Upload
anirbanccim8493
View
214
Download
0
Embed Size (px)
Citation preview
8/13/2019 Introduction to Deivatives
1/44
Introduction to derivatives
8/13/2019 Introduction to Deivatives
2/44
Introduction to derivatives
The emergence of the market for derivativeproducts, most notably forwards, futures andoptions, can be traced back to the willingness ofrisk-averse economic agents to guard themselves
against uncertainties arising out of fluctuations inasset prices. Through the use of derivative products, it is possible
to partially or fully transfer price risksby lockingin asset prices.
As instruments of risk management, these generallydo not influence the fluctuations in the underlyingasset prices.
8/13/2019 Introduction to Deivatives
3/44
Derivatives defined
Derivative is a product whose value isderived from the value of one or morebasic variables, called bases (underlyingasset, index, or reference rate), in acontractual manner.
The underlying asset can be equity, forex,
commodity or any other asset.
8/13/2019 Introduction to Deivatives
4/44
Arbitrage
Arbitrage is an important concept invaluing (pricing ) derivative securities.
If a return greater than risk free returncan be earned by holding a portfolio ofassets that produce a certain (risk less)return, then arbitrage opportunity exists.
Arbitrage opportunity arises whensecurities are mis priced
8/13/2019 Introduction to Deivatives
5/44
Principals of Derivatives
There are 2 types of arbitrage argumentsthat are useful in study and use ofderivative
-law of one price, 2securities that haveidentical cash flow in the future,regardless of the future events, shouldhave the same price. If A & B have theidentical future payoffs and A is priced islower than B, buy A and sell B
8/13/2019 Introduction to Deivatives
6/44
Principals of Derivatives
The second type of arbitrage is used when 2securities with uncertain returns can becombined in a portfolio that have a certain
payoff. If a portfolio consisting of A and B has a
certain pay off, the portfolio should yield therisk free rate. If this no arbitrage condition is
violated in that the certain return of A and Btogether is higher than the risk free rate, anarbitrage opportunity exists.
8/13/2019 Introduction to Deivatives
7/44
Products, participants and
functions
Derivative contracts have several variants.The most common variants are forwards,futures, options and swaps.
The following three broad categories ofparticipants - hedgers, speculators, andarbitrageurs trade in the derivatives market.
8/13/2019 Introduction to Deivatives
8/44
Need for Derivatives Market.
The derivative market helps to transfer the risksfrom those who have them but may not like themto those who appetite for them.
Market Risk
Credit Risk Price Discovery.
Increased integration of national financial markets
with the international markets. Derivative market helps to increase savings andinvestment in the long run.
8/13/2019 Introduction to Deivatives
9/44
Types of derivatives
Forwards
Futures
Swaps Warrants
8/13/2019 Introduction to Deivatives
10/44
DERIVATIVES WORLD
8/13/2019 Introduction to Deivatives
11/44
Types of markets Cash: Payment is made as soon as the deal is struck
Tom:Price is decided today whereas the transactionwill be settled on the next business day
Spot: Price is decided today whereas the transaction issettled two (or More) business days later
Forward/future: Price is decided today whereas thetransaction takes place on a future date (few months)
8/13/2019 Introduction to Deivatives
12/44
Exchange-traded vs. OTC
derivatives markets
The management of counter-party (credit) risk isdecentralized and located within individual institutions,
There are no formal centralized limits on individualpositions, leverage, or margining,
There are no formal rules for risk and burden-sharing, There are no formal rules or mechanisms for ensuring
market stability and integrity, and for safeguarding the collective interests of market participants,
and
The OTC contracts are generally not regulated by aregulatory authority and the exchangesself regulatory
organization, although they are affected indirectly bynational legal systems, banking supervision and marketsurveillance
8/13/2019 Introduction to Deivatives
13/44
Derivatives market in India
The derivatives trading on the exchange commenced withS&P CNX Nifty Index futures on June 12, 2000.
The trading in index options commenced on June 4, 2001and trading in options on individual securities commenced
on July 2, 2001. Single stock futures were launched onNovember 9, 2001.
The index futures and options contract on NSE are basedon S&P CNX Nifty Index. Currently, the futures contractshave a maximum of 3-month expiration cycles. Three
contracts are available for trading, with 1 month, 2 monthsand 3 months expiry. A new contract is introduced on thenext trading day following the expiry of the near monthcontract.
8/13/2019 Introduction to Deivatives
14/44
CLEARING AND SETTLEMENT
8/13/2019 Introduction to Deivatives
15/44
Understanding volume
They benchmark the degree of activity
Volume is the velocity of trading ornumber of contracts traded in a day (andnot the sum of buyers & sellers) .
To determine volume, simply add either allbuyers or all sellers.
Number of contract traded includescreation of new contract, transfer orliquidation of a contract.
8/13/2019 Introduction to Deivatives
16/44
Understanding Open Interest
Open Interest (OI) measures the number ofcontracts held at the conclusion of a tradingsession
It is a description of participation -tradersshow their conviction to the marketparticipation by taking their positions homewith them, at least overnight.
Important as many transactions may takeplace during the day without initiating newcontracts
8/13/2019 Introduction to Deivatives
17/44
An example
Day 1 Trader A buys one contractTrader B sells one contractTrader C buys one contractTrader D sells one contract
OI - 4 contractsVol. - 2 contract
Day 2 Trader E buys one contractTrader A sells to offset
OI - 4 contractsVol. - 1 contract
Day 3 Trader F buys one contractTrader G sells one contractTrader B buys to offsetTrader C sells to offsetTrader E sells to offsetTrader D buys to offset
OI - 2 contracts
Vol. - 3 contracts
8/13/2019 Introduction to Deivatives
18/44
SETTLEMENT MECHANISM Final Settlement: On expiry of the Futures market , all
positions of a CM , as existing at the close of tradinghours on the expiry day, are marked to market at thefinal settlement price of the contract , and theresulting profit/loss shall be settled in cash. The
loss/profit amount shall be debited /credited to therelevant CMson T+1 Day.
Final settlement price shall be the closing price of theunderlying security in the capital market segment of
the NSE/BSE, on the expiration day of the futurescontract.
8/13/2019 Introduction to Deivatives
19/44
SETTLEMENT MECHANISM
Premium Settlement: Buyers of option contracts areliable to pay the premium amount to the sellers. Thepay-in and pay-out of the premium settlement is onT+1 days.
Exercise Settlement: Interim Exercise Settlement: Aninvestor can exercise his in-the-money options atany time during trading hours. It shall be effectedat the close of the trading hours ,on the day ofexercise.
8/13/2019 Introduction to Deivatives
20/44
SETTLEMENT MECHANISM
The investor who has exercised the option willreceive the exercised settlement value per unitof the option from the investor who has beenassigned the option contract. Exercise settlementvalue is the difference between the strike priceand the exercise price. Exercise settlement priceis the closing price of the security on which theoption was purchased
The settlement is on T+1 days.
8/13/2019 Introduction to Deivatives
21/44
SETTLEMENT MECHANISM
Exercise Settlement : Final Exercise settlementshall be effected for all open long in-the-moneystrike price options existing at the close oftrading hours, on the expiration day of an optioncontract.
All such long positions shall be exercised andautomatically assigned to short positions inoption contracts with the same series, on arandom basis.
Final Settlement on T+1 days.
8/13/2019 Introduction to Deivatives
22/44
Trading mechanism
The futures and options trading system of NSE,called NEAT-F&O trading system, provides afully automated screenbased trading for Niftyfutures & options and stock futures & options ona nationwide basis and an online monitoringand surveillance mechanism.
It supports an anonymous order driven marketwhich provides complete transparency oftrading operations and operates on strict pricetime priority. It is similar to that of trading ofequities in the Cash Market (CM) segment.
8/13/2019 Introduction to Deivatives
23/44
Clearing and settlement
NSCCL undertakes clearing and settlementof all deals executed on the NSEs F&Osegment.
It acts as legal counterparty to all deals on theF&O segment and guarantees settlement.
8/13/2019 Introduction to Deivatives
24/44
Clearing
The first step in clearing process is workingout open positions or obligations ofmembers.
Positions are calculated on net basis (buy-sell) for each contract. Clients positions arearrived at by summing together net (buy-sell)
positions of each individual
8/13/2019 Introduction to Deivatives
25/44
Settlement
All futures and options contracts are cashsettled, i.e. through exchange of cash. Theunderlying for index futures/options of the
Nifty index cannot be delivered. Futures and options on individual securitiescan be delivered as in the spot market.However, it has been currently mandated
that stock options and futures would also becash settled.
Risk management system
8/13/2019 Introduction to Deivatives
26/44
Risk management systemThe salient features of risk containment
measures on the F&O segment are:
NSCCL charges an upfront initial margin forall the open positions of a CM up to clientlevel.
It follows the VaR based margining systemNSCCL computes the initial marginpercentage for each Nifty index futures
contract on a daily basis
8/13/2019 Introduction to Deivatives
27/44
Market Index
What are some major uses of security-market indicator series (indexes)?
Factors in Constructing Market Indexes?
What are the major stock-market indexesseries
Bond-market indexes
8/13/2019 Introduction to Deivatives
28/44
Uses of Security Market
For calculating benchmark returns tojudge portfolio performance
For development of an index portfolio
For technical analysis, to predict futureprice movements
To compute a securitys systematic riskbyexamining how its return responds tochanges in the market index
8/13/2019 Introduction to Deivatives
29/44
Factors in Constructing MarketIndexes
The sample of firms to include
What is the intended population that thesample is to represent? How large a sample is
needed for the index to be representative?
Weighting system for sample members
Should the weighting system be based on
price, total firm value, or equally weighted?
8/13/2019 Introduction to Deivatives
30/44
Stock-Market Indicator Series
Price-Weighted Series
Dow Jones Industrial Average (DJIA)
Value-Weighted Series
NYSE Composite
S&P 500 Index
BSE Sensex
8/13/2019 Introduction to Deivatives
31/44
Price weighted Index(DJIA)
Best-known, oldest, most popular index
Price-weighted average of thirty largewell-known industrial stocks, leaders intheir industry and listed.
Total the current price of the 30 stocks anddivide by a divisor
8/13/2019 Introduction to Deivatives
32/44
Criticism of the Price weightedIndex
Sample used is limited
30 non-randomly selected blue-chip stocks are notrepresentative of the all listed stocks
Price-weighted series(emphasis on price ratherthan value)
Places more weight on higher-priced stocks rather than
those with higher market values Introduces a downward bias in DJIA by reducing
weight of growing companies whose stock splits
8/13/2019 Introduction to Deivatives
33/44
Value-Weighted Series
Although the price weighted index is a popularindex, the most popular type is value-weighted.
Derive the initial total market value of all stocksused in the series
Market Value = Number of Shares Outstanding
x Current Market Price
Beginning index value is usually 100, new marketvalues change the value of the index
Automatic adjustment for splits
Weighting depends on market value
8/13/2019 Introduction to Deivatives
34/44
Value-Weighted Series
ValueIndexBeginningIndex t
bb
tt
QP
QP
where:
Indext= index value on day t
Pt= ending prices for stocks on day t
Qt= number of outstanding shares on dayt
Pb = ending price for stocks on base dayQb = number of outstanding shares on base day
8/13/2019 Introduction to Deivatives
35/44
Date Price O/s Shares ProductJanuary 1, 2000 300 10000 3000000
January 1, 2004 360 150000 54000000
Value of Index 1800
8/13/2019 Introduction to Deivatives
36/44
Bond-Market Indicator Series
Relatively new and not widely published
Growth in fixed-income mutual fundsincrease need for reliable benchmarks forevaluating performance
Increasing interest in bond index funds,which requires an index to emulate
Many managers have not matched aggregatebond market return
8/13/2019 Introduction to Deivatives
37/44
Difficulties in Creating a Bond-Market Index
Range of bond quality varies from Treasurysecurities to bonds in default
Bond market changes constantly with newissues, maturities, calls, and sinking funds
Bond prices are affected differently by changinginterest rates dependent on maturity, coupon,and market yield
Correctly pricing individual bond issues can be achallenge without current and continuoustransaction prices available
8/13/2019 Introduction to Deivatives
38/44
Index
Total
ReturnsIndex
Principal
Returnsindex
Avg.
Coupon
Avg.
ResidualMaturity
Portfolio
YTM
Portfolio
Duration
Portfolio
ModifiedDuration
ALL 234.82 127.37 8.93 9.092 7.293 5.751 5.548
1 yr -3 yr 191.8 98.46 10.514 1.913 7.578 1.736 1.673
3-8 yr 229.39 115.92 9.652 5.54 7.064 4.367 4.218
8+ 286.5 145.87 8.235 14.427 7.324 8.427 8.129TB 195.39 195.39 0 0.401 6.043 0.397 0.385
GS 239.28 119.95 8.93 9.778 7.299 6.123 5.908
8/13/2019 Introduction to Deivatives
39/44
Introduction to futures
and options
8/13/2019 Introduction to Deivatives
40/44
Forward contracts
A forward contract is an agreement to buy or sell an asseton a specified date for a specified price.
One of the parties to the contract assumes a long positionand agrees to buy the underlying asset on a certain specified
future date for a certain specified price. The other partyassumes a short position and agrees to sell the asset on thesame date for the same price.
Other contract details like delivery date, price and quantityare negotiated bilaterally by the parties to the contract. The
forward contracts are normally traded outside theexchanges.
8/13/2019 Introduction to Deivatives
41/44
The salient features of forward
contracts are: Bilateral Contracts Custom Designed
Contract price is not availble in publicdomain
Can be off set with the same counterparty
8/13/2019 Introduction to Deivatives
42/44
Limitations of forward markets
Forward markets world-wide are afflictedby several problems:
Lack of centralisation of trading
Counterparty risk
Illiquidity
8/13/2019 Introduction to Deivatives
43/44
Introduction to futures
v
Futures markets were designed to solve the problems that
exist in forward markets.
A futures contract is an agreement between two parties tobuy or sell an asset at a certain time in the future at a certain
price. But unlike forward contracts, the futures contracts are
standardized and exchange traded. To facilitate liquidity in
the futures contracts, the exchange specifies certain
standard features of the contract.
It is a 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 purposes in settlement) and a standard timing ofsuch settlement.
A futures contract may be offset prior to maturity by
entering into an equal and opposite transaction. More than
99% of futures transactions are offset this way.
8/13/2019 Introduction to Deivatives
44/44
Introduction to options
Options are fundamentally different from forwardand futures contracts. An option gives the
holder of the option the right to do something. Theholder does not have to exercise this right.
In contrast, in a forward or futures contract, the twoparties have committed themselves to doing
something. Whereas it costs nothing (except marginrequirements) to enter into a futures contract,
the purchase of an option requires an upfrontpayment.