derivative market study notes

STUDY NOTES ON DERIVATIVE MARKET

INTRODUCTION

A derivative is a financial instrument whose value depends on underlying assets. The underlying assets could be prices of traded securities of gold, copper, aluminum and may even cover prices of fruits and flowers. Derivatives have become important in India since 1995, with the amendment of the Securities Contract Regulation Act of 1956.

Derivatives such as options and futures are traded actively on many exchanges. Forward contracts, swaps and different types of options are regularly traded outside exchanges by financial institutions, banks and corporate clients in over-the-counter markets. There is no single market place or an organized exchange.

Organized exchanges began trading in options on securities in 1973, whereas exchange traded debt options started trading in 1982. On the other hand, fixed income futures began trading in 1975, but equity related futures started trading in 1982. The reasons for debt options being stronger than futures are that stock exchanges tend to introduce those instruments that they think will be successful in trading.

In the equity market, a relatively large proportion of the total risk of a security is unsystematic. At the same time, many securities display a high degree of liquidity that can be expected to be maintained for long periods of time.

These to be successful, the underlying instruments have to be traded in large quantities and with some price continuity so that the option related transactions need not create more than a minor disturbance in the market.

In the debt market, a large proportion of the total risk of the security is systematic — in other words, the risk in debt instruments cannot be diversified by investing in a number of securities. Debt instruments are smaller in size in comparison to equity securities.

Derivatives can be classified as:

1. Commodities derivatives: These are derivatives on commodities like sugar, jute, paper, gur, castor seeds.

2. Financial Derivatives: These derivatives deal in shares, currencies and gilt-edged securities.

3. Basic Derivatives: Futures and Options are basic derivatives.

4. Complex Derivatives: Interest rate futures and swaps are classified as complex derivatives.

5. Exchange traded derivatives are standard contracts traded according to the rules and regulations of a stock exchange. Only members can trade in exchange traded derivatives and they are guaranteed against counter-party default. Contracts are settled daily.

6. OTC Derivatives are regulated by statutory provisions. Swaps, forward contracts in foreign exchange are usually OTC derivatives and have a high risk of default.

Participants in Derivatives Market:

Participants of derivatives market consists of the following:

1. Hedgers are those who try to minimize loses of both the parties entering into a derivative contract. At the same time, they protect themselves against price changes in the products that they deal in. They use options and futures and hedge in both financial derivatives and commodities derivatives.

2. Speculators participate in futures and options. They take high risks for potential gains. Their gains are unlimited but they can take positions and minimize their losses. They trade mainly in futures. They are the major players of the derivatives market.

3. Arbitrageurs enter into two transactions into two different stock markets. They are able to make a profit through the difference in price of the asset in different markets. They make a risk less profit but they have to analyze the market with speed to ensure profitability.

Types of Financial Derivatives

 

Basically there are two major types of financial derivatives i.e. 1. Futures 2. Options

1. Futures:

A futures contract is a legal right and obligation to buy or sell a standard quantity of a commodity, instrument or foreign currency on a specified future date at a price agreed between the two parties. The future contract helps both the parties reduce risk.

The producer faces an uncertain price, in case of over-supply of product; he may not realize the cost. On the other hand, the buyer also runs the risk of a higher price in case of scarcity. Futures helps one to do what he would have otherwise done without disturbing his portfolio and more economically.

A typical future contract could mean an investor agreeing on 26th July 1999 to buy 5 tons of wheat at a price of Rs. 700 on 26th December, 1999. In a way, the futures contract is to fix the price now at which transactions will take place at a future date.

The futures contract can be grouped either as a commodity future contract where the underlying asset is a commodity or financial future contract where the underlying asset is a financial asset. Financial futures contracts comprise pure financial futures contracts, forward contracts, and swaps.

i. Pure Financial Futures:

A financial future is a legal agreement to buy/sell a standard quantity of a financial instrument at a specified future date and at a price agreed between the parties at the time of the contract. The person who agrees to buy would have a long position and the person who agrees to sell will have a short position. A future position does not give the right of ownership to the underlying asset.

A futures contract is just a set of promises; one to deliver the underlying asset and the other to receive and pay for it. It is a rate for a futures contract to be used for exchange of financial instruments. Instead, financial futures markets are independent of the underlying cash market. For instance, currency futures are different instruments from the currencies themselves but currency futures prices move in ways that are related to the movements in currency prices.

However, since futures markets are independent of the markets in the underlying instruments, this relationship is less than perfect and it is possible for futures prices to show changes which have no parallel in the underlying currency markets.

The basic economic function of the futures is to provide a means of hedging. A hedger seeks to minimize an already existing risk. The risk can be minimized by taking a futures position that would tend to show a profit in the event of a loss on the underlying position (and a loss in the case of a profit on the underlying position).

Thus, in the futures market, a price increase would benefit the long position holders while the short position holders would suffer the loss. The rules of the game are such that gains on the one side are to come from losses, on the other side. This is a zero sum game.

Redeeming features of the financial futures are:

1. The underlying securities are delivered through a clearing system and the clearing house guarantees settlement of contracts.

2. The transaction costs on open outcry system tend to be relatively cheaper.

3. The actual delivery against the contract is very rare.

4. Financial futures are normally traded on a regulated exchange.

5. The contracts are highly standardized. Generally, there are specific months for trading of specific instruments.

6. A future contract involves a margin deposit.

There are three types of financial futures, viz., currency futures, stock futures and interest rate futures:

(a) Currency Futures:

Futures can be traded on a number of currencies. Generally, multi-currency investors and transnational corporations buy and sell currencies with a view to reducing currency exposure problems. Whether an organization would buy or sell currency futures to avoid exchange risk essentially depends upon its currency position (whether it is short or long) and the market expectations in regard to the exchange rate movement in future.

For instance, an American company with a payable in Japanese yen can buy the requisite number of yen future contracts if the Japanese currency is expected to go up in future. However, in case a depreciation is likely to take place, buying a future would not be worthwhile.

(b) Stock Index Futures:

Stock index futures are used essentially for hedging undiversified stock market risks. It does not provide any facility for delivery and receipt of stock via exercise of the contract. Under this arrangement, stock price movements are matched by compensatory cash flows. Futures contracts are available on many stock indices.

The basic assumption in using stock index futures to reduce stock market risks is that in case of any loss resulting from fluctuations in stock prices, the same can be offset by gains from parallel movements in futures prices. An investor anticipating fall in the prices of his/her stock can reduce the risk of a reduction in the value of the portfolio by taking a position in the futures market that would provide a gain in the event of a fall in stock prices.

In such a situation, the investor takes a short position in stock index futures contracts. By taking a short position, the investor guarantees a national selling price of a quantity of stock for a specific date in the future. If stock prices decline and stock index futures behave in a corresponding fashion, the notional buying price on that date would be less than the predetermined notional selling price.

(c) Interest Rate Futures:

Future contracts on U.S. Treasury and other securities are called Interest Rate Futures because their prices are determined by market interest rate. Interest rate futures, unlike the stock index futures, are not settled in cash.

Actual delivery of the underlying security has to be effected on contract expiry. Treasury bills are perhaps the single most important money market security actively traded on the futures market.

Utility of Financial Futures:

Financial futures can prove to be beneficial to the investors in two ways. In the first instance, investors can have a hedge against undesired price changes in the cash market. The higher the volatility of the instrument, the greater the need for hedging and financial futures.

Hedging is normally done by taking a position opposite to the anticipated position in the cash market. Another advantage of the financial futures is that the speculating investors can support their forecast with a very high degree of leverage.

Futures can also be used to improve the yield of the investors. One of the choices that an investor or a portfolio manager with short-term funds faces is the longevity of his investment vehicle. The problem is, if he invests in short-term securities with matching maturity in a normal market, his yield will be less. In case he opts for a long-term security with higher yield, he runs the risk of erosion in asset value at the time of sale, should the interest rates shoot up during the period.

This situation can be handled through efficient use of financial futures. Under this, the portfolio manager buys the underlying assets with long-term maturity and higher yield and simultaneously starts in the future market with a maturity matching his short-term availability of funds. This hedges against the possible depreciation in asset value while ensuring a higher yield.

Further, margin deposit in a futures contract ensures contract performance and fosters the financial integrity of the market. Another benefit of the futures is that the clearing house being a seller for the buyer and buyer for the seller ensures that the market is largely risk free as the clearing house apart from clearing, guarantees the exchange’s transactions.

Derivatives market in India:

The derivatives market in India began to be developed after 2000. Equity derivatives were introduced with the submission of the L.C. Gupta Committee report, which recommended derivatives for hedging facility to the investors.

Hedging in the stock market is important because it saves the investors from losses. It is like an insurance against risk from variations in the prices in the stock market. Hedging also helps in bringing about efficiency and liquidity in the capital market.

Derivatives were introduced in the Indian Capital Market in phases. In the first phase, ‘Stock Index Futures’, ‘Stock Index options’, ‘Index Stock options’, and ‘Index Stock Futures’ were adopted for trading in the stock market. SEBI gave permission for Index futures contracts to be based on the S&P, CNX, NIFTY and the BSE SENSEX.

In 2003, Interest Rate Derivatives were introduced by SEBI. These are Exchange Traded Interest Rate Futures. (IRF). These derivatives were to derive their value from a basket of dated Government Securities. The IRF protects the buyers and sellers from the adverse effects of interest rate changes.

It is an example of a Futures Derivative. It is settled through a Clearing Corporation. The minimum size of the IRF is 2,00000 and it has a maximum maturity of one year or 12 months. NRI’s and FII’s are allowed to trade in IRF according to the guidelines issued by the Reserve Bank of India.

Derivatives trading and settlement issues were to be made through the rules and byelaws of stock exchanges, Security Contracts Regulation Act as well as regulations and guidelines framed by SEBI.

The derivative products in India are being traded in two stock exchanges the National Stock Exchange (NSE) and the Mumbai (Bombay) Stock Exchange (BSE). The NSE allows trading according to a prescribed set of provisions.

The trading members and clients dealing in the stock exchange have to trade under the norm and regulations framed by NSE Futures and Options Regulations, 2001. National Stock Exchange allows trading in Nifty Futures, Nifty options, Individual Stock Futures and Individual Stock Options.

Individuals have a choice of Stock Futures and Options in more than 50 shares. The trading system at NSE is called NEAT — F&O. It is an order driven market. Orders are matched according to price, time and quantity of the order. An NSE member can make an active order by trading through his terminal and on-line monitor and generate a transaction by finding out a matching order by another member.

At the Mumbai Stock Exchange, trading is active in BSE Sensex Futures, BSE Sensex Options, Individual Stock Futures and individual Stock Options

The value of a derivative contract for individuals depends on the market value of the share, which is traded in and the number of shares in one contract. A contract for Futures and Options should be of 200 units whether it is a Nifty Index or Sensex and the minimum value of a contract should be Rs. 2,00,000.

In India, derivatives have the distinct feature of being European in nature in Index Option and American in Stock Options. Both Futures and Options are available for 1, 2, or 3 months and contracts expire on the last Thursday of every calendar month.

A March contract would expire on the last Thursday of March and April contract would expire on the last Thursday of April. BSE offers trading even for very short periods like 1 or 2 weeks to allow shorter period maturity and liquidity in the market.

Settlement of Contracts:

Derivatives contracts have the feature of paying margins. SEBI allows the margins in contracts. Daily settlement margin is also possible by payment in cash on T + 1 basis.

A Futures Contract is settled through Mark to Market Method (MTM). This is a method of daily settlement price of the contract at the end of the day but carrying forward till the final settlement day of last Thursday of each month.

Example:

An investor purchases a futures contract in Nifty at 2,000. If Nifty closes at 1,900 at the end of the day, the investor has made a loss of 100 x 200 = 20,000. He has to pay this margin money to the stock exchange and his contract can be carried forward the next day.

The next day supposing Nifty increases to 2050, the investor has a gain of (2050-1950) 100 x 200 = 20,000. His contract would be carried forward the next day at 2050 and this will continue till the last Thursday of the month which is the final settlement day. It is not necessary to continue till the last day. The investor can square up or even take counter-transaction on any day and close the contract.

An Options Contract is settled by paying the option premium upfront. His loss is limited to the premium. The gain or loss has to be settled on a daily basis. Margins are not required to be paid by the option writers and the final gain or loss is settled on the last Thursday of the month.