Fnanca market s a market where nanca nstruments are exchanged
or traded and heps n determnng the prces of the assets that are traded n and s aso caed the prce dscovery process. 1. Organzatons that factate the trade n nanca products. For e.g. Stock exchanges (NYSE, Nasdaq) factate the trade n stocks, bonds and warrants. 2. Comng together of buyer and seers at a common patform to trade nanca products s termed as nanca markets, .e. stocks and shares are traded between buyers and seers n a number of ways ncudng: the use of stock exchanges; drecty between buyers and seers etc. Fnanca markets may be cassed on the bass of types of cams - debt and equty markets maturty - money market and capta market trade - spot market and devery market deas n nanca cams - prmary market and secondary market
Indan Fnanca Market conssts of the foowng markets:
Capta Market/ Securtes Market o Prmary capta market o Secondary capta market Money Market Debt Market
Prmary capta market- A market where new securtes are bought and sod for the rst tme
Types of ssues n Prmary market Inta pubc oher (IPO) (n case of an unsted company), Foow-on pubc oher (FPO), Rghts oher such that securtes are ohered to exstng sharehoders, Preferenta ssue/ bonus ssue/ OIB pacement Composte ssue, that s, mxture of a rghts and pubc oher, or oher for sae (oher of securtes by exstng sharehoders to the pubc for subscrpton).
Dherence between Prmary market Secondary market Deas wth new securtes Market for exstng securtes, whch are aready sted Provdes addtona capta to ssuer companes No addtona capta generated. Provdes qudty to exstng stock
Leadng stock exchanges:
Bombay Stock Exchange Lmted o Odest n Asa o Presence n 417 ctes and towns n Inda o Tradng n equty, debt nstrument and dervatves Natona Stock Exchange New York Stock Exchange NYSE) NASDAO London Stock Exchange
Functons of Stock Exchanges Lqudty and marketabty of securtes Far prce determnaton Source of ong-tern funds Heps n capta formaton Reects genera state of economy
Bascs of Stock Market Indces:
A stock market ndex s the reecton of the market as a whoe. It s a representatve of the entre stock market. Movements n the ndex represent the average returns obtaned by the nvestors. Stock market ndex s senstve to the news of: Company specc Country specc Thus the movement n the stock ndex s aso the reecton of the expectaton of the future performance of the companes sted on the exchange
Index Cacuaton: Step 1: Cacuate the weghtage of each scrp Weghtage = (Mcap t / tota market cap)*100
Step 2: Vaue of ndex n _ {Mcap t * Weght t }/ W b I=1
Where; Mcap t = market cap of scrp "" at tme "t" = prce of the share * number of outstandng shares W b = Sum of a the market cap of a the scrps n the ndex durng the base year
Settement cyces:
Settement s the process whereby the trader who has made purchases of scrp makes payment and the seer seng the scrp devers the securtes. Ths settement process s carred out by Cearng Houses for the stock exchanges. The Cearng House acts ke an ntermedary n every transacton and acts as a seer to a buyers and buyer to a seers.
Capta market and money market: Fnanca markets can broady be dvded nto money and capta market. Money Market: Money market s a market for debt securtes that pay oh n the short term usuay ess than one year, for exampe the market for 90-days treasury bs. Ths market encompasses the tradng and ssuance of short term non equty debt nstruments ncudng treasury bs, commerca papers, bankers acceptance, certcates of deposts, etc. Capta Market: Capta market s a market for ong-term debt and equty shares. In ths market, the capta funds comprsng of both equty and debt are ssued and traded. Ths aso ncudes prvate pacement sources of debt and equty as we as organzed markets ke stock exchanges. Capta market ncudes nanca nstruments wth more than one year maturty Sgncance of Capta Markets A we functonng stock market may hep the deveopment process n an economy through the foowng channes:
1. Growth of savngs, 2. Emcent aocaton of nvestment resources, 3. Better utzaton of the exstng resources.
In market economy ke Inda, nanca market nsttutons provde the avenue by whch ong-term savngs are mobzed and channeed nto nvestments. Condence of the nvestors n the market s mperatve for the growth and deveopment of the market. For any stock market, the market Indces s the barometer of ts performance and reects the prevang sentments of the entre economy. Stock ndex s created to provde nvestors wth the nformaton regardng the average share prce n the stock market. The ups and downs n the ndex represent the movement of the equty market. These ndces need to represent the return obtaned by typca portfoos n the country.
Generay, the stock prce of any company s vunerabe to three types of news:
Company specc Industry specc Economy specc
An a share ndex ncudes stocks from a the sectors of the economy and thus cances out the stock and sector specc news and events that ahect stock prces, (aw of portfoo dverscaton) and reect the overa performance of the company/equty market and the news ahectng t.
The most mportant use of an equty market ndex s as a benchmark for a portfoo of stocks. A dversed portfoos, beongng ether to reta nvestors or mutua funds, use the common stock ndex as a yardstck for ther returns. Indces are usefu n modern nanca appcaton of dervatves.
Capta Market Instruments - some of the capta market nstruments are:
Corporate securtes Shares The tota capta of a company may be dvded nto sma unts caed shares. For exampe, f the requred capta of a company s US $5,00,000 and s dvded nto 50,000 unts of US $10 each, each unt s caed a share of face vaue US $10. A share may be of any face vaue dependng upon the capta requred and the number of shares nto whch t s dvded. The hoders of the shares are caed share hoders. The shares can be purchased or sod ony n ntegra mutpes. Equty shares sgnfy ownershp n a corporaton and represent cam over the nanca assets and earnngs of the corporaton. Sharehoders en|oy votng rghts and the rght to receve dvdends; however n case of qudaton they w receve resduas, after a the credtors of the company are setted n fu. A company may nvte nvestors to subscrbe for the shares by the way of: Pubc ssue through prospectus Tender/ book budng process Oher for sae Pacement method Rghts ssue
Stocks The word stock refers to the od Engsh aw tradton where a share n the capta of the company was not dvded nto "shares" of xed denomnaton but was ssued as one chunk. Ths concept s no more prevaent, but the word "stock" contnues. The word "|ont stock companes" aso refers to ths tradton. Debt Instruments
A contractua arrangement n whch the ssuer agrees to pay nterest and repay the borrowed amount after a speced perod of tme s a debt nstrument. Certan features common to a debt nstruments are: Maturty - the number of years over whch the ssuer agrees to meet the contractua obgatons s the term to maturty. Debt nstruments are cassed on the bass of the tme remanng to maturty Par vaue - the face vaue or prncpa vaue of the debt nstrument s caed the par vaue. Coupon rate - agreed rate of nterest that s pad perodcay to the nvestor and s cacuated as a percentage of the face vaue. Some of the debt nstruments may not have an expct coupon rate, for nstance zero coupon bonds. These bonds are ssued on dscount and redeemed at par. Thus the dherence between the nvestors nvestment and return s the nterest earned. Coupon rates may be xed for the term or may be varabe. Ca opton - opton avaabe to the ssuer, speced n the trust ndenture, to ca n the bonds and repay them at pre determned prce before maturty. Ca feature acts ke a ceng f or payments. The ssuer may ca the bonds before the stated maturty as t may recognze that the nterest rates may fa beow the coupon rate and redeemng the bonds and repacng them wth securtes of ower coupon rates w be economcay beneca. It s the same as the prepayment opton, where the borrower prepays before schedued payments or sated maturty o Some bonds are ssued wth ca protecton feature, .e they woud not be caed for a speced perod of tme o Smar to the ca opton of the ssuer there s a put opton for the nvestor, to se the securtes back to the ssuer at a predetermned prce and date. The nvestor may do so antcpatng rse n the nterest rates wheren the nvestor woud qudate the funds and aternatvey nvest n pace of hgher nterest Debentures are qute often secured, that s, a securty nterest s created on some assets to back up debentures. There s no queston of any securty n case of shares. Share hoders have a rght to attend and vote at the meetngs of the share hoders whereas debenture hoders have no such rghts.
Ouas debt nstruments Preference shares Preference shares are dherent from ordnary equty shares. Preference share hoders have the foowng preferenta rghts () The rght to get a xed rate of dvdend before the payment of dvdend to the equty hoders. () The rght to get back ther capta before the equty hoders n case of wndng up of the company.
Egbty norms for pubc ssue: ICDR Reguatons
IPO
Condtons for IPO: (a condtons sted beow to be satsed) Net tangbe assets of 3 crore n each of the precedng 3 fu years, of whch not more than 50% are hed n monetary assets: Track record of dstrbutabe prots for 3 out of the mmedatey precedng 5 years: Net worth of 1 crore n each of the precedng three fu years; Issue sze of proposed ssue + a prevous ssues made n the same nanca year does not exceed 5 tmes ts pre-ssue net worth as per the audted baance sheet of the precedng nanca year; In case of change of name wthn the ast one year, 50% of the revenue for the precedng 1 fu year earned by t from the actvty ndcated by the new name.
If the ssuer does not satsfy any of the condton sted above, ssuer may make IPO by satsfyng the foowng:
1. Issue through book budng sub|ect to aotment of 50% of net oher to pubc to OIB fang whch fu subscrpton mones to be refunded
O R 15% of the cost of the pro|ect to 2. Mnmum post-ssue face vaue capta of the ssuer s 10 crores
O R Issuer to provde market-makng for 2 yrs from the date of stng of the speced securtes
Promoters contrbuton: o Cannot be ess than 20% of the post ssue capta o Maxmum not dened, but n vew of the requred mnmum pubc oher as per Rue 19 (2) (b) of Securtes Contracts Reguatons, promoters contrbuton pus any rm aotments cannot exceed 90% or 75% of the ssue sze as the case may be (see beow). Mnmum Pubc oher: By pubc oher s meant the securtes beng ohered to pubc by advertsement, excusve of promoters contrbuton and rm aotments. o Rue 19(2)(b) of the Securtes Contracts (Reguatons) Rues, 1957 requres that the mnmum pubc oher shoud be 25% of tota ssued securtes shoud be ohered to pubc through advertsement. o However, a ower pubc oher of 10% s aowed f the foowng condtons are satsed: The mnmum pubc of mnmum aocaton of 60% to OIBs. Frm aotment/ reservatons: Sub|ect to the mnmum pubc oher norms, ssuers are free to make reservatons on compettve bass (as dened herenafter) and/or rm aotments (as dened herenafter) to varous categores of persons for the remanng part of the ssue sze.
Frm aotment: Ths mpes aotment on a rm bass n pubc ssues by an ssung company. Speced Categores for Frm aotment n pubc ssues can be made to the foowng: 1. Indan and Mutatera Deveopment Fnanca Insttutons 2. Indan Mutua Funds 3. Foregn Insttutona Investors (ncudng non resdent Indans and overseas corporate bodes) 4. Permanent / reguar empoyees of the ssuer company - maxmum 10 % of tota proposed ssue amount 5. Schedued Banks 6. Lead Merchant Banker- sub|ect to a ceng of 5 % of the proposed ssue.
FPO
Promoters contrbuton: o In case of FPO, the promoters shoud ensure partcpaton ether to the extent of 20% of the proposed ssue or ther post-ssue share hodng must be to the extent of 20% of the post ssue capta. Requrement to brng n contrbuton from promoters sha be optona for a company sted on a stock exchange for at east 3 years and havng a track record of dvdend payment of 3 years mmedatey precedng the year of ssue. o As for maxmum promoters contrbuton, Rue 19 (2) (b) stated above sha be appcabe. o Partcpaton by promoters n excess of above sha be treated as preferenta aotment, to whch preferenta aotment rues w be appcabe. As for preferenta aotment rues, see Notes under sec. 81. Net Pubc oher: o The mnmum net pubc oher sha be as per Rue 19 (2) (b) - see above.. Frm aotment / reservatons: o The ssuer companes are free to make reservatons on compettve bass (as dened above) and/or rm aotments to varous categores of persons enumerated above, for the remanng ssue sze, that s, after consderng promoters contrbuton and pubc oher.. o The reservaton on compettve bass may aso be made for reta ndvdua sharehoders (RIS). For meanng of the term RIS, see under categores of nvestors beow.
Composte Issue
Promoters contrbuton: o promoters have opton to contrbute ether 20% of the proposed ssue or 20% of post ssue capta o the rght ssue component to be excuded whe computng the post- ssue capta Others: o The rght ssue component to be ohered to the exstng sharehoders o Except the above, the rues of aotment under IPO as above sha appy
Ouaed Insttutona Pacement
Another cass of ssue, not beng a rghts ssue, whch cas for resouton under sec. 81 (1A). Condton for ssue- The equty shares of the same cass were sted on a stock exchange havng naton-wde tradng termnas for a perod of at east one year as on the date of ssuance of notce for ssue of shares to OIBs The ssue shoud not voate the prescrbed mnmum pubc sharehodng requrements speced by the stng agreement.
Reservaton Mnmum of 10 percent of speced securtes ssued sha be aotted to mutua funds. In case the mutua funds do not agree to take shares ssued under ths chapter, such shares may be aotted to other OIBs. However, no aotment sha be made under ths chapter, ether drecty or ndrecty, to any OIB beng a promoter or any person reated to promoters.
Wthdrawa of bd not permtted.- Investors sha not be aowed to wthdraw ther bds after the cosure of ssue.
Number of aottees.- mnmum number of aottees sha not be ess than: o Two, where the ssue sze s ess than or equa to Rs. 250 crores; o Fve, where the ssue sze s greater than Rs. 250 crores. No snge aottee sha be aotted more than 50% of the ssue sze.
Restrctons.- Amount rased through the proposed pacement + a prevous pacements made n the same nanca year sha not exceed ve tmes the net worth of the ssuer as per the audted baance sheet of the prevous nanca year. Lock-n-perod of one year from the date of aotment, except when sod on a recognsed stock exchange.
Investments by Non- resdent Investors
Provsons about nvestments by non-resdents, non resdent Indans, overseas bodes corporates and other foregn nvestors are made by the RBI n pursuance of FEMA provsons. An overvew s as foows:
Foregn nvestment s freey permtted n amost a sectors n Inda. Under Foregn Drect Investments (FDI) Scheme, nvestments can be made by non-resdents n the shares / convertbe debentures of an Indan Company under two routes; Automatc Route; and Government Route.
Dervatves What are dervatves? A dervatve pcks a rsk or voatty n a nanca asset, transacton, market rate, or contngency, and creates a product the vaue of whch w change as per changes n the underyng rsk or voatty. The dea s that someone may ether try to safeguard aganst such rsk (hedgng), or someone may take the rsk, or may engage n a trade on the dervatve, based on the vew that they want to execute. The rsk that a dervatve ntends to trade s caed underyng.
A dervatve s a nanca nstrument, whose vaue depends on the vaues of basc underyng varabe. In the sense, dervatves s a nanca nstrument that ohers return based on the return of some other underyng asset, .e the return s derved from another nstrument. The best way w be take exampes of uncertantes and the dervatves that can be structured around the same. Stock prces are uncertan - Lot of forwards, optons or futures contracts are based on movements n prces of ndvdua stocks or groups of stocks. Prces of commodtes are uncertan - There are forwards, futures and optons on commodtes. Interest rates are uncertan - There are nterest rate swaps and futures. Foregn exchange rates are uncertan - There are exchange rate dervatves. Weather s uncertan - There are weather dervatves, and so on.
Dervatve products ntay emerged as a hedgng devce aganst uctuatons n commodty prces, and commodty nked dervatves remaned the soe form of such products for amost three hundred years. It was prmary used by the farmers to protect themseves aganst uctuatons n the prce of ther crops. From the tme t was sown to the tme t was ready for harvest, farmers woud face prce uncertantes. Through the use of smpe dervatve products, t was possbe for the farmers to partay or fuy transfer prce rsks by ockng n asset prces.
From hedgng devces, dervatves have grown as ma|or tradng too. Traders may execute ther vews on varous underyngs by gong ong or short on dervatves of dherent types. Fnanca dervatves: Fnanca dervatves are nanca nstruments whose prces are derved from the prces of other nanca nstruments. Athough nanca dervatves have exsted for a consderabe perod of tme, they have become a ma|or force n nanca markets ony snce the eary 1970s. In the cass of equty dervatves, futures and optons on stock ndces have ganed more popuarty than on ndvdua stocks, especay among nsttutona nvestors, who are ma|or users of ndex-nked dervatves. Even sma nvestors nd these usefu due to hgh correaton of the popuar ndces wth varous portfoos and ease of use.
DERIVATIVES PRODUCTS Some sgncant dervatves that are of nterest to us are depcted n the accompanyng graph:
Ma|or types of dervatves Dervatve contracts have severa varants. Dependng upon the market n whch they are traded, dervatves are cassed as 1) exchange traded and 2) over the counter. The most common varants are forwards, futures, optons and swaps. Forwards: A forward contract s a customzed contract between two enttes, where settement takes pace as a specc date n the future at todays predetermned prce. Ex: On 1 st |une, X enters nto an agreement to buy 50 baes of cotton for 1 st December at Rs.1000 per bae from Y, a cotton deaer. It s a case of a forward contract where X has to pay Rs.50000 on 1 st December to Y and Y has to suppy 50 baes of cotton. Optons: Optons are of two types - ca and put. Cas gve the buyer the rght but not the obgaton to buy a gven quantty of the underyng asset, at a gven prce on or before a gven future date. Puts gve the buyer the rght, but not the obgaton to se a gven quantty of the underyng asset at a gven prce on or before a gven date. Warrants: Optons generay have maturty perod of three months, ma|orty of optons that are traded on exchanges have maxmum maturty of nne months. Longer- traded optons are caed warrants and are generay traded over-the-counter. Leaps: The acronym LEAPS means Long-term Equty Antcpaton Securtes. These are optons havng a maturty of up to three years. Baskets: Basket Optons are currency-protected optons and ts return-proe s based on the average performance of a pre-set basket of underyng assets. The basket can be nterest rate, equty or commodty reated. A basket of optons s made by purchasng dherent optons. The payout s therefore the addton of each ndvdua opton payout Swaps: Swaps are prvate agreement between two partes to exchange cash ows n the future accordng to a pre-arranged formua. They can be regarded as portfoo of forward contracts. The two commony used Swaps are ) Interest Rate Swaps: - A nterest rate swap entas swappng ony the nterest reated cash ows between the partes n the same currency. ) Currency Swaps: - A currency swap s a foregn exchange agreement between two partes to exchange a gven amount of one currency for another and after a speced perod of tme, to gve back the orgna amount swapped.
FUTURES, FORWARDS AND OPTIONS An opton s dherent from futures n severa ways. At practca eve, the opton buyer faces an nterestng stuaton. He pays for the optons n fu at the tme t s purchased. After ths, he ony has an upsde. There s no possbty of the optons poston generatng any further osses to hm. Ths s dherent from futures, where one s free to enter, but can generate huge osses. Ths characterstc makes optons attractve to many market partcpants who trade occasonay, who cannot put n the tme to cosey montor ther futures poston. Buyng put optons s ke buyng nsurance. To buy a put opton on Nfty s to buy nsurance whch remburses the fu amount to whch Nfty drops beow the strke prce of the put opton. Ths s attractve to traders, and to mutua funds creatng "guaranteed return products".
FORWARDS A forward contract s an agreement to buy or se an asset on a speced date for a speced prce. One of the partes to the contract assumes a ong poston and agrees to buy the underyng asset on a certan speced future date for a certan speced prce. The other party assumes a short poston and agrees to se the asset on the same date for the same prce, other contract detas ke devery date, prce and quantty are negotated bateray by the partes to the contract. The forward contracts are normay traded outsde the exchange. The saent features of forward contracts are: They are batera contracts and hence exposed to counter-party rsk Each contract s custom desgned, and hence s unque n terms of contract sze, expraton date and the asset type and quaty. The contract prce s generay not avaabe n pubc doman On the expraton date, the contract has to be setted by devery of the asset, or net settement.
The forward markets face certan mtatons such as: Lack of centrazaton of tradng Iqudty and Counterparty rsk FUTURES Futures contract s a standardzed transacton takng pace on the futures exchange. Futures market was desgned to sove the probems that exst n forward market. A futures contract s an agreement between two partes, to buy or se an asset at a certan tme n the future at a certan prce, but unke forward contracts, the futures contracts are standardzed and exchange traded To factate qudty n the futures contracts, the exchange speces certan standard quantty and quaty of the underyng nstrument that can be devered, and a standard tme for such a settement. Futures exchange has a dvson or subsdary caed a cearng house that performs the specc responsbtes of payng and coectng day gans and osses as we as guaranteeng performance of one party to other. A futures' contract can be ohset pror to maturty by enterng nto an equa and opposte transacton. More than 99% of futures transactons are ohset ths way.
Yet another feature s that n a futures contract gans and osses on each partys poston s credted or charged on a day bass, ths process s caed day settement or markng to market. Any person enterng nto a futures contract assumes a ong or short poston, by a sma amount to the cearng house caed the margn money
The standardzed tems n a futures contract are: Ouantty of the underyng Ouaty of the underyng The date and month of devery The unts of prce quotaton and mnmum prce change Locaton of settement
FUTURES TERMINOLOGY 1. SPOT PRICE: The prce at whch an asset trades n the spot market. 2. FUTURES PRICE: The prce at whch the futures contract trades n the futures market. 3. CONTRACT CYCLE: The perod over whch a contract trades. The ndex futures contracts on the NSE have one month, two months and three months expry cyces that expres on the ast Thursday of the month. Thus a contract whch s to expre n |anuary w expre on the ast Thursday of |anuary. 4. EXPIRY DATE: It s the date speced n the futures contract. Ths s the ast day on whch the contract w be traded, at the end of whch t w cease to exst. 5. CONTRACT SIZE: It s the quantty of asset that has to be devered under one contract. For nstance, the contract sze on NSEs futures market s 200 Nftes. 6. BASIS: In the context of nanca futures, bass can be dened as the futures prce mnus the spot prce. There w be dherent bass for each devery month, for each contract. In a norma market, bass w be postve; ths reects that the futures prce exceeds the spot prces. 7. COST OF CARRY: The reatonshp between futures prce and spot prce can be summarzed n terms of what s known as the cost of carry. Ths measures the storage cost pus the nterest pad to nance the asset ess the ncome earned on the asset. 8. INITIAL MARGIN: The amount that must be deposted n the margn account at the tme when a futures contract s rst entered nto s known as nta margn. 9. MARK TO MARKET: In the futures market, at the end of each tradng day, the margn account s ad|usted to reect the nvestors gan or oss dependng upon the futures cosng prce. Ths s caed Markng-to-market. 10. MAINTENANCE MARGIN: Ths s somewhat ower than the nta margn. Ths s set to ensure that the baance n the margn account never becomes negatve. If the baance n the margn account fas beow the mantenance margn, the nvestor receves a margn ca and s expected to top up the margn account to the nta margn eve before tradng commences on the next day. Stock futures contract
It s a contractua agreement to trade n stock/ shares of a company on a future date. Some of the basc thngs n a futures trade as speced by the exchange are: Contract sze Expraton cyce Tradng hours Last tradng day Margn requrement
Advantages of stock futures tradng
Investng n futures s ess costy as there s ony nta margn money to be deposted A arge array of strateges can be used to hedge and specuate, wth smaer cash outay there s greater qudty
Dsadvantages of stock futures tradng
The rsk of osses s greater than the nta nvestment of margn money The futures contract does not gve ownershp or votng rghts n the equty n whch t s tradng There s greater vgance requred because futures trades are marked to market day INDEX DERIVATIVES Index dervatves are dervatve contracts that has ndex as the underyng. The most popuar ndex dervatves contract s ndex futures and ndex optons. NSEs market ndex - the S&P CNX Nfty are exampes of exchange traded ndex futures. An ndex s a broad-based weghted average of prces of seected consttuents that form part of the ndex. The rues for constructon of the ndex are dened by the body that creates the ndex. Tradng n stock ndex futures was rst ntroduced by the Kansas Cty Board of Trade n 1982.
Advantages of nvestng n stock ndex futures Dverscaton of the rsks as the nvestor s not nvestng n a partcuar stock Fexbty of changng the portfoo and ad|ustng the exposures to partcuar stock ndex, market or ndustry
OPTIONS An opton s a contract, or a provson of a contract, that gves one party (the opton hoder) the rght, but not the obgaton, to perform a speced transacton wth another party (the opton ssuer or opton wrter) accordng to the speced terms. The owner of a property mght se another party an opton to purchase the property any tme durng the next three months at a speced prce. For every buyer of an opton there must be a seer. The seer s often referred to as the wrter. As wth futures, optons are brought nto exstence by beng traded, f none s traded, none exsts; conversey, there s no mt to the number of opton contracts that can be n exstence at any tme. As wth futures, the process of cosng out optons postons w cause contracts to cease to exst, dmnshng the tota number. Thus an opton s the rght to buy or se a speced amount of a nanca nstrument at a pre-arranged prce on or before a partcuar date. There are two optons whch can be exercsed: Ca opton, the rght to buy s referred to as a ca opton. Put opton, the rght to se s referred as a put opton.
OPTION TERMINOLOGY 1. INDEX OPTION: These optons have the ndex as the underyng. Some optons are European whe others are Amercan. European stye optons can be exercsed ony on the maturty date of the opton, whch s known as the expry date. An Amercan stye opton can be exercsed at any tme upto, and ncudng, the expry date. It s to be noted that the dstncton has nothng to do wth geography. Both type of the opton are traded a over the word 2. STOCK OPTION: Stock optons are optons on ndvdua stocks. A contract gves the hoder the rght to buy or se shares at the speced prce. 3. BUYER OF AN OPTION: The buyer of an opton s the one who by payng the opton premum buys the rght but not the obgaton to exercse the optons on the seer/wrter. 4. WRITER OF AN OPTION: The wrter of a ca/put opton s the one who receves the opton premum and s thereby obged to se/buy the asset f the buyer exercsed on hm. 5. STRIKE PRICE: The prce speced n the opton contract s known as the strke prce or the exercse prce. 6. IN THE MONEY OPTION: An n the money opton s an opton that woud ead to a postve cash ow to the hoder f t was exercsed mmedatey. A ca opton on the ndex s sad to be n-the-money (ITM) when the current ndex stands at a eve hgher than the strke prce (.e. spot prce> strke prce). If the ndex s much hgher than the strke prce, the ca s sad to be deep ITM. In the case of a put, the put s ITM f the ndex s beow the strke prce. 7. AT THE MONEY OPTION: An at the money opton s an opton that woud ead to zero cash ow to the hoder f t were exercsed mmedatey. An opton on the ndex s at the money when the current ndex equas the strke prce(.e. spot prce = strke prce). 8. OUT OF THE MONEY OPTION: An out of the money(OTM) opton s an opton that woud ead to a negatve cash ow for the hoder f t were exercsed mmedatey. A ca opton on the ndex s out of the money when the current ndex stands at a eve ower than the strke prce(.e. spot prce < strke prce). If the ndex s much ower than the strke prce, the ca s sad to be deep OTM. In the case of a put, the put s OTM f the ndex s above the strke prce. 9. INTRINSIC VALUE OF AN OPTION: The opton premum can be broken down nto two components - ntrnsc vaue and tme vaue. The ntrnsc vaue of a ca s the ITM vaue of the opton that s f the ca s OTM, ts ntrnsc vaue w be zero. 10. TIME VALUE OF AN OPTION: The tme vaue of an opton s the dherence between ts premum and ts ntrnsc vaue. Usuay maxmum tme vaue exsts when the opton s ATM. The onger the tme to expraton, the greater s an optons tme vaue, or ese equa. At expraton, an opton shoud have no tme vaue.
Factors ahectng vaue of optons - you woud understand ths whe usng the vauaton technques, but the terms are ntroduced beow:
Prce - vaue of the ca opton s drecty proportonate to the change n the prce of the underyng. Say for exampe Tme - as optons expre n future, tme has an ehect on the vaue of the optons. Interest rates and Voatty - n case where the underyng asset s a bond or nterest rate, nterest rate voatty woud have an mpact on the opton prces. The statstca or hstorca voatty (SV) heps measure the past prce movements of the stock and heps n understandng the future voatty of the stock durng the fe of the opton
Commodty Dervatves
Commodty Dervatves are the rst of the dervatves contracts that emerged to hedge aganst the rsk of the vaue of the agrcutura crops gong beow the cost of producton. Chcago Board of Trade was the rst organzed exchange, estabshed n 1848 to have started tradng n varous commodtes. Chcago Board of Trade and Chcago Mercante Exchange are the argest commodtes exchanges n the word
It s mportant to understand the attrbutes necessary n a commodty dervatve contract:
a) Commodty shoud have a hgh shef fe - ony f the commodty has storabty, durabty w the carrers of the stock fee the need for hedgng aganst the prce rsks or prce uctuatons nvoved b) Unts shoud be homogenous - the underyng commodty as dened n the commodty dervatve contract shoud be the same as traded n the cash market to factate actua devery n the cash market. Thus the unts of the commodty shoud be homogenous c) Wde and frequent uctuatons n the commodty prces - f the prce uctuatons n the cash market are sma, peope woud fee ess ncentvsed to hedge or nsure aganst the prce uctuatons and dervatves market woud be of no sgncance. Aso f by the nherent attrbutes of the cash market of the commodty, the cash market of the commodty was such that t woud emnate the rsks of voatty or prce uctuatons, dervatves market woud be of no sgncance. Takng an oversmped exampe, f an nvestor had purchased 100 tons of rce @ Rs. 10/ kg n the cash market and s of the vew that the prces may fa n the future, he may short a rce future at Rs. 10/ kg to hedge aganst the fa n prces. Now f the prces fa to Rs. 2/ kg, the oss that the nvestor makes n the cash market may be compensated by squarng of the short poston thus emnatng the rsk of prce uctuatons n the commodty market
Commodty dervatve contracts are standardzed contracts and are traded as per the nvestors needs. The needs of the nvestor may be nstrumenta or convenence, dependng upon the needs, the nvestor woud trade n a dervatve product. Instrumenta rsks woud reate to prce rsk reducton and convenence needs woud reate to exbty n trade or emcent cearng process.
Commodty Dervatves n Inda
Commodty dervatves n Inda were estabshed by the Cotton Trade Assocaton n 1875, snce then the market has suhered from qudty probems and severa reguatory dogmas. However n the recent tmes the commodty trade has grown sgncanty and today there are 25 dervatves exchanges n Inda whch ncude four natona commodty exchanges; Natona Commodty and Dervatves Exchange (NCDEX), Natona Mut-Commodty Exchange of Inda (NCME), Natona Board of Trade (NBOT) and Mut Commodty Exchange (MCX)
NCDEX It s the argest commodty dervatves exchange n Inda and s the ony commodty exchange promoted by natona eve nsttutons. NCDEX was ncorporated n 2003 under the Companes Act, 1956 and s reguated by the Forward Market Commsson n respect of the futures tradng n commodtes. NCDEX s ocated n Mumba
MCX MCX s recognsed by the government of Inda and s amongst the words top three buon exchanges and top four energy exchanges. MCXs headquarter s n Mumba and factates onne tradng, cearng and settement operatons for the commodotes futures market n the country.
Over the Counter Dervatves (OTC Dervatves) Dervatves that are prvatey negotated and not traded on the stock exchange are caed OTC Dervatves. Interest Rate Dervatves (IRD) In the OTC dervatves segment, nterest rate dervatves (IRDs) are easy the argest and therefore the most sgncant gobay. In markets wth compex rsk exposures and hgh voatty Interest Rate Dervatves are an ehectve too for management of nanca rsks. In IRDs, the partes are tryng to trade n the voatty of nterest rates. Interest rates ahect a whoe spectrum of nanca assets - oans, bonds, xed ncome securtes, government treasures, and so on. In fact, changes n nterest rates have ma|or macro economc mpcatons for varous economc parameters - exchange rates, state of the economy, and thereby, the entre spectrum of the nanca sector.
Denton of IRDs Interest Rate Dervatves (IRD) are dervatves where the underyng rsk nterest rates. Hence, dependng on the type of the transacton, partes ether swap nterest at a xed or oatng rate on a notona amount, or trade n nterest rate futures, or engage n forward rate agreements. As n case of a dervatves, the contract s mosty setted by net settement, that s payment of dherence amount.
Types: The basc IRDs are smpe and mosty qud and are caed vana products, whereas dervatves beongng to the east qud category are termed as exotc nterest rate dervatves. Some vana products are: 1) Interest Rate Swaps 2) Interest Rate Futures 3) Forward Rate Agreements 4) Interest rate caps/oors
Interest Rate Swaps - These are dervatves where one party exchanges or swaps the xed or the oatng rates of nterest wth the other party. The nterest rates are cacuated on the notona prncpa amount whch s not exchanged but used to determne the quantum of cashow n the transacton. Interest rate swaps are typcay used by corporatons to typcay ater the exposure to uctuatons on nterest rates by swappng xed rate obgatons for oatng and vce-a-versa or to obtan ower rates of nterest than otherwse avaabe.
Interest rate swaps can be a) xed-for-xed rate swap, b) xed-for-oatng rate swap, c) oatng-for-oatng rate swap and so on. As the names suggest nterest rates are beng swapped, ether n the same currency or dherent currency and there coud be as many customzed varatons of the swaps, as desred.
Ths can be further expaned smpy. For nstance f there are two borrowers n the market where Borrower A has borrowed at a xed rate but wants a oatng rate of nterest and Borrower B has borrowed wth oatng and wants a xed rate of nterest. IN such a scenaro they can swap ther exstng nterest rates wthout any further borrowng. Ths woud make the transacton of the two borrowers ndependent of the underyng borrowngs. For nstance f a company has nvestments wth a oatng rate of nterest of 4.7% and can obtan xed nterest rate of 4.5% then the company may enter nto a xed- for-oatng swap and earn a prot of 20 bass ponts.
Forward Rate Agreements (FRAs) - These are cash setted for ward contracts on nterest rate traded among nternatona banks actve n the Eurodoar market.
These are contracts between two partes where the nterest rates are to be pad/ receved on an obgaton at a future date. The rate of nterest, notona amount and expry date s xed at the tme of enterng the contract and ony dherence n the amount s pad/ receved at the end of the perod. The prncpa s caed notona because whe t determnes the amount of payment, actua exchange of prncpa never takes pace. For nstance f A enters an FRA wth B and receves a xed rate of nterest say 6% on prncpa, say P for three years and B receves oatng rate on P. If at the end of contract perod of C the LIBOR rate s 6.5% then A w make a payment of the dherenta amount, (that s .5% on the prncpa P) to B. The settement mechansm can be further expaned as foows:
For nstance at a notona prncpa of USD 1 mon where the borrower buys an FRA for 3 months that carres an nterest rate of 6% and the contract run s 6 months. At the settement date the settement rate s at 6.5%. Then the settement amount w be cacuated n the foowng manner:
Settement amount = |(Dherence between settement rate and agreed rate)* contract run* prncpa amount|/|(36,000 or 36500) + (settement rate*contract perod)| That s, n the above probem Settement amount = |(6.5-6)*180*USD 1 mon|/|36,000 + (6.5%* 90) (Note: 36,000 s used for currences where the bass of cacuaton s actua/360 days and 36,500 s used for currences where the bass of cacuaton of nterest s actua/365 days)
Interest Rate Caps/Foors: Interest rate caps/oors are bascay hedgng nstruments that can gve the nvestor both benets of xed rate nterest and uctuatng rate nterest. The person provdng an nterest rate cap s the protecton seer. The seer assures the borrower or the buyer that n case of hgh voatty n the nterest rates, f nterest rate moves beyond the cap the borrower w be pad amount beyond the cap. In case the market rates do not go beyond the cap mt, the seer need not pay anythng to the borrower. In such a stuaton as ong as the nterest rates are wthn the cap mt borrower en|oys the oatng rates and f rates move above the cap mt he w be compensated wth the requste amount by the protecton seer and the borrower w pay xed to the capped rate of nterest. The same s the case when a person enters a Interest Rate Foor transacton.
In case of Interest Rate Cap transacton the borrower s expects the market nterest rates to go up n the future and hedge aganst the movement of the market rates. Interest Rate Caps/Foors transactons are deay of one, two, ve or ten years and the desred eve of protecton the buyer seeks are 6%, 8% or 10%.