History of derivatives

Derivatives trading began in 1865 when the Chicago Board of Trade (CBOT) listed the first
"exchange traded" derivatives contract in the USA. These contracts were called "futures
contracts". In 1919,the Chicago Butter and Egg Board, a spin-off of CBOT, was reorganized to
allow futures trading. Its name was changed to Chicago Mercantile Exchange (CME).

The first stock index futures contract was traded at Kansas City Board of Trade. Currently
the most popular stock index futures contract in the world is based on the Standard & Poor's
500 Index, traded on the CME. In April 1973, the Chicago Board of Options Exchange was
set up specifically for the purpose of trading in options. The market for options developed so
rapidly that by early 80s the number of shares underlying the option contract sold each day
exceeded the daily volume of shares traded on the New York Stock Exchange. And there has
been no looking back ever since.

Derivatives in India
The Securities and Exchange Board of India (SEBI) allowed trading in equities-based
derivatives on stock exchanges in June 2000. Accordingly the National Stock Exchange
(NSE) and the Bombay Stock Exchange (BSE) introduced trading in futures on June 9, 2000
and June 12, 2000 respectively. Currently futures and options turnover on the NSE is Rs7,000-
8,000 crore approximately. In India stock index options were introduced from July 2, 2001.

Derivatives in India: chronology

December 14, 1995 The NSE sought Sebi's permission to trade index futures.

The LC Gupta Committee set up to draft a policy framework

November 18, 1996
for index futures.

The LC Gupta Committee submitted a report on the policy

May 11, 1998
framework for index futures.

Reserve Bank of India gave permission for OTC forward rate

July 7, 1999
agreements and interest rate swaps.

SIMEX chose Nifty for trading futures and options on an

May 24, 2000
Indian index.

May 25, 2000 Sebi allowed the NSE and the BSE to trade in index futures.
June 9, 2000 Trading of the BSE Sensex futures commenced on the BSE.

June 12, 2000 Trading of Nifty futures commenced on the NSE.

September 25, 2000 Nifty futures trading commenced on the SGX.

What are derivatives?

Derivatives are financial contracts whose value/price is dependent on the behavior of the price
of one or more basic underlying assets (simply known as underlying). These contracts are
legally binding agreements, made on the trading screen of stock exchanges, to buy or sell an
asset in future. The asset can be a share, index, interest rate, bond, rupee/dollar exchange rate,
sugar, crude oil, soyabean , cotton, coffee etc.

How are derivatives useful?

• Leveraged positions
• Lower margins than the margin funding
• Index trading--market directional trading
• Hedging of portfolio
• Through index, covered calls, options buying
• Structured products for higher yields

• Allows to take position in any market condition--bullish, bearish, volatile or neutral.

What are forward contracts ?

A forward contract is a customized contract between the buyer and the seller where settlement
takes place on a specific date in future at a price agreed today.

What are futures ?

Futures are exchange-traded contracts to buy or sell an asset in future at a price agreed upon
today. The asset can be a share, index, interest, bond, rupee-dollar exchange rate, sugar, crude
oil, soya bean, cotton, coffee etc.
Terms in futures
• Quantity of the underlying assets
• Unit of price quotation (not the price)
• Expiration dates
• Minimum fluctuation in price (tick size)

• Settlement cycles
Example : when you are dealing in March 2004 Satyam futures contract the market lot, i.e. the
minimum quantity that you can buy or sell, is 1,200 shares of Satyam; the contract would
expire on March 28, 2004; the price is quoted per share; the tick size is 5 paise per share or
(1,200 * 0.05) = Rs60 per contract/market lot; the contract would be settled in cash; and the
closing price in the cash market on the expiry day would be the settlement price.
Features
• Leveraged positions--only margin required
• Trading in either direction--short/long
• Index trading
• Hedging/Arbitrage opportunity

Advantages of futures over cash trading

• In futures the investor can short sell/buy without having the stock and carry the position
for a long time, which is not possible in the cash segment.
• An investor can buy and sell index components instead of individual securities when he
has a general idea of the direction in which the market may move in the next few
months.
• The investor is required to pay a small fraction of the value of the total contract as
margin. This means trading in stock index futures is a leveraged activity since the
investor is able to control the total value of the contract with a relatively small amount
of margin.
Example: suppose the investor expects a Rs100 stock to go up by Rs10. One option is
to buy the stock in the cash segment by paying Rs100. He will then make Rs10 on an
investment of Rs100, giving about 10% returns. Alternatively he can take futures
position in the stock by paying Rs30 towards initial and mark-to-market margin. Here
he makes Rs10 on an investment of Rs30, i.e about 33% returns.
• In the case of individual stocks, the positions, which remain outstanding on the
expiration date will have to be settled by physical delivery, which is not the case in
futures.

• Regulatory complexity is likely to be less in the case of stock index futures compared to
the other kinds of equity derivatives, such as stock index options, individual stock
options etc.

What are options ?

Options are contracts that give the buyers the right (but not the obligation) to buy or sell a
specified quantity of certain underlying assets at a specified price on or before a specified date.
On the other hand, the seller is under obligation to perform the contract (buy or sell). The
underlying asset can be a share, index, interest rate, bond, rupee-dollar exchange rate, sugar,
crude oil, soya bean, cotton, coffee etc.
Example: suppose you have bought a call option of 2,000 shares of Hindustan Lever Ltd
(HLL) at a strike price of Rs250 per share. This option gives you the right to buy 2,000 shares
of HLL at Rs250 per share on or before March 28, 2004. The seller of this call option who has
given you the right to buy from him is under the obligation to sell 2,000 shares of HLL at
Rs250 per share on or before March 28, 2004 whenever asked.
There are two types of options:
• Call options and

• Put options
Features
• Limited risk, unlimited profit-call options
• Higher returns, higher risk-put options
• Positions in all market conditions/views

What are call options?

The option that gives the buyer the right to buy is called a call option.
Example: suppose you have bought a call option of 2,000 shares of Hindustan Lever Ltd
(HLL) at a strike price of Rs250 per share. This option gives you the right to buy 2,000 shares
of HLL at Rs250 per share on or before March 28, 2004. The seller of this call option who has
given you the right to buy from him is under the obligation to sell 2,000 shares of HLL at
Rs250 per share on or before March 28, 2004 whenever asked.

What are put options?

The option that gives the buyer the right to sell is called a put option
Example: suppose you bought a put option of 2,000 shares of HLL at a strike price of Rs250
per share. This option gives its buyer the right to sell 2,000 shares of HLL at Rs250 per share
on or before March 28, 2004. The seller of this put option who has given you the right to sell to
him is under obligation to buy 2,000 shares of HLL at Rs250 per share on or before March 28,
2004 whenever asked.

What is a strike price?

The price at which you have the right to buy or sell is called the strike price.

What are American style options?

Option contracts ,which can be exercised on or before their expiry are called American options.
All stock option contracts are American in style.

What are European style options?

The options on the Nifty and Sensex are European style options--meaning that the buyer of
these options can exercise his options only on the expiry day. He cannot exercise them before
the expiry of the contracts as in case with options on stocks. As such the buyer of index options
needs to square up his positions to get out of the market.

In India all stock options are American style options and index options are European style
options.
What is the difference between futures and options?
Futures Options

Both the buyer and the seller are The buyer of the option has the right and
Obligation under obligation to fulfill the not the obligation whereas the seller is
contract. under obligation to fulfill the contract.

The seller is subject to unlimited risk of

The buyer and seller are subject
Risk losing whereas the buyer has a limited
to unlimited risk of losing.
potential to lose.

The seller has limited potential to gain

The buyer and seller have
Profit while the buyer has unlimited potential to
unlimited potential to gain.
gain.

It is unidimensional as its price It is bi-dimensional as its price depends

Price
depends on the price of the upon both the price and the volatility of the
Behavior
underlying only. underlying.

Who are the participants in the derivatives market?

The participants in the derivatives market are broadly classified into three groups:
• Hedgers
• Speculators

• Arbitrageurs
Hedgers have a position in the underlying asset or are interested in buying the asset in the
future. For example, a hedger could be an investor who has got funds to invest in stocks.
Hedgers participate in the derivatives market to lock the prices at which they will be able to do
the transaction in the future. Thus they are trying to avoid the price risk.

Speculators participate in the futures market to take up the price risk, which is avoided by the
hedgers.

Arbitrageurs watch the spot and futures markets and whenever they spot a mismatch in the
prices of the two markets they enter to get the extra profit in a risk-free transaction.