What are derivatives?
Derivatives are financial contracts, which derive their value off a spot price time-series, which is called "the underlying". The underlying asset can be equity, index, commodity or any other asset. Some common examples of derivatives are Forwards, Futures, Options and Swaps.
Derivatives help to improve market efficiencies because risks can be isolated and sold to those who are willing to accept them at the least cost. Using derivatives breaks risk into pieces that can be managed independently. From a market-oriented perspective, derivatives offer the free trading of financial risks.
What is the importance of derivatives?
There are several risks inherent in financial transactions. Derivatives are used to separate risks from traditional instruments and transfer these risks to parties willing to bear these risks. The fundamental risk involved in derivative business includes:
- Credit Risk
This is the risk of failure of counterparty to perform its obligation as per the contract. Also known as default or counterparty risk, it differs with different instruments.
- Market Risk
Market risk is a risk of financial loss as a result of adverse movements of prices of the underlying asset/instrument.
- Liquidity Risk
The inability of a firm to arrange a transaction at prevailing market prices is termed as liquidity risk. A firm faces two types of liquidity risks
- Related to liquidity of separate products
- Related to the funding of activities of the firm including derivatives.
- Legal Risk
Derivatives cut across judicial boundaries, therefore the legal aspects associated with the deal should be looked into carefully.
What are the various types of derivatives?
Derivatives can be classified into four types:
- Forwards
- Futures
- Options
- Swaps
Who are the operators in the derivatives market?
- Hedgers - Operators, who want to transfer a risk component of their portfolio.
- Speculators - Operators, who intentionally take the risk from hedgers in pursuit of profit.
- Arbitrageurs - Operators who operate in the different markets simultaneously, in pursuit of profit and eliminate mis-pricing.
Forwards
What is a Forward contract?
In a forward contract, two parties agree to do a trade at some future date, at a price and quantity agreed today. No money changes hands at the time the deal is signed.
What are the features of Forward contract?
The main features of forward contracts are
- They are bilateral contracts and hence exposed to counter-party risk.
- Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality.
- The contract price is generally not available in public domain.
- The contract has to be settled by delivery of the asset on expiration date.
In case, the party wishes to reverse the contract, it has to compulsorily go to the same counter party, which being in a monopoly situation can command the price it wants.
Index Futures
What are Index Futures?
Index Futures are Future contracts where the underlying asset is the Index. This is of great help when one wants to take a position on market movements.
What are the uses of Index Futures?
Index futures can be used for hedging, speculating, arbitrage, cash flow management and asset allocation.
How are Index Futures valued?
The theoretical way of valuing any future contract is as follows:
Future value = Spot price + carry cost – carry returns
Where,
Spot price = current index
Carry cost = Holding cost of the future index
Carry return = Dividends accrued during the period of carry.
Pricing Futures
Cost and carry model of Futures pricing
- Fair price = Spot price + Cost of carry - Inflows
- FPtT = CPt + CPt * (RtT - DtT) * (T-t)/365
Where,
- FPtT - Fair price of the asset at time t for time T.
- CPt - Cash price of the asset.
- RtT - Interest rate at time t for the period up to T.
- DtT - Inflows in terms of dividend or interest between t and T.
- Cost of carry = Financing cost, Storage cost and insurance cost.
- If Futures price > Fair price; Buy in the cash market and simultaneously sell in the futures market.
-
If Futures price < Fair price; Sell in the cash market and simultaneously buy in the futures market.
This arbitrage between Cash and Future markets will remain till prices in the Cash and Future markets get aligned.
Set of assumptions
- No seasonal demand and supply in the underlying asset.
- Storability of the underlying asset is not a problem.
- The underlying asset can be sold short.
- No transaction cost; no taxes.
No margin requirements, and so the analysis relates to a forward contract, rather than a futures contract.
What is hedging?
Hedging is a mechanism to reduce price risk inherent in open positions. Derivatives are widely used for hedging. A Hedge can help lock in existing profits. Its purpose is to reduce the volatility of a portfolio, by reducing the risk.
Hedging does not mean maximization of return. It only means reduction in variation of return. It is quite possible that the return is higher in the absence of the hedge, but so also is the possibility of a much lower return.
What are the general hedging strategies?
The basic logic is "If long in cash underlying - Short Future and If short in cash underlying - Long Future". If you have bought 100 shares of Company A and want to Hedge against market movements, you should short an appropriate amount of Index Futures. This will reduce your overall exposure to events affecting the whole market (systematic risk). In case a war breaks out, the entire market will fall (most likely including Company A). So your loss in Company A would be offset by the gains in your short position in Index Futures.
Some examples of where hedging strategies are useful include:
- Reducing the equity exposure of a Mutual Fund by selling Index Futures;
- Investing funds raised by new schemes in Index Futures so that market exposure is immediately taken; and
- Partial liquidation of portfolio by selling the index future instead of the actual shares where the cost of transaction is higher.
What is hedge ratio?
The hedge ratio is defined as the number of Futures contracts required to buy or sell so as to provide the maximum offset of risk. This depends on the
- Value of a Futures contract;
- Value of the portfolio to be Hedged; and
- Sensitivity of the movement of the portfolio price to that of the Index (Called Beta).
The Hedge Ratio is closely linked to the correlation between the asset (portfolio of shares) to be hedged and underlying (index) from which Future is derived.
Who are hedgers, speculators and arbitrageurs?
Hedgers wish to eliminate or reduce the price risk to which they are already exposed. Speculators are those class of investors who willingly take price risks to profit from price changes in the underlying. Arbitrageurs profit from price differential existing in two markets by simultaneously operating in two different markets. All class of investors are required for a healthy functioning of the market.
Hedgers and investors provide the economic substance to any financial market. Without them the markets would lose their purpose and become mere tools of gambling. Speculators provide liquidity and depth to the market. Arbitrageurs bring price uniformity and help price discovery.
The market provides a mechanism by which diverse and scattered opinions are reflected in one single price of the underlying. Markets help in efficient transfer of risk from Hedgers to speculators. Hedging only makes an outcome more certain. It does not necessarily lead to a better outcome.
What are hedge funds?
A hedge fund is a term commonly used to describe any fund that isn’t a conventional investment fund, i.e., it uses strategies other than investing long. For example
- Short selling
- Using arbitrage
- Trading derivatives
- Leveraging or borrowing
- Investing in out-of-favour or unrecognized undervalued securities
The name hedge fund is a misnomer as the funds may not actually hedge against risk. The returns can be high, but so can be losses. These investments require expertise in particular investment strategies. The hedge funds tend to be specialized, operating within a given niche, specialty or industry that requires the particular expertise.
What are the general strategies for speculating?
In general, the speculator takes a view on the market and plays accordingly. If one is bullish on the market, one can buy Futures, and vice versa for a bearish outlook.
There is another strategy of playing the spreads, in which case the speculator trades the "basis". When a basis risk is taken, the speculator primarily bets on either the cost of carry (interest rate in case of index futures) going up (in which case he would pay the basis) or going down (receive the basis).
Pay the basis implies going short on a future with near month maturity while at the same time going long on a future with longer term maturity.
Receiving the basis implies going long on a future with near month maturity while at the same time going short on a future with longer term maturity.
What are long/ short positions?
In simple terms, long and short positions indicate whether you have a net over-bought position (long) or over-sold position (short).
What is gearing?
Gearing (or leveraging) measures the value of your position as a ratio of the value of the risk capital actually invested. In case of index futures, if the margin requirement is 5%, the gearing possible is 20times as on a given fund availability, an investor can take a position 20 times in size.
What is price risk?
Price risk is defined as the standard deviation of returns generated by any asset. This indicates how much individual outcomes deviate from the mean. For example, an asset with possible returns of 5%, 10% and 15% is more risky than one with possible returns of –10%, 1% and 25%.
What are the different types of price risk?
Diversifiable risk (also known as non market risk or unsystematic risk) of a security arises from the security specific factors like strike in factory, legal claims, non availability of raw material, etc. This component of risk can be reduced by diversification.
Non-diversifiable risk (also known as systematic risk or market risk) is an outcome of economy related events like diesel price hike, budget announcements, etc that affect all the companies. As the name suggests, this risk cannot be diversified away using diversification or adding stocks in portfolio.
Can price risk be controlled?
Yes, but to an extent. As mentioned earlier, the different types of price risk impacting any stock or company can be classified into two categories:
- Company specific; and
-
Economy or market related.
The Company specific risks (also known as diversifiable risk or non-market risk or unsystematic risk) can be reduced by proper diversification.
What is beta and a tick size?
Beta measures the sensitivity of the stock compared to the index. Tick size is the minimum price difference between the two quotes of a similar nature. The tick size is 0.1 point of the BSE Sens*x, which is equivalent to Rs 5. In case of Nifty, tick size is 0.05 which is equal to Rs 10.
What are circuit breakers or circuit filters?
Circuit breaker means trading is halted for a specified period in stocks or / and stock index futures, if the market price moves out of a pre-specified band. Circuit filters do not result in trading halt but no order is permitted if it falls out of the specified price range.
Advantages
- Allows participants to gather new information and to assess the situation - controls panic.
- Brokerages firms can check on customer funding and compliance.
- Exchanges/ Clearing houses can monitor their members.
Disadvantages
- Only postpones the inevitable.
- Limits the flow of market information – no one knows the real value of a stock.
- They precipitate the matter during volatile moves as participants’ rush to execute their orders before anticipated trading halt.
What is margin money?
The aim of margin money is to minimize the risk of default by either counter-party. The payment of margin ensures that the risk is limited to the previous day’s price movement on each outstanding position. However, even this exposure is offset by the initial margin holdings.
Margin money is like a security deposit or insurance against a possible Future loss of value.
Are there different types of margin?
Yes, there can be different types of margin like initial margin, variation margin, maintenance margin and additional margin.
What is the objective of initial margin?
The basic aim of initial margin is to cover the largest potential loss in one day. Both buyer and seller have to deposit margins. The initial margin is deposited before the opening of the day of the Futures transaction. Normally this margin is calculated on the basis of variance observed in daily price of the underlying (say the index) over a specified historical period (say immediately preceding 1 year). The margin is kept in a way that it covers price movements more than 99% of the time. Usually three sigma (standard deviation) is used for this measurement. This technique is also called value at risk (or VAR).
Based on the volatility of market indices in India, the initial margin is expected to be around 8-10%.
What is variation or mark-to-market margin?
All daily losses must be met by depositing of further collateral - known as variation margin, which is required by the close of business, the following day. Any profits on the contract are credited to the client’s variation margin account.
What is the concept of maintenance margin?
Some exchanges work on the system of maintenance margin, which is set at a level slightly less than initial margin. The margin is required to be replenished to the level of initial margin, only if the margin level drops below the maintenance margin limit. For e.g.. If Initial Margin is fixed at 100 and Maintenance margin is at 80, then the broker is permitted to trade till such time that the balance in this initial margin account is 80 or more. If it drops below 80, say it drops to 70, then a margin of 30 (and not 10) is to be paid to replenish the levels of initial margin. This concept is not expected to be used in India.
What is the concept of additional margin?
In case of sudden higher than expected volatility, additional margin may be called for by the exchange. This is generally imposed when the exchange fears that the markets have become too volatile and may result in some crisis, like payments crisis, etc. This is a preemptive move by exchange to prevent breakdown.
What is the concept of cross margining?
This is a method of calculating margin after taking into account combined positions in Futures, options, cash market etc. Hence, the total margin requirement reduces due to cross-Hedges. This is unlikely to be introduced in India immediately.
Who is a market maker?
A dealer is said to make a market when he quotes both bid and offer prices at which he stands ready to buy and sell the security. Thus, he is a person that brings buyers and sellers together. He lends liquidity in the system by making trading feasible.
What is marked-to-market?
This is an arrangement whereby the profits or losses on the position are settled each day. This enables the exchange to keep appropriate margin so that it is not so low that it increases chances of defaults to an unacceptable level (by collecting MTM losses) and is not so high that it increases the cost of transactions to an unreasonable level ( by giving MTM profits).
FUTURES IN INDIA
The National Stock Exchange commenced trading in Index Futures on 12 June, 2000. The NIFTY futures contracts are based on the popular market benchmark S&P CNX NIFTY Index.
Security descripttor
The security descripttor for the S&P CNX Nifty futures contracts will be:
Market type : N
Instrument Type : FUTIDX
Underlying : NIFTY
Expiry date : Date of contract expiry
Trading cycle
S&P CNX Nifty futures contracts have a maximum of 3-month trading cycle - the near month (one), the next month (two) and the far month (three). A new contract will be introduced on the trading day following the expiry of the near month contract.
Expiry day
S&P CNX Nifty futures contracts expire on the last Thursday of the expiry month. If the last Thursday is a trading holiday, the contracts shall expire on the previous trading day.
Contract size
The permitted lot size of S&P CNX NIFTY contracts is 200 and multiples
Price steps for contracts
The price step in respect of NIFTY futures contracts is Re. 0.05.
Price bands
There is no day minimum/maximum price ranges applicable for Futures contract. However in order to prevent erroneous order entry by trading members the operating ranges are kept at + 10 %. In respect of orders which have come under price freeze, the members would be required to confirm to the Exchange that there is no inadvertent error in the order entry and that the order is genuine. On such confirmation the Exchange may approve such order.
What is the underlying for Sens*x Futures?
The underlying for the Sens*x Futures is the BSE Sensitive Index of 30 scrips, popularly called the Sens*x.
What is the contract multiplier?
The contract multiplier is 50. This means that the Rupee notional value of a futures contract would be 50 times the contracted value.
What is the maturity of the futures contract?
Regulations permit introduction of futures up to 12 months maturity. Initially, however, futures for the three near months have been introduced. On 9 June the three futures for June, July and August 2000 were started. These futures would expire on 29 June, 27 July and 31 August respectively. This is because the expiry date has been fixed as the last Thursday of the month for each month. The day after the expiry, a new future would come into existence for three-month maturity. For example on 30 June, the September future would come into existence. This future would expire on 28 September, being the last Thursday of the month.
What is the tick size?
The tick size is "0.1". This means that the minimum price fluctuation in the value of a future can be only 0.1. In Rupee terms, this translates to minimum price fluctuation of Rs. 5 ( Tick size X Contract Multiplier = 0.1 X Rs. 50).
How is the final settlement price determined?
The futures closing price will be calculated based on a set of 120 price points of the cash sens*x values taken between the last half an hour of trading. The highest and lowest 20 price points will be ignored and the closing price computed as an average of the remaining 80 price points. This process will ensure that manipulation of the closing price by moving it in one direction for a short duration or for only a few contracts is eliminated.
What happens to the profit or loss due to daily settlement?
In case the position is not closed the same day, the daily settlement would alter the cash flows depending on the settlement price fixed by the exchange every day. However the net total of all the flows every day would always be equal to the profit or loss calculated above. Profit or loss would only depend upon the opening and closing price of the position, irrespective of how the rates have moved in the intervening days.
How does the initial margin affect the above profit or loss?
The initial margin is only a security provided by the client through the clearing member to the exchange. It can be withdrawn in full after the position is closed. Therefore it does not affect the above calculation of profit or loss.
However there would may be a funding cost / transaction cost in providing the security. This cost must be added to your total transaction costs to arrive at the true picture. Other items in transaction costs would include brokerage, stamp duty etc.
Options
What is an Option?
Options are contracts that confer on the buyer of the contract certain rights (rights to buy or sell an asset) for a predetermined price on or before a pre-specified date. The buyer of the option has the right but not the obligation to exercise the option.
Options come in a variety of forms. Some Option contracts, which have been standardized, are traded on recognized exchanges. Other Option contracts exist that are traded "over-the-counter", i.e., a market where financial institutions and corporates trade directly with each other over the phone. Besides these, options also exist in an embedded form in several instruments.
They popular basic instruments/variables underlying options are:
- Equity – Index Options, Options on individual stocks, Employee Stock Options
- Interest rates – Bond Options, Interest rate Futures Options, Options embedded in bonds, caps & floors, etc
- Foreign exchange – Plain vanilla calls and puts, barrier Options, various kinds of exotic Options
- Others – including commodities, weather, electricity, etc.
Classification
- Option Seller - One who gives/writes the option. He has an obligation to perform, in case option buyer desires to exercise his option.
- Option Buyer - One who buys the option. He has the right to exercise the option but no obligation.
- Call Option - Option to buy.
- Put Option - Option to sell.
- American Option - An option, which can be exercised anytime on or before the expiry date.
- European Option - An option, which can be exercised only on expiry date.
- Strike Price/ Exercise Price - Price at which the option is to be exercised.
- Expiration Date - Date on which the option expires.
- Exercise Date - Date on which the option gets exercised by the option holder/buyer.
- Option Premium - The price paid by the option buyer to the option seller for granting the option.
What are Call Options?
A call option gives the holder (buyer/ one who is long call), the right to buy specified quantity of the underlying asset at the strike price on or before expiration date.
The seller (one who is short call) however, has the obligation to sell the underlying asset if the buyer of the call option decides to exercise his option to buy.
What are Put Options?
A Put option gives the holder (buyer/ one who is long Put), the right to sell specified quantity of the underlying asset at the strike price on or before a expiry date.
The seller of the put option (one who is short Put) however, has the obligation to buy the underlying asset at the strike price if the buyer decides to exercise his option to sell.
What are Covered and Naked Calls?
A call option position that is covered by an opposite position in the underlying instrument (for example shares, commodities etc), is called a covered call.
Writing covered calls involves writing call options when the shares that might have to be delivered (if option holder exercises his right to buy), are already owned.
E.g. A writer writes a call on Reliance and at the same time holds shares of Reliance so that if the call is exercised by the buyer, he can deliver the stock.
Covered calls are far less risky than naked calls (where there is no opposite position in the underlying), since the worst that can happen is that the investor is required to sell shares already owned at below their market value.
When a physical delivery uncovered/ naked call is assigned an exercise, the writer will have to purchase the underlying asset to meet his call obligation and his loss will be the excess of the purchase price over the exercise price of the call reduced by the premium received for writing the call.
What is the Intrinsic Value of an option?
The intrinsic value of an option is defined as the amount by which an option is in-the-money, or the immediate exercise value of the option when the underlying position is marked-to-market.
For a call option: Intrinsic Value = Spot Price - Strike Price
For a put option: Intrinsic Value = Strike Price - Spot Price
The intrinsic value of an option must be a positive number or 0. It cannot be negative. For a call option, the strike price must be less than the price of the underlying asset for the call to have an intrinsic value greater than 0. For a put option, the strike price must be greater than the underlying asset price for it to have intrinsic value.
Who are the players in the Options Market?
Developmental institutions, Mutual Funds, FIs, FIIs, Brokers, Retail Participants are the likely players in the Options Market.
An option gives a person the right but not the obligation to buy or sell something. An option is between two parties wherein the buyer receives a privilege for which he pays a fee (premium) and the seller accepts an obligation for which he receives a fee. The premium is the price negotiated and set when the option is bought or sold. A person who buys an option is said to be long in the option. A person who sells (or writes) an option is said to be short in the option.
How Nifty Options will work
NSE plans to commence trading in Index options shortly. The proposed contract specifications for Index options are as below:
Underlying Index:
S&P CNX Nifty
Contract Size
Permitted lot size shall be 200 or multiples thereof
Price steps for contracts
The price step in respect of NIFTY options contracts is Re. 0.05.
Price bands
not applicable
Style
European/American
Trading cycle
The options contract will have a maximum of three months trading cycle- the near month (one), the next month (two) and the far month (three). New contract will be introduced on the next trading day following the expiry of the near month contract
Expiry day
The last Thursday of the expiry month or the previous trading day if the last Thursday is a trading holiday.
Settlement basis
Cash settlement on a T + 1 basis
Settlement prices
Based on expiration price as may be decided by the Exchange
SWAPS
What is a swap?
A swap is nothing but a barter or exchange but it plays a very important role in international finance. A swap is the exchange of one set of cash flows for another. A swap is a contract between two parties in which the first party promises to make a payment to the second and the second party promises to make a payment to the first. Both payments take place on specified dates. Different formulas are used to determine what the two sets of payments will be.
Classification of swaps is done on the basis of what the payments are based on. The different types of swaps are as follows.
- Interest rate swaps
- Currency Swaps
- Commodity swaps
- Equity swaps
Interest rate swaps
The interest rate swap is the most frequently used swap. An interest rate swap generally involves one set of payments determined by the Eurodollar (LIBOR) rate. Although, it can be pegged to other rates. The other set is fixed at an agreed-upon rate. This other agreed upon rate usually corresponds to the yield on a Treasury Note with a comparable maturity. Although, this can also be variable.
Additionally, there will be a spread of a pre-determined amount of basis points. This is just one type of interest rate swap. Sometimes payments tied to floating rates are used for interest rate swaps. The notional principal is the exchange of interest payments based on face value. The notional principal itself is not exchanged. On the day of each payment, the party who owes more to the other makes a net payment. Only one party makes a payment.
Currency swaps
A currency swap is an agreement between two parties in which one party promises to make payments in one currency and the other promises to make payments in another currency. Currency swaps are similar yet notably different from interest rate swaps and are often combined with interest rate swaps.
Currency swaps help eliminate the differences between international capital markets. Interest rates swaps help eliminate barriers caused by regulatory structures. While currency swaps result in exchange of one currency with another, interest rate swaps help exchange a fixed rate of interest with a variable rate. The needs of the parties in a swap transaction are diametrically different. Swaps are not traded or listed on exchange but they do have an informal market and are traded among dealers.
A swap is a contract, which can be effectively combined with other type of derivative instruments. An option on a swap gives the party the right, but not the obligation to enter into a swap at a later date.
Commodity swaps
In commodity swaps, the cash flows to be exchanged are linked to commodity prices. Commodities are physical assets such as metals, energy stores and food including cattle. E.g. in a commodity swap, a party may agree to exchange cash flows linked to prices of oil for a fixed cash flow.
Commodity swaps are used for hedging against
- Fluctuations in commodity prices or
- Fluctuations in spreads between final product and raw material prices (E.g. Cracking spread which indicates the spread between crude prices and refined product prices significantly affect the margins of oil refineries)
A Company that uses commodities as input may find its profits becoming very volatile if the commodity prices become volatile. This is particularly so when the output prices may not change as frequently as the commodity prices change. In such cases, the company would enter into a swap whereby it receives payment linked to commodity prices and pays a fixed rate in exchange. A producer of a commodity may want to reduce the variability of his revenues by being a receiver of a fixed rate in exchange for a rate linked to the commodity prices.
Equity swaps
Under an equity swap, the shareholder effectively sells his holdings to a bank, promising to buy it back at market price at a future date. However, he retains a voting right on the shares.
What are the components of a swap price?
There are four major components of a swap price.
- Benchmark price
- Liquidity (availability of counter parties to offset the swap).
- Transaction cost
- Credit risk
Benchmark price: Swap rates are based on a series of benchmark instruments. They may be quoted as a spread over the yield on these benchmark instruments or on an absolute interest rate basis. In the Indian markets the common benchmarks are MIBOR, 14, 91, 182 & 364 day T-bills, CP rates and PLR rates.
Liquidity: Liquidity, which is function of supply and demand, plays an important role in swaps pricing. This is also affected by the swap duration. It may be difficult to have counterparties for long duration swaps, especially so in India.
Transaction Costs: Transaction costs include the cost of hedging a swap. Say in case of a bank, which has a floating obligation of 91 day T. Bill. Now in order to hedge the bank would go long on a 91 day T. Bill. For doing so the bank must obtain funds. The transaction cost would thus involve such a difference.
Yield on 91 day T. Bill - 9.5%
Cost of fund (e.g.- Repo rate) – 10%
The transaction cost in this case would involve 0.5%
Credit Risk: Credit risk must also be built into the swap pricing. Based upon the credit rating of the counterparty a spread would have to be incorporated. Say for e.g. it would be 0.5% for an AAA rating.
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