Derivative Market Word 2003

8/8/2019 Derivative Market Word 2003

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INDEX

Srno

Pageno

Topic Remarks Sign

1.0 1 8 Introduction to

derivative market

1.1 4 4 Derivative chart

1.2 5 8 Forward/future contracts

2.0 9 30 Introduction to options

2.1

2.1.

1

2.1.

2

10

17

18

18

18

18

Call option.

Graphs.

Exercising the call option

and what are the

implications on the buyer

and seller.

2.2

2.2.

1

19

21

21

21

Put option

graph

2.3 22 23 Market player

2.4 24 24 Option undertaking

2.5 24 25 Option classification

2.6

2.6.

26 30 Option pricing

Effect of increase in the


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1

2.6.

2

2.6.

3

2.6.

4

2.6.

5

27

29

2929

30

28

29

2929

30

relevant parameter of option

price.

Time to expiration

volatility

risk free rate of interest

dividends

3.0 31 32 History of derivatives

3.1 31 32 Important aspects in the

history of derivative market

4.0 33 39 International derivatives

4.1 33 34 Major equity derivativeexchanges in the world

4.2 35 35 Other financial derivative

exchange in the world

4.3 36 39 Popular stock index future in

the world

5.0 40 46 Benefits of derivatives

6.0 47 58 Introduction of futures in

india


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6.1 47 47 What are index futures

6.2 48 49 Frequently used terms in

the index futures

6.3 49 49 Concept of basis in the

futures market

6.4 50 51 Pricing futures

6.5 51 55 Index future cost and

futures model.

6.6

6.6.

1

6.6.

2

55

55

56

56

55

56

Risk management through

futures

Some specific use of index

futures

Speculation in the futures

market

6.7 56 58 Margining in the futures

market

7.0 59 62 Derivative markets today

7.1 60 60 Operators in the derivative

market

7.2 60 62 Equity derivative exchange

in the world

8.0 63 71 Introduction to indexes

8.1 63 63 Whats an index

8.2 63 63 Whats an stock index


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8.3 64 64 Why do we do need an

index

8.4 64 64 What does the number

mean

8.5 65 65 How are the stocks in the

portfolio weighted?

8.6 65 65 What is better weighing

option

8.7 66 66 Who owns the index? Who

computes it ?

8.8 66 66 Who decides what stocks to

include? How?

8.9 67 67 Selection criteria

8.1

0

68 68 What is benchmark index

8.1

1

68 68 What are the popular

indexes in india?

8.1

2

69 69 What are sectoral indexes

8.1

3

69 71 What are the uses of index

in india?

9.0 7

2

76 Financial risk

management

9.1 76 72 Four steps in risk

management


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DERIVATIVE MARKET IN INDIA

Warren Buffett - (Chairman & CEO of Hathaway,Investor)

- It takes 20 years to build a reputation and five minutes to

ruin it. If you think about that, you'll do things differently.

- Rule No.1: Never lose money. Rule No.2: Never forget rule

No.1.

- Derivatives are financial weapons of mass destruction.

[1] INTRODUCTION TO DERIVATIVE

MARKET
http://www.brainyquote.com/quotes/quotes/w/warrenbuff108887.htmlhttp://www.brainyquote.com/quotes/quotes/w/warrenbuff108887.html


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A Derivative is a financial instrument whose value

depends on other, more basic, underlyingvariables. The variables underlying could be prices

of traded securities and stock, prices of gold or

copper. Derivatives have become increasingly

important in the field of finance,

Broadly Derivatives markets can be classified intotwo categories, those that are traded on the

exchange and those traded one to one or over the

counter. They are hence known as;

1

Exchange Traded Derivatives

Exchange-traded derivative contracts are

standardized derivative contracts (e.g. futures

contracts and options) that are transacted on an

organized futures exchange. Their traded on an

organized stock exchange.

OTC Derivatives (Over The Counter)

Derivatives not traded on a futures exchange are

traded on over-the-countermarkets, also known as
http://en.wikipedia.org/wiki/Futures_contracthttp://en.wikipedia.org/wiki/Futures_contracthttp://en.wikipedia.org/wiki/Futures_contracthttp://en.wikipedia.org/wiki/Futures_contract


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the OTC market. These consist ofinvestment

banks who have traders who make markets in

these derivatives, and clients such as hedge

funds, commercial banks, government sponsoredenterprises, etc.

Derivative is a product/contract which does nothave any value on its own i.e. it derives its valuefrom some underlying. The underlying asset can be

equity, forex,Commodity or any other asset.

2

For example, wheat farmers may wish to sell theirharvest at a future date to eliminate the risk of achange in prices by that date.
http://en.wikipedia.org/wiki/Investment_bankhttp://en.wikipedia.org/wiki/Investment_bankhttp://en.wikipedia.org/wiki/Market_makerhttp://en.wikipedia.org/wiki/Hedge_fundhttp://en.wikipedia.org/wiki/Hedge_fundhttp://en.wikipedia.org/wiki/Commercial_bankhttp://en.wikipedia.org/wiki/Government_sponsored_enterprisehttp://en.wikipedia.org/wiki/Government_sponsored_enterprisehttp://en.wikipedia.org/wiki/Investment_bankhttp://en.wikipedia.org/wiki/Investment_bankhttp://en.wikipedia.org/wiki/Market_makerhttp://en.wikipedia.org/wiki/Hedge_fundhttp://en.wikipedia.org/wiki/Hedge_fundhttp://en.wikipedia.org/wiki/Commercial_bankhttp://en.wikipedia.org/wiki/Government_sponsored_enterprisehttp://en.wikipedia.org/wiki/Government_sponsored_enterprise


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The price of this derivative is driven by the spotprice of wheat which is the underlying.

Derivative products initially emerged as hedging

devices against fluctuations in commodity prices ,and commodity linked derivatives remained thesole form of such products for almost threehundred years. Derivatives are securities under theSCA and hence the trading of derivatives isgoverned by the regulatory framework under theSC(R)A.

In the Indian context the securities contracts(regulation) Act, 1956 (SC(R)A) defines derivativeto include:

1. A security derived from a debt instrument,share, loan whether secured or unsecured,risk instrument or contract for differences or

any other form of security.

2. A contract which derives its value fromthe prices, or index of prices, of underlying

securities.

3

[1.1] Derivative chart


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Derivative

s

Future Option Forward Swaps

TYPES OF DERIVATIVES MARKET

Exchange Traded Derivatives Over The

Counter Derivatives

National Stock Exchange Bombay Stock Exchange National Commodity & Derivative

exchange

Index Future Index option Stock option Stock future

TYPES OF DERIVATIVES

4

[1.2 ] Forward / Future Contracts


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5

Forward contractsA forward contract is an agreement to buy

or sell an asset on a specified date for a

specified price. One of the parties to the

contract assumes a long position and agrees to

buy the underlying asset on a certain specified

future date for a certain specified price. The

other party assumes a short position and agrees

to sell the asset on the same date for the same

price. Other contract details like delivery date,

price and quantity are negotiated bilaterally by

the parties to the contract. The forward

contracts are normal ly traded outside the

exchanges.

Th e salien t feature s o f forwar d contract s

are:


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They are bilateral contracts and hence exposed

to counter-party risk.

Each contract is custom designed, and hence

is unique in terms of contract size,

expiration date and the asset type and quality.

6

The contract price is generally not available in

public domain.

On the expiration date, the contract has to be

settled by delivery of the asset.

If the party wishes to reverse the contract, it

has to compulsorily go to the same counter-party, which often results in high prices being

charged.


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Future contractsIn 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. 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. .

7

Futures contracts are exchange traded derivatives.

The exchange acts as counterparty on all

contracts, sets margin requirements, etc.


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Future contracts are organized/ standardized

contracts, which are traded on the exchanges.

These contracts, being standardized and

traded on the exchanges are very liquid in

nature.

In futures market, clearing corporation/ house

provides the settlement guarantee.

8Donald trump - (Chairman and CEO of the Organization, a US-based real-estatedeveloper.)
http://en.wikipedia.org/wiki/Chairmanhttp://en.wikipedia.org/wiki/CEOhttp://en.wikipedia.org/wiki/Real-estate_developerhttp://en.wikipedia.org/wiki/Real-estate_developerhttp://en.wikipedia.org/wiki/Chairmanhttp://en.wikipedia.org/wiki/CEOhttp://en.wikipedia.org/wiki/Real-estate_developerhttp://en.wikipedia.org/wiki/Real-estate_developer


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- Every time you walk down the street people are screaming,'You're fired!'- I try to learn from the past, but I plan for the future by focusingexclusively on the present. That's were the fun is.- As long as your going to be thinking anyway, think big.

[2.0] Introduction to Options

Options are instruments whereby the right is

given by the option seller to the option buyer

to buy or sell a specific asset at a specificprice on or before a specific date.Options: Is it

just Another Derivative.

Options on stocks were first traded on an organized

stock exchange in 1973. Since then there has been

extensive work on


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9

these instruments and manifold growth in the field

has taken

the world markets by storm. This financialinnovation is present in cases of stocks, stock

indices, foreign currencies, debt instruments,

commodities, and futures contracts.

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

AND PUT OPTION.

[2.1] 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


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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 priceand buys at a lower future price.

10

The following example would clarify the basics on

Call Options.

Illustration :

An investor buys one European Call option on one

share of Reliance Petroleum at a premium of Rs. 2

per share on 31 July . The strike price is Rs.60 and

the contract matures on 30 September . Thepayoffs for the investor on the basis of fluctuating

spot prices at any time are shown by the payoff

table (Table 1). It may be clear form the graph that

even in the worst case scenario, the investor would

only lose a maximum of Rs.2 per share which

he/she had paid for the premium. The upside to ithas an unlimited profits opportunity.

On the other hand the seller of the call option has a

payoff chart completely reverse of the call options


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buyer. The maximum loss that he can have is

unlimited though a profit of Rs.2 per share would

be made on the premium payment by the buyer.

11

Payoff from Call Buying/Long (Rs.)

S Xt c Payoff NetProfit

57 60 2 0 -2

58 60 2 0 -2

59 60 2 0 -2

60 60 2 0 -2

61 60 2 1 -1

62 60 2 2 0

63 60 2 3 1

64 60 2 4 2

65 60 2 5 3


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66 60 2 6 4

A European call option gives the followingpayoff to the investor: max (S - Xt, 0).

The seller gets a payoff of: -max (S - Xt,0)

or min (Xt - S, 0).

Notes:

S - Stock Price

Xt - Exercise Price at time 't'

C - European Call Option Premium

Payoff - Max (S - Xt, O )

15

[ 2.1.1 ] Graphs


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[2.1.2] Exercising the Call Optionand what are its implications for theBuyer and the Seller?

The Call option gives the buyer a right to buy

the requisite shares on a specific date at a

specific price. This puts the seller under theobligation to sell the shares on that specific

date and specific price. The Call Buyer

exercises his option only when he/ she feels it

is profitable. This Process is called "Exercising

the Option".

17

This leads us to the fact that if the spot price

is lower than the strike price then it might be

profitable for the investor to buy the share in

the open market and forgo the premium

paid.


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The implications for a buyer are that it is

his/her decision whether to exercise the

option or not. In case the investor expects

prices to rise far above the strike price in the

future then he/she would surely be interestedin

buying call options.

On the other hand, if the seller feels that his

shares

are not giving the desired returns and they

are not going to perform any better in the

future, a premium can be charged and

returns from selling the call option can be

used to make up for the desired returns. At

the end of the options contract there is an

exchange of the underlying asset. In the real

world, most of the deals are closed with

another counter or reverse deal. There is no

requirement to exchange the underlying

assets then as the investor gets out of the


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contract just before its expiry.

18

[2.2] 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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The following example would clarify the basics on

put option.

Illustration 2:An investor buys one European Put Option on one

share of Reliance Petroleum at a premium of Rs. 2

per share on 31 July. The strike price is Rs.60 and

the contract matures on 30 September. The payoff

table shows the fluctuations of net profit with a

change in the spot price.

19

The payoff for the put buyer is :max (Xt - S,

0)

The payoff for a put writer is : -max(Xt - S, 0)

or min(S - Xt, 0)

Payoff from Put Buying/Long (Rs.)


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S Xt p Payoff Net Profit

55 60 2 5 3

56 60 2 4 257 60 2 3 1

58 60 2 2 0

59 60 2 1 -1

60 60 2 0 -2

61 60 2 0 -2

62 60 2 0 -263 60 2 0 -2

64 60 2 0 -2

20

[2.2.1] Graph


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These are the two basic options that form

the whole gamut of transactions in the

options trading. These in combination with

other derivatives creat a whole world of

instruments to choose form depending on

the kind of requirement and the kind ofmarket expectations.

21


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.They are traders with a view and objective

of making profits. They are willing to take

risks and they bet upon whether the

markets would go up or come down.

22

Arbitrageurs:

Riskless Profit Making is the prime goal of

Arbitrageurs. Buying in one market andselling in another, buying two products in

the same market are common. They could

be making money even without putting


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there own money in and such opportunities

often come up in the market but last for

very short timeframes. This is because assoon as the situation arises arbitrageurs

take advantage and demand-supply forces

drive the markets back to normal.

23

[2.4] Options undertakingsStocks

Foreign Currencies

Stock Indices

Commodities

Others - Futures Options, are options on the

futures contracts or underlying assets arefutures contracts. The futures contract

generally matures shortly after the options

expiration


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[ 2.5 ] Options ClassificationsOptions are often classified as ;

In the money - These result in a positive

cash flow towards the investor.

At the money - These result in a zero-cash

flow to the investor.

Out of money - These result in a negative

cash flow for the investor.

24

Example:

Calls

Reliance 350 Stock Series

Other uncommon options include ;

Naked Options: These are options which


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are not combined with an offsetting contract

to cover the existing positions.

Covered Options: These are option

contracts in which the shares are already

owned by an investor (in case of covered

call options) and in case the option is

exercised then the offsetting of the deal can

be done by selling these shares held.

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[2.6] OPTIONS PRICING ;

Unlike futures which derives there prices


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primarily from prices of the undertaking.

Option's prices are far more complex. The table

below helps understand the affect of each of

these factors and gives a broad picture of option

pricing keeping all other factors constant. The

table presents the case of European as well

as American Options.Changes in the

underlying security price can increase or

decrease the value of an option. These price

changes have opposite effects on calls andputs. For instance, as the value of the underlying

security rises, a call will generally increase and

the value of a put will generally decrease in

price. A decrease in the underlying security's

value will generally have the opposite effect.


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26

[2.6.1] EFFECT OF INCREASE IN THE

RELEVANT PARAMETRE ON OPTION PRICES

EUROPEANOPTIONS

Buying

AMERICANOPTIONS

BuyingPARAMETERS CALL PUT CALL PUTSpot Price (S)Strike Price

(Xt)

Time toExpiration (T)

? ?

Volatility ()Risk Free

Interest Rates

(r)Dividends (D)

Favourab


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strike price would reduce the profits for the

holder of the call option.

28

[2.6.2] TIME TO EXPIRATION:

More the time to Expiration more favorable is the

option. This can only exist in case of American

option as in case of European Options the

Options Contract matures only on the Date of

Maturity.

[2.6.3]VOLATILITY

:


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More the volatility, higher is the probability of

the option generating higher returns to the

buyer. The downside in both the cases of call

and put is fixed but the gains can be unlimited. If

the price falls heavily in case of a call buyer then

the maximum that he loses is the premium paid

and nothing more than that. More so he/ she can

buy the same shares form the spot market at a

lower price. Similar is the case of the put option

buyer.

[2.6.4] RISK FREE RATE OF INTEREST

:

In reality the r and the stock market is inversely

related. But theoretically speaking, when all

other variables are fixed and interest rateincreases this leads to a double effect: Increase

in expected growth rate of stock prices

Discounting factor increases making the price

fall.

29

In case of the put option both these factors

increase and lead to a decline in the put value. A


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higher expected growth leads to a higher price

taking the buyer to the position of loss in the

payoff chart. The discounting factor

increases and the future value becomes

lesser.

In case of a call option these effects work in the

opposite direction. The first effect is positive as

at a higher value in the future the call option

would be exercised and would give a profit. Thesecond affect is negative as is that of

discounting. The first effect is far more dominant

than the second one, and the overall effect is

favorable on the call option.

[2.6.5] DIVIDENDS

:

When dividends are announced then the stock

prices on ex-dividend are reduced. This is

favorable for the put option and unfavorable for

the call option.


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contracts, stating what is to be delivered for a fixed price

at a specified place on a specified date, existed in ancient

Greece and Rome. Roman emperors entered forward

contracts to provide the masses with their supply of

Egyptian grain. These contracts were also undertaken

between farmers and merchants to eliminate risk arising

out of uncertain future prices of grains. Thus, forward

contracts have existed for centuries for hedging price

risk.

31

[3.1] The important aspects in the history of

derivative market

The first organized commodity exchange came into existence

in the early 1700s in Japan.

The first formal commodities exchange, the Chicago Board of

Trade (CBOT), was formed in 1848 in the US to deal with

the problem of credit risk and to provide centralizedlocation to negotiate forward contracts.

On April 26, 1973, the Chicago Board options Exchange (CBOE)

was set up at CBOT for the purpose of trading stock

options. It was in 1973 again that black, Merton, and

Scholes invented the famous Black-Scholes Option


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Formula. This model helped in assessing the fair price of

an option which led to an increased interest in trading of

options.

The collapse of the Bretton Woods regime of fixed parties andthe introduction of floating rates for currencies in the

international financial markets paved the way for

development of a number of financial derivatives which

served as effective risk management tools to cope with

market uncertainties.

The most traded stock indices include S&P 500, the Dow Jones

Industrial Average, the Nasdaq 100, and the Nikkei 225.

(The market in late seventeenth-century London)

32

Richard Branson - (British industrialist, best known for his Virgin brand of over 360companies.)
http://en.wikipedia.org/wiki/British_Peoplehttp://en.wikipedia.org/wiki/Business_magnatehttp://en.wikipedia.org/wiki/Virgin_Grouphttp://en.wikipedia.org/wiki/British_Peoplehttp://en.wikipedia.org/wiki/Business_magnatehttp://en.wikipedia.org/wiki/Virgin_Group


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EurexEurex is owned jointly by Deutsche Borse AG and TheSwiss Exchange, each of which hold 50% stake in thecompany. It was formed by merger of German Deutsche

Terminborse (DTB) and Switzerlands SOFFEX. It has afully electronic trading platform.

Hongkong Futures ExchangeThe Exchange operates futures and options markets on abroad range of products including equity index, stock,interest rate and foreign exchange products. Theseproducts are traded either on the Exchange's trading

floor via open outcry or electronically on its Hong KongFutures

The London International Financial Futures andOptions Exchange (LIFFE)LIFFE offers the most extensive range of derivativeproducts of any exchange in the world providing futures

and options contracts across six different currencies andacross four product lines bonds, short term interestrates, equity indices & individual stocks and commodities.

The London Clearing House (LCH) acts as centralcounterparty to all transactions on LIFFE, and offers theworlds most diverse range of margin offsets.

Singapore ExchangeSingapore exchange is the first demutualised integratedsecurities and derivatives exchange in Asia Pacific.Inaugurated on 1st December 1999, It operates throughseveral subsidiaries


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34

[4.2] Other Financial Derivative Exchanges in the

World

American Stock Exchange

MATIF (France)

Warsaw Stock Exchange (Poland)

Chicago Board Options Exchange

Commodities and Futures Exchange (Brazil)

Commodity and Monetary Exchange of Malaysia

Hong Kong Futures Exchange

Italian Derivatives Market (IDEM)

MICEX (Russia)

Kansas City Board of Trade (USA)

Korea Stock Exchange

New Zealand Futures & Options Exchange Ltd.

Oporto Derivatives Exchange (Portugal)

Oslo Stock Exchange (Norway)

Pacific Exchange (USA)

Philadelphia Stock Exchange

Rio de Janeiro Stock Exchange

Taiwan International Mercantile Exchange

Sao Paulo Stock Exchange

Toronto Futures Exchange

AEX-Options Exchange (Netherlands)

MONEP (France)

Belgian Futures & Options Exchange

Budapest Stock Exchange

Chicago Board of Trade

Helsinki Exchange

Copenhagen Stock Exchange

MICEX (Russia)

Montreal Exchange

New York Board of Trade

New York Mercantile Exchange

OM London Exchange

Osaka Securities Exchange (Japan)

South African Futures Exchange

Spanish Financial Futures Market

Spanish Options Exchange

Swedish Futures & Options Market

Santiago Stock Exchange

Tokyo Stock Exchange


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35[4.3]Popular Stock Index Futures in the World

NYSE Composite :


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The NYSE composite was amongst the first stock indexfutures contract to be listed on May 6, 1982 at the New

York Futures Exchange (NYFE) a subsidiary of NYSE. It isbroadest of the broad stock indexes available

representing every common stock traded on the NYSE. Italso has three choices in terms of its contract sizedepending on the multiplier that best suits an investor.

The regular contract launched on May 6, 1982 has amultiplier of $500 times the index. The NYSE LargeComposite Index Contract has multiplier at $ 1000 whilethe NYSE small Composite Index uses a $ 250multiplier.NYSE large contract was aimed at institutional

users who could reduce their commission costs.

S&P 500

It is a market-cap index representing 500 leadingcompanies in leading industries in U.S. in large cap bluechip stocks. It is most often used as the benchmark by

fund managers for judging their performance in USmarkets.S&P 500 futures contract dominates stock indextrading in the US. Fifteen years later share rise in indexvalue and consequently contract size led to reduction incontract multiplies to $ 250.

Dow Jones Industrial Average

It is the oldest and most well known stock measure in theworld. Dow Jones & Company started it in May 26, 1896.

The next index in US came only 60 years later. Thelongevity accounts for its continued popularity today as apreferred measure of the market.


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36

It is a price-weighted index of 30 of the largest mostliquid blue chip US stocks, a number that has held steady

since 1928.

RUSSEL 1000

This is sub set of the broader Russel 3000 index whichtracks only U. S. companies. NYBOT ( New York Board of

Trade ) started futures and options based on Russel 1000

is march 99, offering two contract size one with $500multiplier and another with a $1000 multiplier.Russel1000 is a market capitalization index, but each onesweighting in the index is based on available marketcapitalization. It is the stocks with the most tradableoutstanding shares at the highest price that will hold themost influence on the index movement.

S & P Midcap 400

It is a capitalization weighted index of 400 U.S. stocksrepresenting companies whose capitalization is in themiddle range of all firms. None of the stocks in S&P 500can be in S&P Midcap 400 and vice versa. Futures &Options on this index are traded at CME with a Contract

multiplier of $500.

NASDAQ 100


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It comprises of top 100 non-financial stocks, domestic aswell as foreign, listed on NASDAQ. It trades on CME withtwo different contract multipliers - $100 and $20. It is amarket cap index with modified capitalization to reduce

the overwhelming influence of its top stocks likemicrosoft.

37

Hang Seng Index

This index is market capitalization weighted index of 33stocks, representing about 70% of the stock marketstotal capitalization. Futures on Hang Seng Index aretraded on Hong Kong futures Exchange with a contractmultiplier of H. K. $50.

Nikkei 225 Average

It is Japans longest running stock index. It is a priceweighted stock index. Future contracts on NIKKEI 225trade or three exchange CME, OSE (Osaka) and Simexwith contract multiples of $5, Yen 1000 & Yen 500respectively.

DAX

It is Germanys blue chip index of 30 leading stocks. It iscalculated on total returns basis and not just on pricebasis.Income from dividends and rights issues arereinvested in the index portfolio and are reflected in the


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company formed in 1995 and jointly owned by LSE andthe Financial times. It is a market capitalization index.Futures & options on the index are traded on LIFFE with acontract multiplier of Pound 10.

(Chicago board of trade building) ( NASDAQ building )

39

Robert Kiyosaki - (Investor, entrepreneur, author, motivational )

-Your future is created by what you do today, not tomorrow
http://en.wikipedia.org/wiki/Investorhttp://en.wikipedia.org/wiki/Entrepreneurhttp://en.wikipedia.org/wiki/Investorhttp://en.wikipedia.org/wiki/Entrepreneur


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- The size of your success is measured by the strength of your

desire; the size of your dream; and how you handle

disappointment along the way

-The only difference between a rich person and poor person is

how they use their time

[5.0] BENEFITS OF DERIVATIVES

Derivative markets help investors in many different ways:

RISK MANAGEMENT

Futures and options contract can be used for altering the

risk of investing in spot market. For instance, consider

an investor who owns an asset. He will always be

worried that the price may fall before he can sell the

asset. He can protect himself by selling a futures

contract, or by buying a Put option. This will help offset

their losses in the spot market. Similarly, if the spotprice falls below the exercise price, the put option can

always be exercised.

40

PRICE DISCOVERY

Price discovery refers to the markets ability to determine

true equilibrium prices. Futures prices are believed to

contain information about future spot prices and help in

disseminating such information. As we have seen,

futures markets provide a low cost trading mechanism.


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EASE OF SPECULATION

Derivative markets provide speculators with a cheaper

alternative to engaging in spot transactions. Also, the

amount of capital required to take a comparable

position is less in this case. This is important becausefacilitation of speculation is critical for ensuring free

and fair markets. Speculators always take calculated

risks. A speculator will accept a level of risk only if he is

convinced that the associated expected return is

commensurate with the risk that he is taking.


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Steve Jobs (Chairman and CEO, Apple Inc. Board of Directors, Walt Disney Company)

- You can't just ask customers what they want and then try togive that to them. By the time you get it built, they'll wantsomething new.- Why join the navy if you can be a pirate?- Be a yardstick of quality. Some people aren't used to anenvironment where excellence is expected.

[6.0] Introduction of futures in India

The first derivative product to be introduced in the Indian

securities market is going to be "INDEX FUTURES".

In the world, first index futures were traded in U.S. on

Kansas City Board of Trade (KCBT) on Value Line

Arithmetic Index (VLAI) in 1982.

[6.1] What are Index Futures ?

Index futures are the future contracts for which

underlying is the cash market index.
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For example: BSE may launch a future contract on "BSE

Sensitive Index" and NSE may launch a future contract on

"S&P CNX NIFTY".

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[6.2] Frequently used terms in Index Futures

market

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 Day - The last day on which the contract is

available for trading.

Open interest - Total outstanding long or short positionsin 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.


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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.

Short position - Outstanding/ unsettled sales position at

any point of time.

Open position - Outstanding/unsettled long or short

position at any point of time.

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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 are

designated as cash settled contracts. Index Futures fall in

this category.

[6.3] Concept of basis in futures market

Basis is defined as the difference between cash and

futures prices:

Basis can be either positive or negative (in Index

futures, basis generally is negative).


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Basis may change its sign several times during the

life of the contract.

Basis turns to zero at maturity of the futures contract

i.e. both cash and future prices converge at maturity

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[6.4] Pricing Futures

Cost and carry model of Futures pricing

Fair price = Spot price + Cost of carry Inflows

FPtT = CPt + CPt (RtT - DtT) (T-t)/365

FPtT - Fair price of the asset at time t for time T.

CPt - Cash price of the asset.

RtT - Interest rate at time t for the period up to T.


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DtT - Inflows in terms of dividend or interest between t

and T.

Cost of carry = Financing cost, Storage cost andinsurance cost.

If Futures price > Fair price; Buy in the cash

market and simultaneously sell in the futures

market.

If Futures price < Fair price; Sell in the cash

market and simultaneously buy in the futures

market.

This arbitrage between Cash and Future markets will

remain till prices in the Cash and Future markets get

aligned.

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Set of assumptions


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- No seasonal demand and supply in the underlying

asset.

- Storability of the underlying asset is not a problem.

- The underlying asset can be sold short.- No transaction cost; No taxes.

- No margin requirements, and so the analysis relates to

a forward contract, rather than a futures contract.

[6.5] Index Futures and cost and carry model

In the normal market, relationship between cash andfuture indices is described by the cost and carry model offutures pricing.

Expectancy Model of Futures pricing

S - Spot prices.

F - Future prices.

E(S) - Expected Spot prices.


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Expectancy model says that many a times it is not the

relationship between the fair price and future price but

the expected spot and future price which leads the

market. This happens mainly when underlying is not

storable or may not be sold short. For instance in

commodities market.

E(S) can be above or below the current spot prices. (This

reflects markets expectations)

[6.6] Risk management through Futures

Which risk are we going to manage through Futures ?

Basic objective of introduction of futures is to manage the

price risk.Index futures are used to manage the systemic risk,

vested in the investment in securities.

Hedge terminology

Long hedge- When you hedge by going long in futures

market.

Short hedge - When you hedge by going short in futuresmarket.

Cross hedge - When a futures contract is not available

on an asset, you hedge your position in cash market on

this asset by going long or short on the futures for


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another asset whose prices are closely associated with

that of your underlying.

[6.6.1] Some specific uses of Index Futures

Portfolio Restructuring - An act of increasing or

decreasing the equity exposure of a portfolio, quickly,

with the help of Index Futures.

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Index Funds - These are the funds whichimitate/replicate index with an objective to generate the

return equivalent to the Index. This is called Passive

Investment Strategy.

[6.6.2] Speculation in the Futures market

Speculation is all about taking position in the futuresmarket without having the underlying. Speculators

operate in the market with motive to make money. They

take:

Naked positions - Position in any future contract.

Spread positions - Opposite positions in two future

contracts. This is a conservative speculative strategy.Speculators bring liquidity to the system, provide

insurance to the hedgers and facilitate the price

discovery in the market.


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[6.7] Margining in Futures market

Whole system dwells on margins:

Daily Margins

Initial Margins

Maintenance margin

Daily Margins

Daily margins are collected to cover the losses which

have already taken place on open positions.Price for daily settlement - Closing price of futures index.

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Price for final settlement - Closing price of cash index.

For daily margins, two legs of spread positions would be

treated independently.Daily margins should be received by CC/CH and/or

exchange from its members before the market opens for

the trading on the very next day.

Daily margins would be paid only in cash.

Initial MarginsMargins to cover the potential losses for one day.

To be collected on the basis of value at risk at 99% of the

days.


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Maintenance margin

This is somewhat lower than the initial margin. This is set

to ensure that the that the balance in the margin accountnever 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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Striking an intelligent balance between safety and

liquidity while determining margins, is a milliondollar point.

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Jehangir Ratanji Dadabhoy Tata(pioneeraviator,Industrialistand was awardedIndia's highest civilian award, the Bharat Ratna in 1992)
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- Money is like manure. It stinks when you pile it; it growswhen you spread it.

- When you work, work as if everything depends on you. Whenyou pray, pray as if everything depends on God.

- Making steel may be compared to making a chappati(tortilla). To make a good chappati, even a golden pin willnot work unless the dough is good.

[7.0] Derivative Markets today

The Reserve Bank of India has permitted options, interest

rate swaps, currency swaps and other risk reductions OTC

derivative products.

Forward Markets Commission has allowed the setting upof commodities futures exchanges. Today we have 18

commodities exchanges most of which trade futures.


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In the equity markets both the National Stock Exchange

of India Ltd. (NSE) and The Stock Exchange, Mumbai

(BSE) have applied to SEBI for setting up their derivatives

segments.

BSE's and NSEs plans

Both the exchanges have set-up an in-house segment

instead of setting up a separate exchange for derivatives.

BSEs Derivatives Segment, will start with Sensex futures

as its first product.NSEs Futures & Options Segment will be launched with

Nifty futures as the first product.

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Product Specifications BSE-30 Sensex Future

Contract Size - Rs. 50 times the Index Active

contracts - 3 nearest months

Tick Size - 0.1 points or Rs. 5

Settlement basis - cash settled

Expiry day - last Thursday of the month Contract

cycle - 3 months

Product Specifications S&P CNX Nifty Futures

Contract Size - Rs. 200 times the Index Active

contracts - 3 nearest months


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Tick Size - 0.05 points or Rs. 10

Settlement basis - cash settled

Expiry day - last Thursday of the month Contract

cycle - 3 months

Membership

Membership for the new segment in both the exchanges

is not automatic and has to be separately applied for.

Membership is currently open on both the exchanges.

All members will also have to be separately registered

with SEBI before they can be accepted.

Trading Systems

NSEs Trading system for its futures and options segment

is called NEAT F&O. It is based on the NEAT system for

the cash segment.

BSEs trading system for its derivatives segment is called

DTSS. It is built on a platform different from the BOLT

system though most of the features are common.

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Settlement and Risk Management systems

Systems for settlement and risk management are

required to satisfy the conditions specified by the L.C.

Gupta Committee and the J.R. Verma committee. These

include upfront margins, daily settlement, online

surveillance and position monitoring and risk

management using the Value-at-Risk concept.

Certification programs


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The NSE certification programme is called NCFM (NSEs

Certification in Financial Markets). NSE has outsourced

training for this to various institutes around the country.

The BSE certification programme is called BCDE (BSEsCertification for the Derivatives Exchange). BSE conducts

its own training run by its training institute. Both these

programmes are approved by SEBI.

Rules and Laws

Both the BSE and the NSE have been give in-principle

approval on their rule and laws by SEBI. According to the

SEBI chairman, the Gazette notification of the Bye-Laws

after the final approval is expected to be completed by

May 2000.

Expected advantages of derivatives to the cash

market

Availability of risk management products attracts

more investors to the cash market.

Arbitrage between cash and futures markets fetches

additional business to cash market.

Improvement in delivery based business.

Lesser volatility

Improved price discovery.

Higher liquidity.

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Late Mr. Enzo Anselmo Ferrari (was an Italian race car driver andentrepreneur, Founder ofFerrari )
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- I use a derivative of this one, "If you buy the engine, I'll give you

everything else for free.

- I don't sell cars; I sell engines. The cars I throw in for free since

something has to hold the engines in.

- If you can dream it you can do it.

[8.0] INTRODUCTION TO INDEXES

[8.1]Whats an Index?

An Index is a number used to represent the changes in a set of

values between a base time period and another time period.

[8.2]Whats a Stock Index?

A Stock Index is a number that helps you measurethe levels of the market. Most stock indexesattempt to be proxies for the market they exist in.Returns on the index thus are supposed torepresent returns on the market i.e. the returnsthat you could get if you had the entire market inyour portfolio.

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[8.3] Why do we need an Index?

Students of Modern Portfolio Theory will appreciatethat the aim of every portfolio manager is to beat

the market.

In order to benchmark the portfolio against themarket we need some efficient proxy for themarket.

Indexes arose out of this need for a proxy.

[8.4] What does the number mean?

The index value is arrived at by calculating theweighted average of the prices of a basket of

stocks of a particular portfolio.This portfolio is called the index portfolio andattempts a high degree of correlation with themarket.


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Most index providers have a index committee of

some sort that decides on the composition of the

index based on standardised selection and

elimination criteria.The criteria for selection of course depends on the

philosophy of the index and its objective.

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[8.9] Selection Criteria

Most indexes attempt to strike a balance between

the following criteria.

Better Industry representation

Maximum coverage of market

capitalisation


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Higher Liquidity or Lower Impact cost.

Industry Representation

Since the objective of any index is to be a proxy for

the market it becomes imperative that the broad

industry sectors are faithfully represented in the

Index too.Though this seems like an easy enough

task, in practice it is very difficult to achieve due to

a number of issues, not least of them being the

basic method of industry classification.

Market Capitalisation

Another objective that most index providers strive

to achieve is to ensure coverage of some minimumlevel of the capitalisation of the entire market. As a

result within every industry the largest market

capitalisation stocks tend to select themselves.

However it is quite a balancing act to achieve the

same minimum level for every industry.

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Liquidity or Impact Cost


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It is important from the point of usability for all the

stocks that are part of the index to be highly liquid.

The reasons are two-fold. An illiquid stock has stale

prices and this tends to give a flawed value to theindex. Further for passive fund managers, the entry

and exit cost at a particular index level is high if

the stocks are illiquid. This cost is also called the

impact cost of the index.

[8.10] What is a Benchmark Index?

An index which acts as the benchmark in themarket has an important role to play.While it has to

be responsive to the changes in the market place

and allow for new industries or give up on dead

industries, at the same time it should also maintain

a degree of continuity in order to survive as an

benchmark index.

[8.11] What are the popular indexes in India?

BSE-30

Sensex

BSE-100

Natex

BSE Dollex

BSE-200

BSE-500

S&P CNX Nifty

S&P CNX Nifty

Jr.

S&P CNX Defty

S&P CNX

Midcap

S&P CNX 500


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[8.12] What are Sectoral Indexes?

These indexes provide the benchmark for sector

specific funds.Fund managers and other investors

who track particular sectors of the economy like

Technology, Pharmaceuticals, Financial Sector,

Manufacturing or Infrastructure use these indexes

to keep track of the sector performance.


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[8.13] What are the uses of an Index ?

Index based funds

These funds tend to replicate the index as it is in

order to match the returns on the market. This is

also know as passive management. Their argument

is that it is not possible to beat the market over a

sustained period of time through active

management and hence its better to replicate the

index. Example in India areUTIs fund on the Sensex , IDBI MFs fund on

the Nifty

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Exchange traded funds (ETFs)

These are similar to index funds that are traded onan exchange.

These are pretty popular world wide with non-

resident investors who like to take an exposure to

the entire market.

S&Ps SPDRs and MSCIs WEBS products are

amongst the most popular products.

Index futures


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Index futures are possibly the single most popular

exchange traded derivatives products today.The

S&P 500 futures products is the largest traded

index futures product in the world.In India both theBSE and NSE are due to launch their own index

futures product on their benchmark indexes

the Sensexand the Nifty.

What is the trend abroad?

Although we have a whole host of popularexchange owned indexes abroad including the DAX

30, the CAC 40 and the Hang Seng we see an

increasing trend where global index providers are

seen to have more influence among the foreign

funds and investing community.

What do Global Index providers bring ?

In the age of cross border capital flows and global

funds, global index provider provide the uniformity

and standardization in their index philosophy and

methodologies that allows a global

70fund to compare performance across regions or

sectors.

By following a common industry classification

standard in all the countries that they operate in,


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index providers hope to wean away liquidity from

the more popular and home grown indexes.Also

global providers are currently, the only ones in a

position to provide pan-continental or pan-globalindexes.

What does the future look like?

The future in India looks pretty exciting with Index

futures being launched and Index options expectedto follow. Hopefully with the growing popularity of

ETFs we might see SEBI allowing them in India

too.Globally while the debate between active and

passive fund management still rages, we see

standardised indexes growing in popularity.


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71Sir Winston Leonard Spencer-Churchill ( Prime Minister of the UnitedKingdom { 26 October1951 7 April 1955 } )

- The price of greatness is responsibility

- I am always ready to learn although I do not always like being

taught.

- We shall fight on the beaches. We shall fight on the landing

grounds. We shall fight in the fields, and in the streets, we shall

fight in the hills. We shall never surrender.

[9.0] Financial Risk Management

[9.1] Four Steps in Risk Management

1. Understand the nature of various risks.2. Define a risk management policy for the

organization and quantifying maximum risk thatorganization is willing to take if quantifiable.

3. Measure the risks if quantifiable and enumerateotherwise.
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4. Build internal control mechanism to control andmonitor all the risks.

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Step 1 Understand the nature of variousrisks

Risks can be classified into four categories.

Price or Market RiskCounterparty or Credit Risk

Dealing Risk

Settlement Risk

Operating Risks

Price or market RisksThis is the risk of loss due to change in marketprices. Price risk can increase further due toMarket Liquidity Risk, which arises when largepositions in individual instruments or exposuresreach more than a certain percentage of the

market, instrument or issue. Such a large positioncould be potentially illiquid and not be capable ofbeing replaced or hedged out at the currentmarket value and as a result may be assumed tocarry extra risk.
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Counterparty or credit risk RisksThis is the risk of loss due to a default of the

Counterparty in honoring its commitment in atransaction (Credit Risk). If the Counterparty issituated in another country, this also involvesCountry Risk, which is the risk of theCounterparty not honoring its commitmentbecause of the restrictions imposed by thegovernment though counterparty itself is capableto do so.

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Dealing RiskDealing Riskis the sum total of all unsettledtransactions due for all dates in future. If the

Counterparty goes bankrupt on any day, allunsettled transactions would have to be redone inthe market at the current rates. The loss would bethe difference between the original contract rateand the current rates. Dealing risk is thereforelimited to only the movement in the prices and ismeasured as a percentage of the total exposure.

Settlement RiskSettlement riskis the risk of Counterpartydefaulting on the day of the settlement. The risk inthis case would be 100% of the exposure if the


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corporate gives value before receiving value fromthe Counterparty. In addition the transaction wouldhave to be redone at the current market rates.

Operating RisksOperational risk is the risk that the organizationmay be exposed to financial loss either throughhuman error, misjudgment, negligence andmalfeasance, or through uncertainty,misunderstanding and confusion as toresponsibility and authority.

Step 2 - Define Risk PolicyDecide the basic risk policy that the organisationwants to have. This may vary from taking norisk(cover all) to taking high risks (open all). Mostorganisations would fall somewhere in between the

two extremes. Risk and reward go hand in hand.

Cost Center Vs. Profit Center

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A cost centre approach looks at exposuremanagement as insurance against adverse

movements. One is not looking for optimisation ofcost or realisation but meeting certain budgeted ortargeted rates. In a profit centre approach, thebusiness is taking deliberate risks to make moneyout of price movements.


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Step 3- Risk MeasurementThere are a number of different measures of price

or market risk which are mainly based on historicaland current market values Examples are Value atRisk (VAR), Revaluation, Modelling, Simulation,Stress Testing, Back Testing, etc.

Step 4- Risk Control

Control of Price RiskPosition limits are established to control the levelof price or market risk taken by the organization.Diversification is used to reduce systematic risk ina given portfolio.

Control of Credit Risk

Credit limits are established for each counterpartyfor both Dealing Risk and Settlement Riskseparatelydepending upon the risk perception ofthe counterparty.

Control of Operating RiskEstablishment of an effective and efficient internal

Documents

Derivative Market Word 2003