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Financial derivatives

Objectives of the Study

The objectives of the study are as follows:
 To have an overview of Indian derivative market.
 To have a look on the evolution of various derivative products.
 To find out the trading mechanism of different derivative products.
 To examine the various issues in the Indian derivative market and future
prospects of
this market.

Definition of Financial Derivatives

A derivative is any financial instrument, whose payoffs depend in a direct way on the
value of an underlying variable at a time in the future. This underlying variable is also
called the underlying asset, or just the underlying, Examples of underlyi9ng assets
include Underlying asset

Usually, derivatives are contracts to buy or sell the underlying asset at a future time,
with the price, quantity and other specifications defined today, contracts can be binding
for both parties or for one party only, with the other party reserving the option to
exercise of not. If the underlying asset is not traded, for example if the underlying is an
index, some kind of cash settlement has to take place. Derivatives are traded in
organized exchanges as well as over the counter.

Participants in the derivative market:

Patwari and Bhargava (2006) stated that there are three broad categories of participants
in the
derivative market. They are: Hedgers, Speculators and Arbitrageurs.

Hedgers

A hedge is an investment to reduce the risk of adverse price movements in an asset.

Normally, a hedge consists of taking an offsetting position in a related security, such as a
futures contract.
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Speculators

a person who invests in stocks, property, or other ventures in the hope of making a
profit.

Arbitrageurs.

A trader who practices arbitrage. That is, an arbitrageur attempts to profit from inefficie
ncies in price by makingtransactions that offset each other. For example, one may buy a
security at a low price, and, within a few seconds,re-
sell it to a willing buyer at a higher price.

Advantage/ Purposes/ Benefits of Derivatives

1. Price Discovery
2. Risk Management
3. They Improve Market Efficiency for the Underlying Asset
4. Derivatives Also Help Reduce Market Transaction Costs

Define forward contract and explain its characteristics?

The forward contract is an over-the-counter (OTC) agreement between two parties, to

buy or sell an asset at a certain time in the future for a certain price. The party that has
agreed to buy has a long position. The party that has agreed to self has a short position.
Usually, the delivery price is such that the initial value of the contract is zero. The
contract is settled at maturity.

Characteristics:

Forward: an agreement between 2 parties that are initiated at one point in time, but
require the parties to the agreement to perform, in accordance with the terms of the
agreement, at some future point in time.

Seller/Holder of the short Position: Party obliged to deliver the Stated Asset.

Buyer/ Holder of the Long Position: Party obliged to pay for the stated Asset.

Deliverable item/ Underlying Asset: asset to be traded under the terms of the contract

Settlement/ Maturity/Expiration: Time at which the contract is to be fulfilled by the

trading of the underlying asset.
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Contract Size: Quantity of the underlying asset that is to be traded at the time the
contract settles.

Invoice Amount/ Forward Contract Price: Amount that must be paid for the contract size
of the underlying asset by the holder of the long position at the time of the settlement.

Forward Contracts are NOT Investments; they are simply agreements to engage in a
trade at a future time and at a fixed price. Thus, it costs NOTHING to enter into such a
contract; since nothing is Bought or Sold; contracts are Entered Into or Sold Out. There
are THREE ways to close out (Settle) a contract

Enter an Offsetting Transaction: Making/ Taking Physical Delivery of the underlying

commodity under the terms & conditions specified by the contract: Cash Settlement.
Over-the- Counter Forward Contracts are Flexible, but 3 major disadvantage o ILLIQUID:
designed for specific needs o CREDIT RISK: No Collateral or marked to marketing, rather
it is just trust o UNREGULATED: no formal body regulates the players in the market.
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'Futures Contract'

Definition:
A futures contract is a contract between two parties where both parties agree to buy
and sell a particular asset of specific quantity and at a predetermined price, at a
specified date in future.
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List out the risks in derivatives market

The primary risks associated with trading derivatives are market, counterparty, liquidity
and interconnection risks. Derivatives are investment instruments that consist of a
contract between parties whose value derives from and depends on the value of an
underlying financial asset. Among the most common derivatives traded are futures,
options, contracts for difference, or CFDs, and swaps.

Market Risk
Market risk refers to the general risk in any investment. Investors make decisions and
take positions based on assumptions, technical analysis or other factors that lead them
to certain conclusions about how an investment is likely to perform. An important part
of investment analysis is determining the probability of an investment being profitable
and assessing the risk/reward ratio of potential losses against potential gains.

Counterparty Risk
Counterparty risk, or counterparty credit risk, arises if one of the parties involved in a
derivatives trade, such as the buyer, seller or dealer, defaults on the contract. This risk is
higher in over-the-counter, or OTC, markets, which are much less regulated than
ordinary trading exchanges. A regular trading exchange helps facilitate contract
performance by requiring margin deposits that are adjusted daily through the mark-to-
market process. The mark-to-market process makes pricing derivatives more likely to
accurately reflect current value. Traders can manage counterparty risk by only using
dealers they know and consider trustworthy.

Liquidity Risk
Liquidity risk applies to investors who plan to close out a derivative trade prior to
maturity. Such investors need to consider if it is difficult to close out the trade or if
existing bid-ask spreads are so large as to represent a significant cost.

Interconnection Risk
Interconnection risk refers to how the interconnections between various derivative
instruments and dealers might affect an investor's particular derivative trade. Some
analysts express concern over the possibility that problems with just one party in the
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derivatives market, such as a major bank that acts as a dealer, might lead to a chain
reaction or snowball effect that threatens the stability of financial markets overall.

Development of Derivatives Markets in India

 Indian Derivatives markets have been in existence in one form or the other for a
long time.

 In the area of commodities, the Bombay Cotton Trade Association started futures
trading in1875. In 1952, with the ban on cash settlement and option trading by
the Government of India, derivatives trading shifted to informal forwards
markets.

 In recent years, government policy has shifted in favor of an increased role of

market-based pricing and less suspicious derivatives trading.

 The first step towards the introduction of financial derivatives trading in India
was the promulgation of the Securities Laws (Amendment) Ordinance, 1995.

 This provided for withdrawal of prohibition on options in securities. In the last

decade, beginning the year 2000, ban on futures trading in many commodities
was lifted out.

 During the same period, National Electronic Commodity Exchanges were also set
up.

 Derivatives trading commenced in India in June 2000 after SEBI granted the final
approval to this effect in May 2001 on the recommendation of L. C Gupta
committee.

 Securities and Exchange Board of India (SEBI) permitted the derivative segments
of two stock exchanges, NSE and BSE, and their clearing house/corporation to
commence trading and settlement in approved derivatives contracts.

 Initially SEBI approved trading in index futures contracts based on various stock
market indices such as, S&P CNX, Nifty and Sensex. Subsequently, index-based
trading was permitted in options as well as individual securities
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The need for a derivatives market

The derivatives market performs a number of economic functions:

1. They help in transferring risks from risk adverse people to risk oriented people
2. They help in the discovery of future as well as current prices
3. They catalyze entrepreneurial activity
4. They increase the volume traded in markets because of participation of risk adverse
people in greater numbers
5. They increase savings and investment in the long run

Derivatives Market in India

Derivatives markets have had a slow start in India. The first step towards introduction of
derivatives trading in India was the promulgation of the Securities Laws (Amendments)
Ordinance, 1995, which withdrew the prohibition on options in securities. The market
for derivatives, however, did not take off, as there was no regulatory framework to
govern trading of derivatives. SEBI set up a 24-member committee under the
Chairmanship of Dr. L.C. Gupta on 18th November 1996 to develop appropriate
regulatory framework for derivatives trading in India. The committee recommended
that derivatives should be declared as 'securities' so that regulatory framework
applicable to trading of 'securities' could also govern trading of securities. SEBI was
given more powers and it starts regulating the stock exchanges in a professional manner
by gradually introducing reforms in trading. Derivatives trading commenced in India in
June 2000 after SEBI granted the final approval in May 2000. SEBI permitted the
derivative segments of two stock exchanges, viz NSE and BSE, and their clearing
house/corporation to commence trading and settlement in approved derivative
contracts.

Introduction of derivatives was made in a phase manner allowing investors and traders
sufficient time to get used to the new financial instruments. Index futures on CNX Nifty
and BSE Sensex were introduced during 2000. The trading in index options commenced
in June 2001 and trading in options on individual securities commenced in July 2001.
Futures contracts on individual stock were launched in November 2001. In June 2003,
SEBI/RBI approved the trading in interest rate derivatives instruments and NSE
introduced trading in futures contract on June 24, 2003 on 91 day Notional T-bills.
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Derivatives contracts are traded and settled in accordance with the rules, bylaws, and
regulations of the respective exchanges and their clearing house/corporation duly
approved by SEBI and notified in the official gazette.

What is a 'Strike Price'

A strike price is the price at which a specific derivative contract can be exercised. The
term is mostly used to describe stock and index options in which strike prices are fixed
in the contract. For call options, the strike price is where the security can be bought (up
to the expiration date); for put options, the strike price is the price at which shares can
be sold.

Swap

Swaps are private agreements between two parties to exchange cash flows in the future
according to a prearranged formula. They can both principal and interest between the
parties, with the cash flows in one direction being in a different be regarded as
portfolios of forward contracts. The two commonly used swaps are interest rate swaps
and currency swaps.
Interest rate swaps: These involve swapping only the interest related cash flows
between the parties in the same currency.
Currency swaps: These entail swapping currency than those in the opposite direction.
 Forward Contract Futures Contract
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Definition A forward contract is an A futures contract is a
agreement between two parties standardized contract,
to buy or sell an asset (which can traded on a futures
be of any kind) at a pre-agreed exchange, to buy or sell
future point in time at a specified a certain underlying
price. instrument at a certain
date in the future, at a
specified price.

Structure & Purpose Customized to customer needs. Standardized. Initial

Usually no initial payment margin payment
required. Usually used for required. Usually used
hedging. for speculation.

Transaction method Negotiated directly by the buyer Quoted and traded on

and seller the Exchange

Market regulation Not regulated Government regulated

market (the Commodity
Futures Trading
Commission or CFTC is
the governing body)

Institutional guarantee The contracting parties Clearing House

Risk High counterparty risk Low counterparty risk

Guarantees No guarantee of settlement until Both parties must

the date of maturity only the deposit an initial
forward price, based on the spot guarantee (margin). The
price of the underlying asset is value of the operation is
paid marked to market rates
with daily settlement of
profits and losses.

Contract Maturity Forward contracts generally Future contracts may

mature by delivering the not necessarily mature
commodity.
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by delivery of
commodity.

Expiry date Depending on the transaction Standardized

Method of pre- Opposite contract with same or Opposite contract on

termination different counterparty. the exchange.
Counterparty risk remains while
terminating with different
counterparty.

Contract size Depending on the transaction and Standardized

the requirements of the
contracting parties.

Market Primary & Secondary Primary

interest rate futures.

An interest rate future is a futures contract with an underlying instrument that
pays interest. An interest rate future is a contract between the buyer and seller
agreeing to the future delivery of any interest-bearing asset.

NSE Bond Futures

An Interest Rate Futures contract is "an agreement to buy or sell a debt instrument at a
specified future date at a price that is fixed today." The underlying security for Interest
Rate Futures is either Government Bond or T-Bill. Exchange traded Interest Rate Futures
on NSE are standardized contracts based on 6 year, 10 year and 13 year Government of
India Security (NBF II) and 91-day Government of India Treasury Bill (91DTB). All futures
contracts available for trading on NSE are cash settled.
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Comparison Chart
BASIS FOR
FUTURES OPTIONS
COMPARISON

Meaning Futures contract is a binding Options are the contract in which

agreement, for buying and the investor gets the right to buy or
selling of a financial instrument sell the financial instrument at a
at a predetermined price at a set price, on or before a certain
future specified date. date, however the investor is not
obligated to do so.

Obligation of Yes, to execute the contract. No, there is no obligation.

buyer

Execution of On the agreed date. Anytime before the expiry of the

contract agreed date.

Risk High Limited

Advance No advance payment Paid in the form of premiums.

payment

Degree of Unlimited Unlimited profit and limited loss.

profit/loss

Definition of ADR

American Depository Receipt (ADR), is a negotiable certificate, issued by a US bank,

denominated in US$ representing securities of a foreign company trading in the United
States stock market. The receipts are a claim against the number of shares underlying.
ADR’s are offered for sale to American investors. By way of ADR, the US investors can
invest in non-US companies. The dividend is paid to the ADR holders, is in US dollars.
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ADR’s are easily transferable, without any stamp duty. The transfer of ADR
automatically transfers the number of shares underlying.

Definition of GDR

GDR or Global Depository Receipt is a negotiable instrument used to tap the financial
markets of various countries with a single instrument. The receipts are issued by the
depository bank, in more than one country representing a fixed number of shares in a
foreign company. The holders of GDR can convert them into shares by surrendering the
receipts to the bank.

Prior approval of Ministry of Finance and FIPB (Foreign Investment Promotion Board) is
taken by the company planning for the issue of GDR.

BASIS FOR
ADR GDR
COMPARISON

Acronym American Depository Receipt Global Depository Receipt

Meaning ADR is a negotiable instrument GDR is a negotiable instrument

issued by a US bank, issued by the international
representing non-US company depository bank, representing
stock, trading in the US stock foreign company's stock trading
exchange. globally.

Relevance Foreign companies can trade in Foreign companies can trade in

US stock market. any country's stock market other
than the US stock market.

Issued in United States domestic capital European capital market.

market.

Listed in American Stock Exchange such Non-US Stock Exchange such as

as NYSE or NASDAQ London Stock Exchange or
Luxemberg Stock Exchange.
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BASIS FOR
ADR GDR
COMPARISON

Negotiation In America only. All over the world.

Disclosure Onerous Less onerous

Requirement

Market Retail investor market Institutional market.

HOW TO TRADE IN DERIVATIVES MARKET:

Trading in the derivatives market is a lot similar to that in the cash segment of the stock
market.
 First do your research. This is more important for the derivatives market. However,
remember that the strategies need to differ from that of the stock market. For example,
you may wish you buy stocks that are likely to rise in the future. In this case, you
conduct a buy transaction. In the derivatives market, this would need you to enter into a
sell transaction. So the strategy would differ.
 Arrange for the requisite margin amount. Stock market rules require you to constantly
maintain your margin amount. This means, you cannot withdraw this amount from your
trading account at any point in time until the trade is settled. Also remember that the
margin amount changes as the price of the underlying stock rises or falls. So, always
keep extra money in your account.
 Conduct the transaction through your trading account. You will have to first make sure
that your account allows you to trade in derivatives. If not, consult your brokerage
or stock broker and get the required services activated. Once you do this, you can place
an order online or on phone with your broker.
 Select your stocks and their contracts on the basis of the amount you have in hand, the
margin requirements, the price of the underlying shares, as well as the price of the
contracts. Yes, you do have to pay a small amount to buy the contract. Ensure all this fits
your budget.
 You can wait until the contract is scheduled to expiry to settle the trade. In such a case,
you can pay the whole amount outstanding, or you can enter into an opposing trade.
For example, you placed a ‘buy trade’ for Infosys futures at Rs 3,000 a week before
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expiry. To exit the trade before, you can place a ‘sell trade’ future contract. If this
amount is higher than Rs 3,000, you book profits. If not, you will make losses.
Thus, buying stock futures and options contracts is similar to buying shares of the same
underlying stock, but without taking delivery of the same. In the case of index futures,
the change in the number of index points affects your contract, thus replicating the
movement of a stock price. So, you can actually trade in index and stock contracts in just
the same way as you would trade in shares.
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Options Contract
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WHAT IT IS:

An options contract is an agreement between a buyer and seller that gives the
purchaser of the option the right to buy or sell a particular asset at a later date at an
agreed upon price. Options contracts are often used in securities, commodities,
and real estate transactions.

HOW IT WORKS (EXAMPLE):

There are several types of options contracts in financial transactions. An exchange

traded option, for example, is a standardized contract that is settled through a clearing
house and is guaranteed. These exchange traded options cover stock
options, commodity options, bond and interest rate options, index options,
and futures options. Another type of option contract is an over –the-counter option
which is a trade between two private parties. This may include interest rate
options, currencyexchange rate options, and swaps (i.e. trading long and
short terms interest rates).

The main features of an exchange traded option, such as a call options contract,
provides a right to buy 100 shares of a security at a given price by a set date. The
options contract charges a market-based fee (called a premium). The stock price listed
in the contract is called the "strike price. At the same time, a put options contract gives
the buyer of the contract the right to sell the stock at a strike price by a specified
date. In both cases, if the buyer of the options contract does not act by the designated
date, the option expires.

For example, in a simple call options contract, a trader may expect Company XYZ's stock
price to go up to $90 in the next month. The trader sees that he can buy an options
contract of Company XYZ at $4.50 with a strike price of $75 per share. The trader must
pay the cost of the option ($4.50 X 100 shares = $450). The stock price begins to rise as
expected and stabilizes at $100. Prior to the expiry date on the options contract, the
trader executes the call option and buys the 100 shares of Company XYZ at $75, the
strike price on his options contract. He pays $7,500 for the stock. The trader can then
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sell his new stock on the market for $10,000, making a $2,050 profit ($2,500 minus $450
for the options contract).

Swap
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WHAT IT IS:

A swap is an agreement between two parties to exchange a series of future cash flows.

HOW IT WORKS (EXAMPLE):

Swaps are financial agreements to exchange cash flows. Swaps can be based on interest
rates, stock indices, foreign currency exchange rates and even commodities prices.

Let's walk through an example of a plain vanilla swap, which is simply an interest rate
swap in which one party pays a fixed interest rate and the other pays a floating interest
rate.

The party paying the floating rate "leg" of the swap believes that interest rates will go
down. If they do, the party's interest payments will go down as well.

The party paying the fixed rate "leg" of the swap doesn't want to take the chance that
rates will increase, so they lock in their interest payments with a fixed rate.

Company XYZ issues $10 million in 15-year corporate bonds with a variable interest rate
of LIBOR + 150 basis points. LIBOR is currently 3%, so Company XYZ
pays bondholders 4.5%.

After selling the bonds, an analyst at Company XYZ decides there's reason to believe
LIBOR will increase in the near term. Company XYZ doesn't want to be exposed to an
increase in LIBOR, so it enters into a swap agreement with Investor ABC.

Company XYZ agrees to pay Investor ABC 4.58% on $10,000,000 each year for 15 years.
Investor ABC agrees to pay Company XYZ LIBOR + 1.5% on $10,000,000 per year for 15
years. Note that the floating rate payments that XYZ receives from ABC will always
match the payments they need to make to their bondholders.

Investor ABC thinks that interest rates are going to go down. He is willing to accept fixed
rates from Company XYZ
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To do this, Company XYZ structures a swap of the future interest payments with an
investor willing to buy the stream of interest payments at this variable rate and pay a
fixed amount for each period. At the time of the swap, the amount to be paid over the
life of the debt is the same.

The investor is betting that the variable interest rate will go down, lowering his or her
interest cost, but the interest payments from Company XYZ will be the same, allowing
a gain (i.e. arbitrage) on the difference.

WHY IT MATTERS:

Interest rate swaps have been one of the most successful derivatives ever introduced. They are
widely used by corporations, financial institutions and governments. According to the Bank for
International Settlements (BIS), the notional principal of over-the-counter
derivatives market was an astounding $615 trillion in the second half of 2009. Of that amount,
swaps represented over $349 trillion of the total.

What is the difference between Options and Swaps?

Options vs Swaps
An option is a right, but not an obligation to buy or sell a A swap is an agreement between two parties to
financial asset on a specific date at a pre-agreed price. exchange financial instruments.

Requirement for an Exchange

Options can be bought/sold through an exchange or Swaps are over the counter financial products.
developed over the counter.

Requirement for a Premium Payment

A premium payment should be paid to acquire an option. Swaps do not involve a premium payment.

Types

Call option and put option are the main types of options. Interest rate swaps, FX swaps, and commodity
swaps are commonly used swaps.
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