futures instead.
Before we loo( into how investent in a derivative contract wor(s$ we ust
failiariDe ourselves with the buyer and the seller of a derivative contract. A buyer of
a derivative contract is a &erson who &ays an initial ar!in to buy the ri!ht to buy or
sell a coodity at a certain &rice and a certain date in the future.
/.
DERIVATIVES
4n the other hand$ the seller acce&ts the ar!in and a!rees to fulfill the a!reed ters
of the contract by buyin! or sellin! the coodity at the a!reed &rice on the aturity
date of the contract.
'ow let us say the investor buys soybean futures contract to buy one tone of soybean
for %s 7$,55 Be)ercise &riceC on 6une 15$ .55-. "he contract is available by &ayin! an
initial ar!in of 15O$ i.e. %s 7,5. 'ote that the investor needs to invest only %s 7,5
here.
4n 6une 15$ .55-$ the &rice of soybean in the ar(et is$ say$ %s #$555 B(nown as S&ot
:rice 00 S&ot :rice is the current ar(et &rice of the coodity at any &oint in tieC.
"he investor can ta(e the delivery of one tone of soybean at %s 7$,55 and
iediately sell it in the ar(et for %s #$555$ a(in! a &rofit of %s 155. So the
return on the investent of %s 7,5 is 1/.-O. 4n the contrary$ if the &rice of soybean
dro&s to %s 7$/55 the investor will end u& a(in! a loss of 1/.-O.
If the investor wants$ instead of ta(in! the delivery of the coodity u&on aturity
of the contract$ an o&tion to settle the contract in cash also e)ists. Cash settleent
co&rises e)chan!e of the difference in the s&ot &rice of the coodity and the
e)ercise &rice as &er the futures contract.
At &resent$ the o&tion of cash settleent lies only with the seller of the contract. If the
seller decides to a(e or ta(e delivery u&on aturity$ the buyer of the contract has to
fulfill his obli!ation by either ta(in! or a(in! delivery of the coodity$ de&endin!
on the s&ecifications of the contract.
In the above e)a&le$ if the seller decides to !o for cash settleent$ the contract can
be settled by the seller &ayin! %s 155 to the buyer$ which is the difference in the s&ot
&rice of the coodity and the e)ercise &rice. 4nce a!ain$ the return on the
investent of %s 7,5 is 1/.-O.
"he above e)a&le shows that with very little investent$ the coodity futures
ar(et offers sco&e to a(e bi! buc(s. 3owever$ tradin! in derivatives is hi!hly ris(y
because <ust as there are hi!h returns to be earned if &rices ove in favour of the
investors$ an unfavorable ove results in hu!e losses.
"he ost critical function in a coodity derivatives e)chan!e is the settleent and
clearin! of trades. Coodity derivatives can involve the e)chan!e of funds and
/1
DERIVATIVES
!oods. "he e)chan!es have a se&arate body to handle all the settleents$ (nown as
the clearin! house.
For e)a&le$ the seller of a futures contract to buy soybean i!ht choose to ta(e
delivery of soybeans rather than closin! his &osition before aturity. "he function of
the clearin! house or clearin! or!aniDation$ in such a case$ is to ta(e care of &ossible
&robles of default by the other &arty involved by standardiDin! and si&lifyin!
transaction &rocessin! between &artici&ants and the or!aniDation.
In s&ite of the sur!e in the turnover of the coodity e)chan!es in recent years$ a lot
of wor( in ters of &olicy liberaliDation$ settin! u& the ri!ht le!al syste$ creatin! the
necessary infrastructure$ lar!e0scale trainin! &ro!ras$ et cetera still needs to be done
in order to catch u& with the develo&ed coodity derivative ar(ets.
Also$ tradin! in coodity o&tions is &rohibited in India. "he re!ulators should loo(
towards introducin! new contracts in the Indian ar(et in order to &rovide the
investors with choice$ &lus &rovide the farers and coodity traders with ore
tools to hed!e their ris(s.
//
DERIVATIVES
INTEREST RATES DERIVATIVES
_____________________________________________________________________
India (i$(s off interest rates ftres tradin"
India (ic(ed off tradin! in interest rates futures on Monday$ the latest in a series of
ste&s to dee&en the countryAs ar(ets$ !ivin! &artici&ants such as ban(s and
co&anies a way to hed!e a!ainst rate ris(s.
"radin! on the 'ational Stoc( E)chan!e be!an si) years after an earlier edition failed
due to faulty benchar(s and coes a year after re!ulators allowed currency futures
tradin!.
More than 1.$555 March and Deceber contracts$ worth about ?/.# illion$ were
traded in the first three hours on the 'ational Stoc( E)chan!e$ the countryAs lar!est
bourse. 4&en interest stood at .$1,7.
At 1;.# &.. B5#-# GM"C$ the Deceber contract was at #1.77 ru&ees after o&enin!
at #/.-5. "he March futures eased to #5.#7,- ru&ees fro #1.11 at the start.
"he contracts$ each of .55$555 ru&ees B?/$5#5C$ are based on 150year !overnent
bonds bearin! a notional cou&on of , &ercent &er annu$ co&ounded every si)
onths.
K"he launch of interest rate derivatives eans a lot to the 'SE$ its constituency of
bro(ers and all econoic entities who face interest rate ris($K 'SE Mana!in! Director
%avi 'arain said.
Futures contracts are e)chan!e traded with an a!reeent to buy or sell an underlyin!
instruent at a certain date in the future at a s&ecified &rice.
"he contracts would be settled in March$ 6une$ Se&teber and Deceber. "he
a)iu aturity will be 1. onths. Deliverable securities under the futures should
ature between ,0Q years and 1- years with iniu outstandin! of 155 billion
ru&ees.
"he central ban( has laid down detailed !uidelines for tradin! in the rates futures.
Coercial ban(s are allowed to ta(e tradin! &ositions for theselves but can not
trade on behalf of their clients.
/-
DERIVATIVES
K"he futures ar(et has !ot a reasonably &ositive res&onse. Rolue is fairly healthy
for the first day and as and when &eo&le !et &erission to trade in this ar(et$
volues should increase$K said Rineet Mali($ head of interest rates tradin! at 3SBC
India.
%e!ulators are also &lannin! to introduce re&urchase deals$ or re&os$ in cor&orate
bonds$ a ove that would enable hed!in! in that ar(et.
DEVE-O0IN/ .ARJETS
*ntil now investors could hed!e their interest rate ris( on their &ortfolios only via the
over0the0counter overni!ht inde)ed swa&s ar(et. Anshuan 6aswal$ an analyst at
Celent$ said the interest rate futures would add de&th to the ar(et.
K"he !reater uncertainty in the !lobal econoy and the hi!her oveent in interest
rate levels in India also ean that this &roduct is bein! re0introduced at the ri!ht
tie$K he said.
A&art fro ban(s$ non0resident Indians$ co&anies$ &riary dealers and forei!ners
can trade in this se!ent. Forei!n investors can trade to the e)tent they &ossess the
underlyin! security$ but not for s&eculative &ur&oses.
In co&arison$ volues were a noral 1,.-- billion ru&ees in the underlyin!
!overnent bond ar(et$ accordin! to the central ban(As electronic tradin! &latfor.
4ther e)chan!es are scrablin! to offer siilar &roducts.
%ival Bobay Stoc( E)chan!e said last wee( it had received re!ulatory a&&roval for
interest rates futures and would launch in 7015 wee(s.
*. Ren(ataraan$ e)ecutive director of the Multi Coodity E)chan!eAs forei!n
e)chan!e derivatives bourse$ said it was awaitin! re!ulatory a&&roval to launch
interest rate futures tradin!.
KI thin( it !ives us o&tiis that this tie the &roduct should succeed$K %eserve Ban(
of India de&uty !overnor Shyaala Go&inath said.
/2
DERIVATIVES
3OREI/N EKC5AN/E DERIVATIVES
_____________________________________________________________________
3orei"n E1$han"e Derivatives
"he !radual liberaliDation of Indian econoy has resulted in substantial inflow of
forei!n ca&ital into India. Siultaneously disantlin! of trade barriers has also
facilitated the inte!ration of doestic econoy with world econoy. Lith the
!lobaliDation of trade and relatively free oveent of financial assets$ ris(
ana!eent throu!h derivatives &roducts has becoe a necessity in India also$ li(e in
other develo&ed and develo&in! countries. As
Indian businesses becoe ore !lobal in their a&&roach$ evolution of a broad based$
active and li=uid fore) derivatives ar(ets is re=uired to &rovide the with a
s&ectru of hed!in! &roducts for effectively ana!in! their forei!n e)chan!e
e)&osures. "he !lobal ar(et for derivatives has !rown substantially in the recent
&ast. "he Forei!n E)chan!e and Derivatives Mar(et Activity survey conducted by
Ban( for International
Settleents BBISC &oints to this increased activity. "he total estiated notional
aount of outstandin! 4"C contracts increasin! to ?111 trillion at endSDeceber
.551 fro ?#/ trillion at endS6une .555. "his !rowth in the derivatives se!ent is
even ore substantial when viewed in the li!ht of declinin! activity in the s&ot
forei!n e)chan!e ar(ets. "he turnover in traditional forei!n e)chan!e ar(ets
declined substantially between 1##7 and .551. In A&ril .551$ avera!e daily turnover
was ?1$.55 billion$ co&ared to ?1$/#5 billion in A&ril 1##7$ a 1/O decline when
volues are easured at constant e)chan!e rates. Lhereas the !lobal daily turnover
durin! the sae &eriod in forei!n e)chan!e and interest rate derivative contracts$
includin! what are considered to be KtraditionalK forei!n e)chan!e derivative
instruents$ increased by an estiated 15O to ?1./ trillion
Evoltion of the fore1 derivatives mar(et in India
"his treendous !rowth in !lobal derivative ar(ets can be attributed to a nuber of
factors. "hey reallocate ris( aon! financial ar(et &artici&ants$ hel& to a(e
financial ar(ets ore co&lete$ and &rovide valuable inforation to investors about
econoic fundaentals. Derivatives also &rovide an i&ortant function of efficient
&rice discovery and a(e unbundlin! of ris( easier.
/,
DERIVATIVES
In India$ the econoic liberaliDation in the early nineties &rovided the econoic
rationale for the introduction of FF derivatives. Business houses started actively
a&&roachin! forei!n ar(ets not only with their &roducts but also as a source of
ca&ital and direct investent o&&ortunities. Lith liited convertibility on the trade
account bein! introduced in 1##1$ the environent becae even ore conducive for
the introduction of these hed!e &roducts. 3ence$ the develo&ent in the Indian fore)
derivatives ar(et should be seen alon! with the ste&s ta(en to !radually refor the
Indian financial ar(ets. As these ste&s were lar!ely instruental in the inte!ration of
the Indian financial ar(ets with the !lobal ar(ets.
/7
DERIVATIVES
3OR7ARD CONTRACTS ON 6ONDS
_____________________________________________________________________
Forward Contracts on Bonds
Characteristics of Forward Contracts on Bonds
The &asi$ $hara$teristi$s of a forward $ontra$t on a &ond are ver! m$h
li(e those of e?it!# A &ond %a!s a $o%on similar to an e?it! %a!in" a
dividend#
The differen$es are,
6onds matre; this means that $ontra$ts mst also matre &efore the
matrit! date#
6onds $an have $alls and $onverti&ilit!#
6onds have a defalt ris(' whi$h means the $ontra$t mst in$lde
remedies for this ris( in $ase it o$$rs#
3orward $ontra$ts $an &e on an individal isse as well as on a %ortfolio
of &onds or on a &ond inde1#
3or =ero:$o%on &onds li(e a T:&ill' a forward $ontra$t has one %art!
a"reein" to &! the T:&ill at a later date' &t &efore its matrit!' at a %ri$e
that is a"reed to at the time the $ontra$t is made#
-oo( OtU
Remem&er that T:&ills are sold at a
dis$ont to %ar and are ?oted in terms
of the dis$ont rate#
E1am%le, Forward Contracts on Tero0Cou&on Bonds
A 175 day "0bill is sellin! at 1.-O. "he &ar of a ?1 &ar value$ therefore$ would e=ual 1
0 .51-B175J125C U ? 5.#7.-. If the bond is held to aturity it will &ay the investor ?1.
/#
DERIVATIVES
"he 125 days in the above forula is ar(et convention for the nuber of days in a
year.
For cou&on0&ayin! bonds$ interest &ayents$ which are ty&ically sei0annual and can
sell at a &reiu or discount to the bondAs &ar value$ ust be ta(en into account.
:rices are usually =uoted without the interest rate that has accrued fro the last
&ayent. Le will ty&ically wor( with a bondAs full &rice$ the &rice that includes
accrued interest. :rices are =uoted by statin! the yield. Forward contracts call for the
delivery of a bond &rior to the bondAs aturity where the short &ays the lon! the
a!reed0u&on &rice.
-5
DERIVATIVES
3UTURES VS 3OR7ARDS
_____________________________________________________________________
Futures vs. Forwards
3tres differ from forwards in several instan$es,
A forward $ontra$t is a %rivate transa$tion : a ftres $ontra$t is not#
3tres $ontra$ts are re%orted to the ftre>s e1$han"e' the $learin"
hose and at least one re"lator! a"en$!# The %ri$e is re$orded and
availa&le from %ri$in" servi$es#
A ftre ta(es %la$e on an or"ani=ed e1$han"e where the all of the
$ontra$t>s terms and $onditions' e1$e%t %ri$e' are formali=ed# 3orwards
are $stomi=ed to meet the ser>s s%e$ial needs# The ftre>s
standardi=ation hel%s to $reate li?idit! in the mar(et%la$e ena&lin"
%arti$i%ants to $lose ot %ositions &efore e1%iration#
3orwards have $redit ris(' &t ftres do not &e$ase a $learin" hose
"arantees a"ainst defalt ris( &! ta(in" &oth sides of the trade and
mar(in" to mar(et their %ositions ever! ni"ht# .ar( to mar(et is the
%ro$ess of $onvertin" dail! "ains and losses into a$tal $ash "ains and
losses ea$h ni"ht# As one %art! loses on the trade the other %art! "ains'
and the $learin" hose moves the %a!ments for the $onter%art! thro"h
this %ro$ess#
3orwards are &asi$all! nre"lated' while ftre $ontra$t are re"lated
at the federal "overnment level# The re"lation is there to ensre that no
mani%lation o$$rs' that trades are re%orted in a timel! manner and
that the %rofessionals in the mar(et are ?alified and honest#
Characteristics of Futures Contracts
-1
DERIVATIVES
In a ftres $ontra$t there are two %arties,
The lon" %osition' or &!er' a"rees to %r$hase the nderl!in" at a later
date or at the e1%iration date at a %ri$e that is a"reed to at the &e"innin"
of the transa$tion# 6!ers &enefit from %ri$e in$reases#
The short %osition' or seller' a"rees to sell the nderl!in" at a later date or
at the e1%iration date at a %ri$e that is a"reed to at the &e"innin" of the
transa$tion# Sellers &enefit from %ri$e de$reases#
0ri$es $han"e dail! in the mar(et%la$e and are mar(ed to mar(et on a dail!
&asis#
At e1%iration' the &!er ta(es deliver! of the nderl!in" from the seller
or the %arties $an a"ree to ma(e $ash settlement#
-.
DERIVATIVES
OT5ER T<0ES O3 DERIVATIVES
____________________________________________________________________
4ther "y&es of Derivatives
Eurodollar Futures
Erodollar ftres wor( the same as T:&ill $ontra$ts e1$e%t the rate is
&ased on -I6OR#
0ri$e ?otes and a$tal %ri$e is determined the in the same wa! as for T:
&ills#
Settles in $ash
One of most a$tive $ontra$ts in the mar(ets
Instead of add:on interest' )for e1am%le a 8AA V 8A2 for a !ear and the
&an( wold owe B88A dollars*' the rate is s&tra$ted from 8AA' Fst as it is
with T:&ills
7ith T:&ills the investor wold re$eive B8 million %er $ontra$t' while in
the Erodollar ftres mar(et the firm wold %a! 8 million eros
"reasury Bond Contracts
A $ontra$t &ased on the deliver! of a U#S# Treasr! &ond with an! $o%on
and at least 8@ !ears to matrit!#
There are man! different &onds that fit the a&ove des$ri%tion#
-1
DERIVATIVES
To "ive some t!%e of standardi=ation' the mar(ets se a $onversion fa$tor
to a$hieve a h!%otheti$al &ond with a Q2 $o%on#
6e$ase &ond %ri$es do not move in a linear fashion' there is a $han$e to
se ar&itra"e to $a%itali=e on the devian$e of a &ond when $om%ared to
the Q2 standardi=ed &ond# To do this' traders loo( for the $hea%est to
deliver &ond )CTD*# This is the least e1%ensive nderl!in" %rod$t that
$an &e delivered %on e1%ir! to satisf! the re?irements of a derivative
$ontra$t# This hel%s minimi=e the sli%%a"e &etween the $onversation
fa$tor and the a$tal %ri$e#
The CTD &ond is alwa!s $han"in" &e$ase %ri$es and !ields are alwa!s
$han"in"#
A $ontra$t $overs B8AA'AAA %ar vale of U#S# Treasries#
Contra$t e1%ires .ar$h' 4ne' Se%tem&er and De$em&er
Stoc( Inde) Contracts
Investors tradin" inde1 o%tions are essentiall! &ettin" on the overall
movement of the sto$( mar(et as re%resented &! a &as(et of sto$(s#
O%tions on the SG0 @AA are some of the most a$tivel! traded o%tions in
the world#
Soted in terms e?al to the inde1 itself# 3or e1am%le if the SG0 @AA is
tradin" at 8A@A the one:month $ontra$t ma! &e at 8AQA#
Ea$h $ontra$t has a mlti%lier# 3or the SG0 @AA' it is D@A# The a$tal
%ri$e in the a&ove %oint wold e?al 8AQATD@A N BDQ@'AAA#
SG0 @AA $ontra$ts e1%ire in .ar$h' 4ne' Se%tem&er and De$em&er and
$an have matrit! dates as far awa! as two !ears#
Settlement is in $ash#
-/
DERIVATIVES
The 3TSE 8AA and 4a%an>s Ni((ei DD@ are other t!%es of inde1es %on
whi$h sto$( inde1 $ontra$ts are &ased#
Currency Contracts
Crren$! $ontra$ts fn$tion in the same wa! as forward $ontra$ts for
$rren$!#
The! are t!%i$all! m$h smaller than forward $ontra$ts#
Ea$h $ontra$t has a stated si=e and ?otation nit#
3tre %ri$e for eros N A#9D' whi$h leads to a $ontra$t %ri$e of
8D@'AAA)this is the $ontra$t si=e* )#9D* N 88@'AAA
Calls for actual delivery throu!h boo( entry of the underlyin! currency.
.ANA/IN/ RISJ 7IT5 O0TIONS STRATE/IES, -ON/ AND S5ORT
CA-- AND 0UT 0OSITIONS
_____________________________________________________________________
Mana!in! %is( with 4&tions Strate!ies; 8on! and Short Call and :ut :ositions
%IS+ MA'AGEME'" A::8ICA"I4'S 4F 4:"I4'S S"%A"EGIES
8on! and Short Call :ositions
-et>s loo( at a t!%i$al lon" $all# -et>s sa! it is 8 .NO .a! 8AA $all V O;
--
DERIVATIVES
essentiall! the s%ot rate for the sto$( has to rise a&ove B8AO )B8AA stri(e
%ri$e %ls BO %remim* to &e in the mone!# In fa$t' the o%tion &e"ins life
at BO ot of the mone! &e$ase of the %remim#
This "ra%h refle$ts the %oint of view of the &!er# The view of the writer : who
"oes short when she sells a $all : is a mirror ima"e,
-2
DERIVATIVES
8on! and Short :ut :ositions
Now let>s loo( at %ts# This e1am%le is a lon" %t : a %t from the
%ers%e$tive of the &!er# Similar to the %revios e1am%le' let>s sa! it is 8
.NO .a! 8AA %t V O; so essentiall! the s%ot rate for the sto$( has to
sin( &elow B9P )B8AA stri(e %ri$e mins BO %remim* to &e in the mone!#
It does not matter how far a&ove the stri(e %ri$e the s%ot %ri$e "oes; if the
o%tion is "oin" to $ost the &!er more than the %remim' he will sim%l!
let it e1%ire ne1er$ised#
A"ain' the writer>s %ers%e$tive : the short %osition : is Fst the fli%:side of the
&!er>s %ers%e$tive,
-,
DERIVATIVES
4ne =uic( &oint about &reius; by fi!urin! the in$ you deterine the &rofit or loss
fro an o&tion. "his is different fro the &ayoff. "o fi!ure the &ayoff$ si&ly assue
the &reiu e=uals ?5.
.ANA/IN/ RISJ 7IT5 O0TIONS STRATE/IES, COVERED CA--S AND
0ROTECTIVE 0UTS
_____________________________________________________________________
Mana!in! %is( with 4&tions Strate!ies; Covered Calls and :rotective :uts
-7
DERIVATIVES
Covered Call and :rotective :ut Strate!ies
There is one more wa! for o%tions to &e $lassified,
Covered
Un$overed' or na(ed
7hether a $ontra$t is $overed or n$overed has a "reat deal to do with the
mar"in' or $redit' re?ired of the %arties involved#
Covered Call
A $overed $all is when the investor has a lon" %osition in an asset
$om&ined with a short %osition in a $all o%tion on the same nderl!in"
asset# A $all writer ma! &e re?ired to deliver the sto$( if the &!er
e1er$ises his o%tion# If the $all writer has the shares on de%osit with her
&ro(er' then she has written a $overed $all# There is no mar"in
re?irement for a $overed $all; this is &e$ase the nderl!in" se$rities
are sittin" ri"ht there : there is no ?estion of $reditworthiness#
An investor will write a $all o%tion when he feels that a %arti$lar sto$(>s
%ri$e will not rise a&ove a $ertain level# Note that if the $all o%tion is
e1er$ised in the mone!' the $all writer will sell the $all o%tion holder>s
sto$( from his inventor! at the stri(e %ri$e indi$ated in the o%tion
$ontra$t# 5is ma1imm loss wold then &e,
.a1imm loss N Call 0remim W E1er$ise 0ri$e I 0ri$e 0aid for
nderl!in" asset#
-et>s loo( at an e1am%le# S%%ose that !o have D@A shares of K<X that
!o &o"ht for B8P and that the K<X 4l DA $all o%tion trades for B8#
The followin" dia"ram illstrates the t!%i$al %a!off to e1%e$t from a
$overed $all#
-#
DERIVATIVES
*ncovered Call
If the $all writer does not have the nderl!in" shares on de%osit' she has
written an n$overed $all' whi$h is m$h ris(ier for the writer than a
$overed $all# If the &!er of a $all e1er$ises the o%tion to $all' the writer
will &e for$ed to &! the asset at the s%ot %ri$e and' sin$e there is no limit
to how hi"h a share %ri$e $an "o' that s%ot %ri$e $an theoreti$all! "o % to
an infinite amont of dollars#
:rotective :ut
A %rote$tive %t is an o%tion in whi$h the writer has $ash on de%osit e?al
to the $ost to %r$hase the shares from the holder of the %t if the holder
e1er$ises his ri"ht to sell# This limits the writer>s ris( &e$ase mone! or
sto$( is alread! set aside#
The ris(' however' is not that "reat# The sto$( is not "oin" to &e %r$hased
at the s%ot %ri$e; it is "oin" to &e %r$hased at the e1er$ise %ri$e' whi$h
was a"reed to the da! of the o%enin" transa$tion# The hi"her the s%ot
%ri$e "oes the more the writer &enefits &e$ase she &!s the sto$( at the
lower e1er$ise %ri$e and sells it for whatever she $an "et in the mar(et#
There is a ris( that the s%ot %ri$e will "o down' &t the lowest it $an "o is
BA and that almost never ha%%ens in the s%an of time $overed &! an
25
DERIVATIVES
o%tions $ontra$t#
-et>s $onsider the worst:$ase s$enario in whi$h the writer has to %a! the
fll e1er$ise %ri$e for a $om%letel! worthless sto$(# If she sold a %t at B8E
and it is now worth nothin"' then she has lost B8E for ea$h share she
%led"ed to &!, if that was a &lo$( of @A'AAA shares' the loss amonts to
B9AA'AAA# No&od! wants to lose that (ind of mone!' &t it is insi"nifi$ant
$om%ared to the astronomi$al losses %ossi&le with writin" n$overed $alls#
E)a&le, Sa! A6C sto$( trades for BP@ and its one:month BPA %ts trade
for BO# A %t writer wold sell the BPA %ts in the mar(et and $olle$t the
BOAA YBO 1 8AAZ %remim# S$h a trader e1%e$ts the %ri$e of A6C to trade
a&ove BQP in the $omin" month' as re%resented &elow,

"hus$ we see that the trader is e)&osed to increasin! losses as the &rice of the stoc(
falls below ?2,. For e)a&le$ at a share &rice of ?2-$ the &ut seller is still obli!ated to
21
DERIVATIVES
buy shares of ABC at the stri(e &rice of ?,5.
3e or she would face a loss of ?.55$ which is calculated as the followin!;
?2$-55 Bar(et valueC 0 ?,$555 B&rice &aidC V ?155 B&reiu collectedC
Un$overed 0t
"he difference in the ris( &rofiles between uncovered calls Bnearly liitless ris(C and
an uncovered &ut Bclearly defined ris(C is why conservative investors who would
never thin( of writin! an uncovered call will not hesitate to write an uncovered &ut.
An uncovered &ut is a short &osition in which the writer does not have cash on de&osit
e=ual to the cost to &urchase the shares fro the holder of the &ut if the holder
e)ercises his ri!ht to sell. A!ain$ the writer (nows$ to the dollar$ e)actly what the
worst0case scenario is and can a(e an infored decision about whether or not it is
worth tyin! u& ca&ital to cover the &ut.
2.
DERIVATIVES
CURRENT A33AIRS
_____________________________________________________________________
Se&i allows mar(et:ma(in" in illi?id e?it! derivatives
)Arti$les 8, The 7all Street 4ornal' Fri, Jun 3 2011)
Bourses can desi!n their own schees to incentiviDe ar(et0a(ers as lon! as they
disclose the ters of such &ro!raes
0ramit 6hatta$har!a
Mubai; In a (ey ove aied at dee&enin! the Indian ar(ets$ ca&ital ar(et
re!ulator Securities and E)chan!e Board of India BSebiC on "hursday allowed ar(et0
a(in! in illi=uid e=uity derivatives.
"he !uidelines for Henhancin! li=uidityI in illi=uid derivatives have been welcoed
by bro(ers as well as the 'ational Stoc( E)chan!e B'SEC and the Bobay Stoc(
E)chan!e BBSEC.
HLe believe that this would hel& to develo& and dee&en the derivative ar(ets in
India both in ters of de&th and breadth$I said Madhu +annan$ BSE ana!in!
director and chief e)ecutive officer.
BSE has been &ushin! for ar(et0a(in! to i&rove its fla!!in! fortunes in the
e=uity derivatives ar(et$ where 'SE has a near ono&oly with over ##O ar(et
share.
HLe had been lobbyin! hard for this for the &ast seven0ei!ht onths and we are !lad
that the current Sebi adinistration has ta(en a &ro!ressive stance on this$I said a
senior BSE official$ who didn>t want to be identified.
Stoc( e)chan!es have been allowed to desi!n their own schees to incentiviDe
ar(et0a(ers as lon! as they disclose the ters of such &ro!raes. E)chan!es can
offer fee discounts$ ad<ustents in fees in other se!ents$ cash &ayents or even
shareholdin! in the stoc( e)chan!e to a ar(et0a(er.
Mar(et0a(ers are bro(ers who ta(e the ris( of holdin! a certain nuber of shares
with theselves to facilitate tradin!$ in return for co&ensation.
"hey offer both buy and sell bids to other ar(et &artici&ants.
Bro(ers say this is a first ste& to brin!in! Indian ar(ets in line with !lobal ones$
where ar(et0a(in! is a coon &ractice.
21
DERIVATIVES
HMar(et0a(in! in the derivatives se!ent has been a coon feature in ost
ar(ets. 8eave alone Lestern ar(ets$ even in other Asian ar(ets li(e Sin!a&ore
and 3on! +on!$ ar(et0a(ers &lay a bi! role in &rovidin! li=uidity$I said 9uvra<
Seh!al$ e)ecutive director BderivativesC at 40 .or"an India 0vt# -td.
"he ove to allow e)chan!es to offer shareholdin! to ar(et0a(ers u& to .-O of
issued ca&ital is a bit unusual thou!h$ bro(ers said.
HLhile cash &ayents for ar(et0a(ers in both cash and derivative se!ents are
=uite coon across the !lobe$ I do not see how offerin! e=uity sta(e is !oin! to
attract bro(ers unless you have a bro(er who is e)treely loyal to a &articular
e)chan!e$I said Sandee& Sin!al$ co0head Binstitutional e=uitiesC at Em(a! /lo&al
3inan$ial Servi$es -td.
"he BSE official cited above$ however$ aintained that there ay be bro(ers who are
lar!e li=uidity &roviders and interested in such an o&tion.
"he ar(et0a(in! schee of the e)chan!e has to be intiated to the ar(et at least
1- days in advance$ should be non0discretionary and the outcoe of the scheeWthe
incentives !ranted as well as the volues achievedWshould be disseinated onthly.
"his would ensure trans&arency in this schee and should hel& &revent abuses of the
syste$ an e)chan!e official said.
Sebi has allowed ar(et0a(in! for futures and o&tions in new listin!s or in
securities where the avera!e turnover is less than 5.1O of ar(et ca&italiDation and
for all securities in case of a new e)chan!e or se!ent.
"his eans if *nited Stoc( E)chan!e or MCF Stoc( E)chan!e 8td were to !et
a&&roval to start e=uity derivatives$ they would be allowed to offer ar(et0a(in!
schees.
Both these e)chan!es as well as the two national stoc( e)chan!es have been
consulted while frain! the !uidelines$ Sebi said.
Such schees would$ however$ be valid only for si) onths or till the avera!e
turnover reaches 1O of the ar(et ca&italiDation.
Lhile welcoin! Sebi>s initiative$ 9o!esh %ad(e$ head of derivatives at Edelweiss
Ca%ital -td$ &ointed out that the success of this easure would de&end on the (ind of
incentives that are offered as well as on the fundaentals of the shares whose
derivatives are bein! traded.
HAlthou!h there are about .15 stoc( derivatives$ li=uidity is restricted to the to& 155
scri&s and such a ove would hel& in drivin! u& li=uidity in soe of the illi=uid
shares$I he added.
%ad(e said that in derivatives where the underlyin! stoc( is e)treely illi=uid$ it
i!ht be difficult to !et ar(et0a(ers as such stoc(s can be sub<ect to hi!h volatility
in &rices.
2/
DERIVATIVES
6: Mor!an>s Seh!al$ however$ &ointed out that in ar(ets abroad$ the usual &ractice
for a ar(et0a(er is to hed!e &ositions once one of the bids is acce&ted$ so that the
losses$ if any$ are iniiDed.
HIf i&leented well$ this will brin! another set of &layers into the ar(et and if the
ar(et0a(in! schee is incentiviDed in a way that ar(et0a(ers are assured that
they won>t a(e losses$ there could be a lot of ta(ers for it$I he added.
Am%le room for IndiaMs e?it! derivatives mar(et to "row,
)Arti$les D , The 7all Street 4ornal' Fri, Oct 29 2010)
Indian e)chan!es need to wor( at buildin! li=uidity in the sin!le stoc( o&tions ar(et
6! .o&is 0hili%ose
India>s ran(in! in the !lobal e)chan!e0traded derivatives ar(et continues to rise.
Accordin! to latest volue ran(in!s for the first half of .515 by the Futures Industry
Association BFIAC$ 'ational Stoc( E)chan!e B'SEC of India>s ran(in! has i&roved
by two &laces and it>s now the fifth lar!est derivatives e)chan!e in the world.
Accordin! to FIA>s lea!ue table$ 'SE now ran(s hi!her than Chica!o Board 4&tions
E)chan!e and the 'asda= 4MF !rou&. 3ow can this beM
Lell$ FIA>s ran(in!s are &urely based on the nuber of contracts traded. "he value of
'SE>s contracts is far lower in co&arison to the Aerican e)chan!es$ and hence the
ran(in! based on volues doesn>t a(e uch sense. Also$ 'SE>s ran(in! has !ot a
boost with the addition of the currency futures se!ent$ where each contract is valued
at <ust ?1$555$ far lower than even 'ifty contracts$ which are valued around ?-$-55.
"he currency futures se!ent accounted for about -5O of total contracts traded on
'SE in the first si) onths of this year$ co&ared with <ust 1-O in the sae &eriod
last year. For &ers&ective$ the avera!e contract siDe of stoc( inde) futures contracts on
the Chica!o Mercantile E)chan!e stood at around ?-$-555 &er contract$ accordin! to
data collated by the Lorld Federation of E)chan!es BLFEC.
FIA$ in an online seinar$ conducted last onth to discuss volue trends in listed
futures and o&tions ar(ets$ re&eatedly referred to the relatively sall siDe of
derivatives contracts in Asian ar(ets. FIA does not &rovide ran(in!s based on
turnover data. 'evertheless$ it &ointed to soe interestin! data collated by the Ban(
for International Settleents$ which shows that the listed ar(et for futures and
o&tions on e=uity inde)es in Asia0:acific is now lar!er than that in 'orth Aerica$
even in ters of notional turnover. In the =uarter ended 6une$ the notional turnover of
e=uity inde) futures and o&tions on Asia0:acific derivatives e)chan!es stood at
?.-.1# trillion. Durin! the sae &eriod$ derivatives e)chan!es in 'orth Aerica had a
turnover of ?...2, trillion in these &roducts. Asian ar(ets had a share of around
/5O$ while the share of 'orth Aerican ar(ets was lower at 1-.2O.
Since this data &ertains to turnover in value ters$ it !ives soe credence to the view
that Asian e)chan!es includin! 'SE are !ivin! serious co&etition to the world>s to&
e)chan!es in attractin! business$ at least in the e=uity derivatives s&ace. But while
that stateent ay be true for Asian e)chan!es in !eneral$ it ay not be for Indian
2-
DERIVATIVES
e)chan!esWat least$ not yet. Accordin! to LFE data$ +orea E)chan!e$ the world>s
lar!est e)chan!e in volue ters$ accounted for around 21O of total turnover in
e=uity inde) futures and o&tions in the Asia0:acific re!ion in the first ei!ht onths of
this calendar year. 'SE accounted for <ust ,O of turnover in the re!ion$ less than
3on! +on! E)chan!es and Clearin!>s share of 15./O and 4sa(a Stoc( E)chan!e>s
share of 7.1O.
Lhile in volue ters$ 'SE>s 'ifty o&tions contracts are ran(ed as the world>s third
lar!est e=uity inde) derivative &roduct$ in value ters the &icture is =uite different.
LFE doesn>t &rovide notional turnover data for all e)chan!es$ but <ust for
co&arison$ it>s i&ortant to note that 'ifty o&tions turnover is only around an ei!hth
of the turnover at +orea E)chan!e.
3avin! said that$ 'ifty contracts were introduced uch later co&ared with other
established e=uity inde) contracts and they have a lon! way to !o. Lith these
contracts now bein! listed on Chica!o Mercantile E)chan!e and Sin!a&ore E)chan!e$
turnover is li(ely to increase further. As one FIA e)ecutive noted durin! its online
seinar entioned earlier$ already ore 'ifty futures contracts are traded on the
Sin!a&ore E)chan!e than futures on the MSCI Sin!a&ore inde).
Indian e)chan!es now need to wor( at buildin! li=uidity in the sin!le stoc( o&tions
ar(et$ which hasn>t ta(en off even thou!h it>s been over nine years since its launch.
It>s te&tin! to rest on laurels such as the hi!h ran(in!s in FIA>s lea!ue tables. But it
is &reature to say that India>s e=uity derivatives ar(et has atured. It has certainly
!rown by lea&s and bounds$ but there>s uch roo for i&roveent in &roduct
innovation and attractin! new &artici&ants. And as is evident fro the notional
turnover data$ there>s a&le roo to !row in siDe as well.
22
DERIVATIVES
5O7 TO INVEST AND EARN 0RO3ITS 3RO. DERIVATIVESL
_____________________________________________________________________
3ow to invest and earn &rofit fro derivativesM
3ow to benefit fro stoc( futures
!o are &llish on a sto$( sa! Sat!am' whi$h is $rrentl! ?otin" at Rs
DEA %er share# <o &elieve that in one month it will to$h Rs OOA#
Nuestion; 7hat do !o doL
Answer; <o &! Sat!am#
Effect; It to$hes Rs OOA as !o %redi$ted I !o made a %rofit of Rs @A on an
investment of Rs DEA i#e# a Retrn of 8E2 in one month I 3antasti$UU
Lait; Can it "et an! &etterL
<es UU
Nuestion; 7hat shold !o do L
Answer; 6! Sat!am 3tres instead#
Effe$t, On &!in" Sat!am 3tres' !o "et the same %osition as Sat!am in the
$ash mar(et' &t !o %a! a mar"in and not the entire amont# 3or
e1am%le' if the mar"in is DA2' !o wold %a! onl! Rs @Q# If Sat!am "oes
% to Rs OOA' !o will still earn Rs @A as %rofit# Now that translates into a
fa&los retrn of E92 in one month#
Un&elieva&leUU6t Tre neverthelessUU
This is the advanta"e of Rlevera"eM whi$h Sto$( 3tres %rovide# 6! investin" a
small mar"in )ran"in" from 8A to D@2*' !o $an "et into the same
2,
DERIVATIVES
%ositions as !o wold &e a&le to in the $ash mar(et# The retrns
therefore "et a$$ordin"l! mlti%lied#
Nuestion ; 7hat are the ris(sL
Answer ; The ris(s are that losses will &e "et levera"ed or mlti%lied in the same
manner as %rofits do# 3or e1am%le' if Sat!am dro%s from Rs DEA to Rs
D@A' !o wold ma(e a loss of Rs OA# The Rs OA loss wold translate to an
882 loss in the $ash mar(et and a @C2 loss in the 3tres mar(et#
Nuestion ; 5ow $an I red$e s$h lossesL
Answer ; It is ver! eas! to red$e+minimi=e s$h losses if !o (ee% a shar% e!e on
the mar(et# S%%ose' !o are &llish and !o hen$e &! Sat!am ftres#
6t Sat!am ftres start movin" down after !o have &o"ht# <o $an
s?are % !or %osition at an! %oint of time thereafter# <o $an &! at
8A,OA in the mornin" and sell off at 88,AA on the same da!# There is no
restri$tion at all#
Ths' &! s?arin" % earl! eno"h !o $old stem !or %ossi&le losses#
Nuestion ; 5ow lon" do 3tres last and when do the! e1%ireL
Answer ; 3tres e1%ire on the last Thrsda! of ever! month# 3or e1am%le'
4anar! 3tres will e1%ire on O8st 4anar! )last Thrsda!*#
Nuestion ; 7hat is the im%li$ation of e1%ir!L
Answer ; S%%ose !o have &o"ht 4anar! 3tres on Sat!am and have not
s?ared % till the end# On O8st 4anar!' !or 3tres will &e
$om%lsoril! sold at the $losin" $ash mar(et %ri$e of Sat!am and !or
%rofit or loss will &e %aid ot or demanded from !o as the $ase ma! &e#
Nuestion ; A%art from levera"e' how $an I se 3tresL
Answer ; A "reat advanta"e of 3tres )at the moment* is that the! are not lin(ed
to Rdeliver!M# 7hi$h means' !o $an sell 3tres )short sell* of Sat!am
27
DERIVATIVES
even if !o do not have an! shares of Sat!amL Ths' !o $an &enefit from
a downtrn as well as from an %trn#
If !o %redi$t an %trn' !o shold &! 3tres and if !o %redi$t a downtrn'
!o $an alwa!s sell 3tres I ths !o $an ma(e mone! in a fallin"
mar(et as well as in a risin" one I an o%%ortnit! that till re$entl! was
availa&le onl! to &ro(ers+o%erators and not easil! to retail investors#
Nuestion ; 5ow $an I do v!aF &adla thro"h 3tresL
Answer ; In v!aF &adla' !or &ro(er sed to &! shares at a lower rate and
immediatel! sell the same shares at a sli"htl! hi"her rate "eneratin" a
retrn for !o# 3or e1am%le' he wold &! Sat!am at Rs 8@A and sell at
Rs 8@D "eneratin" a retrn of Rs D for !o# This wold effe$tivel!
"enerate a $ertain !ield %er annm on !or investment# 6adla sessions
sed to &e held on Satrda!s and one &adla transa$tion wold t!%i$all!
rn for one wee(#
In ftres' s$h &adla o%%ortnities arise $onstantl! I ths ftres $an &e
nderstood as R&adla on ta%M# <o shold loo( for o%%ortnities where
ftres %ri$es are hi"her than $ash %ri$es# 3or e1am%le' if Sat!am is
?otin" at Rs D@A in the $ash mar(et and one month Sat!am ftres are
?otin" at Rs D@O in the ftres mar(et' !o $an earn Rs O as differen$e#
<o will then &! Sat!am in the $ash mar(et and at the same time' sell
Sat!am one month ftres#
On or arond the e1%ir! da! )last Thrsda! of ea$h month*' !o will s?are %
&oth the %ositions' i#e# !o will sell Sat!am in the $ash mar(et and &!
ftres# The two %ri$es will &e the same )or ver! nearl! the same* as $ash
and ftres %ri$es will $onver"e on e1%ir!# It does not matter to !o what
the %ri$e is# <o will ma(e !or %rofit of Rs O an!wa!#
3or e1am%le' if the %ri$e is Rs DPA' !o will ma(e a %rofit of Rs DA on sellin" !or
Cash mar(et Sat!am and a loss of Rs 8P on &!in" &a$( Sat!am ftres#
The net %rofit is Rs O# On the other hand' if the %ri$e is Rs DD@' !o ma(e
2#
DERIVATIVES
a loss of Rs D@ on sellin" Cash mar(et Sat!am and a %rofit of Rs DE on
Sat!am ftres# The net %rofit remains Rs O#
<or investment in this transa$tion will &e Rs D@A on $ash mar(et Sat!am %ls a
mar"in of sa! DA2 on Sat!am ftres )sa! Rs @A a%%ro1*# Ths an
investment of Rs OAA has "enerated a retrn of Rs O i#e# 82 %er month or
8D2 %er annm#
Now ta(e a sitation where onl! 8@ da!s are left for e1%ir! and !o s%ot the same
o%%ortnit! as a&ove# <o will still "enerate Rs O whi$h will translate into
a retrn of D2 %er month or DC2 %er annm#
In this manner' !o will "enerate retrns whenever the ftres %ri$es are a&ove
$ash mar(et %ri$es#
Nuestion ; 7hat %re$ations shold I ta(e in s$h transa$tions and what ris(s
am I e1%osed toL
Answer ; <o need to fa$tor in &ro(era"e $osts and demat $har"es for the a&ove
transa$tions# The net retrns shold &e $onsidered for de$ision ma(in"
%r%oses#
There is an e1e$tion ris( in the sense that !o mi"ht not "et e1a$tl! the same
%ri$e in the $ash mar(et and the ftres mar(et when !o s?are % on
or arond the last da!# 3or e1am%le' if !o sell !or Cash mar(et Sat!am
shares for Rs DPA and &! &a$( Sat!am ftres at Rs DPA#DA' there is a
small differen$e of Rs A#DA whi$h will affe$t !or net %rofit# This im%a$t
mi"ht &e favora&le or adverse &t is nevertheless %ossi&le# It is however
?ite li(el! that the differen$e mi"ht &e ver! small on or arond the last
da!#
Nuestion; Do I need to wait till the last da!L
Answer ; No I !o mi"ht find %rofita&le e1it o%%ortnities m$h &efore the last
da! also# 3or e1am%le' if the %ri$e of Sat!am shares is Rs DCA after O da!s
and Sat!am ftres are ?oted at Rs DC8' !o $old ver! e1it &oth
,5
DERIVATIVES
%ositions# <o will ma(e a loss of Rs 8A on $ash mar(et and a %rofit of Rs
8D on ftres' resltin" in a net %rofit of Rs D#
Derivatives Strate!ies
Strate"ies are s%e$ifi$ "ame %lans $reated &! !o &ased on !or idea of how the
mar(et will move# Strate"ies are "enerall! $om&inations of varios
%rod$ts I ftres' $alls and %ts and ena&le !o to reali=e nlimited
%rofits' limited %rofits' nlimited losses or limited losses de%endin" on
!or %rofit a%%etite and ris( a%%etite#
3ow are Strate!ies forulatedM
The sim%lest startin" %oint of a Strate"! $old &e havin" a $lear view a&ot the
mar(et or s$ri%# There $old &e strate"ies of an advan$ed natre that are
inde%endent of views' &t it wold &e $orre$t to sa! that most investors
$reate strate"ies &ased on views#
Lhat views could be handled throu!h Strate!iesM
There $old &e for sim%le views, &llish view' &earish view' volatile view and
netral view# 6llish and &earish views are sim%le eno"h to $om%rehend#
Volatile view is where !o &elieve that the mar(et or s$ri% $old move
ra%idl!' &t !o are not $lear of the dire$tion )whether % or down*# <o
are however sre that the movement will &e si"nifi$ant in one dire$tion or
the other# Netral view is the reverse of the Volatile view where !o
&elieve that the mar(et or s$ri% in ?estion will not move m$h in an!
dire$tion#
Lhat strate!ies are &ossible if I have a bullish viewM
The followin" strate"ies are %ossi&le,
6! a 3tre
6! a Call O%tion
Sell a 0t O%tion
,1
DERIVATIVES
Create a 6ll S%read sin" Calls
Create a 6ll S%read sin" 0ts
%IS+S I' DE%IRA"IRES "%ADI'G
Nuestion; 7hat are the ris(s involved in Derivatives Tradin"L
Answer ; Investors and traders are re?ired to si"n % a Ris( Dis$losre
Do$ment &efore the! &e"in tradin" in Derivatives# This do$ment sets
ot the varios ris(s involved in this tradin"# These are si"nifi$ant and
investors $an lose h"e amonts within a short s%an of time in derivatives
)m$h more than %ossi&le losses in the $ash mar(et "iven similar invested
amonts*#
Nuestion ; 5ow %ra$ti$al is this isse on a da! to da! &asisL
Answer ; Ris( is a ver! live isse as was demonstrated &! the A%ril 8Ath sa"a# On
this da!' we saw Infos!s fall &! DP2 and .ar(et fall &! C92# These (inds
of %ri$e falls are nanti$i%ated and most investors in short %ositions have
lost s&stantial amonts of mone! on this da!#
Nuestion ; ArenMt mar"ins a&le to $over these sitationsL Is the investor not
aware that his entire mar"in $old &e lost on a &ad da!L
Answer ; .ar"ins are desi"ned to $over 992 of the %ossi&le losses on a sin"le
da!# Te$hni$all!' mar"ins are &ased on a statisti$all! $al$lated level of
%ossi&le losses &ased on histori$al sto$( %ri$e movements# 5owever' on$e
in 8AA da!s a disaster is te$hni$all! %ossi&le where %ri$e movements $an
"o &e!ond the limits set % the statisti$al model#
7hen this ha%%ens' the statisti$al model limits "et violated# As a reslt' investors
$an lose more than their mar"ins' &ro(ers $an lose if investors do not %a!
% the in$remental mar"ins and e1$han"es and the entire settlement
s!stem $an &e at ris( if man! &ro(ers fail to %a! %#
,.
DERIVATIVES
Nuestion ; 5ow $an mar"ins &e$ome insffi$ientL Can the e1$han"es not foresee
the ma1imm %ossi&le lossesL
Mar!ins are calculated in the followin! fashion Ba si&lified e)&lanation for ease of
clarityC;
Ta(e the dail! $losin" %ri$es
7or( ot the dail! $han"e in %ri$es )termed as dail! retrn*
E1%ress this dail! $han"e in %er$enta"e
7or( ot the standard deviation of this dail! $han"e
A%%l! a fa$tor of O#@ to this standard deviation
A %eriod of one !ear is $onsidered for these $al$lations' &t a wei"ht a"e fa$tor
is a%%lied in the sense that re$ent data is "iven more wei"ht a"e and
earlier data is "iven lesser im%ortan$e#
The essen$e is that the volatilit! of the %ast one !ear is the &asis for assmin"
ftre volatilit!# Now in the %ast one !ear )and more %arti$larl! in the
re$ent %ast*' if the volatilit! has &een at a level of sa! O2 %er da!' then the
mar"in wold &e ta(en at 8A#@2 )on the &asis of O2 1 O#@ times*# Ths' if
Infos!s were tradin" at sa! Rs C'8AA a mar"in of 8A#@2 wold have &een
$olle$ted on Infos!s 3tres#
Now the statisti$al model e1%e$ts that the dail! movement in Infos!s wold &e
within the ran"e of 8A#@2 of the $rrent %ri$e of Rs C'8AA )i#e# Rs COA
a%%ro1* on the ne1t tradin" da!# A$$ordin"l!' a mar"in of Rs COA wold
&e $olle$ted from investors )&oth &!ers and sellers of 3tres*#
If Infos!s moves more than Rs COA )% or down* on the ne1t da!' the mar"in will
&e insffi$ient# The investor will find that the &ro(er is $allin" him % the
ne1t da! and as(in" for more mar"ins# 6ro(ers will find that investors
need to %a! % far more and the! are )t!%i$all!* not in a %osition to %a!
,1
DERIVATIVES
enormos amonts overni"ht and e1$han"es mi"ht find that &ro(ers are
na&le to %a! enormos amonts overni"ht either#
Ths' the entire s!stem $an &e at ris( in $ase of h"e movements in sto$( %ri$es#
The $rrent s!stem )Vale at Ris( .ar"inin" as it is termed* is the
internationall! followed %ra$ti$e ins%ite of whatever limitations it ma!
have# At the s!stemi$ level' it is dan"eros to follow this %ra$ti$e
es%e$iall! if some %la!ers have relativel! lar"e mar(et share )whi$h is
?ite %ossi&le in the Indian mar(ets*# If some lar"e %la!ers sffer losses'
the entire settlement s!stem is at ris(# Internationall!' there are several
%la!ers and the s!stem is not so $on$entrated as it is in India and hen$e
ris( levels are m$h lower#
Nuestion ; Are there no $ir$it filters whi$h $an sto% sto$(s from movin" so m$h
within a da!L
Answer ; Cir$it filters are not a%%li$a&le to sto$(s whi$h are traded in the
3tres G O%tions se"ment and to those sto$(s whi$h are %art of the
Sense1 thirt! or the Nift! fift!# 5en$e' an! level of movement is %ossi&le
on these sto$(s#
There is instead' a mar(et wide filter# If the entire mar(et )meanin" the Sense1
or Nift!* moves % 8A2 or more within a da!' the entire mar(et will &e
$losed for s%e$ified %eriod )sa! half an hor or more*#
On the 8Ath of A%ril' the Sense1 and Nift! did not move to this level )movements
were less than @2* and hen$e this filter did not a%%l!#
Nuestion ; 7hat is the lesson in all this for me' a retail investorL
Answer ; If !o invest in 3tres )&! or sell* or !o sell O%tions' !o need to &e
ver! $arefl# <o shold &e mentall! %re%ared to lose the entire mar"in
that !o %aid to the &ro(er# 3rther' on$e in a while )rarel!*' !o mi"ht &e
$alled %on to %a! do&le that mar"in amont and hen$e !o shold &e
mentall! %re%ared for s$h losses#
,/
DERIVATIVES
If !o &! O%tions )$alls or %ts*' the losses are limited to the amont of
%remim !o invested#
If !o had sold 0t O%tions on Infos!s' !o $old have t!%i$all! earned Rs 8OA
on an At the .one! 0t &efore A%ril 8A' and it $old have "one % all the
wa! to Rs 8'8AA on that da!# Ths' !o $old have lost nearl! PAA2 or
more of !or O%tion 0remim In$ome on a sin"le da!# The stor! on
.aste( wold have &een worse#
Nuestion ; Can I %rote$t m! %ositions in some mannerL
Answer ; <es !o $an# Some e1am%les $an &e dis$ssed# If !o &! 3tres' !o
fa$e a downside ris(# To $t off this downside ris(' !o $old &! 0ts#
3or e1am%le' !o $old &! Sat!am 3tres )assmin" !o are &llish*#
6t if !o "o wron"' to $over !o %ossi&le losses !o $old &! a Sat!am
0t# De%endin" on how m$h losses !o $an &ear' !o $old &! an Ot
of the .one! 0t#
If !o sell 3tres' !o fa$e an %side ris(# <o $an hed"e this ris( if !o &!
Calls# This $om&ination will eliminate this %side ris(#
If !o sell an At the .one! Call' !o $old &! another Ot of the .one! Call
and limit !or losses# If !o sell an At the .one! 0t' !o $old &!
another Ot of the .one! 0t and limit !or losses#
Sestion , 7old !o advise s$h hed"in" on a re"lar &asisL
Answer ; A hed"ed strate"! is $ertainl! advisa&le &e$ase of the h"e %otential
for losses# As a retail investor' !o shold &e %re%ared to $om%romise
!or %rofits a &it in retrn for some %rote$tion#
BadlaJ3ed!in! throu!h futures
Nuestion ; In the last Arti$le' !o e1%lained how v!aF &adla $an &e done sin"
Sto$( 3tres# 7hat other &adla $an &e doneL
,-
DERIVATIVES
Answer ; Share &adla $an also &e done sin" Sto$( 3tres# This in$ldes ndha
&adla %ossi&ilities also#
Nuestion ; 0lease tell me a&ot Share &adla# 7ho $an "et into Share &adlaL
Answer ; T!%i$all!' the Share &adla %arti$i%ant owns shares and is in need of
fnds for a short %eriod of time#
Nuestion ; 7h! $anMt I sell the shares if I need $ashL
Answer ; <es !o definitel! $an' &t !o will lose the %rofit from %side if the
share %ri$e were to move %#
Nuestion ; <o mean' I $an %rote$t the %side and still "et $ash for m! sharesL
Answer ; <es I that is e1a$tl! what I mean#
Nuestion ; 5owL
Answer ; S%%ose !o have 8'DAA shares of Sat!am whi$h is $rrentl! ?otin" at
Rs DDA %er share I a total vale of Rs D#QC la(hs# <o need $ash' &t
%rote$t the %side %rofits#
All !o need to do is I one I sell !or shares in the $ash mar(et and "et %aid the
Rs D#QC la(hs and I two I &! Sat!am )one month* ftres in the
derivatives mar(et )sa! at Rs DD8 %er share*#
The ftres %osition will (ee% !or %rofits inta$t' if the share %ri$e moves %#
Nuestion ; 5ow do I "et m! shares &a$( and whenL
Answer ; The ftres will e1%ire on the last Thrsda! of the month# On the last
Thrsda! )or &efore that at an! $onvenient time*' !o shold reverse the
transa$tion i#e# !o will sell !or Sat!am ftres and &! &a$( Sat!am
shares#
Nuestion ; 7ill I not $arr! a %ri$e ris( I %ri$e of Sat!am shares ma! move % or
down in the interim %eriod#
,2
DERIVATIVES
Answer ; No' !or %osition will &e a $overed %osition I an! mar(et movements
will not affe$t !o at all# S%%ose Sat!am moves % to Rs D@A at the
month end' !o will find that !o have made a loss of Rs 8 %er share )Rs
OA loss on the $ash mar(et shares and Rs D9 %rofit on Sat!am ftres*#
On the other hand' if Sat!am moves down to Rs DAA %er share !o will still have
made a loss of Re 8 %er share )Rs DA %rofit on the $ash mar(et shares and
Rs D8 %rofit on Sat!am ftres*#
Nuestion ; 7h! do I ma(e this lossL
Answer ; The loss of Re 8 %er share is !or interest $ost# <o have enFo!ed Rs
D#QC la(hs for a %eriod of )let s sa!* one month# The interest $ost for this
&orrowin" is onl! Rs 8'DAA )Re 8 %er share on 8'DAA shares*# This wor(s
ot to an interest $ost of less than half %er $ent %er month )ver! attra$tive
&orrowin" rate*#
Nuestion ; 5ow do I (now when this t!%e of share &adla is attra$tiveL
Answer ; <o shold wat$h the $ash mar(et and ftres mar(et %ri$es $losel!
and loo( for o%%ortnities when the ftres mar(et %ri$e is not too hi"h#
3or e1am%le in the a&ove $ase' the ftres %ri$es were onl! Re 8 hi"her
than the $ash mar(et %ri$es# <o shold then $onvert this Re 8 $ost into
an annali=ed interest $ost# 3or e1am%le )8+DDA N A#C@2*#
If onl! 8A da!s are left for e1%ir!' this wold translate to a hi"her rate of 8#O@2
%er month )A#C@ T OA+8A*#
Nuestion ; 7hat is ndha &adla and how $an this &e effe$ted in the ftres
mar(etL
Answer ; Undha &adla in the olden da!s was a sitation whi$h $old sometimes
emer"e de to a &ear tra%# If some &ears have short sold shares and are
na&le to deliver them' &lls $old tra% them# 6ears wold then ne"otiate
for deliver! and &lls wold let them have deliver!' &t at a %ri$e# Ths'
the &lls wold enFo! the &est of &oth worlds I vi= I fnds and li?idit!
,,
DERIVATIVES
)on sale thro"h deliver! &asis* and also &adla lon" %osition )advanta"e of
%rofitin" on %ri$e rises*#
Nuestion ; 5ow does this ha%%en in the ftres mar(et nowL
Answer ; In the ftres mar(et' ndha &adla is m$h sim%ler# 7henever ftres
are ?oted at a %ri$e lower than the $ash mar(et %ri$e' the sitation is
ndha# 3or e1am%le' if Sat!am shares are ?otin" in the $ash mar(et at
Rs DDA and Sat!am )one month* 3tres are ?otin" at Rs D8E' !o have a
$lassi$ ndha sitation "oin"#
Nuestion ; 7hat shold I doL
Answer ; <o sell Sat!am shares in the $ash mar(et )!o shold have Sat!am
with !o li(e in the share &adla e1am%le a&ove* at Rs DDA and at the same
time &! Sat!am 3tres are Rs D8E in the derivatives mar(et# On e1%ir!
)or &efore that whenever !o find %ri$es $onver"e*' !o shold li?idate
&oth %ositions# That is' !o shold &! &a$( Sat!am $ash shares and sell
Sat!am 3tres# It does not matter whether Sat!am has moved % or
down in the meantime' as !or %osition is $om%letel! hed"ed#
Nuestion ; 7hat is the &enefit to meL
Answer ; <o have enFo!ed li?idit! for one month )sa! Rs D#QC la(hs in the
a&ove e1am%le* and !o have also enFo!ed a %rofit of Rs D %er share )or
Rs D'CAA on 8'DAA Sat!am shares*# This %rofit is similar to interest earned
&! the ndha &adla %la!er#
Nuestion ; I have heard that hed"in" is %ossi&le sin" 3tres# 7hat does this
meanL
Answer ; 5ed"in" is $ertainl! %ossi&le sin" 3tres# S%%ose !o hold Infos!s
Shares and are nervos a&ot the share in the short rn# <o $an $onsider
5ed"in"#
,7
DERIVATIVES
Nuestion ; If I am nervos' wold I not sell Infos!s strai"ht awa!L
Answer ; <es' !o will if !o &elieve that Infos!s is movin" down in the lon" rn#
6t if !or nervosness is tem%orar!' then sellin" Infos!s mi"ht &e a &ad
soltion# In the first %la$e' after !o sell' Infos!s mi"ht move %# In most
$ases' investors find it diffi$lt to &! the same share at a hi"her %ri$e#
0ra$ti$al eviden$e s""ests that most investors are na&le to a$?ire "ood
shares on$e havin" sold them# The se$ond $ommon %ro&lem is that of
$a%ital "ains# If !or $ost is m$h lower than toda!Ms %ri$e' !o mi"ht
have to %a! $a%ital "ains ta1es on sale of !or shares#
Nuestion ; 7hat is the alternativeL
Answers ; 5old on to !or Infos!s shares and sell Infos!s ftres instead# As a
reslt' !o will have a $overed %osition )no %rofit no loss* for the %eriod of
time $overed &! ftres# 3or e1am%le' if !o sell one month 3tres' !o
are $overed for one month# If Infos!s is ?otin" at Rs C'AAA and !o sold
Infos!s )one month* 3tres for Rs C'AQA' !o have I one I hed"ed !or
%osition for one month I and I two I made a %rofit of Rs QA# It does not
matter whether Infos!s moves % or down#
Nuestion ; If it moves %' I wold have made a %rofitL
Answer ; <es' had !o not hed"ed !or %osition' !o wold have made a %rofit#
5owever' !o have lost that %rofit now# Remem&er' a hed"e is not a devi$e
to ma1imi=e %rofits# It is a devi$e to minimi=e losses# As the! sa!' a hed"e
does not reslt in a &etter ot$ome; it reslts in a more %redi$ta&le
ot$ome#
7hat is the %ro$edre for introd$tion and dro%%in" of se$rities after arrivin"
at the $on$lsions sin" a&ove $riteriaL
Conse?entl!' the %ro$edre for introd$in" and dro%%in" se$rities on whi$h
o%tion and ftre $ontra$ts are traded' as sti%lated &! SE6I in its
$ir$lar S.DR0+DC+CIR :8O+AD dated De$ 8E' DAAD' wold &e as follows,
,#
DERIVATIVES
O%tions and ftres ma! &e introd$ed on new se$rities when the! meet the
eli"i&ilit! $riteria and are a%%roved &! SE6I#
If an e1istin" se$rit! fails to meet the eli"i&ilit! $riteria for three months
$onse$tivel!' then no fresh month $ontra$t shall &e issed on that
se$rit!# 5owever' the e1istin" ne1%ired $ontra$ts ma! &e %ermitted to
trade till e1%ir! and new stri(es ma! also &e introd$ed in the e1istin"
$ontra$t months#
The E1$han"e ma! $om%lsoril! $lose ot all derivative $ontra$t %ositions in a
%arti$lar nderl!in" when that nderl!in" has $eased to satisf! the
eli"i&ilit! $riteria or the E1$han"e is of the view that the $ontinan$e of
derivative $ontra$ts on s$h nderl!in" is detrimental to the interest of
the mar(et' (ee%in" in view the mar(et inte"rit! and safet!#
75
DERIVATIVES
CASE STUD<, DERIVATIVES TRADIN/ IN INDIA
_____________________________________________________________________
CASE S"*D9;0 Derivatives Tradin" in India
Case Details;0
"he case discusses the introduction and !rowth of the derivatives
ar(et in India.
It describes in detail the reasons that led to the introduction of derivatives tradin! in
India and why it faced o&&osition by a section of industry analysts and edia. "he
case then describes the issues that still reain to be addressed by the re!ulatory
authorities to accelerate the lon!0ter !rowth of the derivatives ar(et.
Finally$ the case entions a few ste&s ta(en by the concerned authorities in early
.55/.
Isses;0
Main ob<ectives and reasons for the introduction of derivatives tradin! in
India
"he factors that can accelerateJsu&&ress the !rowth of the derivatives ar(et
in a country
Introduction;0
On 4ne 9' DAAA' the 6om&a! Sto$( E1$han"e )6SE* introd$ed
India>s first derivative instrment : the 6SE:OA)Sense1* inde1 ftres# It
was introd$ed with three month tradin" $!$le : the near month )one*' the
ne1t month )two* and the far month )three*#
The National Sto$( E1$han"e )NSE* followed a few da!s later' &! lan$hin" the
SG0 CNK Nift!
O
inde1 ftres on 4ne 8D' DAAA# The %lan to introd$e
derivatives in India was initiall! mooted &! the National Sto$( E1$han"e
)NSE* in 899@# The main %r%ose of this %lan was to en$ora"e "reater
71
DERIVATIVES
%arti$i%ation of forei"n instittional investors )3IIs* in the Indian sto$(
e1$han"es# Their involvement had &een ver! low de to the a&sen$e of
derivatives for hed"in" ris(# 5owever' there was no $onsenss of o%inion
on the isse amon" indstr! anal!sts and the media# The %ros and $ons of
introd$in" derivatives tradin" were de&ated intensel!# The la$( of
trans%aren$! and inade?ate infrastr$tre of the Indian sto$( mar(ets
were $ited as reasons to avoid derivatives tradin"#
Derivatives were also $onsidered ris(! for retail investors &e$ase of their %oor
(nowled"e a&ot their o%eration# In s%ite of the o%%osition' the %ath for
derivatives tradin" was $leared with the introd$tion of Se$rities -aws
)Amendment* 6ill in 0arliament in 899E#
The introd$tion of derivatives was dela!ed for some more time as the
infrastr$tre for it had to &e set %# Derivatives tradin" re?ired a
$om%ter:&ased tradin" s!stem' a de%ositor!
C
and a $learin"
hose
@
fa$ilit!# In addition' %ro&lems s$h as low mar(et $a%itali=ation of
the Indian sto$( mar(ets' the small nm&er of instittional %la!ers and
the a&sen$e of a re"lator! framewor( $ased frther dela!s# Derivatives
tradin" eventall! started in 4ne DAAA# The introd$tion of derivatives
was well re$eived &! sto$( mar(et %la!ers# Tradin" in derivatives "ained
s&stantial %o%larit!' and soon the trnover of the NSE and 6SE
derivatives mar(ets e1$eeded the trnover of the NSE and 6SE $ash
mar(ets#
3or instan$e' in the month of 4anar! DAAC' the vale of the NSE and 6SE
derivatives mar(ets was Rs#ODPE#@ &illion )&n* whereas the vale of the
NSE and 6SE $ash mar(ets was onl! Rs#899E#E9 &n# )Refer E1hi&it I and
II*# In s%ite of these en$ora"in" develo%ments' indstr! anal!sts felt that
the derivatives mar(et had not !et reali=ed its fll %otential# Anal!sts
%ointed ot that the e?it! derivative mar(ets on the 6SE and NSE had
&een limited to onl! for %rod$ts : inde1 ftres' inde1 o%tions and
individal sto$( ftres and o%tions whi$h were limited to $ertain sele$t
sto$(s#
7.
DERIVATIVES
6a$("rond Note,:
5e initial ste%s to lan$h derivatives were ta(en in 899@ with the introd$tion of
the Se$rities -aws )Amendment* Ordinan$e' 899@ that withdrew the
%rohi&ition on tradin" in o%tions on se$rities in the Indian sto$(
mar(et#
In Novem&er 899Q' a DC:mem&er $ommittee was set % &! the Se$rities
E1$han"e 6oard of India )SE6I*
Q
nder the $hairmanshi% of -C /%ta to
develo% an a%%ro%riate re"lator! framewor( for derivatives tradin"#
The $ommittee re$ommended that the re"lator! framewor( a%%li$a&le
to the tradin" of se$rities wold also "overn the tradin" of derivatives#
3ollowin" the $ommittee>s re$ommendations' the Se$rities Contra$t Re"lation
A$t )SCRA* was amended in 8999 to in$lde derivatives within the s$o%e
of se$rities' and a re"lator! framewor( for administerin" derivatives
tradin" was laid ot#
The a$t "ranted le"alit! to e1$han"e:traded derivatives' &t not OTC )over the
$onter* derivatives# It allowed derivatives tradin" either on a se%arate
and inde%endent derivatives e1$han"e or on a se%arate se"ment of an
e1istin" sto$( e1$han"e# The derivatives e1$han"e had to fn$tion as a
self:re"lator! or"ani=ation )SRO* and SE6I a$ted as its re"lator#
The res%onsi&ilit! of $learin" and settlement of all trades on the e1$han"e
was "iven to the $learin" hose whi$h was to &e "overned inde%endentl!#
Derivatives were introd$ed in a %hased manner# Initiall!' tradin" was
restri$ted to inde1 ftres $ontra$ts &ased on the SG0 CNK Nift! Inde1
and 6SE:OA )Sense1* Inde1#
The De&ate and Reslt,:
Those who o%%osed the introd$tion of derivatives ar"ed that these instrments
wold si"nifi$antl! in$rease s%e$lation in the mar(et
71
DERIVATIVES
The! said that derivatives $old &e sed for s%e$lation &! investors &! ta(in"
lar"e %ri$e %ositions in the sto$( mar(et while $ommittin" onl! a small
amont of $a%ital as mar"in#
3or instan$e' instead of an investor &!in" sto$(s worth Rs#8 million
)mn*' he $old &! ftres $ontra$ts on Rs#8 mn of sto$(s &! investin" a
few thosand r%ees as mar"in# Ths' tradin" in derivatives en$ora"ed
investors to s%e$late : ta(in" on more ris( while %ttin" forward less
investment# The! were ?i$( to %oint ot some of the disasters of the %ast
that had o$$rred de to the mismana"ement of tradin" in derivatives
)Refer E1hi&it III*#
A 3ew Isses Remain,:
6! 4anar! DAAC' more than three and a half !ears of derivatives tradin" had
&een $om%leted# 5owever' a$$ordin" to several anal!sts and media
re%orts' SE6I' NSE and 6SE had still to resolve man! isses so that the
derivatives mar(et $old reali=e its fll %otential#
3or instan$e' the isse of im%osin" ta1es on in$ome arisin" from derivatives
tradin" still remained to &e sorted ot# The In$ome Ta1 A$t of India did
not have an! s%e$ifi$ %rovision re"ardin" ta1a&ilit! of derivatives in$ome#
The ta1 athorities were still nde$ided on the isse' and in the a&sen$e of
an! %rovision' derivatives transa$tions were held on %ar with transa$tions
of a s%e$lative natre )in %arti$lar' the inde1 ftres+o%tions whi$h
were essentiall! $ash settled' were treated this wa!*# Therefore' the loss' if
an!' arisin" from derivatives transa$tions' was treated as a s%e$lative
loss and was eli"i&le to &e set off onl! a"ainst s%e$lative in$ome %to a
ma1imm %eriod of ei"ht !ears#
7/
DERIVATIVES
CONC-USION
_____________________________________________________________________
C4'C8*SI4'
7ithin this %roFe$t' we>ve learned a&ot derivatives' forwards' ftres' o%tions
and swa% mar(ets' the $hara$teristi$s of the varios t!%es of derivatives'
determinin" %a!offs of varios strate"ies and %ositions' and how to a%%l!
o%tion strate"ies to mana"e ris(# In the ne1t to%i$s' we>ll ta(e a loo( at
o%en and $losed:end fnds' e1$han"e traded fnds' real estate
investments' and more#
Derivative securities ar(ets &lay an i&ortant role by allowin! investors who do not
want the ris(s associated with holdin! an asset to transfer it to those who do.
3owever$ because they are ar(ets for ris( as o&&osed to &hysical assets$ derivatives
ar(ets can be very dan!erous &laces for unso&histicated investors. :eo&le who
reduce their ris( by enterin! a derivative ar(et are called hed!ers$ and those who
increase their ris( are called s&eculators.
7-
DERIVATIVES
"he derivative securities ar(ets &lay a vital role in the odern financial systes and
without the any coon business transactions would be rendered uch ris(ier or
&ractically i&ossible.
6I6-IO/RA05<
_____________________________________________________________________
6i&lio"ra%h!
7E6SITES,:
www.derivativesindia.co
www.wi(i&edia.co
www.investo&edia.co
www.scribd.co
www.bseindia.co
www.ana!eent&aradise.co
www.liveint.co
6OOJS,:
Credit Derivatives :ricin! Models by :hili&& 6. SchXnbucher
72
DERIVATIVES
Derivatives 3andboo( by %obert 6. SchwartD BEditorC$ Clifford L. Sith
BEditorC
Derivatives; A Mana!erAs Guide to the LorldAs Most :owerful Financial
Instruents by :hili& McBride 6ohnson
Derivatives Mar(ets by %obert 8. McDonald
Derivatives; Raluation Y %is( Mana!eent by David A. Dubofs(y$
"hoas L. Miller
4&tions$ Futures and 4ther Derivatives by 6ohn C. 3ull
ARTIC-ES,:
Money and Mar(ets BMaMC is &ublished by Leiss %esearch$ Inc. and written
by Martin D. Leiss alon! with 'ilus Mattive$ Claus Ro!t$ %on %owland$
Michael 8arson and Bryan %ich.
3ow Much Do Firs 3ed!e Lith DerivativesM
Sebi allows ar(et0a(in! in illi=uid e=uity derivatives by :rait
Bhattacharya$ in "he Lall Street 6ournal.
A&le roo for India>s e=uity derivatives ar(et to !row by By Mobis
:hili&ose in "he Lall Street 6ournal.
7,