DERIVATIVES

A derivative is a security whose price ultimately depends on that of another asset called underlying asset. Derivative means forward, futures or option contract of predetermined fixed duration, linked for the purpose of contract fulfillment to the value of specified real or financial asset or to an index security L.C. Gupta Committee

 A financial derivative is described as a financial contract whose value is derived from the performance of financial assets, interest rates, currency exchange rates or stock market indices. Financial derivatives have been used as a tool for hedging the risk involved in buying, holding and selling various kinds of financial assets.

Classification of Derivatives
Derivatives are classified on the basis of the following features:

1. Nature of Contract
- Forwards - Futures - Options and - Swaps

2.Underlying Asset
- Foreign Exchange - Interest Rate - Commodities and - Equities

3. Market Mechanism
- Exchange Traded Derivatives - OTC derivatives

Exchange Traded Derivatives Derivatives that are created and traded in an organized exchanges at the national and regional level are called exchange traded derivatives. Over The Counter Derivatives Derivatives that are created and traded in an international network of dealers and end-users in which transactions are executed privately is called over the counter derivatives.

Features of Derivatives 1. Relation between the values of derivatives and their underlying assets. 2. It is easier to take short position in derivatives than in other assets. 3. Exchange traded derivatives are liquid and have low transaction cost. 4. It is possible to construct portfolio which is exactly needed, without having the underlying asset.

Participants in Derivative Markets The participants can be banks, FIs, Corporates, Brokers, Individuals, etc. All these participants can be classified in to three categories: 1. Hedgers 2. Speculators 3. Arbitrageurs

Major Derivatives Exchanges in the World

Chicago Board of Trade Chicago Mercantile Exchange Australian Options Market Commodity Exchange, New York London Commodity Exchange London Securities and Derivatives Exchange London Metal Exchange Singapore International Financial Futures Exchange Sydney Futures Exchange Tokyo International Financial Futures Exchange National Stock Exchange, etc.

Derivative Market in India

On December 1999, the Securities Contract Regulation Act was amended to include derivatives within the sphere of securities. Derivatives trading commenced in June 2000. SEBI approved trading in Index Futures Contracts based on Nifty and Sensex. Trading in index options commenced in June 2001, options on individual securities in July 2001 and Futures on individual stocks in November 2001.

FORWARDS
It is a contract between two parties to buy or sell an underlying asset at todays pre-agreed price on a specified date in the future. It is the most basic form of derivative contract. These contracts are not standardized, the end users can tailor make the contracts to fit their very specific needs.

FUTURES
Futures are financial contracts to eliminate the risk of change in price in the future date. Futures are highly standardized contracts for either deferred delivery of some underlying asset or a final cash settlement based on some clearly defined rules. These contracts are traded on organized futures exchanges. Going Short : The act of selling. Going Long : The act of buying. Futures Price: The price agreed by the two traders on the floor of exchange.

Futures Contract It is defined as an agreement to buy or sell a standard quantity of a specific instrument at a predetermined future date and at a price agreed between the parties through open outcry on the floor of an organized futures exchange.

Margin It is the initial deposit required to open a trading account in a futures trading exchange. The initial margin is fixed by the broker, but has to satisfy an exchange minimum. The variation margin i.e. the change in the amount of an account on a given day in response to a market tomarket process, is settled on daily basis. It is called margin transfers

 Initial Margin The amount that must be deposited in the margin account when establishing a position. Marking to Market In the futures market at the end of each trading day, the margin account is adjusted to reflect the investors gain or loss depending upon the futures closing account. Maintenance Margin This is set to ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin, the investor is expected to top up the initial level before trading commences on the next day.

Advantages of Futures
The futures are considered to be better than forwards because of the following reasons: Standard volume Liquidity Counterparty guarantee by exchange Intermediate cash flows

Types of Futures
Basically there are two types of futures. They are:

Commodity futures (Wheat, corn, etc.) and Financial futures

Financial futures include:

Foreign currencies Interest rate Market index futures (Market index futures are directly related with the stock market) Individual stock.

Difference between Futures and Forwards

Futures contracts are traded on futures exchanges while forward contracts are traded in over- the-counter dealer type markets. Futures contracts are highly standardized, with all contract terms, except price, defined by the exchange on which they trade. But forward contracts are negotiated between the contracting parties with all contract terms subject to mutual agreement. A clearing association stands between the parties to a futures contract. As a result, counterparties identities are irrelevant. But in a forward contract each party is directly responsible to the other, and consequently, the identities of the counter parties are critically important. Futures markets are usually regulated, while forward markets in general are not regulated.

 The financial integrity of the futures markets is protected by requiring each party to a contract to post a performance bond called margin. Through a market-tomarket process, with corresponding transfers of margin, each party to a contract is assured of the other partys performance. No such market-wide systematic margining requirement is employed in the forward markets. Consequently, market makers in the forward markets tend to limit their contracting to parties who are wellknown to them. The institutional structure of futures contracts makes them very easy to terminate via simple offsetting transactions. Forward contracts are much more difficult to terminate in fact, termination is often not possible.

 Credit risk is almost not in futures market but in forward market credit risk depends on the counterparty. Transactions costs like commission, clearing charges, exchange fees etc. are high in the case of futures contracts where as transaction costs are generally low in the case of forward contracts. Valuation in futures are based on market tomarket every day, while there is no unique method of valuation in forward contract.

Open Interest It is the number of outstanding futures contracts. In other words, the number of futures contracts that have to be settled on or before maturity date.

OPTIONS
An option is a contract between two parties in which one party has the right but not the obligation to buy or sell some underlying asset on a specified date at a specified price. The option buyer has the right not an obligation to buy or sell. If the buyer decides to exercise his right the seller of the option has an obligation to deliver or take delivery of the underlying asset at the price agreed upon.

Types of Options
On the basis of the nature of the rights and obligations in the option contract, options are classified in to two categories. They are: Call Options and Put Options.

CALL OPTIONS
A call option is a contract that gives the option holder the right to buy some underlying asset from the option seller at a specified price on or before a specified date. Eg. The current market price Ashok Leyland is Rs.69. An option contract is created and traded on this share. A call option on the share would give the right to buy the share at a specified price (Rs.70) during September 2010. This call option would be traded between two parties P (the purchaser and S ( the seller). The purchaser P would be prepared to pay a small price known as option premium (Rs.2) to S, the seller of the option.

PUT OPTIONS
A put option is a contract which gives its owner the right to sell some underlying asset at a specified price on or before a specified date. The seller of the put option has the obligation to take delivery of the underlying asset, if the owner of the option decides to exercise the option.

 Option Writer or Option Grantor: The seller of option. Strike price or Exercise price : The price at which the option holder may purchase the underlying asset from the option seller. Time to Expiration or Time to Expiry : The period of time specified for exercising the option. Expiration Date : The precise date on which the option right expires.

Types of Options
On the basis of maturity pattern of options, option contracts are categorized in to two. They are: European Style Options American Style Options

 European Style Options Options which can be exercised only on the maturity date of the option or on the expiry date. American Style Options Options which can be exercised at any time up to and including the expiry date. Most of the exchange traded options are American style. In India stock options are American style while index options are European style.

Types of Options
Based on the mode of trading options are classified in to two: Over-the-counter Options Exchange Traded Options

 Over-the-counter Options OTC options result from private negotiations between two parties i.e. a bank and a client. In OTC options, financial institutions and corporate clients trade directly with each other and the terms of the option contracts are tailored by a financial institution to meet the specific needs of a corporate client. OTC options on foreign exchange and interest rate.

 Exchange Traded Options These are options which are bought and sold on organized exchanges. These options are standardized as to the amount and exercise price of the underlying asset, the nature of the underlying asset and the available expiry dates. Options are traded in the futures and options segment of BSE and NSE. Trading in Nifty index commenced in June 2001 and on shares started in July 2001.

Moneyness of Options
Moneyness of an option describes the relationship between the strike price of the option and the current stock price. This takes three forms: 1. In the Money 2. At the Money 3. Out of the Money

1. In the Money Options When the strike price of a call option is lower than the current stock price, the option is said to be in the money. This is because the owner of the option has the right to buy the stock at a price which is lower than the price which he has to pay if he had to buy it from the open market. Similarly in the case of put option, when the strike price is greater than the stock price, the option is said to be in the money. If an in the money option is exercised, there will be an immediate cash inflow.

2. At the Money Options When the strike price of a call option is equal to the current stock price, the option is said to be at the money option. In the case of a put option if the strike price of the option is equal to the stock price, the put option is said to be at the money.

3. Out of the Money When the strike price of a call option is more than the stock price, the option is termed as out of the money option. In the case of put option, if the strike price is less than the stock price, the option is said to be out of the money option.

When the Shares of A Ltd. is Trading at Rs.450

Strike Price (Rs.) 420 430 440 450 460 470 480 Out of the Money In the Money At the Money At the Money In the Money Out of the Money Call Option Put Option

References
John C Hull, Options, Futures and other Derivatives, Pearson Education. David A and Thomas W, Derivatives, Oxford University Press. Marshall, J. F. and Bansal, V. K, Financial Engineering: A Complete Guide to Financial Innovation, Prentice Hall of India. Kumar S.S.S, Financial Derivatives, PHI Learning. Rene M Stulz, Risk Management, Thomson.