Derivatives Market

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Derivatives Market


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Types of Derivative Contracts:

Types of Derivative Contracts 3


FORWARD CONTRACTS These are promises to deliver an asset at a pre- determined date in future at a predetermined price . Forwards are highly popular on currencies and interest rates . The contracts are traded over the counter (i.e. outside the stock exchanges, directly between the two parties) and are customized according to the needs of the parties . Since these contracts do not fall under the purview of rules and regulations of an exchange, they generally suffer from counterparty risk i.e. the risk that one of the parties to the contract may not fulfill his or her obligation. 4


FUTURES CONTRACTS A futures contract is an agreement between two parties to buy or sell an asset at a certain time in future at a certain price. These are basically exchange traded , standardized contracts. The exchange stands guarantee to all transactions and counterparty. Thus risk is largely eliminated. The buyers of futures contracts are considered having a long position whereas the sellers are considered to be having a short position. Futures contracts are available on variety of commodities , currencies, interest rates, stocks and other tradable assets. They are highly popular on stock indices, interest rates and foreign exchange . 5


OPTIONS CONTRACT Options give the buyer (holder) a right but not an obligation to buy or sell an asset in future. Options are of two types - calls and puts . Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date. Buyer has a long position & the seller has a short position. 6


…..continued It should be noted that, in the first two types of derivative contracts ( forwards and futures ) both the parties (buyer and seller) have an obligation; i.e. the buyer needs to pay for the asset to the seller and the seller needs to deliver the asset to the buyer on the settlement date. In case of options only the seller (also called option writer) is under an obligation and not the buyer (also called option purchaser). The buyer has a right to buy (call options) or sell ( put options ) the asset from / to the seller of the option but he may or may not exercise this right. Incase the buyer of the option does exercise his right , the seller of the option must fulfill whatever is his obligation (for a call option the seller has to deliver the asset to the buyer of the option and for a put option the seller has to receive the asset from the buyer of the option). 7


…..continued An option can be exercised at the expiry of the contract period (which is known as European option contract) or anytime up to the expiry of the contract period (termed as American option contract ). 8


SWAPS Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts . The two commonly used swaps are: Interest rate swaps : These entail swapping only the interest related cash flows between the parties in the same currency . Currency swaps : These entail swapping both principal and interest between the parties, with the cash flows in one direction, being in a different currency, than those in the opposite direction. 9


HISTORY OF DERIVATIVE TRADING AT NSE Commenced on June 12 th 2000 with Futures Trading Subsequent trading in index options and options on individual securities commenced on June 4, 2001 and July 2, 2001 . NSE : largest Derivatives exchange in India. The derivatives contracts have a maximum of 3-month expiration cycles , except for a long dated Nifty Options contract which has a maturity of 5 years. Three contracts are available for trading, with 1 month, 2 months and 3 months to expiry . A new contract is introduced on the next trading day following the expiry of the near month contract. 10


PARTICIPANTS IN A DERIVATIVE MARKET Hedgers : These are investors with a present or anticipated exposure to the underlying asset which is subject to price risks. Hedgers use the derivatives markets primarily for price risk management of assets and portfolios. Speculators : These are individuals who take a view on the future direction of the markets . They take a view whether prices would rise or fall in future and accordingly buy or sell futures and options to try and make a profit from the future price movements of the underlying asset. 11


….continued Arbitrageurs : They take positions in financial markets to earn riskless profits . The arbitrageurs take short and long positions in the same or different contracts at the same time to create a position which can generate a riskless profit . 12


ECONOMIC FUNCTIONS OF THE DERIVATIVE MARKET H elp in discovery of future as well as current prices. H elps to transfer risks from those who have them but do not like them to those who have an appetite for them . With the introduction of derivatives, the underlying market witnesses higher trading volumes. Speculative trades shift to a more controlled environment in derivatives market. In the absence of an organized derivatives market, speculators trade in the underlying cash markets . 13


….continued The derivatives have a history of attracting many bright, creative, well-educated people with an entrepreneurial attitude. They often energize others to create new businesses, new products and new employment opportunities , the benefit of which are immense. 14


FUTURES TERMINOLOGY Spot price : The price at which an underlying asset trades in the spot market. Futures price : The price that is agreed upon at the time of the contract for the delivery of an asset at a specific future date . Contract cycle : It is the period over which a contract trades. The index futures contracts on the NSE have 1-mnth , 2-mnth & 3-mnth expiry cycles which expire on the last thursday of the month . Thus a January expiration contract expires on the last T hursday of Jan and a Feb expiration contract ceases trading on the last Thursday of Feb. On the Friday following the last Thursday, a new contract having a three-month expiry is introduced for trading. 15


….continued Expiry date : It is the date on which the final settlement of the contract takes place. Contract size : The amount of asset that has to be delivered under one contract. This is also called as the lot size . Basis : Basis is defined as the futures price minus the spot price. There will be a different basis for each delivery month for each contract. In a normal market, basis will be positive. This reflects that futures prices normally exceed spot prices. Cost of carry : {Storage cost + Interest} - Income Initial margin :The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin . 16


….continued Marking-to-market : In the futures market, at the end of each trading day, the margin account(stocks) is adjusted to reflect the investor’s gain or loss depending upon the futures closing price . Maintenance margin : Investors are required to place margins with their trading members before they are allowed to trade. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day. 17


OPTIONS TERMINOLOGY Index options : Have index as the underlying. They can be European or American. They are also cash settled. Stock options : They are options on individual stocks and give the holder the right to buy or sell shares at the specified price. They can be European or American. Buyer of an option : The buyer of an option is the one who by paying the option premium (price paid by buyer to seller) buys the right but not the obligation to exercise his option on the seller. Writer/Seller of an option : The writer of a call/put option is the one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him. 18


….continued Call option : It gives the holder right but not obligation to buy an asset by a certain date for a certain price. Put option : It gives the holder the right but not the obligation to sell an asset by a certain date for a certain price. Expiration date : The date specified in the options contract. Also called the exercise date, the strike date or the maturity. Strike price : The price specified in the options contract is known as the strike price or the exercise price. American options : These can be exercised at any time upto the expiration date. European options : These can be exercised only on the expiration date itself. 19


….continued In-the-money option : A call option on the index is said to be in-the-money when the current index stands at a level higher than the strike price. At-the-money option : An option on the index is at-the-money when the current index equals the strike price. Out-of-the-money option : A call option on the index is out-of-the money, when the current index stands at a level which is less than the strike price. Intrinsic value of an option : Intrinsic value of an option at a given time is the amount the holder of the option will get if he exercises the option at that time. 20


….continued Time value of an option : The time value of an option is the difference between its premium and its intrinsic value. Both calls and puts have time value. The longer the time to expiration, the greater is an option’s time value, all else equal. At expiration, an option should have no time value. 21

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