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Introduction to Derivatives

Introduction: Risk ManagementRisk is inherent in all our day to day activities and is defined as deviation from expectedIt is not possible to eliminate all the risks, however one can manage the risksThe impact or magnitude of risk is estimated from the following two factors:The probability of an adverse event happeningIn case the even occurs, the magnitude of loss it can cause

..contd.From the perspective of its management, risk can be viewed in two ways:Risk of small losses with high probability: eg. Changes in commodity prices, exchange rates, interest rates etc. Risk of large losses with low probability: strategic in nature like capital budgeting, capital structure etc.

Types of Business RisksRisks with large probabilites of small losses are: Price Risk Exchange Rate RiskInterest Rate Risk

5Derivative InstrumentsA derivative (or derivative security) is a financial instrument whose value depends upon the value of other, more basic, underlying variables.

Underlying Price Change

Derivative Price Change

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Origin of DerivativesAncient Greece in some formFarmers need to protect their crops therefore derivatives market initially developed in commodities.First futures contract traced back to Yodoyo rice market in Osaka, Japan in 1650In 1848 Chicago Board of Trade (CBOT) was established to facilitate trading of forward contracts in various commodities

7Indian derivatives marketNotable early exchangesBombay Cotton Trade Association Ltd 1875Gujarati Vyapari Mandali 1900 for oilseedsFutures market in raw jute, Calcutta - 1912Chamber of Commerce, Hapur 1913 for wheatBullion futures market, Bombay - 1920Forward Contracts Regulation Act, 1952Forward Markets Commission (FMC), 1953Kabra Committee Report, 1994 provided regulatory framework for the forward trading

8Indian Commodity ExchangesThe National Level Multi Commodity Exchanges:National Commodity & Derivatives Exchange Limited (NCDEX) since 2003Multi Commodity Exchange of India Ltd (MCX) since 2003National Multi Commodity Exchange of India Limited (NMCEIL) since 2002National Board of Trade Limited (NBOT) since 1999In addition, there are about 25 recognized commodities exchanges.All the exchanges have been set up under overall control of Forward Market Commission (FMC).There are more than 100 commodity derivatives trading on these exchanges.Trading is fragmented over multiple market venues due to lack of free movement of commodities and differential taxation in different states.

9Trading in futures & optionsPrecursors to modern day instruments Teji (call), mandi (put), fatak (straddles), etc. Operating in unorganized markets all kinds of options banned in 1956.Badla trade involving some elements of forward trading banned by SEBI in 2001.Securities Contracts Regulation Act, 1956: amended in 1995 derivatives were declared securities withdrew prohibition on options in securities. Securities and Exchange Board of India Act, 1992L C Gupta Committee (1996) set up by SEBI to develop appropriate regulatory framework recommended phased introduction of derivativesbi-level regulation (self-regulation by exchange with SEBI providing a supervisory and advisory role.J R Verma Committee (1998) worked out various operational details for derivatives trading such as margining system.

10Trading in futures & options1999 RBI permitted OTC trades in currency (forwards, swaps, options) and interest rate derivatives (FRA, swaps) deep & liquid market, except in currency options.2000 - Derivatives segments of NSE and BSE were approved by SEBI.2000-01 Trading commenced at NSE/BSE June 2000: Index Futures at NSE and BSEJune 2001: Index OptionsJuly 2001: Options in Single StocksNovember 2001: Futures on single stocks2003 Interest rate futures at NSE not very successful due to faulty contract specifications.2008 Currency futures at NSE2009 Interest rate futures reintroduced at NSE

Classification based on Underlying AssetCommoditiesCurrenciesInterest RatesEquity SharesIndicesCredit: eg: credit default swapsWeather

12Derivatives Classification based on TradingExchange traded:Traditionally an open outcry system, but gradually switching to electronic systemNo credit risk due to default because of standard contractsOver-the-counter (OTC):A network of dealers at financial institutions, corporations and fund managersContracts are non-standard and there is some credit risk involved

Classification based on ProductForwardsFuturesOptions Swaps

14Functions of Derivatives MarketPrice DiscoveryRisk Transfer

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15Nature of the instrumentsUnderlying assets: Real asset Physical assets such as wheat and oilseedsFinancial asset Interest rate, bond, stock, exchange rateOther assets Weather, electricity, creditUnlike financial markets, derivative markets do not create or destroy wealth they merely provide a means to transfer risk.

16Why do we use derivativesSpeculationHedgingThree Purposes

Arbitrage

17Traders in derivative marketsHedgers:Hedgers face risk associated with the price of an asset; they use these instruments to reduce or eliminate that risk.These are firms that face a business risk. They wish to get rid of this uncertainty using a derivative. For example, an airline might use a derivatives contract to hedge the risk that jet fuel prices might change.Speculators:They bet on the future movement in the price of an asset. These instruments give them large leverage by putting small amount of money, they can take large positions large potential gains / losses.Arbitragers:They trade to profit from the disequilibrium or imperfections in prices in different markets cash and derivative.

Global Exchange Traded Derivatives by CategoryCategoryJan Dec 2010 (in $mn)Jan Dec 2011 (in $mn)

Equity Index7,4168,460Individual Equity6,2957,062Interest Rate3,2053,491Agriculture1,306991Energy724815Currency2,5263,147Precious Metal175341Non Precious Metal644435Other138230Total Volume22,42524,972

Global Futures and Options VolumeRank 2011ExchangeJan Dec 2011 (in $mn)

1Korea Exchange3,9282CME Group (includes CBOT and Nymex)3,3873Eurex ( includes ISE)2,8224NYSE Euronext2,2835NSE2,2006BM &F Bovespa1,5007Nasdaq OMX Group1,2968Chicago Board Options Exchange Group1,2179MCX (Multi commodity Exchange of India)1,19610Russian Trading Systems Stock Exchange1,083

Product-wise Turnover of Equity Derivatives Market NSE (%)PeriodIndex FuturesStock FuturesIndex OptionsStock OptionsTotal2009-1022.329.445.42.910020101-1114.918.862.83.51002011-1211.413.072.53.1100April Sep 20129.212.773.05.1100