Introduction of Futures

7/29/2019 Introduction of Futures

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DerivativesIndian Scenario - 1 -

TYPES OF FINANCIAL DERIVATIVES

Financial derivatives are those assets whose values are determined by the

value of some other assets, called as the underlying. Presently there are

Complex varieties of derivatives already in existence and the markets are

innovating newer and newer ones continuously. For example, various

types of financial derivatives based on their different properties like,

plain, simple or straightforward, composite, joint or hybrid, synthetic,

leveraged, mildly leveraged, OTC traded, standardized or organized

exchange traded, etc. are available in the market. Due to complexity in

nature, it is very difficult to classify the financial derivatives, so in the

present context, the basic financial derivatives which are popularly in the

market have been described. In the simple form, the derivatives can be

classified into different categories which are shown below :

DERIVATIVES

Financials Commodities

Basics Complex

1. Forwards 1. Swaps

2. Futures 2.Exotics (Non STD)

3. Options


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4. Warrants and Convertibles

One form of classification of derivative instruments is between

commodity derivatives and financial derivatives. The basic difference

between these is the nature of the underlying instrument or assets. In

commodity derivatives, the underlying instrument is commodity which

may be wheat, cotton, pepper, sugar, jute, turmeric, corn, crude oil,

natural gas, gold, silver and so on. In financial derivative, the underlying

instrument may be treasury bills, stocks, bonds, foreign exchange, stock

index, cost of living index etc. It is to be noted that financial derivative is

fairly standard and there are no quality issues whereas in commodity

derivative, the quality may be the underlying matters.

Another way of classifying the financial derivatives is into basic and

complex. In this, forward contracts, futures contracts and option contracts

have been included in the basic derivatives whereas swaps and other

complex derivatives are taken into complex category because they are

built up from either forwards/futures or options contracts, or both. In fact,

such derivatives are effectively derivatives of derivatives.

Derivatives are traded at organized exchanges and in the Over

The Counter ( OTC ) market :

Derivatives Trading Forum


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Organized Exchanges Over The

Counter

Commodity Futures Forward Contracts

Financial Futures Swaps

Options (stock and index)

Stock Index Future

INTRODUCTION OF FUTURES

Futures markets were designed to solve the problems that exist in forward

markets. A futures contract is an agreement between two parties to buy or

sell an asset at a certain time in the future at a certain price. But unlike

forward contract, the futures contracts are standardized and exchange traded.

To facilitate liquidity in the futures contract, the exchange specifies certainstandard features of the contract. It is standardized contract with standard

underlying instrument, a standard quantity and quality of the underlying

instrument that can be delivered,

(Or which can be used for reference purpose in settlement) and a standard

timing of such settlement. A futures contract may be offset prior to maturity

by entering into an equal and opposite transaction. More than 90% of

futures transactions are offset this way.

The standardized items in a futures contract are:

Quantity of the underlying

Quality of the underlying

The date and the month of delivery


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The units of price quotation and minimum price

change

Location of settlement

DIFINITION

A Futures contract is an agreement between two parties to buy or

sell an asset at a certain time in the future at a certain price. Futures

contracts are special types of forward contracts in the sense that the former

are standardized exchange-traded contracts.

HISTORY OF FUTURES

Merton Miller,the 1990 Nobel Laureate had said that financial futures

represent the most significant financial innovation of the last twenty years.

The first exchange that traded financial derivatives was launched in Chicago

in the year1972. A division of the Chicago Mercantile Exchange, it was

called the international monetary market (IMM) and traded currency futures.

The brain behind this was a man called Leo Melamed, acknowledged as the

father of financial futures who was then the Chairman of the Chicago

Mercantile Exchange. Before IMM opened in 1972, the Chicago Mercantile

Exchange sold contracts whose value was counted in millions. By 1990, the

underlying value of all contracts traded at the Chicago Mercantile Exchange

totaled 50 trillion dollars.

These currency futures paved the way for the successful marketing of a

dizzying array of similar products at the Chicago Mercantile Exchange, the

Chicago Board of Trade and the Chicago Board Options Exchange. By the


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1990s, these exchanges were trading futures and options on everything from

Asian and American stock indexes to interest-rate swaps, and their success

transformed Chicago almost overnight into the risk-transfer capital of the

world.

DISTINCTION BETWEEN FUTURES AND FORWARDS CONTRACTS

Forward contracts are often confused with futures contracts. The

confusion is primarily because both serve essentially the same economic

functions of allocating risk in the presence of futures price uncertainty.

However futures are a significant improvement over the forward contracts as

they eliminate counterparty risk and offer more liquidity. Comparison

between two as follows:

FUTURES FORWARDS


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1.Trade on an

Organized Exchange

2.Standardized

contract terms

3. hence more liquid

4. Requires margin

payment

5. Follows daily

Settlement

1. OTC in nature

2.Customized contract

terms

3. hence less liquid

4. No margin payment

5. Settlement happens

at end of period

Table 2.1

FEATURES OF FUTURES

Futures are highly standardized.

The contracting parties need not pay any down

payment.

Hedging of price risks. They have secondary markets too.

TYPES OF FUTURES


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On the basis of the underlying asset they derive, the futures are divided into

two types:

Stock Futures

Index Futures

PARTIES IN THE FUTURES CONTRACT

There are two parties in a futures contract, the buyers and the seller. The

buyer of the futures contract is one who is LONG on the futures contract and

the seller of the futures contract is who is SHORT on the futures contract.The pay-off for the buyers and the seller of the futures of the contracts are

as follows:

PAY-OFF FOR A BUYER OF FUTURES


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Figure 2.1

CASE 1:- The buyers bought the futures contract at (F); if the futures

PriceGoes to E1 then the buyer gets the profit of (FP).

CASE 2:-The buyers gets loss when the futures price less then (F); if

The Futures price goes to E2 then the buyer the loss of (FL).

PAY-OFF FOR A SELLER OF FUTURES

LOSS

PROFIT

F

L

P

E1

E2


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Figure 2.2

F = FUTURES

PRICE

E1, E2 = SETLEMENT PRICE

CASE 1:-The seller sold the future contract at (F); if the future goes to

E1Then the seller gets the profit of (FP).

CASE 2:-The seller gets loss when the future price goes greater than (F);

If the future price goes to E2 then the seller get the loss of (FL).

MARGINS

F

LOSS

PROFIT

E1

P

E2

L


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Margins are the deposits which reduce counter party risk, arise in a futures

contract. These margins are collect in order to eliminate the counter party

risk. There are three types of margins:

Initial Margins:-

Whenever a future contract is signed, both buyer and seller are required to

post initial margins. Both buyers and seller are required to make security

deposits that are intended to guarantee that they will infect be able to fulfill

their obligation. These deposits are initial margins and they are often

referred as purchase price of futures contract.

Mark to market margins:-

The process of adjusting the equity in an investors account in order to

reflect the change in the settlement price of futures contract is known as

MTM margin.

Maintenance margin:-

The investor must keep the futures account equity equal to or greater than

certain percentage of the amount deposited as initial margin. If the equity

goes less than that percentage of initial margin, then the investor receives a

call for an additional deposit of cash known as maintenance margin to bring

the equity up to the initial margin.

ROLE OF MARGINS

The role of margins in the futures contract is explained in the following

example:Siva Rama Krishna sold an ONGC July futures contract to Nagesh

at Rs.600; the following table shows the effect of margins on the Contract.

The contract size of ONGC is 1800. The initial margin amount is say Rs.

30,000 the maintenance margin is 65% of initial margin.


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PRICING FUTURES

Pricing of futures contract is very simple. Using the cost-of-carry logic,

we calculate the fair value of a future contract. Every time the observed

price deviates from the fair value, arbitragers would enter into trades to

captures the arbitrage profit. This in turn would push the futures price back

to its fair value. The cost of carry model used for pricing futures is given

below.

F = SerT

Where:

F = Futures price

S = Spot Price of the Underlying

r = Cost of financing (using continuously compounded

Interest rate)

T = Time till expiration in years

e = 2.71828

(OR)

F = S (1+r- q) t

Where:

F = Futures price

S = Spot price of the underlying

r = Cost of financing (or) interest Rate

q = Expected dividend yield

t = Holding Period

FUTURES TERMINOLOGY


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Spot price:

The price at which an asset trades in the spot market.

Futures Price:

The price at which the futures contract trades in the futures market.

Contract cycle:

The period over which a contract trades. The index futures contracts on the

NSE have one-month and three-month expiry cycles which expire on the

last Thursday of the month. Thus a January expiration contract expires on

the last Thursday of January and a February expiration contract ceases

trading on the last Thursday of February. On the Friday following the last

Thursday, a new contract having a three-month expiry is introduced for

trading.

Expiry date:

It is the date specified in the futures contract. This is the last day on which

the contract will be traded, at the end of which it will cease to exist.

Contract size:

The amount of asset that has to be delivered under one contract. For

instance, the contract size on NSEs futures markets is 200 Nifties.

Basis:

In the context of financial futures, basis can be defined as the futures price

minus the spot price. These 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:


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The relationship between futures prices and spot prices can be summarized

in terms of what is known as the cost of carry. This measures the storage

cost plus the interest that is paid to finance the asset less the income earned

on the asset.

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.

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 price. This is called marking-to-market.

Maintenance margin:

This is some what lower than the initial 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 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.


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INTRODUCTION TO OPTIONS

In this section, we look at the next derivative product to be traded on the

NSE, namely options. Options are fundamentally different from forward

and futures contracts. An option gives the holder of the option the right to

do something. The holder does not have to exercise this right. In contrast,

in a forward or futures contract, the two parties have committed themselves

to doing something. Whereas it costs nothing (except margin requirement) to

enter into a futures contracts, the purchase of an option requires as up-front

payment.

DEFINITION

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 buyers 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.

HISTORY OF OPTIONS

Although options have existed for a long time, they we traded OTC,

without much knowledge of valuation. The first tradingin options began in

Europe and the USas early as the seventeenth century. It was only in the

early 1900s that a group of firms set up what was known as the put and call

Brokers and Dealers Association with the aim of providing a mechanism for

bringing buyers and sellers together. If someone wanted to buy an option,

he or she would contact one of the member firms. The firms would then

attempt to find a seller or writer of the option either from its own clients of

those of other member firms. If no seller could be found, the firm would

undertake to write the option itself in return for a price.

This market however suffered form two deficiencies. First, there was no

secondary market and second, there was no mechanism to guarantee that the


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writer of the option would honour the contract. In 1973, Black, Mertonand

scholes invented the famed Black-Scholes formula. In April 1973, CBOE

was set up specifically for the purpose of trading options. The market for

option developed so rapidly that by early 80s, the number of shares

underlying the option contract sold each day exceeded the daily volume of

shares traded on the NYSE. Since then, there has been no looking back.

Option made their first major mark in financial history during the tulip-

bulb mania in seventeenth-century Holland. It was one of the most

spectacular get rich quick brings in history. The first tulip was brought Into

Holland by a botany professor from Vienna. Over a decade, the tulip

became the most popular and expensive item in Dutch gardens. The more

popular they became, the more Tulip bulb prices began rising. That was

when options came into the picture. They were initially used for hedging.

By purchasing a call option on tulip bulbs, a dealer who was committed to a

sales contract could be assured of obtaining a fixed number of bulbs for a set

price. Similarly, tulip-bulb growers could assure themselves of selling their

bulbs at a set price by purchasing put options. Later, however, options were

increasingly used by speculators who found that call options were an

effective vehicle for obtaining maximum possible gains on investment. As

long as tulip prices continued to skyrocket, a call buyer would realize returns

far in excess of those that could be obtained by purchasing tulip bulbs

themselves. The writers of the put options also prospered as bulb prices

spiraled since writers were able to keep the premiums and the options were

never exercised. The tulip-bulb market collapsed in 1636 and a lot of

speculators lost huge sums of money. Hardest hit were put writers who were

unable to meet their commitments to purchase Tulip bulbs.


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PROPERTIES OF OPTION

Options have several unique properties that set them apart from other

securities. The following are the properties of option:

Limited Loss

High leverages potential

Limited Life

PARTIES IN AN OPTION CONTRACT

There are two participants in Option Contract.

Buyer/Holder/Owner of an Option:

The Buyer of an Option is the one who by paying the option premium buysthe right but not the obligation to exercise his option on the seller/writer.

Seller/writer 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.

TYPES OF OPTIONS

The Options are classified into various types on the basis of various

variables. The following are the various types of options.

1. On the basis of the underlying asset:

On the basis of the underlying asset the option are divided in to two types:

Index options:

These options have the index as the underlying. Some options are

European while others are American. Like index futures contracts, index

options contracts are also cash settled.

Stock options:


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Stock Options are options on individual stocks. Options currently trade on

over 500 stocks in the United States. A contract gives the holder the right to

buy or sell shares at the specified price.

2. On the basis of the market movements :

On the basis of the market movements the option are divided into two types.

They are:

Call Option:

A call Option gives the holder the right but not the obligation to buy an

asset by a certain date for a certain price. It is brought by an investor when

he seems that the stock price moves upwards.

Put Option:

A put option gives the holder the right but not the obligation to sell an asset

by a certain date for a certain price. It is bought by an investor when he

seems that the stock price moves downwards.

3.On the basis of exercise of option:

On the basis of the exercise of the Option, the options are classified into two

Categories.

American Option:

American options are options that can be exercised at any time up to the

expiration date. Most exchangetraded options are American.

European Option:

European options are options that can be exercised only on the expiration

date itself. European options are easier to analyze than American options,

and properties of an American option are frequently deduced from those of

its European counterpart.

PAY-OFF PROFILE FOR BUYER OF A CALL OPTION


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The Pay-off of a buyer options depends on a spot price of an underlyingasset. The following graph shows the pay-off of buyers of a call option.

Figure 2.3

S = Strike price ITM = In the MoneySp = premium/loss ATM = At the MoneyE1 = Spot price 1 OTM = Out of the Money

E2 = Spot price 2SR = Profit at spot price E1

CASE 1:(Spot Price > Strike price)As the Spot price (E1) of the underlying asset is more than strike price (S).The buyer gets profit of (SR), if price increases more than E1 then profit alsoincrease more than (SR)

CASE 2:(Spot Price < Strike Price)

As a spot price (E2) of the underlying asset is less than strike price (S)The buyer gets loss of (SP); if price goes down less than E2 then also his lossis limited to his premium (SP)

PAY-OFF PROFILE FOR SELLER OF A CALL OPTION

The pay-off of seller of the call option depends on the spot price of theunderlying asset. The following graph shows the pay-off of seller of a calloption:

OTM

LOSS

S

PE2

RPROFIT

ITM

ATM E1


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Figure 2.4

S = Strike price ITM = In the MoneySP = Premium / profit ATM = At The moneyE1 = Spot Price 1 OTM = Out of the MoneyE2 = Spot Price 2SR = loss at spot price E2

CASE 1:(Spot price < Strike price)As the spot price (E1) of the underlying is less than strike price (S). Theseller gets the profit of (SP), if the price decreases less than E 1 then also

profit of the seller does not exceed (SP).

CASE 2:(Spot price > Strike price)As the spot price (E2) of the underlying asset is more than strike price (S) theSeller gets loss of (SR), if price goes more than E2 then the loss of the selleralso increase more than (SR).

PAY-OFF PROFILE FOR BUYER OF A PUT OPTION

The Pay-off of the buyer of the option depends on the spot price of theunderlying asset. The following graph shows the pay-off of the buyer of acall option.

ITM

PROFIT

E1

P

S

ATM

E2

OTM

R

LOSS


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Figure 2.5

S = Strike price ITM = In the MoneySP = Premium / loss ATM = At the MoneyE1 = Spot price 1 OTM = Out of the MoneyE2 = Spot price 2SR = Profit at spot price E1

CASE 1: (Spot price < Strike price)As the spot price (E1) of the underlying asset is less than strike price (S). Thebuyer gets the profit (SR), if price decreases less than E1 then profit alsoincreases more than (SR).

CASE 2:(Spot price > Strike price)As the spot price (E2) of the underlying asset is more than strike price (S),The buyer gets loss of (SP), if price goes more than E2 than the loss of the

buyer is limited to his premium (SP).

PAY-OFF PROFILE FOR SELLER OF A PUT OPTION

The pay-off of a seller of the option depends on the spot price of theunderlying asset. The following graph shows the pay-off of seller of a putoption.

PROFIT

ITM

R

E1 ATM

P LOSS

OTM

E2S


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Figure 2.6

S = Strike price ITM = In The MoneySP = Premium/profit ATM = At The MoneyE1 = Spot price 1 OTM = Out of the MoneyE2 = Spot price 2SR = Loss at spot price E1

CASE 1:(Spot price < Strike price)As the spot price (E1) of the underlying asset is less than strike price (S), theseller gets the loss of (SR), if price decreases less than E1 than the loss alsoincreases more than (SR).

CASE 2:(Spot price > Strike price)As the spot price (E2) of the underlying asset is more than strike price (S),the seller gets profit of (SP), of price goes more than E2 than the profit ofseller is limited to his premium (SP).

FACTORS AFFECTING THE PRICE OF AN OPTION

The following are the various factors that affect the price of an option theyare:Stock Price:

LOSS

OTM

R

S

E1

P

PROFIT

ITM

ATM

E2


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The pay-off from a call option is an amount by which the stock price

exceeds the strike price. Call options therefore become more valuable as the

stock price increases and vice versa. The pay-off from a put option is the

amount; by which the strike price exceeds the stock price. Put options

therefore become more valuable as the stock price increases and vice versa.

Strike price:

In case of a call, as a strike price increases, the stock price has to make a

larger upward move for the option to go in-the money. Therefore, for a

call, as the strike price increases option becomes less valuable and as strike

price decreases, option become more valuable.

Time to expiration:

Both put and call American options become more valuable as a time to

expiration increases.

Volatility:

The volatility of a stock price is measured of uncertain about future stock

price movements. As volatility increases, the chance that the stock will do

very well or very poor increases. The value of both calls and puts therefore

increases as volatility increase.

Risk- free interest rate:

The put option prices decline as the risk-free rate increases where as the

price of call always increases as the risk-free interest rate increases.

Dividends:

Dividends have the effect of reducing the stock price on the X- dividend

rate. This has a negative effect on the value of call options and a positive

effect on the value of put options.


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PRICING OPTIONS

An option buyer has the right but not the obligation to exercise on the

seller. The worst that can happen to a buyer is the loss of the premium paid

by him. His downside is limited to this premium, but his upside is

potentially unlimited. This optionality is precious and has a value, which is

expressed in terms of the option price. Just like in other free markets, it is

the supply and demand in the secondary market that drives the price of an

option.

There are various models which help us get close to the true price of an

option. Most of these are variants of the celebrated Black- Scholes model

for pricing European options. Today most calculators and spread-sheets

come with a built-in Black- Scholes options pricing formula so to price

options we dont really need to memorize the formula. All we need to know

is the variables that go into the model.

The Black-Scholes formulas for the price of European calls and puts on a

non-dividend paying stock are:


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Call option

CA = SN (d1)Xe- rT

N (d2)

Put OptionPA = Xe

- rTN (- d2)SN (- d1)

Where d1 = ln (S/X) + (r + v2/2) T

vTAnd d2 = d1 - vT

Where

CA = VALUE OF CALL OPTION

PA = VALUE OF PUT OPTION

S = SPOT PRICE OF STOCK

N = NORMAL DISTRIBUTION

VARIANCE (V) = VOLATILITY

X = STRIKE PRICE

r = ANNUAL RISK FREE RETURN

T = CONTRACT CYCLEe = 2.71828

r = ln (1 + r)

Table 2.2

OPTIONS TERMINOLOGY

Option price/premium:

Option price is the price which the option buyer pays to the option seller. It

is also referred to as the option premium.

Expiration date:


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The date specified in the options contract is known as the expiration date,

the exercise date, the strike date or the maturity.

Strike price:

The price specified in the option contract is known as the strike price or the

exercise price.

In-the-money option:

An in-the-Money (ITM) option is an option that would lead to a positive

cash flow to the holder if it were exercised immediately. 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 (i.e. spot price > strike price). If the index is

much higher than the strike price, the call is said to be deep ITM. In the case

of a put, the put is ITM if the index is below the strike price.

At-the-money option:

An at-the-money (ATM) option is an option that would lead to zero cash

flow if it were exercised immediately. An option on the index is at-the-

money when the current index equals the strike price (i.e. spot price = strike

price).

Out- ofthe money option:

An out-of-the-money (OTM) option is an option that would lead to a

negative cash flow it was exercised immediately. A call option on the index

is out-of-the-the money when the current index stands at a level which is less

than the strike price (i.e. spot price < strike price). If the index is much

lower than the strike price, the call is said to be deep OTM. In the case of a

put, the put is OTM if the index is above the strike price.

Intrinsic value of an option:

The option premium can be broken down into two components- intrinsic

value and time value. The intrinsic value of a call is the amount the option is

ITM, if it is ITM. If the call is OTM, its intrinsic value is zero.


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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. An option that is OTM

or ATM has only time value. Usually, the maximum time value exists when

the option is ATM. The longer the time to expiration, the greater is an

options time value, all else equal. At expiration, an option should have no

time value.

DISTINCTION BETWEEN FUTURES AND OPTIONS

Table 2.3

CALL OPTION

STRIKE PRICE

PREMIUM

CONTRACTINTRINSIC

VALUE

TIME

VALUE

TOTAL

VALUE

560

540

520

0

0

0

2

5

10

2

5

10

OUT OF

THE

MONEY

FUTURES OPTIONS

1. Exchange traded,with Novation

2. Exchange definesthe

product3. Price is zero, strike

price moves4. Price is Zero5. Linear payoff6. Both long and

shortat risk

1. Same as futures

2. Same as futures

3. Strike price is fixed,price moves

4. Price is always positive5.Nonlinear payoff

6. Only short at risk


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500 0 15 15 AT THE

MONEY

480

460

440

20

40

60

10

5

2

30

45

62

IN THE

MONEY

Table 2.4

PUT OPTION

STRIKE PRICEPREMIUM

CONTRACTINTRINSIC

VALUE

TIME

VALUE

TOTAL

VALUE560

540

520

60

40

20

2

5

10

62

45

30

IN THE

MONEY

500 0 15 15

AT THE

MONEY

480

460

440

0

0

0

10

5

2

10

5

2

OUT OF

THE

MONEY

Table 2.5

PREMIUM = INTRINSIC VALUE + TIME VALUE

The difference between strike values is calledinterval

SWAPSA contract between two parties, referred to as counter parties, to exchange two streams of

payments for agreed period of time. The payments, commonly called legs or sides, are

calculated based on the underlying notional using applicable rates. Swaps contracts also

include other provisional specified by the counter parties. Swaps are not debt instrument

to raise capital, but a tool used for financial management. Swaps are arranged in many


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different currencies and different periods of time. US$ swaps are most common followed

by Japanese yen, sterling and Deutsche marks. The length of past swaps transacted has

ranged from 2 to 25 years.

3.1 Why did swaps emerge?

In the late 1970's, the first currency swap was engineered to circumvent the currency

control imposed in the UK. A tax was levied on overseas investments to discourage

capital outflows. Therefore, a British company could not transfer funds overseas in order

to expand its foreign operations without paying sizeable penalty. Moreover, this British

company had to take an additional currency risks arising from servicing a sterling debt

with foreign currency cash flows. To overcome such a predicament, back-to-back loans

were used to exchange debts in different currencies. For example, a British company

wanting to raise capital in the France would raise the capital in the UK and exchange its

obligations with a French company, which was in a reciprocal position. Though this type

of arrangement was providing relief from existing protections, one could imagine, the

task of locating companies with matching needs was quite difficult in as much as the cost

of such transactions was high. In addition, back-to-back loans required drafting multiple

loan agreements to state respective loan obligations with clarity. However this type of

arrangement lead to development of more sophisticated swap market of today.

Facilitators

The problem of locating potential counter parties was solved through dealers and brokers.

A swap dealer takes on one side of the transaction as counterparty. Dealers work for

investment, commercial or merchant banks. "By positioning the swap", dealers earn bid-

ask spread for the service. In other words, the swap dealer earns the difference between

the amount received from a party and the amount paid to the other party. In an ideal

situation, the dealer would offset his risks by matching one step with another to

streamline his payments. If the dealer is a counterparty paying fixed rate payments and

receiving floating rate payments, he would prefer to be a counterparty receiving fixed

payments and paying floating rate payments in another swap. A perfectly netted position

as just described is not necessary. Dealers have the flexibility to cover their exposure by

matching multiple parties and by using other tools such as futures to cover an exposed

position until the book is complete.


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Swap brokers, unlike a dealer do not take on a swap position themselves but simply

locate counter parties with matching needs. Therefore, brokers are free of any risks

involved with the transactions. After the counter parties are located, the brokers negotiate

on behalf of the counter parties to keep the anonymity of the parties involved. By doing

so, if the swap transaction falls through, counter parties are free of any risks associated

with releasing their financial information. Brokers receive commissions for their services.

3.2 Swaps Pricing:

There are four major components of a swap price.

Benchmark price

Liquidity (availability of counter parties to offset the swap).

Transaction cost

Credit risk1

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, 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 counter

parties for long duration swaps, specially so in India 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%

1 Source: www.appliederivatives.com


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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.

Swap Market Participations

Since swaps are privately negotiated products, there is no restriction on who can use the

market. However, parties with low credit quality have difficulty entering the market. This

is due to fact that they cannot be matched with counter parties who are willing to take on

their risks. In the U.S. many parties require their counter parties to have minimum assets

of $10 million. This requirement has become a standardized representation of "eligible

swap participants".

3.3 Introduction of Forward Rate Agreements and Interest

Rate Swaps

The Indian scene 2

Objective

To further deepen the money markets

To enable banks, primary dealers and all India financial institutions to hedge interest

rate risks.

These guidelines are intended to form the basis for development of Rupee derivative

products such as FRAs/IRS in the country. They have been formulated in consultation

with market participants. The guidelines are subject to review, on the basis of

development of FRAs/IRS market.

Accordingly, it has been decided to allow scheduled commercial banks (excluding

Regional Rural Banks), primary dealers and all -India financial institutions to undertake

FRAs/IRS as a product for their own balance sheet management and for market making

purposes.

Prerequisites

2 Source: RBI Guidelines


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Participants are to ensure that appropriate infrastructure and risk management systems are

put in place. Further, participants should also set up sound internal control system

whereby a clear functional separation of trading, settlement, monitoring and control and

accounting activities is provided.

Description of the product

A Forward Rate Agreement (FRA) is a financial contract between two parties

exchanging or swapping a stream of interest payments for a notional principal amount on

settlement date, for a specified period from start date to maturity date. Accordingly, on

the settlement date, cash payments based on contract (fixed) and the settlement rate, are

made by the parties to one another. The settlement rate is the agreed benchmark/reference

rate prevailing on the settlement date.

An Interest Rate Swap (IRS) is a financial contract between two parties exchanging or

swapping a stream of interest payments for a notional principal amount of multiple

occasions on specified periods. Accordingly, on each payment date that occurs during the

swap period-Cash payments based on fixed/floating and floating rates are made by the

parties to one another.

Currency swaps can be defined as a legal agreement between two or more parties to

exchange interest obligation or interest receipts between two different currencies. It

involves three steps:

Initial exchange of principal between the counter parties at an agreed upon rate of

exchange which is usually based on spot exchange rate. This exchange is optional and

its sole objective is to establish the quantum of the respective principal amounts for

the purpose for calculating the ongoing payments of interest and to establish the

principal amount to be re-exchanged at the maturity of the swap.

Ongoing exchange of interest at the rates agreed upon at the outset of the transaction.

Re-exchange of principal amount on maturity at the initial rate of exchange.

This straight forward, three step process results in the effective transformation of the debt

raised in one currency into a fully hedged liability in other currency.

Participants


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Schedule commercial banks.

Primary dealers

All India financial institutions

3.5 Currency Swaps in India

RBI in its slack season credit policy '97 allowed the authorized dealers to arrange

currency swap without its prior approval. This was to enable those requiring long-term

forward cover to hedge themselves without altering the external liability of the country.

Prior to this policy RBI had been approving rupee foreign currency swaps between

corporates on a case basis, but no such swaps were taking place.

RBI in its process of making the Indian corporates globally competitive has simplified

their access to this instrument by making changes in its credit policy. But despite an

easing regulation, swaps have not hit the market in a big way.

India has a strong dollar-rupee forward market with contracts being traded for one, two,

six-month expiration. Daily trading volume on this forward market is around $500

million a day. Indian users of hedging services are also allowed to buy derivatives

involving other currencies on foreign markets. Outside India, there is a small market for

cashsettled forward contracts on the dollarrupee exchange rate.

While studying swaps in the Indian context, the counter parties involved are Indian

corporates and the swap dealers are the Authorized dealers of foreign exchange, i.e., the

banks allowed by RBI to carry out the swaps. These banks form the counterparty to the

corporates on both sides of the swap and keep a spread between the interest rates to be

received and offered. One of the currencies involved is the Indian rupee and the other

could be any foreign currency. The interest rate on the rupee is most likely to be fixed,

and on foreign currency it could be either fixed or floating.

3.5.1 The Players

Swaps are instruments, which allow the user to hedge - that are to offset risk or to take

risk deliberately in the expectation of making profit. The user in this case would be any


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corporate having a foreign exchange exposure/ a risk. A foreign exchange exposure will

arise out of the mismatch between the currency of inflow and outflow. The outflow being

considered here is the interest and the principal payment on the borrowings of the

corporates. Corporates having such currency mismatches would be of the following types

3.5.2Corporates with rupee loan and forex revenue

Mainly the exporters would fall in this category. Corporates with foreign subsidiaries

would also be having forex revenues but due to cheaper availability of funds abroad, it is

unlikely that these subsidiaries would be funded by a rupee loan. Thus the main players

meeting this criterion would be the exporters. The main players in the Indian market are

Tata Exports, Hindustan Levers Ltd., ITC Ltd., and Nestle Indian Ltd. among the others.

3.5.3 Corporates with forex loan and rupee revenue

The corporates having foreign currency loan could further be classified into two groups.

One which have net imports and thus may have raised loans to meet their import

requirements, for example Bharat Heavy Electricals Ltd., Apollo Tyres Ltd., Tata Power

Co. Ltd.

Two, which do not have net imports but have raised foreign currency loan for funding

requirements, for example Arvind Mills Ltd., Ballarpur Industries etc.

3.5.4 Corporates with no foreign exposure

There may be corporates with no existing exposure but willing to take up an exposure in

an expectation of making profit out of this transaction. Thus they would be willing to

swap their rupee loan with forex loan and book in forward cover or make the payments

on spot basis on the day of disbursements. These corporates may also consider the option

of raising new loans in foreign currency and swap a rupee loan if it turns out to be

cheaper option. Thus many corporates would fall under this category.

3.5.5 Banks

Banks act as the authorized dealers and are instrumental in arranging swaps. They have to

take the swaps on their books. A bank would enter into swap with a party and then try to

find another with opposite requirement to hedge itself against any fluctuation in exchange


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rates. They would normally keep a spread between the offer and bid rate thus make profit

from transaction. They also take up the credit risk of counterparties.

3.6 The needs of the players and how currency swaps help meet

these needs

3.6.1 To manage the exchange rate risk

Since the international trade implies returns and payments in a variety of currencies

whose relative values may fluctuate it involves taking foreign exchange risk. The players

mentioned above are facing this risk. A key question facing the players then is whether

these exchange risks are so large as to affect their business. A related question is what, if

any, special strategies should be followed to reduce the impact of foreign exchange risk.One-way to minimize the long-term risk of one currency being worth more or less in the

future is to offset the particular cash flow stream with an opposite flow in the same

currency. The currency swap helps to achieve this without raising new funds; instead it

changes existing cash flows.

3.6.2 To lower financing cost

Currency swaps can be used to reduce the cost of loan. The following example deals with

such a case.

Consider two Indian corporates A & B. Corporate A is an exporter with a rupee loan at

14% fixed rate. B has a dollar loan at LIBOR + 0.25% floating rate. Due to difference in

the credit rating of the two companies, the rates at which the loans are available to them

are different. A has access to 14% rupee loan and dollar loan at LIBOR + 0.25%.

A would like to convert its rupee loan into a dollar loan, to reverse its revenue in dollars

and B would like to convert the dollar loan into a fixed rupee loan thus crystallizing its

cost of borrowing. They can enter into a swap and reduce the cost compared to what it

would have been if they had taken a direct loan in the desired currencies.

- Comparative advantage

Company A Exporter Company B

Options: Options:

Borrow ruppe at 13% Borrow ruppe at 14.5%


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Borrow dollars at LIBOR +100 bps Borrow dollars at LIBOR +200 bps

Company A has an absolute advantage over B in both the markets/ rates. The advantage

in terms of rupee funds is 150 bps while it is 100 bps in case of dollar rates. Thus B has a

comparative advantage in terms of dollar rates.

Now as A is an exporter he would be more interested in a dollar denominated loan to

offset his future receivables.

Therefore it would be advantageous if A would borrow at rupee rates and B borrows at

LIBOR rates. Then they may go in for a currency swap. The net gain arising out of such a

swap will be 50 bps, which may be shared between the parties.

The swap will thus result in A paying B a floating rate of LIBOR + 75 bps in return for a

13% fixed rupee rate. The swap will take place on a notional principal basis.

The effective cost for A is LIBOR + 75 bps and for B it is 14.25%. The effective cost for

A is 12.75%. This results into a net saving of 25 bps for both the parties.

Figure 3.1

LIBOR +75 bps

Company A Company B

12.75% in INR

13% in INR

Libor +200 bps


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- To access restricted markets

Many countries have restrictions on the type of borrowers that can raise funds in their bond

markets. Foe example an Indian firm exporting goods to Japan may wish to issue bonds in yen to

form a natural hedge by reversing their cash flows. To issue a yen bond, the borrower must

qualify for a single A credit rating. If the company does not qualify in this regard it would fail to

issue yen denominated bond.

By issuing bonds in the rupee market and then entering into a currency swap, the firm can meet

its expectation of raising a yen denominated loan.

3.6.3 Swaps for reducing the cost of borrowing

With the introduction of rupee derivatives the Indian corporates can attempt to reduce their costof borrowing and thereby add value. A typical Indian case would be a corporate with a high fixed

rate obligation.

Eg.

Mehta Ltd. an AAA rated corporate, 3 years back had raised 4-year funds at a fixed rate of

18.5%. Today a 364-day T. bill is yielding 10.25%, as the interest rates have come down. The 3-

month MIBOR is quoting at 10%.

Fixed to floating 1 year swaps are trading at 50 bps over the 364-day T. bill vs 6-month MIBOR.

The treasurer is of the view that the average MIBOR shall remain below 18.5% for the next one

year.

The firm can thus benefit by entering into an interest rate fixed for floating swap, whereby it

makes floating payments at MIBOR and receives fixed payments at 50 bps over a 364 day

treasury yield i.e. 10.25 + 0.50 = 10.75 %.

Figure 3.2

Fixed 10.75Mehta Ltd Counter Party

3 Months MIBOR


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18.75%s MIBOR

The effective cost for Mehta Ltd. = 18.5 + MIBOR - 10.75

= 7.75 + MIBOR

At the present 3m MIBOR at 10%, the effective cost is = 10 + 7.75 = 17.75%

The gain for the firm is (18.5 - 17.75) = 0.75 %

The risks involved for the firm are

- Default/ credit risk of counterparty. This may be ignored, as the counterparty is a bank. This

risk involves losses to the extent of the interest rate differential between fixed and floating rate

payments.

- The firm is faced with the risk that the MIBOR goes beyond 10.75%. Any rise beyond 10.75%

will raise the cost of funds for the firm. Therefore it is very essential that the firm hold a strong

view that MIBOR shall remain below 10.75%. This will require continuous monitoring on the

path of the firm.

How does the bank benefit out of this transaction?

The bank either goes for another swap to offset this obligation and in the process earn a spread.

The bank may also use this swap as an opportunity to hedge its own floating liability. The bank

may also leave this position uncovered if it is of the view that MIBOR shall rise beyond 10.75%.

Taking advantage of future views/ speculation

If a bank holds a view that interest rate is likely to increase and in such a case the return on fixedrate assets will not increase, it will prefer to swap it with a floating rate interest. It may also swap

floating rate liabilities with a fixed rate.

3.7 Factors to be looked at while doing a swap


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Though swaps can be used in the above conditions effectively, corporates need to look at a few

factors before deciding to swap.

The estimated net exposure

They need to estimate the net exposure that they are likely to have in the future. Projecting the

growth in exports/ imports, taking into account the changes in management and government

policies can do this.

Expected range of exchange rates

This can be determined by a fundamental and technical analysis. For fundamental analysis one

needs to keep track of the balance of payment condition, GDP growth rate, etc. of the country.

The technical factors look at past trends and expected demand-supply position. Other factors like

political stability also needs to be considered.

Expected interest rates

Since currency swaps include exchange of interest payments, the interest rates also need to be

traced. By keeping an eye on the yield curve of long term bonds and the macro economic

variables of different countries, the interest rates can be estimated.

Amount of cover to be taken

Having estimated the amount of exposure, the expected exchange rates and the interest rates, the

parties can determine the risks involved and can decide upon the amount of cover to be taken.

This shall depend on the management policy whether they believe in minimizing the risk for a

given level of return or maximizing the gain for a given level of risk. The risk taking capability

of a corporate will depend upon the financial backup to absorb the losses, if any, the availability

of time and resources to monitor the forex market.

(i) FUTURE CONTRACT

In finance, a futures contract is a standardized contract, traded on a futures exchange,

to buy or sell a certain underlying instrument at a certain date in the future, at a pre-set

price. The future date is called the delivery date or final settlement date. The pre-set

price is called the futures price. The price of the underlying asset on the delivery date is


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called the settlement price. The settlement price, normally, converges towards the

futures price on the delivery date.

A futures contract gives the holder the right and the obligation to buy or sell, which

differs from an options contract, which gives the buyer the right, but not the obligation,

and the option writer (seller) the obligation, but not the right. To exit the commitment,

the holder of a futures position has to sell his long position or buy back his short

position, effectively closing out the futures position and its contract obligations. Futures

contracts are exchange traded derivatives. The exchange acts as counterparty on all

contracts, sets margin requirements, etc.

BASIC FEATURES OF FUTURE CONTRACT

1. Standardization:

Futures contracts ensure their liquidity by being highly standardized, usually by

specifying:

The underlying. This can be anything from a barrel of sweet crude oil to a short

term interest rate.

The type of settlement, either cash settlement or physical settlement.

The amount and units of the underlying asset per contract. This can be the

notional amount of bonds, a fixed number of barrels of oil, units of foreign

currency, the notional amount of the deposit over which the short term interest

rate is traded, etc.

The currency in which the futures contract is quoted.

The grade of the deliverable. In case of bonds, this specifies which bonds can be

delivered. In case of physical commodities, this specifies not only the quality of

the underlying goods but also the manner and location of delivery. The delivery

month.

The last trading date.

Other details such as the tick, the minimum permissible price fluctuation.


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2. Margin:

Although the value of a contract at time of trading should be zero, its price constantly

fluctuates. This renders the owner liable to adverse changes in value, and creates a

credit risk to the exchange, who always acts as counterparty. To minimize this risk, the

exchange demands that contract owners post a form of collateral, commonly known as

Margin requirements are waived or reduced in some cases for hedgers who have

physical ownership of the covered commodity or spread traders who have offsetting

contracts balancing the position.

Initial Margin: is paid by both buyer and seller. It represents the loss on that contract,

as determined by historical price changes, which is not likely to be exceeded on a usual

day's trading. It may be 5% or 10% of total contract price.

Mark to market Margin: Because a series of adverse price changes may exhaust the

initial margin, a further margin, usually called variation or maintenance margin, is

required by the exchange. This is calculated by the futures contract, i.e. agreeing on a

price at the end of each day, called the "settlement" or mark-to-market price of the

contract.

To understand the original practice, consider that a futures trader, when taking a

position, deposits money with the exchange, called a "margin". This is intended to

protect the exchange against loss. At the end of every trading day, the contract is

marked to its present market value. If the trader is on the winning side of a deal, his

contract has increased in value that day, and the exchange pays this profit into his

account. On the other hand, if he is on the losing side, the exchange will debit his

account. If he cannot pay, then the margin is used as the collateral from which the loss

is paid.

3. Settlement

Settlement is the act of consummating the contract, and can be done in one of twoways, as specified per type of futures contract:

Physical delivery - the amount specified of the underlying asset of the contract is

delivered by the seller of the contract to the exchange, and by the exchange to the

buyers of the contract. In practice, it occurs only on a minority of contracts. Most are

cancelled out by purchasing a covering position - that is, buying a contract to cancel


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out an earlier sale (covering a short), or selling a contract to liquidate an earlier

purchase (covering a long).

Cash settlement - a cash payment is made based on the underlying reference

rate, such as a short term interest rate index such as Euribor, or the closing value of

a stock market index. A futures contract might also opt to settle against an index

based on trade in a related spot market.

Expiry is the time when the final prices of the future are determined. For many equity

index and interest rate futures contracts, this happens on the Last Thursday of certain

trading month. On this day the t+2 futures contract becomes the t forward contract.

PRICING OF FUTURE CONTRACT

In a futures contract, for no arbitrage to be possible, the price paid on delivery (the

forward price) must be the same as the cost (including interest) of buying and storing

the asset. In other words, the rational forward price represents the expected future

value of the underlying discounted at the risk free rate. Thus, for a simple, non-dividend

paying asset, the value of the future/forward, , will be found by discounting the

present value at time to maturity by the rate of risk-free return .

This relationship may be modified for storage costs, dividends, dividend yields, and

convenience yields. Any deviation from this equality allows for arbitrage as follows.

In the case where the forward price is higher:

1. The arbitrageur sells the futures contract and buys the underlying today (on the

spot market) with borrowed money.

2. On the delivery date, the arbitrageur hands over the underlying, and receives the

agreed forward price.

3. He then repays the lender the borrowed amount plus interest.

4. The difference between the two amounts is the arbitrage profit.

In the case where the forward price is lower:

1. The arbitrageur buys the futures contract and sells the underlying today (on the

spot market); he invests the proceeds.

2. On the delivery date, he cashes in the matured investment, which has

appreciated at the risk free rate.


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3. He then receives the underlying and pays the agreed forward price using the

matured investment. [If he was short the underlying, he returns it now.]

4. The difference between the two amounts is the arbitrage profit.


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TABLE 1-

DISTINCTION BETWEEN FUTURES AND FORWARDS CONTRACTS

FEATURE FORWARD CONTRACT FUTURE CONTRACT

Operational

Mechanism

Traded directly between

two parties (not traded on

the exchanges).

Traded on the exchanges.

Contract

Specifications

Differ from trade to trade. Contracts are standardized

contracts.

Counter-party

risk

Exists. Exists. However, assumed by the

clearing corp., which becomes the

counter party to all the trades or

unconditionally guarantees their

settlement.

Liquidation

Profile

Low, as contracts are

tailor made contracts

catering to the needs ofthe needs of the parties.

High, as contracts are standardized

exchange traded contracts.

Price discovery Not efficient, as markets

are scattered.

Efficient, as markets are centralized

and all buyers and sellers come to a

common platform to discover the

price.

Examples Currency market in India. Commodities, futures, Index Futures

and Individual stock Futures in India.


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OPTIONS -

A derivative transaction that gives the option holder the right but not the obligation to

buy or sell the underlying asset at a price, called the strike price, during a period or on a

specific date in exchange for payment of a premium is known as option. Underlyingasset refers to any asset that is traded. The price at which the underlying is traded is

called the strike price.

There are two types of options i.e., CALL OPTION & PUT OPTION.

CALL OPTION:

A contract that gives its owner the right but not the obligation to buy an underlying

asset-stock or any financial asset, at a specified price on or before a specified date is

known as a Call option. The owner makes a profit provided he sells at a higher current

price and buys at a lower future price.

PUT OPTION:

A contract that gives its owner the right but not the obligation to sell an underlying asset-

stock or any financial asset, at a specified price on or before a specified date is known

as a Put option. The owner makes a profit provided he buys at a lower current price

and sells at a higher future price. Hence, no option will be exercised if the future price

does not increase.

Put and calls are almost always written on equities, although occasionally preference

shares, bonds and warrants become the subject of options.


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SWAPS -

Swaps are transactions which obligates the two parties to the contract to exchange a

series of cash flows at specified intervals known as payment or settlement dates. They

can be regarded as portfolios of forward's contracts. A contract whereby two parties

agree to exchange (swap) payments, based on some notional principle amount is called

as a SWAP. In case of swap, only the payment flows are exchanged and not the

principle amount. The two commonly used swaps are:

INTEREST RATE SWAPS:

Interest rate swaps is an arrangement by which one party agrees to exchange his series

of fixed rate interest payments to a party in exchange for his variable rate interest

payments. The fixed rate payer takes a short position in the forward contract whereas

the floating rate payer takes a long position in the forward contract.

CURRENCY SWAPS:

Currency swaps is an arrangement in which both the principle amount and the interest

on loan in one currency are swapped for the principle and the interest payments on loan

in another currency. The parties to the swap contract of currency generally hail from two

different countries. This arrangement allows the counter parties to borrow easily and

cheaply in their home currencies. Under a currency swap, cash flows to be exchanged

are determined at the spot rate at a time when swap is done. Such cash flows are

supposed to remain unaffected by subsequent changes in the exchange rates.

FINANCIAL SWAP:

Financial swaps constitute a funding technique which permit a borrower to access one

market and then exchange the liability for another type of liability. It also allows the

investors to exchange one type of asset for another type of asset with a preferred

income stream.


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1 1 FUTURES

Futures contract is a firm legal commitment between a buyer & seller in which they

agree to exchange something at a specified price at the end of a designated period of time. The

buyer agrees to take delivery of something and the seller agrees to make delivery.

1.1

1.2 2.2 STOCK INDEX FUTURES

Stock Index futures are the most popular financial futures, which have been

used to hedge or manage the systematic risk by the investors of Stock Market. They are called

hedgers who own portfolio of securities and are exposed to the systematic risk. Stock Index is

the apt hedging asset since the rise or fall due to systematic risk is accurately shown in the Stock

Index. Stock index futures contract is an agreement to buy or sell a specified amount of an

underlying stock index traded on a regulated futures exchange for a specified price for settlement

at a specified time future.

Stock index futures will require lower capital adequacy and margin requirements

as compared to margins on carry forward of individual scrips. The brokerage costs on index

futures will be much lower.

Savings in cost is possible through reduced bid-ask spreads where stocks are

traded in packaged forms. The impact cost will be much lower in case of stock index futures as

opposed to dealing in individual scrips. The market is conditioned to think in terms of the index

and therefore would prefer to trade in stock index futures. Further, the chances of manipulation

are much lesser.

The Stock index futures are expected to be extremely liquid given the speculative

nature of our markets and the overwhelming retail participation expected to be fairly high. In the

near future, stock index futures will definitely see incredible volumes in India. It will be a

blockbuster product and is pitched to become the most liquid contract in the world in terms ofnumber of contracts traded if not in terms of notional value. The advantage to the equity or cash

market is in the fact that they would become less volatile as most of the speculative activity

would shift to stock index futures. The stock index futures market should ideally have more

depth, volumes and act as a stabilizing factor for the cash market. However, it is too early to base

any conclusions on the volume or to form any firm trend.


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The difference between stock index futures and most other financial futures

contracts is that settlement is made at the value of the index at maturity of the contract.

1.3 2.3 FUTURES TERMINOLOGY

1.4

Contract Size

The value of the contract at a specific level of Index. It is

Index level * Multiplier.

Multiplier

It is a pre-determined value, used to arrive at the contract size. It

is the price per index point.

Tick Size

It is the minimum price difference between two quotes

of similar nature.

Contract Month

The month in which the contract will expire.

Expiry DayThe last day on which the contract is available for trading.

Open interest

Total outstanding long or short positions in the market at any specific point in

time. As total long positions for market would be equal to total short positions, for

calculation of open Interest, only one side of the contracts is counted.

Volume

No. Of contracts traded during a specific period of time. During a day, during a

week or during a month.

Long position

Outstanding/unsettled purchase position at any point of time.


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Short position

Outstanding/ unsettled sales position at any point of time.

Open position

Outstanding/unsettled long or short position at any point of time.

Physical delivery

Open position at the expiry of the contract is settled through delivery of the

underlying. In futures market, delivery is low.

Cash settlement

Open position at the expiry of the contract is settled in cash. These contracts

Alternative Delivery Procedure (ADP) - Open position at the expiry of the contract is settled

by two parties - one buyer and one seller, at the terms other than defined by the exchange.

World wide a significant portion of the energy and energy related contracts (crude oil,

heating and gasoline oil) are settled through Alternative Delivery Procedure.

2.4 Pay off for futures:

A Pay off is the likely profit/loss that would accrue to a market participant with change in

the price of the underlying asset. Futures contracts have linear payoffs. In simple words, it means

that the losses as well as profits, for the buyer and the seller of futures contracts, are unlimited.

Pay off for Buyer of futures: (Long futures)The pay offs for a person who buys a futures contract is similar to the pay off for a

person who holds an asset. He has potentially unlimited upside as well as downside. Take the

case of a speculator who buys a two-month Nifty index futures contract when the Nifty

stands at 1220. The underlying asset in this case is the Nifty portfolio. When the index moves


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up, the long futures position starts making profits and when the index moves down it starts

making losses

.

Pay off for seller of futures: (short futures)

The pay offs for a person who sells a futures contract is similar to the pay off for a

person who shorts an asset. He has potentially unlimited upside as well as downside. Take

the case of a speculator who sells a two-month Nifty index futures contract when the Nifty

stands at 1220. The underlying asset in this case is the Nifty portfolio. When the index moves

down, the short futures position starts making profits and when the index moves up it starts

making losses.

OPTIONS


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2 3.1 OPTIONS

An option agreement is a contract in which the writer of the option grants the buyer of theoption the right to purchase from or sell to the writer a designated instrument at a specific price

within a specified period of time.

Certain options are shorterm in nature and are issued by investors another group of

options are long-term in nature and are issued by companies.

2.1

2.2 3.2 OPTIONS TERMINOLOGY:

Call option:

A call is an option contract giving the buyer the right to purchase the stock.

Put option:

A put is an option contract giving the buyer the right to sell the stock.

Expiration date:

It is the date on which the option contract expires.

Strike price:

It is the price at which the buyer of a option contract can purchase or sell the stock

during the life of the option

Premium:

Is the price the buyer pays the writer for an option contract.

Writer:

The term writer is synonymous to the seller of the option contract.

Holder:

The term holder is synonymous to the buyer of the option contract.

Straddle:


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A straddle is combination of put and calls giving the buyer the right to either buy

or sell stock at the exercise price.

Strip:

A strip is two puts and one call at the same period.

Strap:

A strap is two calls and one put at the same strike price for the same period.

Spread:

A spread consists of a put and a call option on the same security for the same time

period at different exercise prices.

The option holder will exercise his option when doing so provides him a benefit over

buying or selling the underlying asset from the market at the prevailing price. These are three

possibilities.

1. In the money: An option is said to be in the money when it is

advantageous to exercise it.

2. Out of the money: The option is out of money if it not advantageous to exercise it.

3. At the money: IF the option holder does not lose or gain whether he exercises his option

or buys or sells the asset from the market, the option is said to be at the money. The exchanges

initially created three expiration cycles for all listed options and each issue was assigned to one

of these three cycles.

January, April, July, October.

February, March, August, November.

March, June, September, and December.

In India, all the F and O contracts whether on indices or individual stocks are available for

one or two or three months series and they expire on the Thursday of the concerned month.


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2.3 3.3 CALL OPTION:

An option that grants the buyer the right to purchase a designated instrument is

called a call option. A call option is a contract that gives its owner the right, but not the

obligation, to buy a specified price on or before a specified date.

An American call option can be exercised on or before the specified date only. European

options can be exercised on the specified date only.

3.4 PUT OPTION:An option contract giving the owner the right, but not the obligation, to sell a specified

amount of an underlying security at a specified price within a specified time. This is the oppositeof a call option, which gives the holder the right to buy shares.

A put becomes more valuable as the price of the underlying stock depreciates relativeto the strike price. For example, if you have one Mar 09 Taser 10 put, you have the right to sell100 shares of Taser at $10 until March 2008 (usually the third Friday of the month). If shares

of Taser fall to $5 and you exercise the option, you can purchase 100 shares of Taser for $5 inthe market and sell the shares to the option's writer for $10 each, which means you make $500(100 x ($10-$5)) on the put option. Note that the maximum amount of potential proft in thisexample ignores the premium paid to obtain the put option.

3 3.5 FACTORS DETERMINIG OPTION VALUE:

Stock price

Strike price

Time to expiration Volatility

Risk free interest rate

Dividend

4

5 3.6 DIFFERENCE BETWEEN FUTURES & OPTION:

FUTURES

1) Both the parties are obligated to perform.

2) With futures premium is paid by either party.

OPTIONS

1) Only the seller (writer) is obligated to perform.

2) With options, the buyer pays the seller a


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3) The parties to futures contracts must perform

at the settlement date only. They are not

obligated to perform before that date.

4) The holder of the contract is exposed to the

entire spectrum of downside risk and had the

potential for all upside return.

5) In futures margins to be paid. They are

approximate 15-20% on the current stock

price.

premium.

3) The buyer of an options contract can exercise

any time prior to expiration date.

4) The buyer limits the downside risk to the option

premium but retain the upside potential.

5) In options premiums to be paid. But they are

very less as compared to the margins.

5.1.1.1.13.7 Advantages of option trading:

Risk management:put option allow investors holding shares to hedge against a possible

fall in their value. This can be considered similar to taking out insurance against a fall in

the share price.

Time to decide: By taking a call option the purchase price for the shares is locked in.

This gives the call option holder until the Expiry day to decide whether or exercised the

option and buys the shares. Likewise the taker of a put option has time to decide whether

or not to sell the shares.

Speculations: The ease of trading in and out of option position makes it possible to trade

options with no intention of ever exercising them. If investor expects the market to rise,

they may decide to buy call options. If expecting a fall, they may decide to buy put

options. Either way the holder can sell the option prior to expiry to take a profit or limit a

loss. Trading options has a lower cost than shares, as there is no stamp duty payable

unless and until options are exercised.

Leverage: Leverage provides the potential to make a higher return from a smaller initial

outlay than investing directly however leverage usually involves more risks than a direct


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investment in the underlying share. Trading in options can allow investors to benefit from

a change in the price of the share without having to pay of the share.

3.8 Summary of options

Call option buyer Call option writer (seller)

Pays premium

Right to exercise and buy the share

Profits from rising prices

Limited losses, potentially unlimited

gain

Receives premium

Obligation to sell shares if exercised

Profits from falling prices or remaining

neutral

Potentially unlimited losses, limited gain

Put option buyer Put option writer (seller)

Pays premium

Right to exercise and sell shares

Profits from falling prices

Limited losses, potentially unlimited

gain

Receives premium

Obligation to buy shares if exercised

Profits from rising prices or remaining

neutral

Potentially unlimited losses, limited gain

Options in India: Teji and MandiThe operations in the Indian market have been confined to call options (known as teji), put

options (know as mandi), their combination in the form of straddles (know as jhota or du-

ranga) and bhav- bhav on stock only. While in options trading markets in the world, options

with exercise price less than, equal to, greater than the stock price are available in the markets

only out-of-the-money call options i.e. options with an exercise price higher than the current

stock price, are traded. Hence the name teji. The seller or the writer of such an option is called

teji khaii-wal as he agrees to sell the share in case of teji (the price arising out above

the exercise price) for a value, the option premium. The buyer of the option is called teji lagaii-

wal.


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Similarly, the put options traded are also those which are out-of-the-money options i.e. options

with an exercise price lower than the current stock price. The writers of such options agree to

buy a share in the event of its price falling below the exercise price, i.e. mandi, in

consideration for a premium. The writer of an option of this type is called the mandi khaii-wal

while the buyer is a mandi lagaii-wal.Both teji and mandi have an expiry time at the stroke of 15 minutes before the closing time of

trading of the next business day. However, sometimes they are event-based, so that while they

can originate any day the exercise date is fixed, like the day following the budget day or the

day following the annual general meeting of the company whose share underlies the teji/mandi

contract. The premium on teji/mandi options is fixed customarily, usually at 25 paise per

share, and is not negotiable, although the strike price may be negotiated. On event-based

options, the premium payable is double than that on the ordinary options.The greater part of the derivative trading in India is in the form of jhota or fatak, which

involves the buyer, known variously as lagaii-wal or lagane-wale or punter, the writer, known

by various names like khaii-wal, khane-wala or bookie, and a broker, the mediator. A fatak

involves a call option and put option available to the punter at exercise prices higher and lower

than a certain value, which is generally the closing price of a share on a given day. The size of

fatak, that is to say, the gap between the exercise prices of call and put options is generally

higher before and after the market trading hours and it is smaller during these hours.Another derivative traded in the market is known as bhav-bhav or nazrana. In this case, the

closing price of the day is taken as the exercise price and the holder of nazrana can exercise a

call or put option depending on the price of the stock. For instance, if the closing price of a

stock is Rs 66 on a given day, then the holder shall hold both options with him: buy the share

from the bookie at a price of Rs 66 or sell to him the share at the same price (Rs 66) at the time

of exercise. It will obviously pay the option buyer to buy at Rs 66 if the share price goes

beyond this level and sell it to the writer at Rs 66 if the share price decreases below Rs 66.


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In nazrana, then, the exercise price is fixed and so is the date of expiry. However, the premium

is negotiable. The premium is roughly one-half of the amount of gap in fatak. Thus, with the

share price of Rs 66 and a fatak with exercise prices of Rs 63 and Rs 69, the gap is equal to Rs

3. In such case, the premium payable by a buyer shall be around Rs 1.50 per share.The nazrana apparently exposes the writer to greater risk by providing call and put options to

the buyer at the same exercise price, in contrast to a fatak where the same options are given but

with a gap in the exercise prices. However, a closer look at the two reveals that for a given

amount of premium, one has to write option on a larger number of shares in case of a fatak

than in case of nazrana. Accordingly, when there are significant fluctuations in the price of the

underlying share, a fatak involves a far greater degree of risk than a nazrana. The chronology of introduction of the futures and options in India is given

below:Although exchanges like Bombay Stock Exchanges and Vadodara Stock Exchange have for

long shown their willingness for trading in futures and options, but a concerted effort in this

direction was made by the National Stock Exchange (NSE) only in July 1995, when it

considered the modalities of introducing deritivative trading, mainly futures and options.

Within a few months, NSE developed a system of future and option trading aiming at

modifying the carry forward system to include future and options in its scope. By January

1996, the NSE started work on the scheme of such trading in March 1996; it made a

presentation to SEBI on its plan to commence trading in futures and options. The exchange

proposed to start with index based future and index base of options, which are seen as

comparably safer forms of derivatives.By May 1996, the NSE finalized the net worth requirement for the membership of the

purposed future and options trading segments, which was set at 5 crore. These constitute

NSEs first step towards initialing futures and options trading, which, the NSE visualized,

would commence in the month of November, 1996.


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The NSE decided for the future and options segment to have two type of membership (restrict

to just corporate members): member trading only in futures products, and those who write

options. The members were to further earmark cash deposits for the National securities

Clearing Corporation Limited (NSCCOL). The deposits collected by the NSCCL were to form

part of members contribution to a separate settlement fund for the future and options

segment, which was to commence operations along with trading in futures and options.Around this time the Bombay Stock Exchange (BSE) also decided to form a committee to

consider the introduction of trading in derivatives, government paper and debt market

instruments. It proposed to be working on index- based future and submitted a proposal to

SEBI.THE SEBI, in the mean time, set up a special derivatives regulatory department which would

coordinate and ensure the sharing the information between stock exchanges. It also set up the

L.C. Gupta Committee to go into the question of derivatives trading and to suggest various

policy and regulatory measures that need to be undertaken before trading is

Introduction of Futures

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Transcript of Introduction of Futures