Derivatives

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CHAPTER – 1

INTRODUCTION TO
DERIVATIVES

 DEFINITION OF DERIVATIVES

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Derivatives

CHAPTER 1

INTRODUCTION :

Derivatives are one of the most complex instruments. The

word derivative comes from the word ‘to derive’. It indicates that it has no
independent value. A derivative is a contract whose value is derived from
the value of another asset, known as the underlying asset, which could be
a share, a stock market index, an interest rate, a commodity, or a
currency. The underlying is the identification tag for a derivative contract.
When the price of the underlying changes, the value of the derivative also
changes. Without an underlying asset, derivatives do not have any
meaning. For example, the value of a gold futures contract derives from
the value of the underlying asset i.e., gold. The prices in the derivatives
market are driven by the spot or cash market price of the underlying
asset, which is gold in this example.

Derivatives are very similar to insurance. Insurance protects

against specific risks, such as fire, floods, theft and so on. Derivatives on
the other hand, take care of market risks - volatility in interest rates,
currency rates, commodity prices, and share prices. Derivatives offer a

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Derivatives
sound mechanism for insuring against various kinds of risks arising in the
world of finance. They offer a range of mechanisms to improve
redistribution of risk, which can be extended to every product existing,
from coffee to cotton and live cattle to debt instruments.

In this era of globalisation, the world is a riskier place and

exposure to risk is growing. Risk cannot be avoided or ignored. Man,
however is risk averse. The risk averse characteristic of human beings
has brought about growth in derivatives. Derivatives help the risk averse
individuals by offering a mechanism for hedging risks.

Derivative products, several centuries ago, emerged as

hedging devices against fluctuations in commodity prices. Commodity
futures and options have had a lively existence for several centuries.
Financial derivatives came into the limelight in the post-1970 period; today
they account for 75 percent of the financial market activity in Europe,
North America, and East Asia. The basic difference between commodity
and financial derivatives lies in the nature of the underlying instrument. In
commodity derivatives, the underlying asset is a commodity; it may be
wheat, cotton, pepper, turmeric, corn, orange, oats, Soya beans, rice,
crude oil, natural gas, gold, silver, and so on. In financial derivatives, the
underlying includes treasuries, bonds, stocks, stock index, foreign
exchange, and Euro dollar deposits. The market for financial derivatives
has grown tremendously both in terms of variety of instruments and
turnover.

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Derivatives
Presently, most major institutional borrowers and investors
use derivatives. Similarly, many act as intermediaries dealing in derivative
transactions. Derivatives are responsible for not only increasing the range
of financial products available but also fostering more precise ways of
understanding, quantifying and managing financial risk.

Derivatives contracts are used to counter the price risks

involved in assets and liabilities. Derivatives do not eliminate risks. They
divert risks from investors who are risk averse to those who are risk
neutral. The use of derivatives instruments is the part of the growing trend
among financial intermediaries like banks to substitute off-balance sheet
activity for traditional lines of business. The exposure to derivatives by
banks have implications not only from the point of capital adequacy, but
also from the point of view of establishing trading norms, business rules
and settlement process. Trading in derivatives differ from that in equities
as most of the derivatives are market to the market.

DEFINITION OF DERIVATIVES :

Derivative is a product whose value is derived from the value

of one or more basic variables, called bases (underlying asset, index, or
reference rate), in a contractual manner. The underlying asset can be
equity, forex, commodity or any other asset.

According to Securities Contracts (Regulation) Act, 1956

{SC(R)A}, derivatives is

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Derivatives

 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.

 A contract which derives its value from the prices, or index of

prices, of underlying securities.

Derivatives are securities under the Securities Contract

(Regulation) Act and hence the trading of derivatives is governed by the
regulatory framework under the Securities Contract (Regulation) Act.

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Derivatives

CHAPTER – 2

HISTORY OF DERIVATIVES

DERIVATIVES IN INDIA

DEVELOPMENT OF DERIVATIVES
MARKET IN INDIA

 Factors contributing to the growth of

derivatives

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Derivatives

CHAPTER 2

HISTORY OF DERIVATIVES :

The history of derivatives is quite colourful and surprisingly a

lot longer than most people think. Forward delivery 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.

The first organized commodity exchange came into

existence in the early 1700’s 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 centralised
location to negotiate forward contracts. From ‘forward’ trading in
commodities emerged the commodity ‘futures’. The first type of futures
contract was called ‘to arrive at’. Trading in futures began on the CBOT in

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Derivatives
the 1860’s. In 1865, CBOT listed the first ‘exchange traded’ derivatives
contract, known as the futures contracts. Futures trading grew out of the
need for hedging the price risk involved in many commercial operations.
The Chicago Mercantile Exchange (CME), a spin-off of CBOT, was
formed in 1919, though it did exist before in 1874 under the names of
‘Chicago Produce Exchange’ (CPE) and ‘Chicago Egg and Butter
Board’ (CEBB). The first financial futures to emerge were the currency in
1972 in the US. The first foreign currency futures were traded on May 16,
1972, on International Monetary Market (IMM), a division of CME. The
currency futures traded on the IMM are the British Pound, the Canadian
Dollar, the Japanese Yen, the Swiss Franc, the German Mark, the
Australian Dollar, and the Euro dollar. Currency futures were followed
soon by interest rate futures. Interest rate futures contracts were traded
for the first time on the CBOT on October 20, 1975. Stock index futures
and options emerged in 1982. The first stock index futures contracts were
traded on Kansas City Board of Trade on February 24, 1982.

The first of the several networks, which offered a trading link

between two exchanges, was formed between the Singapore
International Monetary Exchange (SIMEX) and the CME on September
7, 1984.

Options are as old as futures. Their history also dates back

to ancient Greece and Rome. Options are very popular with speculators in
the tulip craze of seventeenth century Holland. Tulips, the brightly
coloured flowers, were a symbol of affluence; owing to a high demand,
tulip bulb prices shot up. Dutch growers and dealers traded in tulip bulb

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Derivatives
options. There was so much speculation that people even mortgaged their
homes and businesses. These speculators were wiped out when the tulip
craze collapsed in 1637 as there was no mechanism to guarantee the
performance of the option terms.

The first call and put options were invented by an American

financier, Russell Sage, in 1872. These options were traded over the
counter. Agricultural commodities options were traded in the nineteenth
century in England and the US. Options on shares were available in the
US on the over the counter (OTC) market only until 1973 without much
knowledge of valuation. A group of firms known as Put and Call brokers
and Dealer’s Association was set up in early 1900’s to provide a
mechanism for bringing buyers and sellers together.

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 Formula. This model helped in assessing the fair
price of an option which led to an increased interest in trading of options.
With the options markets becoming increasingly popular, the American
Stock Exchange (AMEX) and the Philadelphia Stock Exchange (PHLX)
began trading in options in 1975.

The market for futures and options grew at a rapid pace in

the eighties and nineties. The collapse of the Bretton Woods regime of
fixed parties and the introduction of floating rates for currencies in the
international financial markets paved the way for development of a

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Derivatives
number of financial derivatives which served as effective risk
management tools to cope with market uncertainties.

The CBOT and the CME are two largest financial exchanges
in the world on which futures contracts are traded. The CBOT now offers
48 futures and option contracts (with the annual volume at more than 211
million in 2001).The CBOE is the largest exchange for trading stock
options. The CBOE trades options on the S&P 100 and the S&P 500
stock indices. The Philadelphia Stock Exchange is the premier exchange
for trading foreign options.

The most traded stock indices include S&P 500, the Dow
Jones Industrial Average, the Nasdaq 100, and the Nikkei 225. The US
indices and the Nikkei 225 trade almost round the clock. The N225 is also
traded on the Chicago Mercantile Exchange.

DERIVATIVES IN INDIA :

India has started the innovations in financial markets very

late. Some of the recent developments initiated by the regulatory
authorities are very important in this respect. Futures trading have been
permitted in certain commodity exchanges. Mumbai Stock Exchange has
started futures trading in cottonseed and cotton under the BOOE and
under the East India Cotton Association. Necessary infrastructure has
been created by the National Stock Exchange (NSE) and the Bombay
Stock Exchange (BSE) for trading in stock index futures and the

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Derivatives
commencement of operations in selected scripts. Liberalised exchange
rate management system has been introduced in the year 1992 for
regulating the flow of foreign exchange. A committee headed by
S.S.Tarapore was constituted to go into the merits of full convertibility on
capital accounts. RBI has initiated measures for freeing the interest rate
structure. It has also envisioned Mumbai Inter Bank Offer Rate (MIBOR)
on the line of London Inter Bank Offer Rate (LIBOR) as a step towards
introducing Futures trading in Interest Rates and Forex. Badla
transactions have been banned in all 23 stock exchanges from July 2001.
NSE has started trading in index options based on the NIFTY and certain
Stocks.

A.} EQUITY DERIVATIVES IN INDIA –

In the decade of 1990’s revolutionary changes took place in

the institutional infrastructure in India’s equity market. It has led to wholly
new ideas in market design that has come to dominate the market. These
new institutional arrangements, coupled with the widespread knowledge
and orientation towards equity investment and speculation, have
combined to provide an environment where the equity spot market is now
India’s most sophisticated financial market. One aspect of the
sophistication of the equity market is seen in the levels of market liquidity
that are now visible. The market impact cost of doing program trades of
Rs.5 million at the NIFTY index is around 0.2%. This state of liquidity on
the equity spot market does well for the market efficiency, which will be
observed if the index futures market when trading commences. India’s
equity spot market is dominated by a new practice called ‘Futures – Style

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Derivatives
settlement’ or account period settlement. In its present scene, trades on
the largest stock exchange (NSE) are netted from Wednesday morning till
Tuesday evening, and only the net open position as of Tuesday evening is
settled. The future style settlement has proved to be an ideal launching
pad for the skills that are required for futures trading.

Stock trading is widely prevalent in India, hence it seems

easy to think that derivatives based on individual securities could be very
important. The index is the counter piece of portfolio analysis in modern
financial economies. Index fluctuations affect all portfolios. The index is
much harder to manipulate. This is particularly important given the
weaknesses of Law Enforcement in India, which have made numerous
manipulative episodes possible. The market capitalisation of the NSE-50
index is Rs.2.6 trillion. This is six times larger than the market
capitalisation of the largest stock and 500 times larger than stocks such
as Sterlite, BPL and Videocon. If market manipulation is used to artificially
obtain 10% move in the price of a stock with a 10% weight in the NIFTY,
this yields a 1% in the NIFTY. Cash settlements, which is universally used
with index derivatives, also helps in terms of reducing the vulnerability to
market manipulation, in so far as the ‘short-squeeze’ is not a problem.
Thus, index derivatives are inherently less vulnerable to market
manipulation.

A good index is a sound trade of between diversification and

liquidity. In India the traditional index- the BSE – sensitive index was
created by a committee of stockbrokers in 1986. It predates a modern
understanding of issues in index construction and recognition of the

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pivotal role of the market index in modern finance. The flows of this index
and the importance of the market index in modern finance, motivated the
development of the NSE-50 index in late 1995. Many mutual funds have
now adopted the NIFTY as the benchmark for their performance
evaluation efforts. If the stock derivatives have to come about, the should
restricted to the most liquid stocks. Membership in the NSE-50 index
appeared to be a fair test of liquidity. The 50 stocks in the NIFTY are
assuredly the most liquid stocks in India.

The choice of Futures vs. Options is often debated. The

difference between these instruments is smaller than, commonly
imagined, for a futures position is identical to an appropriately chosen long
call and short put position. Hence, futures position can always be created
once options exist. Individuals or firms can choose to employ positions
where their downside and exposure is capped by using options. Risk
management of the futures clearing is more complex when options are in
the picture. When portfolios contain options, the calculation of initial price
requires greater skill and more powerful computers. The skills required for
pricing options are greater than those required in pricing futures.

B.} COMMODITY DERIVATIVES TRADING IN INDIA –

In India, the futures market for commodities evolved by the

setting up of the “Bombay Cotton Trade Association Ltd.”, in 1875. A
separate association by the name "Bombay Cotton Exchange Ltd” was
established following widespread discontent amongst leading cotton mill
owners and merchants over the functioning of the Bombay Cotton Trade

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Association. With the setting up of the ‘Gujarati Vyapari Mandali” in 1900,
the futures trading in oilseed began. Commodities like groundnut, castor
seed and cotton etc began to be exchanged.

Raw jute and jute goods began to be traded in Calcutta with

the establishment of the “Calcutta Hessian Exchange Ltd.” in 1919. The
most notable centres for existence of futures market for wheat were the
Chamber of Commerce at Hapur, which was established in 1913. Other
markets were located at Amritsar, Moga, Ludhiana, Jalandhar, Fazilka,
Dhuri, Barnala and Bhatinda in Punjab and Muzaffarnagar, Chandausi,
Meerut, Saharanpur, Hathras, Gaziabad, Sikenderabad and Barielly in
U.P. The Bullion Futures market began in Bombay in 1990. After the
economic reforms in 1991 and the trade liberalization, the Govt. of India
appointed in June 1993 one more committee on Forward Markets under
Chairmanship of Prof. K.N. Kabra. The Committee recommended that
futures trading be introduced in basmati rice, cotton, raw jute and jute
goods, groundnut, rapeseed/mustard seed, cottonseed, sesame seed,
sunflower seed, safflower seed, copra and soybean, and oils and oilcakes
of all of them, rice bran oil, castor oil and its oilcake, linseed, silver and
onions. All over the world commodity trade forms the major backbone of
the economy. In India, trading volumes in the commodity market have
also seen a steady rise - to Rs 5,71,000 crore in FY05 from Rs 1,29,000
crore in FY04. In the current fiscal year, trading volumes in the commodity
market have already crossed Rs 3,50,000 crore in the first four months of
trading. Some of the commodities traded in India include Agricultural
Commodities like Rice Wheat, Soya, Groundnut, Tea, Coffee, Jute,
Rubber, Spices, Cotton, Precious Metals like Gold & Silver, Base Metals

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Derivatives
like Iron Ore, Aluminium, Nickel, Lead, Zinc and Energy Commodities like
crude oil, coal. Commodities form around 50% of the Indian GDP. Though
there are no institutions or banks in commodity exchanges, as yet, the
market for commodities is bigger than the market for securities.
Commodities market is estimated to be around Rs 44,00,000 Crores in
future. Assuming a future trading multiple is about 4 times the physical
market, in many countries it is much higher at around 10 times.

DEVELOPMENT OF DERIVATIVES MARKET IN INDIA :

The first step towards introduction of derivatives trading in

India was the promulgation of the Securities Laws (Amendment)
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
November 18, 1996 to develop appropriate regulatory framework for
derivatives trading in India. The committee submitted its report on March
17, 1998 prescribing necessary pre–conditions for introduction of
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 also
set up a group in June 1998 under the Chairmanship of Prof.J.R.Varma,
to recommend measures for risk containment in derivatives market in
India. The report, which was submitted in October 1998, worked out the
operational details of margining system, methodology for charging initial

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margins, broker net worth, deposit requirement and real–time monitoring
requirements. The Securities Contract Regulation Act (SCRA) was
amended in December 1999 to include derivatives within the ambit of
‘securities’ and the regulatory framework was developed for governing
derivatives trading. The act also made it clear that derivatives shall be
legal and valid only if such contracts are traded on a recognized stock
exchange, thus precluding OTC derivatives. The government also
rescinded in March 2000, the three decade old notification, which
prohibited forward trading in securities. Derivatives trading commenced in
India in June 2000 after SEBI granted the final approval to this effect in
May 2001. 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. To
begin with, SEBI approved trading in index futures contracts based on
S&P CNX Nifty and BSE–30 (Sense) index. This was followed by approval
for trading in options based on these two indexes and options on
individual securities.

The trading in BSE Sensex options commenced on June 4,

2001 and the trading in options on individual securities commenced in
July 2001. Futures contracts on individual stocks were launched in
November 2001. The derivatives trading on NSE commenced with S&P
CNX Nifty Index futures on June 12, 2000. The trading in index options
commenced on June 4, 2001 and trading in options on individual
securities commenced on July 2, 2001. Single stock futures were
launched on November 9, 2001. The index futures and options contract
on NSE are based on S&P CNX Trading and settlement in derivative

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contracts is done in accordance with the rules, byelaws, and regulations
of the respective exchanges and their clearing house/corporation duly
approved by SEBI and notified in the official gazette. Foreign Institutional
Investors (FIIs) are permitted to trade in all Exchange traded derivative
products.

The following are some observations based on the trading

statistics provided in the NSE report on the futures and options (F&O):

• Single-stock futures continue to account for a sizable proportion of

the F&O segment. It constituted 70 per cent of the total turnover
during June 2002. A primary reason attributed to this phenomenon
is that traders are comfortable with single-stock futures than equity
options, as the former closely resembles the erstwhile badla
system.

• On relative terms, volumes in the index options segment continues

to remain poor. This may be due to the low volatility of the spot
index. Typically, options are considered more valuable when the
volatility of the underlying (in this case, the index) is high. A related
issue is that brokers do not earn high commissions by
recommending index options to their clients, because low volatility
leads to higher waiting time for round-trips.

• Put volumes in the index options and equity options segment have
increased since January 2002. The call-put volumes in index
options have decreased from 2.86 in January 2002 to 1.32 in June.

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The fall in call-put volumes ratio suggests that the traders are
increasingly becoming pessimistic on the market.

• Farther month futures contracts are still not actively traded. Trading
in equity options on most stocks for even the next month was non-
existent.

• Daily option price variations suggest that traders use the F&O
segment as a less risky alternative (read substitute) to generate
profits from the stock price movements. The fact that the option
premiums tail intra-day stock prices is evidence to this. If calls and
puts are not looked as just substitutes for spot trading, the intra-day
stock price variations should not have a one-to-one impact on the
option premiums.

FACTORS CONTRIBUTING TO THE GROWTH OF

DERIVATIVES :

Factors contributing to the explosive growth of derivatives

are price volatility, globalisation of the markets, technological
developments and advances in the financial theories.

A.} PRICE VOLATILITY –

A price is what one pays to acquire or use something of

value. The objects having value maybe commodities, local currency or

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foreign currencies. The concept of price is clear to almost everybody
when we discuss commodities. There is a price to be paid for the
purchase of food grain, oil, petrol, metal, etc. the price one pays for use of
a unit of another persons money is called interest rate. And the price one
pays in one’s own currency for a unit of another currency is called as an
exchange rate.

Prices are generally determined by market forces. In a

market, consumers have ‘demand’ and producers or suppliers have
‘supply’, and the collective interaction of demand and supply in the market
determines the price. These factors are constantly interacting in the
market causing changes in the price over a short period of time. Such
changes in the price is known as ‘price volatility’. This has three factors :
the speed of price changes, the frequency of price changes and the
magnitude of price changes.

The changes in demand and supply influencing factors

culminate in market adjustments through price changes. These price
changes expose individuals, producing firms and governments to
significant risks. The break down of the BRETTON WOODS agreement
brought and end to the stabilising role of fixed exchange rates and the
gold convertibility of the dollars. The globalisation of the markets and rapid
industrialisation of many underdeveloped countries brought a new scale
and dimension to the markets. Nations that were poor suddenly became a
major source of supply of goods. The Mexican crisis in the south east-
Asian currency crisis of 1990’s have also brought the price volatility factor
on the surface. The advent of telecommunication and data processing

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bought information very quickly to the markets. Information which would
have taken months to impact the market earlier can now be obtained in
matter of moments. Even equity holders are exposed to price risk of
corporate share fluctuates rapidly.

These price volatility risk pushed the use of derivatives like

futures and options increasingly as these instruments can be used as
hedge to protect against adverse price changes in commodity, foreign
exchange, equity shares and bonds.

B.} GLOBALISATION OF MARKETS –

Earlier, managers had to deal with domestic economic

concerns ; what happened in other part of the world was mostly irrelevant.
Now globalisation has increased the size of markets and as greatly
enhanced competition .it has benefited consumers who cannot obtain
better quality goods at a lower cost. It has also exposed the modern
business to significant risks and, in many cases, led to cut profit margins

In Indian context, south East Asian currencies crisis of 1997

had affected the competitiveness of our products vis-à-vis depreciated
currencies. Export of certain goods from India declined because of this
crisis. Steel industry in 1998 suffered its worst set back due to cheap
import of steel from south east asian countries. Suddenly blue chip
companies had turned in to red. The fear of china devaluing its currency
created instability in Indian exports. Thus, it is evident that globalisation of
industrial and financial activities necessitiates use of derivatives to guard

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Derivatives
against future losses. This factor alone has contributed to the growth of
derivatives to a significant extent.

C.} TECHNOLOGICAL ADVANCES –

A significant growth of derivative instruments has been

driven by technological break through. Advances in this area include the
development of high speed processors, network systems and enhanced
method of data entry. Closely related to advances in computer technology
are advances in telecommunications. Improvement in communications
allow for instantaneous world wide conferencing, Data transmission by
satellite. At the same time there were significant advances in software
programmes without which computer and telecommunication advances
would be meaningless. These facilitated the more rapid movement of
information and consequently its instantaneous impact on market price.

Although price sensitivity to market forces is beneficial to the

economy as a whole resources are rapidly relocated to more productive
use and better rationed overtime the greater price volatility exposes
producers and consumers to greater price risk. The effect of this risk can
easily destroy a business which is otherwise well managed. Derivatives
can help a firm manage the price risk inherent in a market economy. To
the extent the technological developments increase volatility, derivatives
and risk management products become that much more important.

D.} ADVANCES IN FINANCIAL THEORIES –

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Derivatives
Advances in financial theories gave birth to derivatives.
Initially forward contracts in its traditional form, was the only hedging tool
available. Option pricing models developed by Black and Scholes in
1973 were used to determine prices of call and put options. In late 1970’s,
work of Lewis Edeington extended the early work of Johnson and started
the hedging of financial price risks with financial futures. The work of
economic theorists gave rise to new products for risk management which
led to the growth of derivatives in financial markets.

The above factors in combination of lot many factors led to

growth of derivatives instruments.

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Derivatives

CHAPTER – 3

Types of DERIVATIVES

 FUTURES VS. FORWARD MARKETS

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Derivatives

CHAPTER 3

TYPES OF DERIVATIVES :

There are mainly four types of derivatives i.e. Forwards,

Futures, Options and swaps.

Derivatives

Forwards Futures Options Swaps

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Derivatives
1. FORWARDS -

A contract that obligates one counter party to buy and the

other to sell a specific underlying asset at a specific price, amount and
date in the future is known as a forward contract. Forward contracts are
the important type of forward-based derivatives. They are the simplest
derivatives. There is a separate forward market for multitude of
underlyings, including the traditional agricultural or physical commodities,
as well as currencies and interest rates. The change in the value of a
forward contract is roughly proportional to the change in the value of its
underlying asset. These contracts create credit exposures. As the value of
the contract is conveyed only at the maturity, the parties are exposed to
the risk of default during the life of the contract. Forward contracts are
customised with the terms and conditions tailored to fit the particular
business, financial or risk management objectives of the counter parties.
Negotiations often take place with respect to contract size, delivery grade,
delivery locations, delivery dates and credit terms.

2. FUTURES -

A future contract is an agreement between two parties to

buy or sell an asset at a certain time the future at the certain price.
Futures contracts are the special types of forward contracts in the sense
that are standardized exchange-traded contracts.

Equities, bonds, hybrid securities and currencies are the

commodities of the investment business. They are traded on organised

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Derivatives
exchanges in which a clearing house interposes itself between buyer and
seller and guarantees all transactions, so that the identity of the buyer or
the seller is a matter of indifference to the opposite party. Futures contract
protect those who use these commodities in their business.

Futures trading are to enter into contracts to buy or sell

financial instruments, dealing in commodities or other financial
instruments for forward delivery or settlement on standardised terms. The
futures market facilitates stock holding and shifting of risk. They act as a
mechanism for collection and distribution of information and then perform
a forward pricing function. The futures trading can be performed when
there is variation in the price of the actual commodity and there exists
economic agents with commitments in the actual market. There must be a
possibility to specify a standard grade of the commodity and to measure
deviations from this grade. A futures market is established specifically to
meet purely speculative demands is possible but is not known. Conditions
which are thought of necessary for the establishment of futures trading
are the presence of speculative capital and financial facilities for payment
of margins and contract settlement. In addition, a strong infrastructure is
required, including financial, legal and communication systems.

3. OPTIONS -

A derivative transaction that gives the option holder the right

but not the obligation to buy or sell the underlying asset at a price, called
the strike price, during a period or on a specific date in exchange for
payment of a premium is known as ‘option’. Underlying asset refers to

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Derivatives
any asset that is traded. The price at which the underlying is traded is
called the ‘strike price’.

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

PUT OPTION.

a. 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 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 price and buys at a lower future price.

b. 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.

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Derivatives
Put and calls are almost always written on equities, although
occasionally preference shares, bonds and warrants become the subject
of options.

4. SWAPS -

Swaps are transactions which obligates the two parties to

the contract to exchange a series of cash flows at specified intervals
known as payment or settlement dates. They can be regarded as
portfolios of forward's contracts. A contract whereby two parties agree to
exchange (swap) payments, based on some notional principle amount is
called as a ‘SWAP’. In case of swap, only the payment flows are
exchanged and not the principle amount. The two commonly used swaps
are:

a. INTEREST RATE SWAPS :

Interest rate swaps is an arrangement by which one

party agrees to exchange his series of fixed rate interest
payments to a party in exchange for his variable rate interest
payments. The fixed rate payer takes a short position in the
forward contract whereas, the floating rate payer takes a long
position in the forward contract.

b. CURRENCY SWAPS :

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Derivatives
Currency swaps is an arrangement in which both
the principle amount and the interest on loan in one currency
are swapped for the principle and the interest payments on loan
in another currency. The parties to the swap contract of
currency generally hail from two different countries. This
arrangement allows the counter parties to borrow easily and
cheaply in their home currencies. Under a currency swap, cash
flows to be exchanged are determined at the spot rate at a time
when swap is done. Such cash flows are supposed to remain
unaffected by subsequent changes in the exchange rates.

c. FINANCIAL SWAP :

Financial swaps constitute a funding technique

which permit a borrower to access one market and then
exchange the liability for another type of liability. It also allows
the investors to exchange one type of asset for another type of
asset with a preferred income stream.

The other kind of derivatives, which are not, much

popular are as follows :

5. BASKETS -

Baskets options are option on portfolio of underlying asset.

Equity Index Options are most popular form of baskets.

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Derivatives
6. LEAPS -

Normally option contracts are for a period of 1 to 12 months.

However, exchange may introduce option contracts with a maturity period
of 2-3 years. These long-term option contracts are popularly known as
Leaps or Long term Equity Anticipation Securities.

7. WARRANTS -

Options generally have lives of up to one year, the majority

of options traded on options exchanges having a maximum maturity of
nine months. Longer-dated options are called warrants and are generally
traded over-the-counter.

8. SWAPTIONS -

Swaptions are options to buy or sell a swap that will become

operative at the expiry of the options. Thus a swaption is an option on a
forward swap. Rather than have calls and puts, the swaptions market has
receiver swaptions and payer swaptions. A receiver swaption is an option
to receive fixed and pay floating. A payer swaption is an option to pay
fixed and receive floating.

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Derivatives

Settlements
F u t u r e sareM
made
a r kdaily
e t through Settlement
F o r w a roccurs
d Mon a rdate
k eagreed
t
the exchange clearing house. Gains upon between the parties to each
on opendeposits
Margin positionsaremaytobebe required transaction.
Typically, no money changes hands
withdrawn and losses are collected until delivery, although a small
of all participants.
daily. margin deposit might be required of
Long and short positions are usually Forward positions are not as easily
non-dealer customers on certain
liquidated easily. offset or transferred to the other
occasions.
Contract terms are standardised participants.
All contract terms are negotiated
Settlements are normally made in Most transactions result in delivery.
with all buyers and sellers privately by the parties.
cash, with only a small percentage
negotiating only with respect to
of all contracts resulting actual
price.
delivery.
Non-member participants deal Participants deal typically on a
A single, round trip (in and out of No commission is typically charged if
through brokers (exchange principal-to-principal basis.
the market) commission is charged. the transaction is made directly with
members who represent them on
It is negotiated between broker and another dealer. A commission is
the exchange floor)
customer
Participants and is include
relatively small in charged
banks, to born
Participants are buyer andinstitutions
primarily seller,
relation to the value
corporations, of theinstitutions,
financial contract. however,
dealing withif transacted through
one other and aother
individual investors, broker.
and
interested parties dealing through
Trading is regulated. Trading is mostly unregulated.
speculators. one
The or
The delivery price is the spot price. more dealers.
delivery price is the forward
The clearing house of the exchangeA participant must examine the
price.
becomes the opposite side to each credit risk and establish credit limits
cleared transactions; therefore, the for each opposite party.
credit risk for a futures market
participant is always the same and
there is no need to analyse the
credit of other market participants.

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Derivatives

CHAPTER – 4

Participants in derivatives market

 role of derivatives

32
Derivatives

CHAPTER 4

PARTICIPANTS IN THE DERIVATIVES MARKET :

The participants in the derivatives market are as follows:

A.} TRADING PARTICIPANTS :

1.] HEDGERS –

The process of managing the risk or risk management is

called as hedging. Hedgers are those individuals or firms who manage
their risk with the help of derivative products. Hedging does not mean
maximising of return. The main purpose for hedging is to reduce the
volatility of a portfolio by reducing the risk.

2.] SPECULATORS –

Speculators do not have any position on which they enter

into futures and options Market i.e., they take the positions in the futures
market without having position in the underlying cash market. They only

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Derivatives
have a particular view about future price of a commodity, shares, stock
index, interest rates or currency. They consider various factors like
demand and supply, market positions, open interests, economic
fundamentals, international events, etc. to make predictions. They take
risk in turn from high returns. Speculators are essential in all markets –
commodities, equity, interest rates and currency. They help in providing
the market the much desired volume and liquidity.

3.] ARBITRAGEURS –

Arbitrage is the simultaneous purchase and sale of the same

underlying in two different markets in an attempt to make profit from price
discrepancies between the two markets. Arbitrage involves activity on
several different instruments or assets simultaneously to take advantage
of price distortions judged to be only temporary.

Arbitrage occupies a prominent position in the futures world.

It is the mechanism that keeps prices of futures contracts aligned properly
with prices of underlying assets. The objective is simply to make profits
without risk, but the complexity of arbitrage activity is such that it is
reserved to particularly well-informed and experienced professional
traders, equipped with powerful calculating and data processing tools.
Arbitrage may not be as easy and costless as presumed.

B.} INTERMEDIARY PARTICIPANTS :

4.] BROKERS –

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Derivatives

For any purchase and sale, brokers perform an important

function of bringing buyers and sellers together. As a member in any
futures exchanges, may be any commodity or finance, one need not be a
speculator, arbitrageur or hedger. By virtue of a member of a commodity
or financial futures exchange one get a right to transact with other
members of the same exchange. This transaction can be in the pit of the
trading hall or on online computer terminal. All persons hedging their
transaction exposures or speculating on price movement, need not be and
for that matter cannot be members of futures or options exchange. A non-
member has to deal in futures exchange through member only. This
provides a member the role of a broker. His existence as a broker takes
the benefits of the futures and options exchange to the entire economy all
transactions are done in the name of the member who is also responsible
for final settlement and delivery. This activity of a member is price risk free
because he is not taking any position in his account, but his other risk is
clients default risk. He cannot default in his obligation to the clearing
house, even if client defaults. So, this risk premium is also inbuilt in
brokerage recharges. More and more involvement of non-members in
hedging and speculation in futures and options market will increase
brokerage business for member and more volume in turn reduces the
brokerage. Thus more and more participation of traders other than
members gives liquidity and depth to the futures and options market.
Members can attract involvement of other by providing efficient services at
a reasonable cost. In the absence of well functioning broking houses, the
futures exchange can only function as a club.

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Derivatives
5.] MARKET MAKERS AND JOBBERS –

Even in organised futures exchange, every deal cannot get

the counter party immediately. It is here the jobber or market maker plays
his role. They are the members of the exchange who takes the purchase
or sale by other members in their books and then square off on the same
day or the next day. They quote their bid-ask rate regularly. The difference
between bid and ask is known as bid-ask spread. When volatility in price
is more, the spread increases since jobbers price risk increases. In less
volatile market, it is less. Generally, jobbers carry limited risk. Even by
incurring loss, they square off their position as early as possible. Since
they decide the market price considering the demand and supply of the
commodity or asset, they are also known as market makers. Their role is
more important in the exchange where outcry system of trading is present.
A buyer or seller of a particular futures or option contract can approach
that particular jobbing counter and quotes for executing deals. In
automated screen based trading best buy and sell rates are displayed on
screen, so the role of jobber to some extent. In any case, jobbers provide
liquidity and volume to any futures and option market.

C.} INSTITUTIONAL FRAMEWORK :

6.] EXCHANGE –

Exchange provides buyers and sellers of futures and option

contract necessary infrastructure to trade. In outcry system, exchange has
trading pit where members and their representatives assemble during a

36
Derivatives
fixed trading period and execute transactions. In online trading system,
exchange provide access to members and make available real time
information online and also allow them to execute their orders. For
derivative market to be successful exchange plays a very important role,
there may be separate exchange for financial instruments and
commodities or common exchange for both commodities and financial
assets.

7.] CLEARING HOUSE –

A clearing house performs clearing of transactions executed

in futures and option exchanges. Clearing house may be a separate
company or it can be a division of exchange. It guarantees the
performance of the contracts and for this purpose clearing house
becomes counter party to each contract. Transactions are between
members and clearing house. Clearing house ensures solvency of the
members by putting various limits on him. Further, clearing house devises
a good managing system to ensure performance of contract even in
volatile market. This provides confidence of people in futures and option
exchange. Therefore, it is an important institution for futures and option
market.

8.] CUSTODIAN / WARE HOUSE –

Futures and options contracts do not generally result into

delivery but there has to be smooth and standard delivery mechanism to
ensure proper functioning of market. In stock index futures and options

37
Derivatives
which are cash settled contracts, the issue of delivery may not arise, but it
would be there in stock futures or options, commodity futures and options
and interest rates futures. In the absence of proper custodian or
warehouse mechanism, delivery of financial assets and commodities will
be a cumbersome task and futures prices will not reflect the equilibrium
price for convergence of cash price and futures price on maturity,
custodian and warehouse are very relevant.

9.] BANK FOR FUND MOVEMENTS –

Futures and options contracts are daily settled for which

large fund movement from members to clearing house and back is
necessary. This can be smoothly handled if a bank works in association
with a clearing house. Bank can make daily accounting entries in the
accounts of members and facilitate daily settlement a routine affair. This
also reduces a possibility of any fraud or misappropriation of fund by any
market intermediary.

10.] REGULATORY FRAMEWORK –

A regulator creates confidence in the market besides

providing Level playing field to all concerned, for foreign exchange and
money market, RBI is the regulatory authority so it can take initiative in
starting futures and options trade in currency and interest rates. For
capital market, SEBI is playing a lead role, along with physical market in
stocks, it will also regulate the stock index futures to be started very soon
in India. The approach and outlook of regulator directly affects the

38
Derivatives
strength and volume in the market. For commodities, Forward Market
Commission is working for settling up national National Commodity
Exchange.

ROLE OF DERIVATIVES :

Derivative markets help investors in many different ways :

1.] 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. If the spot price falls, the short hedgers will gain in
the futures market, as you will see later. This will help offset their losses in
the spot market. Similarly, if the spot price falls below the exercise price,
the put option can always be exercised.

Derivatives markets help to reallocate risk among investors.

A person who wants to reduce risk, can transfer some of that risk to a
person who wants to take more risk. Consider a risk-averse individual. He
can obviously reduce risk by hedging. When he does so, the opposite
position in the market may be taken by a speculator who wishes to take
more risk. Since people can alter their risk exposure using futures and
options, derivatives markets help in the raising of capital. As an investor,

39
Derivatives
you can always invest in an asset and then change its risk to a level that
is more acceptable to you by using derivatives.

2.] 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.
Thus information pertaining to supply and demand easily percolates into
such markets. Accurate prices are essential for ensuring the correct
allocation of resources in a free market economy. Options markets
provide information about the volatility or risk of the underlying asset.

3.] OPERATIONAL ADVANTAGES –

As opposed to spot markets, derivatives markets involve

lower transaction costs. Secondly, they offer greater liquidity. Large spot
transactions can often lead to significant price changes. However, futures
markets tend to be more liquid than spot markets, because herein you can
take large positions by depositing relatively small margins. Consequently,
a large position in derivatives markets is relatively easier to take and has
less of a price impact as opposed to a transaction of the same magnitude
in the spot market. Finally, it is easier to take a short position in derivatives
markets than it is to sell short in spot markets.

4.] MARKET EFFICIENCY –

40
Derivatives

The availability of derivatives makes markets more efficient;

spot, futures and options markets are inextricably linked. Since it is easier
and cheaper to trade in derivatives, it is possible to exploit arbitrage
opportunities quickly and to keep prices in alignment. Hence these
markets help to ensure that prices reflect true values.

5.] 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 because facilitation 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.

41
Derivatives

CHAPTER – 5

HOW BANKS USE DERIVATIVES

• ASSET liability management

42
Derivatives

CHAPTER 5

HOW BANKS USE DERIVATIVES :

ASSET LIABILITY MANAGEMENT -

Banks have traditionally taken deposits from their customers and

put those deposits to work as loans. Because the deposits and the loans
are dominated in the same currency, this activity has no associated
foreign exchange risk. But it does limit banks to lending to customers
which need to borrow in the currencies which the banks have available on
deposits.

If a bank is asked to lend to a customer in a currency other than

one of those it has on deposits it creates a currency exposure for the
bank. Suppose a customer wants to borrow EUROS from a US Bank for 5
years and that the US bank has no natural source of EUROS. It is
possible for the banks to cover this exposure in the forward market by
selling EUROS forwards and buying US dollars. The transaction costs
associated with this, in particular the bid / offer spread in the medium term

43
Derivatives
foreign exchange forward market, would make the resultant cost of the
loan prohibitively expensive for the borrower.

Currency swaps provide an economic alternative to this problem for

banks. In order to cover the exposure created by a loan to a customer in
EUROS funded by a bank’s deposit in US dollar, a bank could receive
fixed rate US dollars in a currency swap and pay fixed rate EUROS.

One of the consequences of the development of the currency swap

market is that banks now often make much more competitive medium
term forward foreign exchange prices than they used to. Most banks
quote forward foreign exchange and currency swap prices from the same
desk and increases liquidity in the latter has improved liquidity in the
former. Banks therefore, need no longer restrict their lending activities to
the currencies in which they have natural deposits. They are free to fund
themselves in the most competitively priced currency and to lend to their
customers in the currency of the customer’s preference, using a currency
swap as an asset and liability matching tool

The “Normal yield curve”, reflects that it is much easier for banks to
borrow at the short end of the curve than the long end. This means that
banks can fund themselves much more effectively in the inter bank market
in maturities such as the overnight, tom / next (overnight from tomorrow,
or tomorrow to the next day), spot / next, one week, one month, three
months and six months than they can in maturities such as five years or
20 years.

44
Derivatives
With the development of the swaps market it is possible for banks
to satisfy their customers demands for fixed rate funding while ensuring
that the banks assets and liabilities are matched. Suppose a bank has a
customer who needs 5 years fixed rate funds. Let us say that the bank
finances in this loan in the interbank market at 3 month LIBOR. The bank
now has a 3 month liability and a 5 year asset (Figure 1).

The bank is short floating rate interest at 3 month LIBOR and long
fixed rate interest at the rate at which it lends to its customer. This is
called the asset liability mismatch. So in order to hedge its position the
banks needs to match its exposure to 3 month LIBOR by receiving on a
floating rate basis in an interest rate swap, and match its exposure on a
fixed rate basis by paying a fixed rate in a interest rate swap. This is a
hedge which is ideally suited to an interest rate swap which the bank
receives a floating rare of interest and pays a fixed rare (Figure 2).

45
Derivatives
This structure has the benefit for the bank that it eliminates the
bank’s exposure to interest rate risk. The bank can no longer profit from a
fall in interest rates but it cannot lose money on its asset and liability
mismatch as a result of an increase in rates. The bank will make or lose
money based on its pricing of the credit risk in the transaction and its
overall loan exposure rather than on its ability to forecast interest rates.
Hence the interest rate swaps provide banks with an opportunity to
change their risks from interest rate to credit.

46
Derivatives

CHAPTER – 6

CASE STUDIES

• hedging interest rate risk

• Hedging foreign exchange risk

47
Derivatives

CHAPTER 6

CASE STUDIES :

CASE STUDY 1

Hedging interest rate risk

Scenario

A major aircraft manufacturer has decided to replace his mainframe

computer. The cost after trade in is $ 10 million, payable on delivery.

Delivery

Mid December, 2006.

Funding

A projected cash flow short fall will create a $ 10 million borrowing

requirement.

48
Derivatives

Borrowing Rate

LIBOR + 50 Basis points

Outlook
The treasurer is worried that the central bank’s future policy directions will
lead to an increase in short term rates.

Market Conditions

Current LIBOR - 8.38 %

Euro-Dollar Options On Futures :
December 91.25 (implied rate of 8.75%) Put, Premium of .25
December 91.00 (implied rate of 9.00%) Put, Premium of .15

Strategy

The treasurer buys the December Put Option with a strike price of 91.25
(implied rate of 8.75%), which allows the manufacturer to enter into a Euro
– Dollar futures contract for a premium price of .25. the notional principal,
that is the size of the contract is $ 1 million, so ten contracts are taken to
cover the full short-term borrowing cost. The put will make money only if
the underlying future falls below the strike price less the price paid for the
option. Remember, the Euro-Dollar future is quoted as an index on a base
of 100, a lower price means a higher rate of interest

49
Derivatives
Results

In Mid-December, depending upon how the LIBOR rate has changed, the
treasurer will use or not use the put option on the future which was
purchased. If the cost of short-term borrowing has remained the same or
declined, the put option will expire worthless. The money expended upon
the premium, of 0.25 % per $ 1 million contract, will have been lost. If,
however, interest rates were to rise, the put option contract on the Euro-
Dollar future will be exercised. If, for example, Euro – Dollar Rates rise to
10.76% (89.10 on the index) which would have given the treasurer a
borrowing cost of 11.26% (LIBOR + 50 bases points), the Put would be
utilised, exercising the right to sell the option on the future at the strike
price of 91.25, for an intrinsic value of 2.1 (Or 2% in interest terms).

The gain in value on the Put options contract compensates for the
increased cost of borrowing on the LIBOR Rate. The risk of funding the
new mainframe computer has been managed.

CASE STUDY 2

Hedging foreign exchange rate risk

50
Derivatives

Scenario

An American manufacturer of clothing imports fabric from the United

Kingdom. In 6 months time, in anticipation of the 2005-06 winter season,
he will need to purchase 1 million Pounds Sterling, in order to pay for the
desired imports, in order for his finished goods to be competitive and
ensure adequate margins, the exchange rate must not fluctuate
significantly. A weakening of the US dollar by more than 5% may create
problems in terms of price competitiveness and profit margins.

Delivery

In Mid June, 2005, the manufacturer is scheduled to receive and pay for
the imports.

Funding

The manufacturer has no funding exposure as the imports will be paid

from working capital.

Exchange Rate

The present rate is STG/ USD = 1.50, which is satisfactory with respect to
commercial objectives, but a weakening of more than 5% will result in
diminished margins or a non competitive position.

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Derivatives
Outlook

The manufacturer is worried that because of declining rates of interests

and the current account deficits, the US dollar may waken against the
Pound Sterling, from its current rate of 1.50.

Market Conditions

Current spot rate - STG/USD = 1.50

June calls @ strike price of STG/USD = $1.51, premium of 2.50% per

contract, that is 4 US cents.

June calls @ Strike price of STG/USD = $1.52, premium of 2.00% per

contract, that is 3 US cents.

Strategy

The manufacturer buys one call option contract with a Strike or Exercise
price of 1.51. If the US dollar weakens the call contract will be used to buy
the Pounds – Sterling at the set price. If, the US dollar stays the same or
strengthens, the contract will expire worthless and the premium paid for
the option will have been lost.

Results

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Derivatives
In June 2005, the Us dollar does weaken and the new spot exchange rate
is STG/USD = 1.60. Hence, the call option at 1.51 has intrinsic value of 9
US cents. Instead of the 1 million Pound Sterling required by the
manufacturer costing 1.6 million US dollars, the exercise of the call
contract will net $ 90000 US ( $ 1.6 million – $ 1.51 million).

After subtracting the price of the premium of 2.5%, the net gain will be $
50000 US ( $ 1.6 million – $ 1.55 million), which partially off-sets the
depreciation in the US Dollar exchange Rate, and is within the
manufacturer’s target range of 5% to remain competitive on pricing.

Through this hedging technique the underlying commercial objective will

be ensured. If the US Dollar exchange rate had not weakened, the
expenditure on the premium would still have kept his net cost of the
imports within the self imposed 5% competitive range.

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Derivatives
RECOMMENDATIONS

 RBI should play a greater role in supporting derivatives.

 Derivatives market should be developed in order to keep it at

par with other derivative markets in the world.

 Speculation should be discouraged.

 There must be more derivative instruments aimed at individual

investors.

 SEBI should conduct seminars regarding the use of

derivatives to educate individual investors.

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Derivatives
BIBLIOGRAPHY :

BOOKS

 Futures markets – Sunil. K. Parameswaran

 Understanding futures market – Robert. W. Klob

 Derivatives Market in India – Susan Thomas

 Financial Derivatives – V. K. Bhalla

 Financial Services and Markets – Dr. S. Guruswamy

 Futures and Options – D. C. Gardner

INTERNET

 www.cxotoday.com

 www.indiainfoline.com

 www.indiamart.com

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Derivatives

ABBREVIATION

AMEX - American Stock Exchange.

BSE - Bombay Stock Exchange.

CHE - Calcutta Hessian Exchange Ltd.

CBOE - Chicago Board options Exchange.

CBOT - Chicago Board of Trade.

CEBB - Chicago Egg and Butter Board.

CME - Chicago Mercantile Exchange.

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Derivatives

CPE - Chicago Produce Exchange.

IMM - International Monetary Market.

LIBOR - London Inter Bank Offer Rate.

LEAPS - Long term Equity Anticipation Securities.

MCX – Multi Commodity Exchange

MIBOR - Mumbai Inter Bank Offer Rate.

NCDX – National Commodities and Derivatives Exchange

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Derivatives

NSE - National Stock Exchange.

OTC - Over the counter.

PHLX - Philadelphia Stock Exchange.

SIMEX - Singapore International Monetary Exchange.

S&P - Standard and Poor.

SC(R) A - Securities Contracts (Regulation) Act, 1956.

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