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Derivatives & Derivatives Market

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Meaning Derivative comes from the word “ to derive” A derivative is a contract whose value is derived from the value of another asset called underlying asset. This underlying asset could be a share, a stock market Index, interest rate, currency, commodity etc. The prices in the derivatives market are driven by the spot or cash market price of the underlying asset.

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Purpose of using derivative Insurance provides protection against specific risks like fire, floods, theft, etc. Derivatives provide protection against market risks associated with Finance.

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Types of Derivatives Commodity Derivatives (underlying assets are Wheat, corn, sugarcane, soyabean, rice, orange, crude oil, gold, silver etc.). Financial derivatives the underlying assets include: Foreign currencies Interest rate Market index futures (Market index futures are directly related with the stock market) Individual stock.

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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 market risk, interest rate risk & exchange rate risk.

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Types of Financial Derivatives Forwards Futures Options Warrants Swaps Swaptions

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OTC (over-the-counter) contracts, such as forwards and swaps, are bilaterally negotiated between two parties. The terms of an OTC contract are flexible, and are often customized to fit the specific requirements of the user. OTC contracts have substantial credit risk which is the risk that the counterparty that owes money defaults on the payment. An exchange-traded contract, such as a futures contract, has a standardized format that specifies the underlying asset to be delivered, the size of the contract, and the logistics of delivery. They trade on organized exchanges with prices determined by the interaction of many buyers and sellers. In India, two exchanges offer derivatives trading: BSE & NSE . NSE now accounts for virtually all exchange-traded derivatives in India, accounting for more than 99% of volume in 2003-2004. Exchange Traded vs Over the counter contracts

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

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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.

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Derivative Market in India Derivative market was known as Tezi-mandi in 1960s & forward trading was done in this market. In 1969 govt. banned all forward trading but allowed it only for rupee dollar exchange rates. On December 1999, the Securities Contract Regulation Act was amended to include derivatives within the sphere of securities. Derivative trading formally commenced in June 2000 on BSE & NSE.

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Forwards & Futures Forwards are OTC traded customised contracts between two parties where settlement takes place on a specific date in the future at a price agreed upon by buyers & sellers today. Futures are Exchange traded standardised contracts between two parties where settlement takes place on a specific date in the future at a price agreed upon by buyers & sellers today. One party takes LONG position (by agreeing to buy at a certain date & price & becomes the owner) & other party takes a short position (by agreeing to sell the asset at a same time & price of which he is not an owner)

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Futures vs Forwards Futures are ETC while Forwards are OTC. Only price is negotiated, while all elements are negotiated in forwards. Transparency is there in the futures but not in forwards. Futures are more liquid & flexible. Do not carry credit risk as there is a clearing house & as a result, counterparties’ identities are irrelevant. but in forwards investors are exposed to default risk as no clearing house is there. Futures have a regulated market while forwards do not have. Futures are marked-to-market daily but forwards are not. Transactions costs like commission, clearing charges, exchange fees etc. are high in the case of futures contracts where as transaction costs are low in the case of forward contracts.

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Futures vs Forwards thru an example The standard contract size (amount of asset that has to be delivered under one contract) on NSE’s futures market is 200 Nifties. If anybody wants to take less than 200 Nifties, he should enter into a forward market & not futures market.

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Options Contracts that give the holder the right but not the obligation to buy or sell underlying assets at a particular strike or exercise price. The holder has the option to exercise the right , unlike futures & forwards. For this advantage, the holder has to pay a price known as option premium to the option writer. It can be ETC or OTC. The option writer is obliged to fulfill his obligation if the holder wants to exercise his right. Two types: Call & Put option

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Call option Call option is the right to buy the underlying asset at a specified price on or before a particular day by paying a premium. It represents a Long position.

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Example of Call option An investor buys a call option to buy 500 Infosys shares at Rs. 1000 per share on 15 th Dec. 2010. The premium is Rs. 100 per share i.e. Rs. 50,000. On 15 th Dec. 2010, the price of Infosys’s share becomes 1200 per share, the holder of call option will exercise his right by buying shares at Rs. 1000 per share in the derivative market & will sell at Rs. 1200 per share in the spot market. He can gain 1,00,000 (6,00,000 – 5,00,000) But Net gain = 1,00,000 – 50,000 = 50,000.

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Example contd.. If the price becomes 800 per share on 15 th Dec. 2010 the Investor will not exercise his option & has to bear a loss of Rs. 50,000 only.

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Put option Put option is the right to sell the underlying asset at a specified price on or before a particular day by paying a premium. It represents a short position.

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Example of Put option An investor buys a put option to sell 500 Infosys shares at Rs. 1,000 per share on 15 th Dec. 2010. The premium is Rs. 100 per share i.e. Rs. 50,000. On 15 th Dec. 2010, the price of Infosys’s share becomes 1,200 per share, the holder of put option will not exercise his right by selling shares & will bear a loss of Rs. 50,000.

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Example contd.. If the price becomes 800 per share on 15 th Dec. 2010 the Investor will exercise his put option & will sell the shares at Rs. 5,00,000 (500 X 1000) after buying the shares at Rs. 4,00,000 (500 X 800). His gain = 1,00,000 Net gain = 50,000

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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

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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.

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

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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.

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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.

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Clearing House Acts as a counter party to all deals in the derivatives market. Provides unconditional guarantee for settlement of all trades. It matches transactions & reconciles sales & purchases & does daily settlement. NSCCL (National Securities Clearing Corporation Limited) undertakes clearing & settlement of all deals executed on the NSE’s F & O segment. BACK

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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. Marking to Market – In the futures market at the end of each trading day, the margin account is adjusted to reflect the investor’s gain or loss depending upon the futures closing account. Through a market-to-market process, with corresponding transfers of margin, each party to a contract is assured of the other party’s performance. But it is not there in the forward markets hence market makers in the forward markets tend to limit their contracting to parties who are well-known to them. BACK

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