21 Derivative

8/10/2019 21 Derivative

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DERIVATIVES (Instrument for risk reduction)

WHAT IS A DERIVATIVE?

Derivatives is a product contract# which does not have an$ value on its

own i"e" it# derives its value from some underl$ing" Derivatives or derivatives

securities are contracts which are written etween two parties (counter

parties) and whose values is derived from underl$ing widel$ held and easil$

marketale assets such as agricultural and other ph$sical (tangile)

commodities or currencies or short term and long term financial instruments

tangile things like commodities price inde% (inflation rate)# euit$ price inde%

or ond price inde%" The counter parties to such contract are those other than

the original issuer (holder ) of the underl$ing assets " The e%change*traded

derivatives are uit liuid and have low transaction cost" It is possile to

comine them to match specific reuirements"

The value of derivatives and those of their underl$ing assets are

closel$ related" +suall$ in trading derivatives# the taking or making of deliver$

of underl$ing assets is not involved & the transactions are mostl$ settled $

taking offsetting positions in the derivatives themselves" There is therefore# no

effective limit on the claims# which can e traded in respect of underl$ing

assets" Derivatives are ,off alance- instruments# a fact is said to e oscure

the leverage and financial might give to the part$" The$ are mostl$ secondar$

market instruments and have little usefulness in moili!ing fresh capital $ the

companies" Although the standardi!ed# general e%change traded derivatives

are eing increasingl$ evolved# still there are man$ privatel$ negotiated#

customi!ed# .T/* traded financial contracts which are in vogue and which

e%pose the uses to operational risk" There is also and uncertaint$ aout the

regulator$ status of such derivatives"

Derivatives are used to facilitate hedging of price risk of inventor$

holding or a financial commercial transaction over a certain period" In

practice# ever$ derivatives 0contract1 has a fi%ed e%piration date # mostl$ in the

range of 2 to 23 months from the date of commencement of the contract"

(4resentl$ 2#3#5# month-s contracts are availale in India)

Example: A ver$ simple e%ample of derivatives is curd# which is

derivative of milk" The price of curd depends upon the price of milk which inturn depends upon the demand 6 suppl$ of milk"

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HISTORY OF DERIVATIVES

The first centrali!ed commodities market in 9ritain was founded in

the 2:; the =ondon /ommodit$ E%change in the Virginian

and 9altic coffee house the =ondon ?etal E%change in @erusalem and the

=ondon Stock E%change in @onathans" At the same time there was an

options market in olland at the Amsterdam Trade /enter ased on tulips"

+nfortunatel$ the speculative use of these options rought aout the

collapse of the Dutch econom$

.rgani!ed futures markets# as we know them toda$ reall$ developed in

the last centur$# primaril$ in the +S# when the /hicago 9oard of Trade

(/9.T) was estalished in 2BCB" At that time /hicago was not onl$ at the

center of the railroads& it was also an important port on the 8reat =akes and

close to the ?idwest farmlands" ith /hicago eing such an important center

for agricultural markets the /9.T was estalished to provide farmers with a

central market place to guarantee the prices for their livestock and grain"

THE NEED FOR A DERIVATIVES MARKET

The derivatives market performs a numer of economic functions>

2" The$ help in transferring risks from risk averse people to risk oriented

people

3" The$ help in the discover$ of future as well as current prices

5" The$ catal$!e entrepreneurial activit$

C" The$ increase the volume traded in markets ecause of participation of risk

averse people in greater numers

:" The$ increase savings and investment in the long run

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FACTORS DRIVING THE GROWTH OF FINANCIAL

DERIVATIVES:

2" Increased volatilit$ in asset prices in financial markets#

3" Increased integration of national financial markets with the international

markets#

5" ?arked improvement in communication facilities and sharp decline in their

costs#

C" Development of more sophisticated risk management tools# providing

economic agents a wider choice of risk management strategies# and

:" Innovations in the derivatives markets# which optimall$ comine the risks

and returns over a large numer of financial assets leading to higher returns#

reduced risk as well as transactions costs as compared to individual financial

assets"

WHAT KINDS OF RISKS DO PARTICIPANTS IN THEDERIVATIVES MARKETS FACE?

Some example o! "#$ a"e p"o%#&e& 'elo(>Co)*+e"pa"+, -o" &e!a)l+. "#$ ver$ low or almost !ero ecause

the e%change takes on the responsiilit$

Ope"a+#o*al "#$ risk that operational s$stems might fail

Le/al "#$ risk that legal oFections might e raised# regulator$

framework might disallow some activities

Ma"$e+ "#$ risk that market prices ma$ move ups or down

L#0)#+, "#$ risk that unwinding of transactions might e

difficult if the market is illiuid"

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DERIVATIVES MEM1ERSHIP

The Derivatives Segment memership is open to the e%isting memers

of the /ash Segment as well as non*memers provided the$ fulfill the

memership reuired as laid down from time to time" The following are the

different t$pes of memership presentl$ availale for the Derivatives Segment>

2) P"o!e#o*al Clea"#*/ Mem'e" -PCM.: 4/? means a /learing

?emer# who is permitted to clear and settle trades on his own account# on

account of his clients and or on account of trading memers and their clients"

3) C)+oa* Clea"#*/ Mem'e" -CCM.: //? means /ustodian

registered as /learing ?emer# who ma$ clear and settle trades on his own

account# on account of his clients and or on account of trading memers and

their clients"

5) T"a*/ C)m Clea"#*/ Mem'e" -TCM.: A T/? means a Trading

?emer who is also a /learing ?emer and can clear and settle trades on his

own account# on account of his clients and on account of associated Trading

?emers and their clients"

C) Sel! Clea"#*/ Mem'e" -SCL)> A S/? means a Trading ?emer who is

also a /learing ?emer and can clear and settle trades on his own account and

on account of his clients"

:) T"a*/ Mem'e" -TM.:AT? is a memer of the E%change who has

onl$ trading rights and whose trades are cleared and settled $ the /learing

?emer with whom he is associated"

;) L#m#+e& T"a*/ Mem'e" -LTM.:A =T? is a memer# who is not the

memers of the /ash Segment of the E%change# and would like to e a Trading?emer in the Derivatives Segment at 9SE" An =T? has onl$ the trading rights

and his trades are cleared and settled $ the clearing memer with whom he

is associated"

As on @anuar$ 2# 3


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E8AMPLE

Imagine $ou are a farmer" Jou grow 2#


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T2)9 +2e +(o mao" l#m#+a+#o* o! !o"(a"& a"e:

K /ounter part$ risk

K 4rice not eing transparent

/ounter part$ risk is also referred to as ,default- risk or ,credit- risk"

FUTURE CONTRACT

7utures trading was started in the mid western part of +SA during

2HG


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FEATURES OF FUTURES

K /ontract etween two parties through an e%change

K E%change is the legal counter part$ to oth partiesK 4rice decided toda$

K Luantit$ decided toda$ (uantities have to e in standard denominations

specified $ the e%change)

K Lualit$ decided toda$ (ualit$ should e as per the specifications decided $

the e%change)

K Tick si!e (i"e" the minimum amount $ which the price uoted can change) is

decided $ the e%change

K Deliver$ will take place sometime in future (e%pir$ date is specified $ the

e%change)

K ?argins are pa$ale $ oth the parties to the e%change

K In some cases# the price limits (or circuit filters) can e decided $ the

e%change"

LIMITATION OF FUTURE:

7utures suffer from lack of fle%iilit$"

Suppose $ou want to u$ 2


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Mea*#*/ o! exp#", o! F)+)"e

7utures contracts will e%pire on a certain pre*specified date" In India# futures

contracts e%pire on the last Thursda$ of ever$ month"

7or e%ample# a 7eruar$ 7utures contract will e%pire on the last Thursda$ of

7eruar$" In this case# 7eruar$ is referred to as the /ontract month"

If the last Thursda$ is a holida$# 7utures and .ptions will e%pire on the

previous working da$" .n e%pir$# all contracts will e compulsoril$ settled"

Settlement can e effected in cash or through deliver$"

Co*%e"/e*3e a+ Exp#"a+#o*

7utures pricing have e%pectations and a time value uilt into them" This

is the reason as time period e%pires the e%pectation value and the time value

deca$s and the futures price converges into the cash market price" This

process of convergence results in price discover$ of cash inde% at a given

point in time" /onvergence also forces the respective market participants to

suare off their respective e%posures or rollover their e%posures to the ne%t

contract month" /onvergence also reiterates the fact that derivatives

instruments have limited life"

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WHAT TYPE OF MARGINS ARE PAYA1LE ON

FUTURES?

9oth u$ers and sellers of 7utures should pa$ an Initial ?argin to the

e%change at the point of entering into 7utures contracts" This Initial ?argin is

retained $ the e%change till these transactions are suared up"

7urther# ?ark to ?arket ?argins are pa$ale ased on closing prices at the

end of each trading da$" These ?argins will e paid $ the part$ who suffered

losses and will e received $ the part$ who made profits"

The e%change thus collects these margins from the losers and pa$s them to

the winners on a dail$ asis"

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MARK = TO< MARKET

Ever$ da$ all the open positions in 7utures contracts are marked to the

closing price and the variation# if an$# is collected paid to the memers $

deiting crediting their settlement ank accounts with the respective clearing

anks on T O 2 morning" Also# where the positions are closed# profit loss on

such positions is also credited deited to the memer-s ank accounts"

Me+2o&olo/, !o" 3al3)la+#*/ 3lo#*/ p"#3e !o" &a#l, ma"$ +o

ma"$e+:

The dail$ closing price of the futures contract for calculating mark*to*market

margin is arrived at using following algorithm>*

eighted average price of all the trades in last half an hour of the continuous

trading session"

If there are no trades during last half an hour# then the theoretical price would

e taken as the official closing price" The theoretical price is arrived at $

using the following algorithm>*

T2eo"e+#3al p"#3e > Clo#*/ %al)e o! )*&e"l,#*/ - 3lo#*/

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%al)e o! )*&e"l,#*/ @ No5 o! &a, +o exp#", @ "#$ !"ee #*+e"e+

"a+e - a+ p"ee*+ 5B . B .5

HOW CAN I S7UARE UP A FUTURES CONTRACT?

If $ou have ought a 7utures contract# $ou can sell it and thus suare up" If

$ou sold a 7utures contract# $ou can u$ it ack and suare up"

If $ou do not suare up till the da$ of e%pir$# it will e automaticall$ suared up

$ the e%change"

HOW TO 1ENEFIT FROM STOCK FUTURES

Jou are ullish on a stock sa$ Sat$am# which is currentl$ uoting at Rs 3B It touches Rs 55< as $ou predicted $ou made a profit of Rs :< on an

investment of Rs 3B< i"e" a Return of 2B in one month 7antastic PP

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Wa#+> /an it get an$ etter M

Ye

7)e+#o*> hat should $ou do M

A*(e"> 9u$ Sat$am 7utures instead"

E!!e3+> .n u$ing Sat$am 7utures# $ou get the same position as Sat$am in

the cash market# ut $ou pa$ a margin and not the entire amount" 7or

e%ample# if the margin is 3


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even if $ou do not have an$ shares of Sat$am" Thus# $ou can enefit from a

downturn as well as from an upturn"

If $ou predict an upturn# $ou should u$ 7utures and if $ou predict a downturn#

$ou can alwa$s sell 7utures thus $ou can make mone$ in a falling market as

well as in a rising one an opportunit$ that till recentl$ was availale onl$ to

rokersoperators and not easil$ to retail investors"

Jou should look for opportunities where futures prices are higher than cash

prices" 7or e%ample# if Sat$am is uoting at Rs 3:< in the cash market and

one month Sat$am futures are uoting at Rs 3:5 in the futures market# $ou

can earn Rs 5 as difference" Jou will then u$ Sat$am in the cash market andat the same time# sell Sat$am one month futures"

.n or around the e%pir$ da$ (last Thursda$ of each month)# $ou will suare up

oth the positions# i"e" $ou will sell Sat$am in the cash market and u$

futures" The two prices will e the same (or ver$ nearl$ the same) as cash

and futures prices will converge on e%pir$" It does not matter to $ou what the

price is" Jou will make $our profit of Rs 5 an$wa$"

Fo" example# if the price is Rs 3G


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In this manner# $ou will generate returns whenever the futures prices are

aove cash market prices"

TRADERS PARTICIPANTS OPERATORS OF

FUTURE MARKETS

HEDGER

SPECULATOR

AR1ITRAGEURS

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SPREADERS

7uture contracts are ought and sold u$ large numer of individuals#

usiness organi!ations# governments and others for variet$ of purposes"The trader in the future market can e categori!ed on the asis of the

purposes for which the$ deal in the market"

U)all, !#*a*3#al &e"#%a+#%e a++"a3+ !ollo(#*/ +,pe o! +"a&e" a

)*&e":

HEDGERA edging is a position taken in futures or other markets for the purpose of

reducing e%posure to one or more t$pes of risk" A person who undertakes

such position is called as 0edger1" In other words# a hedger uses future

markets to reduce risk caused $ the movement in prices of securities#

commodities# e%change rate# interest rate# indices# etc" as such# a hedger

will take an opposite position to a perceived risk is called (hedging strateg$

in future markets1" The essence of hedging strateg$ is the adoption of future

position that# on average# generates profits when the market value of the

commitment is higher than the e%pected value"

SPECULATOR

A Speculator ma$ e defined as investors who are willing to take a risk

$ taking future position with the e%pectation to earn profits" The

speculators forecast the future economic condition and decide which

position (long and short) to e taken that will $ield a profit if the forecast

is reali!ed" In other words# Speculators are those who do not have an$

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position on which the$ enter in futures and options market" The$ onl$

have a particular view on the market# stock# commodit$# etc" In short#

speculators put their mone$ at risk in the hope of profiting from an

anticipated price change" The$ consider various factors such as demand#

suppl$# market positions# open interests# economic fundamentals and

other data to take their positions"

Ill)+"a+#o*:

Speculators usuall$ trade in the future markets to earn profits on

the asis of difference in spot and future prices of the underl$ing asset"

Ram is a trader ut has no time to track and anal$!e the stocks"owever# he fancies his chances in predicting the market trend" So

instead of u$ing different stocks# he u$s SE'SEN futures"

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An aritrageur is asicall$ risk averse" e enters into those contracts

were he can earn risk less profits" hen markets are imperfect# u$ing in

one market and simultaneousl$ selling in other market gives risk less

profit" Aritrageurs are alwa$s in the look out for such imperfections"

In the futures market one can take advantages of aritrage opportunities

$ u$ing from lower priced market and selling at the higher priced

market" In Inde% futures aritrage is possile etween the spot market

and the futures market ('SE has provided a special software for u$ing

all :< 'ift$ stocks in the spot market)"

Take the case of the 'SE 'ift$"

Assume that 'ift$ is at 23


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factor which causes changes in the spreads" In a profitale spread

position# normall$# there is a large gain on one side of the spread in

comparison to the loss on the other side of the spread" In this wa$# a

spread reduces the risks even if the forecast is incorrect" .n the other

hand# the pure speculators would make mone$ $ taking onl$ the

profitale side of the market ut at ver$ high risk"

TYPES OF FUTURES

F)+)"e 3o*+"a3+ a"e '"oa&l, %#&e& #*+o +(o +,pe:

COMMODITY FUTURES

FINANCIAL FUTURES

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COMMODITY FUTURES

A commodit$ futures is a contract in commodit$ like agricultural products#

metals 6 minerals etc" in organi!ed commodit$ futures markets#

contractscontracts are standardi!ed with standard uantities" .f course this

standard varies from commodit$ to commodit$ "the$ also have fi%ed deliver$

dates in each month or a few months on a $ear"

I* I*a 3ommo+, !)+)"e #* a/"#3)l+)"al p"o&)3+ a"e pop)la"5

Some o! +2e (ell e+a'l#2e& 3ommo+, !)+)"e a"e a

!ollo(:

2" =ondon metal stock e%change (=?E) to deal in gold

3" /hicago oard of trade (/9T) to deal in so$aean oil

5" 'ew Jork cotton e%change (/T') to deal in cotton

C" /ommodit$ e%change# 'E Jork (/.?EN) to deal in agricultural

products

:" International petroleum e%change of =ondon (I4E) to deal in crude oil

FINANCIAL FUTURES

The standardi!ed features or specification make 7utures tradale like a

contract" And since 7utures are derivatives# the 7utures contracts are ased

on an underl$ing" It is the movement of the underl$ing that decides how the

7utures price will move"

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There are onl$ two possile trades with a futures contract 9u$ or Sell" If

investor-s e%pectations for the underl$ing asset are ullish the$ should u$

futures" If the e%pectations prove to e correct# the futures contract will rise in

value allowing them to close out the position at a profit" If# on the other hand#

investors view the underl$ing asset as earish# then the$ should sell the

futures contract" If the view is correct# the$ will e ale to u$ ack the futures

at a lower price than the$ were sold for# the difference eing the profit the$

have made" Inde% 7utures contracts can e used to take a view on the

directions of the overall market with the added advantage of gearing"

7or e%ample# lets take the underl$ing asset on SE'SEN" If $ou elieve the

SE'SEN will rise $ou can u$ the futures contract ($ going long on the

SE'SEN futures) or if $ou elieve the SE'SEN will fall# $ou can sell the

SE'SEN futures ($ going short on the SE'SEN futures)"

7inancial Derivatives like futures do not generall$ terminate in deliver$" ?ost

positions are closed out efore e%pir$" So if investor# 0A1 had ought two

SE'SEN futures contracts giving them a long position# then he is reuired to

sell two SE'SEN futures# which will result in the investor having a short

position" This will mean that as far as the /learing ouse is concerned the

investor is oth long and short of two contracts"

Sell it ack into the market (If he is long)

9u$ it ack from the market (If he is short)

These two positions are then filed awa$ together netting one off with the

other" 'ot onl$ this will result in the investors having no outstanding position

in the futures# ut will also enale investors either to reali!e their profits or

reduce their losses"

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TYPES OF FINANCIAL FUTURE

4. INTEREST RATE FUTURE CONTRACT:

It is one of the important financial future instruments in the world" 7uture

trading on interest earing securities started onl$ in 2HG:# ut growth in the

market has een tremendous" Important interest earing securities are like

treasur$ ills# notes# onds# deenture# euro dollar time deposits and

municipal onds" In this market almost entire ranges of maturities earing

securities are traded"

Fo" e/> Three month maturit$ instruments like treasur$ ills 6 # including

foreign det instruments at /?E# 9ritish govt" ond at =ondon International "

financial future e%change (=I77E)# @apanese govt" ond at /9.T etc" are

traded"

6. FOREIGN CURRENCY FUTURE CONTRACT:

This financial future # as the name indicates# trade in 7oreign currencies # thusknown as e%change rate futures " active future trading in certain currencies

started in the earl$ 2HG


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which is to e delivered to fulfill the oligations as inde% futures are cash

settled" As other derivatives# the contract derives its value from the

underl$ing inde%" The underl$ing indices in this case will e the various

eligile indices and as permitted $ the Regulator from time to"

CONTRACT SPECIFICATIONS OF SENSE8 FUTURES

Fea+)"e SENSE8 F)+)"e

+nderl$ing inde% 9SE sensitive inde% (SE'SEN)

/ontract ?ultiplier :

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21 Derivative